A total of 1,403 companies went into administration during 2019, compared to 1,341 in 2018. The increase was the consequence of a significant spike in insolvencies during the third quarter of 2019 (in which 420 businesses went into administration). Notwithstanding the various Government grant, loan and relief schemes put in place to assist businesses and business owners through the coronavirus outbreak, it is likely that 2020 will see a significant increase in the number of insolvencies and administrations.
There is no definition of ‘insolvent’ in the Insolvency Act 1986 (‘IA1986’). However, the two main tests of insolvency are the ‘cashflow’ test (set out in section 123(1)(e) IA1986) and the ‘balance sheet’ test (set out in section 123(2) IA1986).
(a) The cashflow test - The company cannot pay its debts as they fall due. This test is primarily directed at short-term and medium-term liquidity.
(b) The balance sheet test - The liabilities of the company (including contingent and prospective liabilities) are in excess of its assets. This test is primarily directed at long-term capital structure.
Where a Company is insolvent and the directors consider that there is no realistic prospect of trading out of insolvency, the company should enter into insolvency proceedings. There are four principal types of insolvency proceedings applicable to UK companies – administration, receivership, liquidation and company voluntary arrangements and schemes. This article will deal with administration.
Administration is an insolvency process by which a company is placed under the control of an insolvency practitioner to enable him to achieve objectives laid down by the IA1986.
An Administrator can be appointed by the board of directors of a company taking a majority decision, the shareholders of a company at a general meeting, a qualifying floating charge holder (usually a bank holding a debenture), a creditor applying to the court (because they have not been paid) or the supervisor of a company voluntary arrangement.
The Administrators must give their written consent to act.
The Administrator’s objectives are set out in paragraph 3(1)(a) -(c), Schedule B1, IA1986. They are as follows:
The first objective of any administration is to rescue the company (as opposed to the business that the company carries on) so that it can continue trading as a going concern (paragraph 3(1)(a), Schedule B1, IA1986).
If the rescue of the company is impossible, the administrator must aim to achieve a better result for the company's creditors as a whole than would be likely if the company were put into liquidation (paragraph 3(1)(b), Schedule B1, IA1986).
If the administrator cannot achieve a better result for creditors as a whole, the purpose of the administration is to realise the company's property to make a distribution to the company's secured or preferential creditors (paragraph 3(1)(c), Schedule B1, IA1986).
When a company is placed in administration, the Administrators will usually collate as much information and documentation about the company as possible within a short period of time and assess it with a view to achieving the best result possible in line with the Administrator’s objectives set out in paragraph 3(1)(a) -(c), Schedule B1, IA1986. Usually, this means that Administrator will be seeking a buyer of the insolvent business and its assets straight away. However, where the company has sufficient funds to facilitate it, the sale may take place after a period of trading (for example, where a valuable contract can be completed).
We have set out below 15 important legal issues to consider before buying an insolvent business. This list is not exhaustive, every business is different, each insolvency will raise different issues and each potential buyer may be interested in the business (and/or its assets) for different reasons.
Where a company is in administration, it is the validly appointed Administrator rather than the directors who will be running the company and have the power to negotiate and conclude a sale. A Buyer should obtain appropriate evidence that the Administrator has been properly and validly appointed and that they have the power to sell its assets.
It is critical to know what form the proposed transaction will take – a business sale or asset sale. Once an Administrator has been appointed, a share sale is unlikely except where a purchaser can utilise tax losses. Buying the business and/or assets of a company from an Administrator will leave most liabilities with the insolvent company. Accordingly, the Buyer will usually need to determine whether it wishes to buy the business and/or assets (or only some of them). The Administrator will try to maximise the return for creditors and will usually prefer the former (save for certain assets such as cash and book debts). The majority of transactions relating to insolvent companies proceed by way of the purchase of selected assets.
Business and/or Asset Sale Agreements involving solvent target companies usually contain a very long list of warranties together with representations and indemnities to be given by the Seller to the Buyer. These have 2 primary functions (a) they allocate responsibility and risk between the parties (in so far as any failure of the Seller to comply with them may result in a claim by the Buyer against the Seller), and (b) they act as a further level of due diligence by flushing out potential problems with the business. Any warranties, representations and indemnities will usually be heavily negotiated between the parties.
Administrators act as agents of the Seller company. They will probably know relatively little about the target business and will be unwilling to take on any liabilities as a seller. Accordingly, a Buyer is unlikely to obtain significant warranties, representations or indemnities or obtain any formal disclosure. The sale of an insolvent business or its assets is carried out on a “sold as seen” basis. The Buyer will buy only such right, title and interest as the Seller has in the assets, if any. The Buyer will need to rapidly assess all available information and documentation and physically inspect any assets it wants to buy in order to satisfy itself as to title, condition, and transferability and the level of commercial risk.
The Administrators may seek indemnities from the Buyer against any liabilities that may arise in connection with the assets and business or as a result of the sale. This may include matters such as employee liabilities, third party claims to assets and landlord’s claims.
