Insolvency Law Changes Affect English Law Deals
A new law that takes effect this summer will radically change the law relating to corporate insolvency in Great Britain.
The changes reflect a shift from an insolvency regime previously recognized as being strongly “pro-secured creditor” to one that endeavors to uphold the collective interests of all creditors, particularly unsecured creditors.
The changes raise important issues for project finance lenders. The new rules follow enactment of an “Enterprise Act” last November. The UK government is still in the process of writing rules to implement the changes, although the rules are expected out before the changes take effect this summer.
In most project financing transactions, a facility agreement is entered into between the borrower and a single lender or syndicate of lenders that is obliged to make loans on set conditions.
The security granted to support the loans will usually comprise a security in the nature of a first fixed legal charge over the borrower’s real estate interest in the project site that extends to all buildings and equipment affixed to the land, an assignment of project contracts, shareholder’s agreements, bank accounts, debts and insurances, and a floating charge over all the borrower’s other assets. In addition, separate direct agreements between the lenders and key counterparties of the borrower are typically obtained. These agreements provide for cure periods in the event of the borrower’s default or insolvency and for the lenders or their substitute or nominee to be able to “step in” and rectify any defaults in connection with the relevant contract.
A fixed charge over the sponsor’s shares in the borrower may also be sought coupled with other possible sponsor support. The security sought by the borrower to the lenders could be granted in a series of security documents or in a composite security on debenture.
Popularity of Administrative Receivership
Prior to the new reforms, secured creditors typically exercised enforcement rights under the security package by appointing a receiver on the occurrence of a default. A receiver is a licensed insolvency practitioner – usually a partner in an accounting firm – and his appointment is over the assets that are the subject of the various securities. The powers of a receiver are spelled out in any applicable security. These powers, which are augmented by other powers under statute, typically include the power to take possession of the property subject to the security and sell it by public auction or private bargain.
The receiver is in an unusual position in that he is an agent for different persons. He owes duties to the borrower and to third parties with an interest in the “equity of redemption” associated with borrower’s property managed by him. However, under the common law in England, a receiver is also the agent of the banks or creditors appointing him under a security document and, as such, he owes his primary duty to those persons when selling assets or carrying out his functions. He is “not simply a person appointed to manage the company’s affairs for the benefit of the Company,” in the words of one court decision.
Receivership has, to date, been the most commonly invoked insolvency procedure involving the continued trading of a bankrupt company or more importantly its business. It is quick, can be implemented out of court and does not require a public auction of assets. In practice, receivers act in close tandem with their appointers. This is also why receivership is a popular procedure with secured creditors. A receiver will be subject to one overriding duty in exercising a power of sale: he must take reasonable care to obtain a proper price. Connected with this duty is an obligation to take account of the effect of a receiver’s actions on the value of goodwill of a business and to manage property with due diligence and, of course, to act in good faith. None of these duties is overly onerous, and it is rare for appointing creditors to become liable as a result of any negligent act of breach of duty by a receiver. These are some of the other reasons why receivership has been so popular in Great Britain.
The “Insolvency Act 1986” introduced a new type of receiver to British insolvency law – an administrative receiver. An administrative receiver is a receiver appointed by a secured creditor under a security package comprising not only fixed charges over specific assets, but also a “floating charge” such that the secured package extends to all or substantially all of a borrower’s assets.
After 1986, secured creditors invariably included floating charges in their security packages for one important reason: the holder of a floating charge who had appointed an administrative receiver could always block the appointment by a court of an administrator over whom the secured creditor would have far less control.
Administration Under the 1986 Rules
“Administration” has, in the past, often been likened to a chapter 11 bankruptcy proceeding in the United States. That is a proceeding where the borrower gets some breathing space to try to reorganize its affairs.
To date, an administration order could be obtained from a court by, among others, the borrower, its directors or a creditor if supported by an affidavit and accountants’ report setting out the grounds for the administration order.
To obtain an administration order from a court, the borrower must be insolvent in the sense of being unable or likely to become unable to pay its debts. Moreover the court had to be satisfied that the making of an administration order would be likely to achieve one or more of a list of four purposes. For example, one might show that by putting the borrower into administration, this might lead to the survival of the company as a whole or any part of its undertaking as a going concern. Alternatively, one might show that putting the borrower into administration might lead to a more advantageous realization of the company’s assets than would be effected on a winding up.
The effect of the making of the order is that a moratorium operates to stop secured and other creditors from trying to liquidate or take proceedings against the company until the petition is dismissed or the administration order is discharged or varied.
