The Elephant in the Room (Pre-Packs)
This is the sixth article in a series of articles aimed at informing directors of their duties and options for small to medium enterprises (SME) if faced with insolvency or financial distress. We now look at one of the more controversial mechanisms to restructure a business, being what is commonly referred to as a pre-pack transaction.
What is a Pre-Pack Insolvency Arrangement?
In contrast to formal restructuring processes such as a Small Business Restructure (SBR) or Voluntary Administration (VA), a pre-pack transaction involves a sale of assets or a business as a going concern prior to, and completed before or shortly after, a formal insolvency appointment (either a VA or liquidation). In this process, the business is often, but not always, sold to a related party (Director/Shareholder controlled entity). A pre-pack has the following key elements:
A company (Old Co) is insolvent, or likely to be insolvent;
Old Co’s business or assets are transferred for commercial consideration to a new (often) related entity (New Co); and
Old Co is placed into VA or liquidation.
In our view, there are two key characteristics of an insolvent company that may make it more suitable for a pre-pack insolvency arrangement (compared to a VA), which are:
That there is a serious risk the goodwill in a business will be damaged by a formal VA appointment scenario; and
The costs of a VA compared to the size of the business or value of the assets are excessive and therefore not feasible.
Elephant in the Room
If done correctly and for the right reasons, a pre-pack can be a legitimate means to restructure a business. However, this type of activity is not without controversy, with a long standing crack down by the Regulators (ASIC, AFSA, ATO) into misuse of the process, leading to the term “illegal phoenix activity’ being coined. Illegal phoenix activity will often involve the sale or transfer of a business/assets for little or no value, without regard to the underlying value of the business and with a clear intention of defeating creditors. Unfortunately, the prevalence of this activity has created a lot of uncertainty as to what is a legitimate attempt to save a business and what is illegal.
To address this ‘elephant in the room’, ASIC released guidance material designed to assist with drawing the distinction between illegal phoenix activity and a legitimate business restructure (click here). Whilst there are various distinguishing factors, ASIC have cited the key difference being “the director’s dishonest intentions or recklessness”.
Accordingly, it would appear sufficiently clear on our reading, ASIC has determined pre-pack arrangements can be a legitimate tool for Directors to restructure their business. This is of course, provided that the parties involved are viewed as acting responsibly, they obtain independent valuations of assets (tangible and intangible), true market value is paid for the assets/business, and sale proceeds are made available for, and therefore at no disadvantage to creditors. It also helps to engage an appropriately qualified advisor to assist.
What is Involved?
In simple terms, we see that a pre-pack process can be broken down into four key phases:
Assessment Phase – review of underlying business viability and based on the outcome of that assessment, present Directors with options for restructuring, including safe harbour protections, SBR, pre-pack transactions, VA or liquidation.
Planning Phase – assuming the business is fundamentally viable, the planning phase will focus on obtaining independent valuations for the business/assets to be sold, and obtaining legal transactional advice to ensure operational, commercial and legal risks are considered and mitigated. For example, addressing consent requirements from key stakeholders such as customers and secured lenders. In addition, planning needs to take into account the practical implications of a sale.
Execution Phase – once the practical and financial elements have been considered, a sale contract is prepared, and the sale of business or assets executed and transferred to a new entity. Employees will ordinarily be transferred to the new entity, which accepts liability for accrued entitlements.
Completion Phase – an Administrator or Liquidator is appointed to the old entity, and the purchase price is paid to the old entity (either before or after an appointment). The insolvency practitioner will undertake their own investigations into the pre-pack sale and ratify/accept the sale contract where their investigations determine it is appropriate to do so.
As a general rule, we at WCT Advisory do not see the point in undertaking a pre-pack transaction if the underlying business is not viable. That tends to just put off confronting the real issue of business underperformance or failure.
What is True Market Value?
Whether market value has been applied to a sale transaction, in most cases will ultimately be for the appointed Liquidator or Administrator to determine and form a view on whether a particular transaction has been undertaken on a proper, commercial basis and the Directors have complied with all their duties.
Accordingly, it is essential any Director contemplating an asset or business transfer obtains appropriate advice from an independent and qualified person to avoid adverse action. One aspect of pre-pack transactions we often see missed is the correct and true valuation of intellectual property, licenses and certifications required to operate machinery or the business. That is why it is important to seek appropriate, professional assistance before embarking on a pre-pack.
What are the Pros and Cons of a Pre-Pack Insolvency Arrangement?
Pros
Advocates of the pre-pack process consider it provides a better chance for existing management to save the business and also provide the best possible outcome for creditors. In terms of specific benefits, it can be said these may include:
Avoiding the potentially prohibitive costs, both in terms of remuneration (often on a time basis) and costs (including legal fees, new insurance and other disbursements) of an Administrator being appointed and trading the business, pending a sale or Deed of Company Arrangement.
An Administrator is personally liable for debts and costs incurred and has control so may choose to cease trading.
The relative efficiency of completing the sale, since all the ‘pre-work’ is done for the sale prior to the appointment of the Administrator or Liquidator.
Operations of the business can continue largely uninterrupted, which avoids disrupting cashflow or progress of current projects.
Preserving the goodwill and public perception or image of the company/brand.
Directors maintaining control of the business.
Allowing new investments to be used to build the business rather than repay old debts.
Cons
Critics of the pre-pack process point to the position whereby the director who has been in control of the business, and who may very well be the reason for it’s potential failure, controls the process, and the very real personal interest risk in a transaction. Some other specific cons include:
Public perception of the pre-pack process and its association with the term “phoenix activity”.
The requirement for funding for new entity to complete purchase and have sufficient working capital.
Potential restrictions/covenants within contracts and other commercial arrangements with customers and suppliers which may otherwise be preserved by utilising formal restructuring process like SBR or VA.
Conduct of Directors will be vigorously investigated by the appointed Liquidator or Administrator.
Each situation is different and the above needs to be balanced with what is in the Company’s best interests and that of the creditors.
Who do I talk to?
Any pre-appointment sale of the business or assets prior to the liquidation will be investigated, at law and practically, by the appointed Administrator or Liquidator. Therefore, it is crucial that an experienced, professional advisor or insolvency practitioner is engaged for advice on a pre-pack arrangement.
At WCT Advisory, we have a team of insolvency practitioners who, as ARITA professional members, are fully qualified to assist in preparing such arrangements while satisfying the complex requirements of Australian insolvency laws.