A “pre-pack” is a sale of all or part of a distressed company’s business or assets, negotiated before the company enters a formal insolvency process and executed by the appointed insolvency practitioner immediately after the insolvency process begins.
Although there are mixed views on pre-packs, the European Commission appears to appreciate their economic merits and has taken steps towards introducing them throughout the EU. On 7 December 2022, the Commission issued a proposal for a directive to harmonise aspects of insolvency law, including a requirement for member states to introduce pre-pack proceedings into their national insolvency laws.
Since it has left the EU, the UK will not be bound by this directive if and when it becomes law. However, because the UK has a tried and tested pre-pack practice developed over several decades, it is instructive to consider its main features when reviewing the Commission’s proposal.
A pre-pack minimises the impact of the insolvency process on the distressed company’s business and helps to optimise the sale value achieved for the benefit of its creditors.
If the sale is not pre-arranged in this way, there is a greater risk of business interruption and consequent loss of enterprise value upon news of the insolvency.
How do you pre-pack in the UK?
In the UK, the pre-pack is not a creature of statute. It is a business rescue technique developed by creative restructuring professionals.
In a typical pre-pack, a small number of key stakeholders collaborate to organise the pre-pack in the following way:
- The distressed company’s directors or secured creditors involve a licensed insolvency practitioner in an advisory capacity.
- The insolvency practitioner runs or oversees the sales process and negotiates the sale terms with the chosen buyer.
- The buyer may be an independent third party or someone connected to the company, such as the existing owners or management.
- When everything is in agreed form, the insolvency practitioner is formally appointed (either as an administrator of the company or receiver of the assets to be sold) and executes the sale on behalf of the company.
- The buyer is then free to trade the business and/or assets, largely free of the historical debts of the distressed company, although some of these debts may automatically transfer to the buyer by operation of law (e.g. certain employee liabilities) or it may agree to meet them for commercial reasons.
- Generally the distressed company’s unsecured creditors are not involved in organising the pre-pack, although some may be consulted for particular reasons. This means that most (if not all) unsecured creditors do not find out about the pre-pack until after it has been executed.
How is the sale price determined?
In discharge of their duties, the prospective administrator or receiver will seek to ensure that a fair market value is achieved for the assets being sold.
Ideally this is achieved via a marketing exercise, which may need to be conducted on an accelerated basis if the company’s financial position is deteriorating or the cash-flow runway is short.
Sometimes there is little or no time to market the assets or it may not be advisable to do so, in which case the sale price may be determined by reference to independent professional valuations.
Is a court sanction required?
No. In the UK, a pre-pack does not require court sanction although the court may be involved in appointing an administrator or determining any disputes arising from the pre-pack.
What happens to employees?
In a pre-pack involving a business sale, it is typical for the employees’ accrued rights to transfer automatically to the buyer by operation of employment laws derived from EU laws designed to protect employees. In the UK, this is known as a “TUPE” transfer.
This is not necessarily the case in pre-packs involving a more limited sale of assets.
How do pre-packs benefit creditors?
In a well-executed pre-pack, creditors of the insolvent company benefit from:
- Greater asset realisations for distribution to creditors, arising from assets being sold with a going concern enterprise value rather than a break-up value.
- Less competing claims against the insolvent company, where employee liabilities transfer to the buyer or the buyer continues to perform contracts that might otherwise have been terminated leading to breach of contract claims.
- Reduced costs in the insolvency process because the administrator does not have the expense of running or closing the business.
- A continuing business to deal with in the future, at their discretion.
Are there other benefits of pre-packs?
Yes. These benefits include:
- Pre-packs preserve jobs.
- Pre-packs are typically cheaper than alternative upstream restructuring procedures, such as schemes of arrangement or restructuring plans, which have more court and creditor involvement.
- Buyer companies are more likely to succeed where they have purchased a business in a pre-pack rather than after a period of administration trading.
Why are pre-packs still controversial for some?
Not everyone supports pre-packs. Critics of pre-packs point to:
- The lack of transparency that is inherent in the process: Typically, unsecured creditors are kept in the dark until the pre-pack has occurred whereas secured creditors are involved in the process. Some consider this differing treatment to be unfair to unsecured creditors even though a pre-pack may produce a better outcome for them.
- Levels of accountability: Because pre-packs have been developed by practitioners rather than law makers, there are no purpose-made avenues for challenging them. Nonetheless they can be challenged. If an administrator has not properly discharged their duties (e.g. by selling at an undervalue), regulatory action can be taken against them and they can be sued for loss they have caused.