It is important that due diligence is carried out as thoroughly and as quickly as possible in order to enable the Buyer to gain an understanding as to the level of risk involved in buying the business and/or assets from the Administrator. It is likely that only limited information will be available from the Administrator and there is unlikely to be any easy right of recourse if such information is incorrect as (a) as stated above, the Administrator is unlikely to provide any significant warranties, representations or indemnities, and (b) any given by the Seller are likely to be relatively worthless (as they will rank with other unsecured debts in any liquidation). A Buyer should carry out as many of the usual checks as possible (including legal, financial and commercial due diligence) and inspect any stock, property, plant and machinery and similar assets and ask as many questions as possible to anyone connected with the business, who will talk to the Buyer (subject to any confidentiality provisions of any non-disclosure agreement).
There are 2 critical issues. Firstly, which employees are key to enable the Buyer to take the business forward after any acquisition? Secondly, what is the extent of employee liabilities?
In relation to the first issue, it is important to find out whether key employees have already left or are planning to leave and, if not, whether they are motivated to move the business forward.
In relation to the second issue, it is vital to identify the current employees of the business and any (current or former) employees who may have a claim against the business so as to understand the extent of the employee liabilities that will fall on the Buyer. The Transfer of Undertaking (Protection of Employment) Regulations 2006 (‘TUPE’) will usually apply to an acquisition from an Administrator (although the extent of their application may vary depending on the nature of the transaction). They have the effect of transferring employee contracts (without variation – although there is a limited ability to change their terms) and rights (such as continuity of employment) to the Buyer automatically. It also imposes duties on the Buyer to inform, and possibly consult, with the trade unions or elected employee representatives.
The appointment of an insolvency practitioner will not automatically terminate contracts of employment (save in cases of compulsory liquidation). However, an Administrator will often dismiss some of the employees, on or shortly after appointment, in order to make the business more attractive to a potential buyer or more commercially viable. If a Buyer does not want to take on any of the employees then it is better to purchase from a Liquidator. Once a Buyer has assessed what liabilities you may have to take on as a result of TUPE you may want the purchase price to reflect those TUPE obligations.
An Administrator can only pass on the title which the Seller has in such assets. Stock may be subject to retention of title claims where a supplier has not been paid. The supplier may claim that they continue to own the assets until the price has been paid where the relevant contract contained a retention of title clause. Accordingly, there is a risk that some stock will need to be returned to the supplier, if a valid retention of title claim can be proven, thereby reducing the amount and value of the stock.
Alternatively, an agreement may need to be reached with the supplier about the payment to be made to the supplier prior to the sale by the Administrator or after the sale by the Buyer. Retention of title stock can often be purchased from the relevant supplier at a very favourable price but communication is vitally important, particularly where the Buyer wishes to have an on-going relationship with the relevant supplier.
A Buyer may also wish to know whether key suppliers will continue to work with the business and, if so, on what terms. If not, a Buyer may need to identify and make an agreement with an alternative supplier quickly. Where appropriate, it may be necessary to enter into a novation agreement so that the benefit and burden of contracts are transferred to the Buyer. It should be possible to leave any issues with non-key suppliers with the insolvent Seller.
A Buyer will need to determine what assets exist, whether they are subject to any form of encumbrance and, if so, the extent to which it is possible to acquire them subject to or free of any such encumbrance. By way of example, assets may have been acquired on hire, hire-purchase or conditional contracts or they may form part of the security of a lender to the Seller. Particular caution is required where the Seller is part of a group as assets may be owned by another group company or there may be cross-guarantees. A Buyer will need a release from any security. It may also be possible to reduce the impact of any encumbrances through negotiations with the relevant third party.
Sellers will often have a loan or other credit facility, which is supported by some kind of security in favour of the lender. This will usually be a debenture, which will contain a number of fixed charges and floating charges over assets. Whilst an Administrator is able to sell assets which are subject to a floating charge (for example, stock), he will not be able to sell assets which are subject to a fixed charge (typically, property, plant and machinery, goodwill, intellectual property and similar assets) without the agreement of the lender. Even if the assets can be sold, the Administrators should be asked to secure a release of any charges over the assets sold.
There are 3 important initial questions. Firstly, does the Buyer need some or all of the properties occupied by the Seller? Secondly, if so, does the Buyer need a right to occupy the property immediately upon completion of the business acquisition? Thirdly, are those properties freehold, leasehold or occupied under licence?
If the properties occupied by the Seller are not required by the Buyer then they can be excluded from the sale. The Administrator will then deal with them separately.
Where the Buyer needs a right to occupy the property immediately upon completion of the business acquisition then it may be that the Buyer will initially have to obtain a Licence to occupy the premises from the Administrator and/or the Landlord (as the case may be).