Among the administrator’s powers is the power to dispose of the borrower’s property. However, in the case of fixed charge property of a secured creditor, a court order is required and the proceeds must be paid to the secured creditor. Assets that are the subject of a floating charge may be disposed of without a court order, but the administrator must respect the priorities of the secured creditors with respect to proceeds of realization.
The New Regime
There will be fundamental changes under the new regime.
The cornerstone of these changes is the introduction of a prohibition against secured creditors holding of certain “qualifying floating charges” from appointing an administrative receiver to a company. This means that creditors will no longer be able to block the appointment of an administrator by taking a “qualifying floating charge” as part of the security for a loan.
This change in law reflects concerns by the current government that the large number of administrative receivership appointments in the recession of the early 1990s may have represented precipitate behavior by lenders that led many companies to fail unnecessarily.
However, some types of floating charges can still be used by lenders to block the court appointment of an administrator.
First, the regime will not extend to floating charges created before a date sometime this spring or summer when the corporate insolvency parts of the Enterprise Act come into force. Such floating charges are thus “grandfathered” by the new legislation.
Second, the new regime does not apply to floating charges granted in the context of a capital markets arrangement where a party incurs or is expected to incur a debt of at least £50 million and a “capital market investment” is issued. A “capital market arrangement” is defined to involve derivatives. In addition, the security must be held by a security trustee with some obligations being guaranteed by a third party. A “capital market investment” is one that satisfies one of two criteria. The investment must consist of a bond or commercial paper issuance and must be issued to one or more sophisticated investors. Alternatively, the investment must be a debt instrument that is or is “designed to be” rated by an internationally-recognized rating agency, listed on the official list of the Financial Services Authority, or traded on certain approved and “recognized investment exchanges” or “foreign markets.” Securitization transactions are a main intended target of this exemption.
The third exception to which the new regime will not extend is the appointment of an administrative receiver of a “project company” of a project that is a public-private partnership project and that includes qualifying step-in rights.
A “project company” includes a company that holds property for a purpose of a project, or has sole or principal contractual responsibility for carrying out a project, or is one of a number of companies that together carry out a project, or that has the purpose of supplying finance to a project or is the holding company of any of the foregoing.
Companies that also perform activities unrelated to the project in addition to the foregoing do not qualify as “project companies.”
A creditor has qualifying step-in rights if it provides finance in connection with a project and has a conditional contractual entitlement to assume sole or principal contractual responsibility for carrying out all or part of the project or to make arrangements for carrying out all of part of a project.
The fourth exception extends to certain designated utility companies in sectors such as electricity, water and sewerage, rail, air traffic services, and telecoms.
Fifth, the regime does not extend to the appointment of an administrative receiver of a “project company” if the project company incurs or is expected to incur debt of at least £50m for the purposes of carrying out the project, and the project creditor providing the debt has qualifying step-in rights as defined earlier.
Sixth, security from certain companies operating in the financial markets and certain social landlords under social housing schemes are exempted from the prohibition.
Crown Preference and Ringfencing
In Great Britain, as in most jurisdictions, certain creditors are mandatorily preferred by law on the winding up of a company.
Among the debts so preferred under British rules are debts owed to the government, or “Crown,” on account of income tax, capital gains tax, value added tax, and debts owed on account of UK social security contributions.
Following trends in other jurisdictions, notably Australia and Germany, the Enterprise Act provides that all such tax and social security debts will lose their preferred creditor status (although some other categories of preferred creditor will remain). The result will be that more assets should be available for other creditors on a winding up.
A benefit that is afforded currently to preferred creditors under section 40 of the Insolvency Act should be noted. That section provides that if a receiver is appointed under a charge that, when created, was a floating charge, preferential debts will have priority to the security held by the floating charge holder from the floating charge assets coming into the receiver’s hands. Section 40 will remain. However, the removal of preferred creditor status to tax and social security debts should see proceeds from assets comprising “changing pools”– such as trade receivables, some moneys in bank accounts and trading stock – more readily available to secured creditors.
However, there is a qualification. Floating charge holders will not benefit entirely from this increased pool of assets liberated from the Crown. A new ringfencing provision has been inserted in the Insolvency Act under which a portion of recoveries from a floating charge may be paid to unsecured creditors. The liquidator, administrator or receiver has some discretion to decide how much the unsecured creditors will receive. It remains to be seen how this ringfencing will operate as the “statutory instruments” that are supposed to designate the portion of such assets that will go to the unsecured creditors are still being drafted.
The treatment of foreign obligors and borrowers under the administration provisions of the new insolvency regime remains a point of confusion.
