The pre-pack administration - assessing its pros and cons

The pre-pack administration is becoming ever more common, with more than 50 per cent of companies that enter insolvency being sold on in this way.

Whilst the pre-pack dates back to the 1980s, The Enterprise Act of 2002 made them easier to implement and, as a result of the current economic climate, the pre-pack is becoming ever more widely used in insolvency circles.

The pre-pack administration is recognised as a good way of siphoning off value from assets and writing off debts prior to the insolvency practitioner being appointed.

Other positives of the pre-pack include its ability to keep existing staff and management involved in the business, whilst making the possibility of continual trading more likely. For this reason, pre-packs are most often associated with so called 'people businesses,' such as IT software firms, due to the concern that key staff will look elsewhere if a long drawn-out administration process was to take place.

The soon-to-be appointed insolvency practitioner will often advise on the terms of the pre-pack as these practitioners have a duty to recover the maximum value for all creditors.

This form of administration is also used in instances where it is unlikely that enough money will be available to cover the costs of a trading administration, whilst potential buyers are sought.

Independent research has also shown that pre-packs perform better in terms of the number of jobs retained and the amount of money returned to secured creditors. The research, which was conducted by Dr Sandra Frisby, Baker & McKenzie Lecturer in company and commercial law at the University of Nottingham, revealed that, in 89 per cent of cases, pre-packs retained the entire workforce. This was in comparison to 57 per cent of business sales occurring via the traditional administration procedure.

Dr Frisby's 'Preliminary analysis of pre-packaged administrations’, which was carried out on behalf of R3 – The Association of Business Recovery Professionals, in 2007, also showed that secured creditors involved in a pre-pack administration received an average return of 42 per cent of their cash, compared with just 28 per cent in a straightforward business sale via administration.

Proponents of the pre-pack also point to the damage that a widespread public sales process can sometimes cause. Torex Retail is an example of a company sold via a pre-pack following considerable negative publicity about the business, which exacerbated the cash haemorrhaging. Had a pre-pack administration not been executed, the residual value of the goodwill and prospects for the company’s survival would have been wiped out by the negative exposure in the press.

Critics of the pre-pack

Like anything, the pre-pack administration has critics. “The rise of the ‘pre-pack’ administration has seen arguably the most heated and public debate ever to materialise in relation to insolvency law,” said Dr Frisby in her research paper.

Critics of the pre-pack say that the speed and secrecy of the process means that creditors often walk away with less cash than they are entitled to. However, as the alternatives to the pre-pack administration include being wound up or liquidated, this could mean that the creditors receive even less than they would through a pre-pack.

Many creditors feel that the rising accessibility of this style of administration makes it easier for business owners to leave their failing company and debts behind, then retake control at a later date, having not paid the creditors as much as they should. In instances where the buyers are the company's former directors, critics of pre-packs say that creditors will not be a priority.

The Insolvency Practices Council (IPC) released its Tenth Annual Report earlier this year and, whilst it acknowledged that pre-packs could, in certain cases, ensure better returns for creditors, it criticised this form of administration’s typical lack of consultation that creditors receive during the process. The IPC also highlighted complaints from rivals of the failing companies who see pre-packs as a form of protection offered to their competitors. The pre-pack allows a company to walk away from its commercial obligations and then, with no debt servicing commitments, swipe business opportunities from competitors at a later date.

Whilst supporters of pre-pack administrations say that they are the best way of ensuring minimal job losses, the IPC suggested that redundancies are often merely delayed before happening later on. In her research, Dr Frisby noted a 'high level of second failures of businesses that were sold to previous directors.' The IPC said that any jobs saved at a company which undergoes a pre-pack may be subsequently lost – unfairly - at a rival company, which loses business to the saved firm.

Parliamentary enquiry

A parliamentary inquiry into insolvency laws, including pre-pack administrations, began at the end of 2008 and a report by the House of Commons' Business and Enterprise Committee said that the entire pre-pack rules were 'damaging confidence in Britain's insolvency regime,' by 'initially keeping creditors in the dark and then leaving them empty-handed.'

However, trade association TMA challenged the committee's findings and said it needed to 'produce hard evidence for its damning claims over pre pack administration.'

TMA (UK) director Justin Stephenson, a partner at London law firm Jeffrey Russell Green, said, “Yes, there have been occasions when pre-packs have been abused, but legal powers already exist to strike off directors and disqualify insolvency practitioners involved in such cases.

“And neither these abuses nor the small disadvantage to unsecured creditors alter the fact that pre-packs can be a very valuable tool in the right circumstances to save businesses and jobs and minimise losses to secured creditors. Saving viable businesses must be the ultimate goal for the greater good of UK plc.

“The Committee's criticisms overstated the problems and glossed over the fact that the administrator's role is to recover as much value as possible as quickly as possible, and if a pre-pack is the most effective and appropriate way of achieving it then that is the option the administrator ought to select,” he added.

In a bid to weed out those company directors who were using pre-packs in an unethical way, creating so-called ‘phoenix companies’, the Joint Insolvency Committee introduced SIP 16 in January 2009. This new set of rules required insolvency practitioners to offer creditors a range of certain information when carrying out a pre-pack administration.

At the time, the committee said, “If [SIP 16] does not prove effective, then it will be necessary to take more radical action, possibly by giving stronger powers to creditors or the court.”

Pre-packs look set to remain the most controversial part of the insolvency sector, with strong feelings on either side. Peter Sargent, president of R3 said that, despite concerns over the nature of the pre-pack, the most crucial factor was preventing companies from going under and jobs being lost. “As yet, there has been no evidence of any systematic abuse of pre-packs and there are clear benefits in pre-packs for saving jobs,” he said.

But the question remains whether the management team responsible for the failure of the business deserve another chance, something the creditors do not get themselves.

Essential research that many look forward to will show the performance of the pre-pack management teams in creating long-term sustainability of the rescued businesses.

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