Where the property is required then the steps to be taken will be different depending on whether the property is freehold, leasehold or occupied under licence. The majority of premises are likely to be occupied on a lease or licence but this will vary from sector to sector.
(a) Freehold - Where the insolvent business owns the freehold property, it is likely that the property will need to be sold to help repay the secured creditors and clear any fixed charges. Normally, a Buyer would carry out pre-contractual enquiries regarding the property but, in an administration, it is unlikely that an insolvency practitioner will provide replies. The purchase is, therefore, very much as the Buyer’s risk.
(b) Leasehold - Where the insolvent business occupies the property under a lease, the terms of the lease need to be assessed quickly. The Buyer needs to determine whether it wishes to and is able to procure an assignment of the lease. Alternatively, it may be more appropriate to seek a new lease from the landlord.
It may be that the lease permits the landlord to terminate or forfeit the lease on insolvency (or for non-payment of rent or other breach) or that it requires consent for any assignment, underlease, shared occupation or licensing of the premises. Unless the Landlord wishes to redevelop to property or believes that it can obtain a better price for the premises than under the current lease, it is likely to consent to an assignment of the lease. Communication with the Landlord will be important. If the Landlord will not agree to an assignment or new Lease then the Buyer has no premises. Where the Buyer proposes to obtain an assignment of a lease then he needs to be aware of potential liabilities (such as unpaid rent and future dilapidations).
(c) Licence - Where the insolvent business occupies the property under a licence, it is likely to be necessary to approach the landlord for a new licence. Again, communication with the Landlord will be important.
The Buyer will need to identify the customers of the Seller and, where appropriate (for example, key customers), talk to as many of them as possible to see whether they will continue to support the business once the purchaser has acquired it. It may be that the reputation of the business has been irreversibly damaged or that certain customers will refuse to deal with the Buyer. The Buyer is likely to require the consent of the Administrator to speak to customers in order to avoid being in breach of any duty of confidentiality contained in a non-disclosure agreement (or otherwise).
Where the Seller had a long term agreement with a customer, it may be possible to assign that agreement. It may be necessary to enter into a novation agreement with the customer and Seller so that the benefit and burden of contracts are transferred to the Buyer or to enter into a new customer agreement. A third party to a contract cannot be forced to enter into a new contract with a Buyer. The Buyer should bear in mind that long term agreements often contain termination provisions permitting a customer to terminate the agreement in a range of scenarios, including insolvency.
A Buyer will need to determine whether it wishes to buy the book debts, act as a collection agent for the Administrator or leave them behind. A Buyer will need to assess whether those debts are likely to be collectable, the amount of time and cost involved in collecting them and the impact debt collection may have on preserving any existing trading relationships.
It is rare that bad debts are paid in full. They may be subject to defences and counterclaims (due to alleged breaches by the Seller). The price paid for any book debts should reflect this.
Ultimately, book debts are commonly excluded from the sale and retained for the benefit of the administration. However, and the Administrator will offer commission to the Buyer for physically collecting in the book debts.
A Buyer will need to determine what intellectual property is used by the business and whether it is important for the continuation of the business. It may be the principal reason for buying the business. Where it is owned by the Seller, it will need to be assigned. Where it is licenced to the business, the Buyer will need to determine whether the licence is transferable (with or without the consent of the licensor) or whether it needs to obtain a new licence from the owner of the intellectual property.
The Buyer will need to consider whether there is any value in the trading name of the Business. If the Buyer wishes to acquire it, then it will need to ensure that it complies with S216 IA1986. This provision seeks to prevent directors (including shadow directors) of a failed enterprise from starting a new company with the same (or a similar) name, to exploit the goodwill of the previous company, whilst escaping liability for the debts (so called ‘phoenix trading’).
Any person who has been a director of the company at any time in the 12 months prior to the insolvency should not act as a director or be otherwise involved in the business of a company with the same or the similar name for 5 years following the insolvency unless certain conditions are satisfied. If a person acts in contravention of this section, he is (a) liable to imprisonment or a fine, or both, and (b) may become personally responsible for some or all of the relevant debts of the Seller company.
The Buyer will usually wish to commence trading the Business as soon as possible after completion. Where any licence or permit is required in order to trade, the Buyer will need to ensure that these are acquired before trading commences and try to determine whether such licence or permit is likely to be obtained and how long it will take to obtain. It may be that the Buyer’s business already has the relevant licence or permit.
Need to talk?
If you are considering buying a business and/or some or all of the assets of an insolvent company, please contact us. We can help you to plan and prepare for the buyer due diligence process and assist you with the acquisition in a way that is right for you and your business.
If you would like more information about buying a business and/or some or all of the assets of an insolvent company or would like to discuss a potential or existing transaction, please contact us by telephone on +44 (0)20 3126 4520 or +45 38 88 16 00 or by email at firstname.lastname@example.org
This information is for guidance purposes only and should not be regarded as a substitute for taking legal advice. Please refer to the full Legal Notices on our website.
©Orr Litchfield 2020