In April 2021, a new set of regulations came into effect concerning pre-pack administrations in which the affected business was acquired by a “connected party”. While not an attempt to rigidly dictate how pre-pack sales happened, the regulations sought to improve the credibility and overall perception surrounding the process by making them more transparent.
The regulations came into force after years of mounting concerns that many pre-pack sales to connected parties did not reflect the best value deal available and that creditors were often left out of pocket in the wake of hastily conducted sales.
Two years on from the regulations coming into force, however, it is somewhat unclear whether the new rules have helped to improve the perception of pre-pack administrations or made the process fairer for creditors of insolvent businesses.
With insolvencies mounting in the UK, moreover, it is vital to again look at pre-pack administrations and the rules surrounding them. There are several key questions to ask in this ongoing period of economic uncertainty and widespread (and growing) financial distress: Are pre-pack administrations still a viable option for owners at struggling businesses? And, with unpaid debts increasingly putting many companies at risk, have the new rules offered adequate protection to the creditors of insolvent companies?
The basics: What is a pre-pack administration?
In brief, a pre-pack administration is a process in which the sale of a company’s business and/or assets is arranged, negotiated and agreed prior to the appointment of an insolvency practitioner as the company’s administrator.
An insolvency practitioner is typically engaged to value the company’s business and assets and arrange a sale, identifying potential buyers and negotiating the terms of the sale. The company will then be placed into administration, with the relevant documentation being signed and the sale of the company and/or its assets then being completed.
As the company in question is only briefly placed into administration, a pre-pack sale offers the benefit of minimal disruption to trading operations, making it an effective (and potentially invaluable) method of securing the viable elements of a struggling business, such as jobs, assets and contracts, while minimising the impact on the firm’s brand and value.
The acquirer may be an existing company or, as is the case in many instances, a newco founded for the purpose of acquiring the business as a going concern – often led by the directors, management or shareholders of the affected company.
What were the concerns around pre-pack administrations?
Despite the numerous benefits that they can offer – including for creditors, who could benefit from the value of the affected company’s assets being protected in a quick sale – pre-pack administrations were, for a long time, the target of a wide range of criticisms.
The most common criticisms come in instances where the company was sold to a connected party (I.e. a venture led by someone previously involved in the business), with concerns often raised about the marketing process that precedes such a sale, as well as the value of the transaction.
Pre-pack administrations are rapid, sometimes highly secretive, processes and, as a result, such transactions have often been closed without consultation with the business’ unsecured creditors. As a result, unsecured creditors will find that the company has been sold and that the liability to pay its unsecured debts has now gone.
Naturally, in such instances, and when the pre-pack administration involves the business being acquired by a buyer connected to the company (such as a newco led by the firm’s existing directors, shareholders or management), the perception could easily be that the sale was orchestrated in a pre-meditated fashion to free the business of its debts while retaining its existing management and ownership structure.
The issue was particularly contentious due to the level of control that owners could be afforded over the process, ranging from the timescale under which it is conducted to the composition of the insolvency team overseeing the process. This prompted widespread suspicions that many pre-pack administrations were specifically structured in such a way that the owners would be the preferred bidders selected prior to the company being placed into administration – regardless of whether their bid valued the business the highest - and that the deals did not represent the best value for creditors.
The crux of these concerns was the almost complete lack of regulation that surrounded these transactions prior to 2021. Before the new regulations were introduced, the main protection for creditors of companies undergoing pre-pack administrations was the “pre-pack pool”, a group of qualified, experienced business people who would objectively analyse, evaluate and report on pre-pack deals.
However, referring deals to the pre-pack pool was entirely voluntary on behalf of either the company owner or the insolvency practitioner and – in 2019 – just 8 per cent of pre-pack deals conducted were referred to the pre-pack pool, demonstrating how ineffective the system was at providing any real regulation of pre-pack sales to connected parties.
The new regulations
Due to the seemingly severe inefficiency of the pre-pack pool system when it came to ensuring pre-pack administrations were conducted in a responsible, honest manner, new regulations were introduced in 2021 aimed at providing some structure to how pre-pack sales to connected parties were conducted.
