Distressed M&A and corporate insolvency: what are the options?
Insight
Corporate insolvencies in England and Wales are now at their highest level since 2009. The rise in insolvencies follows the end to the Government’s Covid-19 support schemes, the buildup of debt post-pandemic, unprecedented inflation and interest rate increases.
More frequently than ever, questions are being raised as to what happens if a company is suffering financial difficulties. This could mean delayed or non-existent creditor payments, cashflow shortages, overdue bills, difficulties in making payroll, decreasing sales and the accumulation of more debt. Board directors might be asking whether there are any options left or value to be realised.
In this article, Nyla Yousuf and Georgia Slater explore the options available when a company is in distress, paying particular attention to the duties that a director has to a company until the very end.
Distressed M&A
Amid economic instability, businesses are encountering increasing challenges in staying financially viable, resulting in a rise in both accelerated and distressed sales.
All M&A transactions present their challenges, but distressed M&A transactions in particular present a unique set of challenges and opportunities for both buyers and sellers. As distressed M&A occurs when a company is in financial turmoil and usually facing insolvency, the acquisition process can be far more intricate, stressful and demanding on the parties.
Speed: Timing of a distressed M&A transaction will hinge on (1) the liquidity of the company and (2) the impact that the seller’s financial position is having on the business or assets that it is selling. Key contracts may have been terminated, customers and suppliers might be demanding more arduous terms and employees could be starting to resign. As such, it is likely that the M&A process will have to be executed and completed over a matter of days (rather than the weeks or months that are typically set aside for a transaction).
Due diligence: Given the likely speed of a distressed M&A transaction, a buyer will typically conduct little or no due diligence on the company or assets that it is acquiring. Buyers should focus any limited due diligence that they have time to conduct on the ‘bottom lines’ ie matters of specific material importance to them. These could be financial matters, legal aspects, key employees of the business or ESG. Nonetheless, those ‘bottom lines’ will always depend on the type of business being acquired and the risk appetite of the buyer.
Risk: In a distressed transaction, sellers are unlikely to be willing or able to give the usual raft of warranties and indemnities that are seen in typical M&A deals. The most that a seller will be willing to give to a buyer are warranties confirming that they have title to and the requisite capacity to sell the shares or assets. As such, a key concern for a buyer will be the limited recourse that it will have against a seller. There is also the risk that, even if a seller is willing to give a set of more fulsome warranties or indemnities, it could be insolvent by the time the buyer makes a claim against it. It may be possible to mitigate the risk by obtaining warranty and indemnity (W&I) insurance. However, given the need for speed, it is not always feasible to obtain a policy within the timeframe of the transaction. Any policy obtained may also be heavily caveated, but it is nonetheless worth exploring this option as, given the current climate, some insurers have brought to market new insurance products that are specially designed for use in distressed M&A situations.
Sellers will need to exercise caution when contemplating a distressed disposal of shares or assets, especially in circumstances where they sit on the board of directors of the company too.
Directors of distressed companies will need to have regard to their usual statutory and fiduciary duties and ensure that a sale (rather than a winding up) will promote the success of the company for the benefit of its members as a whole. In addition, they will also need to consider the interests of creditors where insolvency may be inevitable. Due to the number of advisors involved, running the M&A process will lead to a depletion in the company’s cash resources, so the directors should consider whether the sale has a reasonable prospect of a successful conclusion before heading down this unavoidably costly path.
However, what happens if there is no willing buyer to be found and time is running out, or if the directors have taken the view that the sale route is not in the best interests of the company as a whole (including its creditors)?
Insolvency
The Insolvency Act 1986 does not actually define “insolvency”. Typically speaking, however, there are two types of insolvency:
- Balance Sheet Insolvency: where, in short, the liabilities of the company exceed the assets of the company, or
- Cash Flow Insolvency: where the company is unable to pay its debts as they fall due.
Insolvency procedures in England broadly fall under two umbrellas. The first is a set of procedures that are intended for, or at least consider or allow for, reorganisation of a company or the realisation of its assets. The second is a set of procedures solely focused on the winding up of any ongoing business, the liquidation of assets and the distribution of any monies derived from the process to the company’s creditors.
Rescue procedures: a view to resuming trading
Administration
Administration is a procedure designed to give a distressed company “breathing space”, either to secure the company’s survival as a going concern or, if this is not achievable, to secure a better outcome for creditors than an immediate liquidation would allow. However, in practice, we predominantly see administration used as a vehicle to transfer the assets of a company (save for the tax liabilities) into a separate newco to keep the business going.
