When is a dead horse really a dead horse? Given that ‘insolvency’ opens the door to various procedures for creditors and others, it should (in theory) be fairly easy to define. In practice, however, it is not.
In South Africa, one of the conditions that has to be met prior to the initiation of business rescue proceedings is that the directors have reasonable grounds to believe that the company is financially distressed or, if the application for business rescue is by way of court order, that the court is satisfied of the same (see sections 129 and 131 of the Companies Act 2011 (“SA Act”)). UK insolvency law uses the concept of an "inability to pay debts", defined under s.123 Insolvency Act 1986, as a gateway to a number of insolvency proceedings and does not define ‘insolvency’.
Whilst the statutory jig-saw differs, the analysis is similar. Both jurisdictions will look at whether a company: (i) is unable pay its debts as they fall due (cash flow insolvency); (ii) has greater liabilities than it does assets (balance sheet insolvency); (iii) has failed to pay a statutory demand; and / or (iv) has failed to pay a judgment debt. Recent case law in the UK has blurred the line between the balance sheet and the cash flow insolvency tests: when considering the balance sheet test, the company's balance sheet is only the starting point – the assessment cannot be carried out as a pure accounting exercise. It then becomes necessary to compare the company's present assets with its present and future liabilities, discounted for contingencies and deferment. The cash flow test is also concerned with both present and future liabilities, in that consideration has to be given to liabilities falling due in the "reasonably near future" (which depends, for example, on the nature of the company's business). A holistic approach therefore needs to be taken when assessing whether a company is (or is not) able to pay its debts.
Unlike business rescue, it is still possible for the holder of a qualifying floating charge (discussed further below) to place a company into administration- or ask the court to place it into administration- even though the company is not unable to pay its debts. However, where the appointment is by the company, the directors or any other creditor, the applicant still has to certify or demonstrate (depending on the nature of the appointment process) that the company is or is likely to become unable to pay its debts- which can be difficult if the party seeking to place the company into administration does not have access to live financial data.
Outlining Administration and Business Rescue
Generally, business rescue can be used for a broader set of purposes than administration. Although its primary purpose is to turn around a financially distressed company, it is a flexible tool which has been used for debt collection, avoidance of onerous contracts and to resolve shareholder disputes. The primary objective of an administration is to rescue the company, though, in reality, it is more often used to secure a distribution to the creditors of the company by selling off the business or individual assets of the company in administration. A company that enters an administration rarely emerges from the process as it was since the business/assets are likely to have been sold off to a 'Newco'.
Both processes benefit from the protection of a moratorium (on which see more below) and the insolvency practitioner in an administration will take control of the company in much the same way that a business rescue practitioner (“BRP”) temporarily supervises and manages the company's affairs assuming all the powers of the board of directors.
Administration and business rescue can be instigated using either an in or out-of-court process. However, the categories of creditor that have the legal right to start the processes extrajudicially reveals a significant policy difference between South Africa and the UK. An administrator can be appointed using the out-of-court process by the directors of the company, the company itself and a certain type of security holder (known as a qualifying floating charge holder ("QFCH"). General trade creditors and others are limited to applying to the court for an administration order if they want to see the company put into administration. By comparison, voluntary business rescue (ie. an out-of-court business rescue) can only be instigated by the directors; other "affected persons" must apply via the court route. The ambit of affected persons is relatively large – as it includes not only creditors but also shareholders, employees and trade unions.
In South Africa, therefore, all affected persons (including all secured and unsecured creditors) are in exactly the same position as they can only place the company into business rescue through the court route. However, with administration in the UK, a QFCH has an advantage over other creditors of the company as it can use the out-of-court appointment process which, as well as being quicker and cheaper, has the benefit that the QFCH does not have to show that the company is unable to pay its debts.
In business rescue, there is a general moratorium on legal proceedings or enforcement action against a company or its property. In similar fashion, the administration moratorium restricts the ability of third parties to take action against or enforce certain rights against the company without the prior consent of the administrator or the court. This includes: (i) the taking of steps to enforce security over the company's property (permitted with consent of the BRP in South Africa); (ii) the taking of steps to repossess goods under a hire-purchase agreement (permitted with the consent of the BRP in South Africa); (iii) with limited exceptions, a creditor, or the company itself, seeking to wind the company up (permitted in South Africa); (iv) a landlord forfeiting a lease granted to the tenant (same position in South Africa); and (v) the taking of any legal process against the company (same position in South Africa).