Under the new regulations, insolvency practitioners cannot make a “substantial disposal” (I.e. of the business as a going concern or a substantial part of its business and/or assets) to a party connected to the business within eight weeks of their appointment as administrators, unless they gain approval from the firm’s creditors or an independent evaluator’s qualifying report.
Qualifying reports have essentially replaced the pre-pack pool as offering independent oversight of pre-pack transactions. Under the process, buyers connected to the company in question must pay for and obtain a report from an independent evaluator, detailing the evaluator’s credentials (the relevant knowledge and experience they have that qualifies them to provide a report on the transaction) and professional indemnity (PI) insurance cover.
Providing the approval of a qualified independent evaluator is gained and a qualifying report submitted, then a connected buyer is free to acquire the business in a pre-pack deal. Without the approval of an independent evaluator, however, connected buyers would have to take their bid to the company’s creditors in order to gain approval, something that, in many cases, could prove far more complicated to attain.
What is the current status of pre-pack administrations?
Insolvencies are currently soaring in the UK. In the wake of the COVID-19 pandemic, many businesses are saddled with huge levels of debt as a result of protections against creditor action ending and the government-backed loans that many took on during the pandemic now needing to be repaid.
While many businesses may have hoped to trade their way out of financial peril as the economy recovered post-pandemic, ongoing economic headwinds have left companies even more vulnerable – as they have been impacted by supply chain disruption, soaring costs and inflation and plummeting consumer sentiment amid the ongoing cost of living crisis.
According to official figures from the government’s Insolvency Service, corporate insolvencies have reached their highest level in three years. In March 2023, the Insolvency Service recorded 2,457 corporate insolvencies, a 16 per cent increase on the 2,120 seen in March 2022 and 145 per cent higher than March 2021, when government pandemic support measures meant that just 999 UK businesses fell into insolvency.
In separate reports, insolvency practitioners have said they have seen a surge in appointments amid the current wave of distress. Insolvency firm Begbies Traynor has reported it is set to see double-digit revenue growth, boosted by “good momentum” in new insolvency appointments, with a “significant increase in higher value cases”.
The uptick in higher value insolvencies is salient when it comes to pre-pack administrations, which are a particularly popular option for mid-sized and larger firms struggling with large debt piles. A raft of recent insolvencies makes clear that the process remains a popular option for struggling mid and large businesses, with a range of prominent companies – including Tile Giant, streetwear brand Just Hype, retailer Paperchase, precision engineer Nasmyth and restaurant chain Tapas Revolution – among those to have been acquired in pre-pack deals over recent months.
With little sign of the economic headwinds substantially easing, and many firms still having huge piles of debt, struggling owners will be desperate to avoid liquidation and many will be seeking the best option to help their company carry on. For owners looking to free their company of their unworkable debts while remaining in control, pre-pack administrations would typically offer the best chance compared to other insolvency processes.
Discussing current trends in insolvencies, Oury Clark Insolvency Partner Nick Parsk observed: “Business owners tend to favour a pre-pack administration as a way of trying to buy their business back free from debt. It is likely that we will see the numbers of pre-pack administrations rise significantly over the next two years.”
According to a new set of regulationsreport from Global Restructuring Review from March 2022, pre-pack administrations (at the time) represented approximately 29 per cent of all administrations in the UK. Meanwhile, according to an Oxford Journal of Legal Studies report from October 2022, while the number of pre-pack sales to connected parties fell from around two-thirds of such deals to approximately half a year after the reforms, this figure has subsequently begun to increase once again.
Clearly, amid the current wave of insolvencies, pre-pack administrations are still being widely used by those in control of a business to free it of its debts and enable it to continue trading. Of course, this doesn’t necessarily mean that all these pre-pack deals are shady transactions being carried out in a deviously calculated manner.
Therefore, the truly pertinent questions are, what impact have the regulations had? And are creditors now better protected than they were prior to the introduction of the reforms?
Have reforms gone far enough?
The new regulations around pre-pack administrations have not been without their critics and some argue that the process still, in general, suffers from a negative perception in the media and among the wider population.