The process begins with the appointment of a licensed insolvency practitioner as administrator. This can be by court order, the company, its directors or by a holder of a qualifying floating charge over the company's assets filing prescribed documents at court (this is often known as the out-of-court route). Once the administrator is appointed, an automatic stay, known as a moratorium, is imposed. The moratorium period allows the business to be restructured or sold while it is protected from legal action from its creditors.
During the moratorium, the administrator will assess the company’s financial situation and explore options for its recovery. This could involve negotiations with the company’s creditors, selling the business as a whole or selling the assets to repay its debts and then liquidating or dissolving the company. The distribution of assets is usually in accordance with a statutory hierarchy, prioritising certain classes of creditors.
Company Voluntary Arrangement (CVA)
A CVA is a formal plan between a company and its creditors which allows for unmanaged debts to be repaid over an agreed period (typically three to five years) at a rate that is manageable to the company and amenable to its creditors. A CVA must be implemented and overseen by a licenced insolvency practitioner.
In October 2023, CVA’s were up 14 per cent from September 2022, showing that they are a popular rescue option for distressed companies that want to try to keep trading. However, while a CVA may be an appealing prospect, not all companies will be able to initiate one, as at least 75 per cent of a company’s voting creditors must agree to the CVA and a creditor will only likely give its approval if it is reasonably confident that the company will be able to sustain the payments due to it for the CVA term. If approved, a CVA will be binding on all unsecured creditors.
A CVA can be used together with other types of insolvency procedures, such as administration, to allow the company the benefit of a moratorium to give time for any CVA arrangements to be agreed.
Scheme of arrangement
As an alternative to a CVA, the company could look to reach a compromise with its creditors or shareholders under a scheme of arrangement, which, if approved by the requisite number of creditors/shareholders and the court, will bind all creditors and shareholders of the company, even if they were not given notice of the scheme of arrangement. This distinguishes a scheme of arrangement from a CVA, which does not bind secured creditors.
As with a CVA, unlike a formal administration process, a scheme of arrangement does not itself trigger a moratorium. However, it can be used in conjunction with administration to give the company some ‘breathing space’ too.
Restructuring plans
A restructuring plan is a statutory process under Part 26 of the Companies Act 2006 which allows a struggling company to come to a binding agreement with its members or creditors for the purpose of alleviating such issues. A restructuring plan is similar to a scheme of arrangement in that it can bind secured creditors but can also be used to force dissenting creditors to agree to a compromise as the Court has the ability to ‘cram down’ dissenting classes of creditors too.
Concluding business: winding up/ liquidation
As a final resort, and if the directors determine that it is in the best interest of the company and its creditors, the company can be liquidated and/or wound up. The process involves the appointment of a liquidator to identify all of the company’s assets and sell them for the benefit of the company’s creditors. Any unsatisfied debts will be written off and the company will be wound up at Companies House and its name removed from the Register.
The winding up and liquidation of a company can be initiated at any time: the company does not necessarily need to be insolvent. For solvent companies, the process is done by way of a Members’ Voluntary Liquidation, whereas insolvent companies are liquidated either by a Creditors’ Voluntary Liquidation or by Compulsory Liquidation.
Voluntary liquidation requires the approval of the majority of a company’s shareholders or creditors, whereas compulsory liquidation is instigated by order of the court.
Considerations for directors
Regardless of the route taken by a company in times of uncertainty, be it a distressed sale, the undertaking of a rescue process or concluding the business entirely, directors always need to be mindful of their duties.
As examined in the case of Sequana[1], directors are also required to have regard to the interests of a company’s creditors and this duty arises when a company is, or is likely to become, insolvent. See here for a briefing by our litigation and insolvency colleagues on directors' duties when insolvency becomes a real possibility and for some further commentary on the case of Sequana.
When desperately trying to get a company back on its feet, directors of a company in distress are also far more susceptible to committing wrongful trading (where they allow the company to trade when there is no reasonable prospect that the company could avoid going insolvent) or fraudulent trading (where they knowingly intend to defraud the company’s creditors, for example), both of which carry personal and potentially criminal liability.
This is one of the many reasons why it is imperative that directors of a distressed company and its shareholders seek professional advice as to their options, their duties and their responsibilities to their companies, in times of uncertainty.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, January 2024