A number of the legal terms (such as "security", "legal process" and “taking steps”) have received judicial scrutiny in the UK and this may be instructive to help frame the interpretation of the moratorium provisions in business rescue:
- 'security' is defined as "any mortgage, charge, lien or other security". UK case law has accepted that this should be given a wide definition and generally includes any right to look to another's property to secure a payment of a debt, though it is generally accepted that this is unlikely to include exercising rights of set-off.
- 'legal process' has been interpreted broadly and includes not only court proceedings by creditors but almost all judicial and quasi-judicial processes, including arbitration proceedings, criminal proceedings and proceedings before the Gambling Commission (the position is similar in business rescue but in South Africa a regulatory authority is exempt from the moratorium in the performance of its duties).
- taking steps to enforce means more than “you shall not enforce”- the wording indicates that even preparatory steps in the enforcement cycle would fall foul of the moratorium. However, exactly which steps would be caught by this phrase is unclear and it seems, for example, that a demand for repayment may not constitute a 'step' in the enforcement process. The general consensus is that any step that would in some way inhibit the company's ability to enjoy its property will be caught.
As with business rescue, it is important to remember that administration does not alter a party's substantive rights against a company, but simply suspends them. Further, the moratorium does not stay all actions: for example, a counterparty to a contract could still exercise a right of termination or serve a contractual notice pursuant to the contract- save for “essential supply” contracts (ie. gas, water, and electricity) where the termination rights of such providers are statutorily proscribed. There are no specific proscriptions in business rescue.
Whilst the effect on contracts is broadly the same in business rescue and administration, the powers for administrators and BRPs in respect of pre-insolvency contracts differ. Section 136 of the SA Act allows the BRP to partially or conditionally suspend any obligation of the company that arises under an agreement entered into prior to the business rescue. Moreover, the BRP may apply to the court requesting that any obligation of the company or any term be cancelled where it is just and reasonable (except for employment-related obligations of the company).
In contrast, an administrator has no statutory power to disclaim onerous terms or renege on pre-administration contracts. Instead, using a general power to do all things necessary for the management of the company, it could be argued by the administrator that suspending certain obligations of the company is conducive to advancing the purpose of the administration. However, the more likely option is for the administrator to apply to the court for directions if he / she feels that certain obligations need to be cancelled or suspended.
A topic that restructuring legal teams are often asked to advise on is post-commencement finance ("PCF"). How can an entity obtain vital funding after it has entered a rescue process and where does a rescue financier rank in the insolvency waterfall?
Section 135(2) of the SA Act expressly provides that a company may obtain financing during business rescue and use its assets as security for such financing. It further provides that PCF debts will have preference over all unsecured claims. This preference will survive in a subsequent liquidation. Nevertheless, the fluctuating state of the economy and some judicial uncertainty concerning the ranking of PCF financiers in the insolvency waterfall has contributed to difficulties with the application of this type of financing in South Africa. PCF lenders are not afforded the ranking of costs of business rescue. In consequence, there is no PCF market in South Africa.
The UK also currently lacks a market for PCF in administration and it is not expressly contemplated by the insolvency legislation. The existence of a strong bank market, the dominance of floating charge security and the existence of negative pledges are all factors which make establishing a flourishing PCF ecosystem more challenging in the UK. At present, any such loan will most likely need a court direction that it ranks as an expense of the administration. However, things may be changing- very slowly. There are proposals to introduce a rescue finance regime and a government consultation process is underway. Current suggestions include:
- giving the PCF provider ‘super-priority’ as part of the administrator's expenses (whilst this is already a possibility but it is not provided for in statute);
- allowing the PCF financier to take security over property that is already secured and is subordinate to the other security or ranks equally to the current security where the holder of the security consents; and
- the ability to override negative pledges in some circumstances.
It is clear that the UK regime is borrowing slightly from Chapter 11 in the United States but also has something to learn from post-commencement finance options in South Africa.
There has been little commentary comparing the rescue regimes in the UK and South Africa. Yet, with the economies in both countries coming under considerable pressure in recent times, the use of procedures to rescue dead horses may (again) come under the spotlight. As administration and business rescue evolve, our view is that practitioners should be looking for inspiration both north and south of the Sahara.
*This article first appeared in Without Prejudice in August 2017 and is reproduced with kind permission of the publishers.