Section 254 of the Enterprise Act enables the Secretary of State, by way of statutory instrument, to make provision for the Insolvency Act to apply to foreign companies. It remains to be seen if the new rules will be extended beyond the current position under the Insolvency Act, but if past trends are a guide, this is possible. This is because over time, mainly through the influence of EU insolvency laws, administration has increasingly expanded so as to apply potentially to more foreign companies.
At present the administration provisions of the Insolvency Act, by virtue of the implementation of Article 3 of the “EC Regulation on Insolvency Proceedings,” apply in the following circumstances. They apply to companies incorporated under the British “Companies Act” or in an EU member state (other than Denmark) whose “center of main interests” is in the UK. Following a recent court decision in a case called Re: Brac Rent-A-Car International Inc. in February, they apply to companies incorporated outside the EU whose “center of main interests” is in the UK. They also apply to secondary proceedings involving foreign companies with an establishment in the UK but their “center of main interests” in another EU member country. Finally, they apply to administration orders issued after a request from another country under section 426 of the Insolvency Act. That section promotes cooperation with bankruptcy courts mainly in former British Commonwealth countries.
Traditionally, British insolvency procedures were not intended to be used for foreign companies because of the general proposition that establishment and dissolution of a foreign company should be dealt with mainly by the laws of the foreign country in which the relevant company is incorporated. However, if the present rules are further extended, then English law transactions involving foreign companies granting securities permitting appointments of administrative receivers or even receivers of specific assets could find the relevant lenders’ rights eroded or, at least muddied, by the intrusion of court-ordered administration in the UK. In discussions with drafters of the new rules, Chadbourne has been advised that it is not intended, at this stage, to extend the reach of administration any further and that any proposal to do so would be preceded by consultation. Nevertheless, the applicable detailed statutory instruments covering this topic should be monitored by international lenders.
Appointing an Administrator
The Enterprise Act has also recast the provisions in the Insolvency Act relating to administration.
In the future, an administrator of an insolvent company may still be appointed by order of the court, but he may also be appointed directly by the holder of a floating charge or by the borrower or its directors. However he is appointed, an administrator will be an officer of the court and an agent of the company.
The goals of administration have also been revised. In the future, an administrator will have to perform his functions with the objectives of rescuing the company as a going concern or, if this is not possible, achieving a better result for creditors as a whole than if the company were wound up or, if neither purpose is achievable, realizing property in order to make a distribution to one or more secured or preferential creditors. The administrator must also exercise his functions in the interests of creditors “as a whole” and must perform his functions as quickly and efficiently as possible.
An inherent tension will exist given these new goals. The main stated objective of the new insolvency rules is to pursue a corporate rescue. However, it is the disposal of the business of the company as a going concern that is usually in the best interests of the company’s secured and unsecured creditors and employees. This tension reflects a concern in the market that the new legislation does not distinguish between a rescue of the business of a distressed company and a rescue of the company itself and that both should be treated with equal weight as policy objectives.
Floating charge holders who hold a qualifying floating charge can appoint an administrator directly. Security will qualify for this right of appointment if it expressly refers to the relevant provision of the Insolvency Act permitting such an appointment, or if it authorizes a floating charge holder to appoint an administrator.
Two days’ written notice of appointment must be given to the holder of any prior floating charge.
Following the administrator’s appointment, his appointer must file a notice of appointment at court together with a statutory declaration as to the security held by the appointer and right to make an appointment. If a false statutory declaration is sworn, a lender commits an offense (in the absence of it believing reasonably that the relevant statement is true). If there are doubts as to the ability to make an appointment the appointer risks swearing a false declaration and, in such a case, it may be safer to pursue a court appointed administration. In addition, the filings must be accompanied by a statement from the administrator that he consents to his appointment and that, in his opinion, the purpose of the administration is reasonably likely to be achieved (as to which he may rely on information provided by the borrower’s directors). The costly accountants’ reports currently required to support the appointment of an administrator will be discarded.
The borrower or its directors may also appoint an administrator out of court, but not within 12 months after the cessation of a previous administration appointment by the company or its directors. Moreover, neither the company not its directors may appoint an administrator if a winding-up petition has been presented, another administration order application is outstanding or an administrative receiver is in office. Five business days’ prior written notice must be given to floating charge holders of the company’s or directors’ intention to appoint an administrator.
Once an administrator is appointed by the company or its directors, similar documents to those required to be filed by a floating charge holder must be lodged with the court (for example, a statutory declaration from the appointer, administrator’s consent and statement as to likelihood whether purposes of the administration may be achieved).