One of the most fundamental criticisms has been that the new regulations are somewhat vague in places, leaving the potential for misinterpretation and giving a lack of clarity over how pre-pack deals must now be conducted.
The most common criticism here relates to the stipulation that the new reforms only apply in the case of a “substantial disposal”, which legislation defines as a transaction involving what the administrators consider to be “all or a substantial part of the company's business or assets." With regards to company property, the rules again state that regulations only apply to the disposal of the "whole or substantially the whole of the company's property".
The regulations do not give an explicit threshold (such as, for example, a certain percentage of the company valuation) for what constitutes a “substantial part” of a company’s business or assets, instead offering a few guidelines for administrators to consider:
- The value of the business and/or the assets involved in the transaction
- How much of the business is being sold through the disposal
- If the business’ goodwill and trading style constitutes part of the transaction
Again, however, the regulations only state that considering whether the disposal is substantial “should include but is not limited to” these considerations, potentially leaving further room for misinterpretation.
While a pre-pack administration in which the business is sold as a going concern would clearly seem to constitute a “substantial disposal”, in other areas it is not so clear. For example, in a scenario in which only a certain amount of the afflicted business’ assets are being acquired, administrators may face uncertainty as to whether the regulations apply.
This is particularly relevant in the current environment. Since the COVID-19 pandemic, many prominent pre-pack administrations have involved disposals in which buyers cherry pick certain assets from the business, leaving substantial parts behind.
For example, as retail trends shift away from the high street model and towards online and hybrid retail models, numerous high-profile administrations involving well-known retailers have seen the buyer acquire certain assets, such as the brand, domains and intellectual property, while leaving huge amounts of assets – including stock, property and massive networks of brick-and-mortar stores – behind.
In a deal like this in which the buyer is a connected party, for example a newco formed by the company’s existing directors, it may be unclear to administrators whether the sale constitutes a “substantial” disposal and, as a result, falls under the remit of the new regulations.
One might expect administrators to proceed with caution and either seek creditor approval or a qualifying report. However, in insolvencies in which time is tight and a sale needs to be closed in a timely, cost-effective manner in order to preserve the value of the business and/or its assets, the uncertainty of the regulations could prove complicated and potentially leave room for misinterpretation or even a justification for administrators to not apply the regulations.
There is further uncertainty around the rules on evaluators and qualifying reports. As with what constitutes a “substantial disposal”, the regulations do not specify in clear terms what makes an evaluator qualified to provide a qualifying report for the transaction, beyond stating that they are able to fulfil the role providing that they and the administrators are confident they have “sufficient relevant knowledge and experience” to do so.
Creditors of companies undergoing a pre-pack sale to a connected party will take some confidence from the fact that, under the new regulations, evaluators providing qualifying reports must be independent and have no connection to the company undergoing the transaction or the party acquiring the business/assets. However, the fact that the rules do not explicitly state what qualifications the evaluator must have or what other specific criteria they must meet may mean there is a lack of transparency and trust inherent in the process, undermining the ultimate aim of the 2021 reforms.
There could be further doubt surrounding the role of the independent evaluator due to two other crucial facts: the connected buyer is the one that chooses the evaluator; and there is no limit on how many attempts can be made to obtain a qualifying report that approves the transaction.
Although the new rules seek to improve transparency and accountability in the pre-pack process, the fact that connected buyers have control over selecting the evaluator (even if they are independent and the administrator must be satisfied that they are qualified) could further undermine trust in the process on behalf of creditors and among the wider population.
A report from Global Restructuring Review argues that, with connected parties and administrators likely to sometimes have agreed on the evaluator in advance, the lack of regulation around the evaluator’s qualification and the buyer’s control over their identity could “create the impression of collusion between the parties as opposed to a robust and independent process.”
Additionally, the allowance for buyers to seek qualifications from an unlimited number of evaluators has raised eyebrows, leaving open the possibility that connected buyers could, in effect, “shop around” with multiple evaluators until they are able to attain approval and a qualifying report in support of their acquisition, even if they receive multiple negative qualifying reports. While any previous negative reports are required to be provided to the evaluator in such a scenario, the new regulations do not stipulate any sanctions if a negative report is not disclosed to a new evaluator.