- The “Phoenix” syndrome: A pre-pack can involve a sale to a connected person (e.g. existing shareholders or management). There is, therefore, potential for the process to be abused by unscrupulous connected parties (e.g. to avoid paying debts in an “oldco” while continuing the business in a “newco”). This practice fuels the image of “the same directors driving the same Rolls Royce through the same factory gate” while creditors are left unpaid.
How does the UK regulate pre-packs?
By regulation, after a pre-pack has been executed, an administrator is required to provide creditors of the insolvent company with detailed information that should enable them to assess whether the pre-pack was appropriate and properly conducted (i.e. a “SIP 16” report).
In the last major review of pre-packs conducted in the UK, pre-packs were generally endorsed, but with recommendations to improve them. A report prepared by Teresa Graham OBE published in 2014, concluded that:
- Pre-packs benefit “UK plc” – the collective economy as a whole – and “definitely have a place in the insolvency arena”.
- Outlawing pre-packs to address suboptimal behaviours would be “throwing the baby out with the bathwater”.
Instead of suggesting that pre-packs be outlawed, Graham made several recommendations to improve pre-packs, particularly those involving connected parties. Graham’s recommendations included:
- The creation of a “pre-pack” pool: A pool of experienced business people that connected party buyers can ask to provide opinions on a pre-pack before it is executed (on a voluntary basis).
- The introduction of viability reports: An option for connected party buyers to prepare a report on how the business is expected to survive for at least the next 12 months.
- Better marketing: All marketing should comply with six specified principles of good marketing.
- Better valuations: Valuations should be conducted by valuers with professional indemnity insurance.
- A revised SIP 16: Amended to require more narrative about the background to the pre-pack, the reasons for it and the steps taken to market and value the assets to be sold.
Following Graham’s report, the bodies that regulate insolvency practitioners took steps to implement all her recommendations on a voluntary basis (i.e. without the need for changes in law).
What are the latest developments for UK pre-packs?
The regulation of certain pre-packs was further tightened in early 2021 when the government introduced additional rules for any administration pre-pack involving the disposal of all or a substantial part of the insolvent company’s business or assets to a connected person within eight weeks of the commencement of the administration.
In this scenario, the administrator is required to either obtain creditor approval of the pre-pack or obtain from the buyer a qualifying report from an “evaluator”. The evaluator must meet specified requirements, including that they are independent, have professional indemnity insurance and sufficient relevant knowledge and experience to make the report.
The evaluator’s report must contain specified information, including a statement with reasons that:
- the evaluator is satisfied that the consideration to be provided for the relevant property and the grounds for the substantial disposal are reasonable in the circumstances; or
- the evaluator is not satisfied that the consideration to be provided for the relevant property and the grounds for the substantial disposal are reasonable in the circumstances (i.e. a "case not made opinion").
The administrator must provide the qualifying report (excluding information that the administrator considers commercially sensitive) to creditors of the company in administration and the registrar of companies.
If a case not made opinion is given in the qualifying report or in a previously obtained qualifying report, the administrator may still proceed with the disposal but must additionally provide a statement to the creditors and the registrar of companies giving their reasons for proceeding with it.
How will the directive benefit the EU?
Following the UK’s lead, several EU member states already have laws or practices conducive to pre-packs, but many do not. For those that do, there are vast differences in approach and legal uncertainties.
For example, in France a going concern sale is already available in the context of confidential conciliation proceedings. In the Netherlands, up until 2017 pre-packs had developed as a means of transferring businesses as a going concern but without an automatic transfer of accrued employment liabilities to the buyer. However, this practice largely halted in 2017 when a European Court of Justice decision in the Estro case determined that the buyer could not avoid employment liabilities in this way.
The mandatory introduction of pre-pack laws throughout the EU will be a game-changer in member states whose business rescue laws and practices are currently less developed than in the UK. Restructuring professionals throughout the EU will have an additional tool to rescue a good business from an over-indebted company, an important step towards the EU’s ambitions of a capital markets union.
For more information on the UK's pre-pack regulations, contact your CMS client partner or these local CMS experts.
This article is part of our Law-Now blog series "Harmonisation of Insolvency Laws in the EU", which will provide an overview of the EU Commission's draft directive, including the most important objectives and planned measures. The series itself will deal with the two exciting topics of the draft directive, "pre-pack proceedings" and "insolvency avoidance actions" and show how these topics are being discussed in the Member States and what the situation is like in individual non-Member States.