Administration results in a winding-up petition being either dismissed or suspended generally and winding-up resolutions and orders being prohibited. Moreover, an administrative or other receiver will be required to vacate office on the appointment of an administrator. No secured creditor may enforce security without the administrator’s or the court’s consent. No legal process may be instituted or continued against the company to which an administrator has been appointed.
Interim variants of the administration moratorium apply where an administration application has been made to the court but not yet granted. All these moratoria are designed to provide breathing space to the company to develop a rescue package. One problem, though, with the reforms is that, in the past, a senior lender often provided funds to the business of the insolvent company to assist it in continuing to trade and on the basis that the funding was secured by his security package and given to his appointed administrative receiver. The changes in the rules will probably make lenders less willing to continue such practices.
Within eight weeks after being appointed, the administrator must publish his proposals for achieving the purposes of his administration and notify the registrar of companies and the borrower’s creditors and shareholders of the same.
As soon as reasonably practicable, but within 10 weeks after his appointment, an initial creditors’ meeting must be held, except where the administrator determines that creditors will be paid in full, or that insufficient property is available to creditors for a distribution or he has already decided that the key purposes for which he was appointed will not be achieved. Procedures exist for creditors to insist on a creditors’ meeting to be held nevertheless.
Another policy goal of the new legislation is to shorten the duration of administrations. Consequently, administration appointments now will be required to cease within a year of their taking effect in the absence of a court order or creditor consent to the extension. Where creditor consent is obtained, the extension cannot exceed a further six months but, in the case of an extension by the court, the period is unlimited. Secured creditors are effectively given a veto to any creditor extension. Other procedures also exist to bring an administration to an end.
So what do all these proposals mean for secured creditors in practice?
A number of points emerge depending on whether a transaction is governed by English law and involves a corporate borrower incorporated in Great Britain.
First, all lenders – both foreign and domestic – should review standard forms or prospective new transaction documents to see if events of default and other provisions should be amended to reflect the new rules and if floating charge security should permit, for example, the appointment of an administrator. Certainly with the concept of qualifying floating charges having been introduced, floating charges will continue to be taken as holders of such security are still granted “favored creditor status” of sorts. After all, they enjoy similar rights to appoint an administrator directly as they enjoyed in appointing an administrative or other receiver previously.
Also, secured creditors should treat floating charge security granted prior to the new regime with reverence since they will enjoy “grandfather” rights to appoint an administrative receiver and veto an administrator’s appointment in such cases. This should have an impact on refinancings and, where possible, may encourage assignment of security from an outgoing secured creditor to a refinancier rather than creation of new security.
For the great number of transactions involving foreign incorporated borrowers that are largely unconnected with Great Britain but for the presence of, say, project accounts in London over which security is created, the new regime should not have a material impact unless the British government proposes, by statutory instrument, to extend administration beyond companies having their main centers of interest in the EU. If English law security is taken in such cases with provisions for appointment of receivers, then security arrangements should be unaffected, if the rules stay as they are at present, and secured creditors should be able to continue to appoint receivers without the specter of court administration affecting their rights by virtue of the new regime. However, the situation should be monitored.
For British domestic transactions or transactions with obligors incorporated in Great Britain, the rules should have a huge impact and could well influence the basic structuring of future transactions. The possibility that domestic deals will be structured so as to continue to allow administrative receivers to be appointed under floating charge security so as to block the appointment of a court administrator is a very real one. This is, in effect, what happened after 1986 when the Insolvency Act opened the door to this course of action; for some, the door remains ajar.
For example, large transactions that would not otherwise be project deals could be structured by lenders to fall within, say, the project finance exclusion to qualifying floating charges. Conversely, smaller deals involving, say, a mezzanine lender and senior lenders could be restructured as a multi-tranche loan facility sharing a common security structure so as to equal, in aggregate, the £50m debt requirement. The new rules may also result in an increasing use of special-purpose vehicles in financing transactions in excess of £50 million. Disappointingly, however, the £50m debt threshold excludes many small and medium-sized projects for no coherent reason, and projects in sectors such as renewables may be particularly affected. Moreover, the complex exceptions to the general prohibition against qualifying floating charge holders from appointing an administrative receiver may result in project finance deals carrying less than £50 million in debt being structured with more recourse to a sponsor than would be the case for a larger deal.
Another issue (although perhaps not a frequent concern in practice) is the introduction of “purpose” tests and the exclusion of non-project activities in the context of the definition of “project company.” These requirements may exclude entities operating multiple projects or undertaking other activities. (An example is companies operating different projects through branches in different countries, which sometimes arises in the oil and gas sector.) Project lenders may look differently on such cases than those where they can appoint an administrative receiver.