Finally, perhaps the most glaring gap in the new regulations is that, in the event that a qualifying report is not able to be provided that approves the transaction, the pre-pack sale to a connected party can still go ahead on the condition that an explanation is provided to creditors and to Companies House outlining why this was done.
While it is unlikely that an administrator would proceed with a pre-pack disposal without obtaining either creditor approval or a qualifying report from an independent evaluator (unless there was no other option, I.e. if a pre-pack disposal was the only viable alternative to placing the company into liquidation and the best method available of securing recoveries for creditors), the lack of really binding legislation again leaves a considerable degree of uncertainty for creditors and does little to improve trust in the overall pre-pack sale process.
What are the challenges for connected buyers?
The statistics quoted above testify to the fact that pre-pack administrations remain a highly popular method of restructuring a business and limiting the damage that can be caused by insolvency, with numerous predictions that their usage will increase as financial distress intensifies over the coming months.
However, that is not to say that the new regulations haven’t introduced challenges for buyers, as well as a considerable dose of uncertainty for creditors and insolvency practitioners alike. After all, the reforms were introduced to tighten up the regulation of pre-pack sales to connected parties, so it’s only natural that there will be areas in which buyers deemed to be “connected” could face difficulties.
The most obvious way in which the new rules impact connected parties seeking to acquire a business and/or its assets through a pre-pack sale is the time and cost that they add to the process. As well as the cost that buyers must pay to obtain a qualifying report from an evaluator, the new regulations can also make the process less cost-effective by delaying the acquisition.
By extending the period in which the business is trading while insolvent to up to eight weeks before an acquisition can be closed, the new regulations could mean that additional costs accrue, such as amounts due to creditors, and potentially diminish the business’ value and brand.
According to law firm White & Case, the regulations “will add an additional layer of complexity, time and cost to any pre-packs where the purchaser is connected to the seller. This may cause issues in certain restructurings, particularly debt-for-equity swaps where a debtholder already has a substantial equity state in the target company.”
An additional complication for potential buyers in pre-pack deals comes in situations where the buyer is a secured creditor of the company. In line with the 2015 Graham Review into pre-pack administrations, which was a crucial precursor to the 2021 reforms, there has long been an argument that regulations around pre-pack sales to connected parties should exclude secured lenders from that definition.
However, when instituting the new reforms, the government decided that many high-profile pre-pack sales over recent years had involved secured creditors and, in order to ensure greater transparency in the process, there was no provision for secured lenders to be excluded from the scope of the rules. This could add a significant layer of complexity, uncertainty and cost for secured lenders seeking to acquire a company through a pre-pack, as they may be deemed to be a “connected party” due to voting rights they may hold in connection with financial instruments such as debt.
Conclusion – Have the reforms worked?
Overall, the success of the reforms so far has seemingly been mixed. On the one hand, it is likely that the increased scrutiny of connected party pre-pack acquisitions will have provided some reassurance to creditors and an improved degree of transparency in the process, while figures seem to suggest that the more stringent rules have not significantly impacted the attractiveness of pre-pack acquisitions to struggling business owners and connected buyers.
However, the new rules still hold a significant degree of uncertainty, with the vagueness of their language and significant gaps leaving scope for transaction to be perceived as suspicious and unlikely to help with the government’s aim of improving broader trust in the process.
Ultimately, the very nature of pre-pack acquisitions by connected parties means that they are always likely to be viewed with a modicum of wariness among the media and the general public, even if the rules are tightened sufficiently to satisfy the majority of creditors and minimise disposals that seem to raise genuine concern.
As the 2021 reforms demonstrate, there is an extremely fine balance to be struck between tightening regulations around pre-pack sales to connected parties and ensuring that the regulations do not strip pre-pack administrations of the key benefits they can offer to struggling businesses, opportunistic buyers and even creditors: flexibility and a swift conclusion that preserves the value of a struggling business and its assets.
Given this delicate balancing act, it is likely that any future tightening of the legislation around pre-pack sales will involve a similar level of caution as the 2021 regulations.
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