We have updated the section, How do pre-packs affect employees?, following the decision in OTG Ltd v Barke and others UKEAT 0320/09 and other cases.
Pre-packs in administration: a quick guide
Although not a new restructuring strategy, the use of pre-packaged sales in administrations, known as "pre-packs", is growing. This practice note is an introduction to the key issues surrounding the controversial use of pre-packs in administrations.
What is a "pre-pack"?
The term "pre-pack" is used, in the context of administration (www.practicallaw.com/9-107-6363), to describe the process through which a company is put into administration and its business or assets (or both) immediately sold under a sale which was arranged before the administrator (www.practicallaw.com/2-107-6366) was appointed. Pre-packs are not a new restructuring (www.practicallaw.com/1-384-6171) strategy but their use is growing.
Often a pre-pack involves the sale of a company's business, together with its assets, on a going concern basis. However, sometimes a pre-pack will just involve the sale of some or all of the assets of the company. The rest of the company's assets or the business may be sold off in a separate pre-pack transaction, or the company may be put into liquidation (www.practicallaw.com/5-107-6770). For details of the judicial approach to pre-packs and an example of a company's assets being sold off in a pre-pack, see What is the approach of the courts to pre-packs? below.
Why are pre-packs controversial?
The main criticisms of pre-packs are:
A lack of transparency. Unsecured creditors (www.practicallaw.com/2-379-0852) often do not realise that a pre-pack is going to happen and so have no opportunity to protect their interests by considering and voting on the pre-pack proposal. (Secured creditors must be involved because they need to consent to the release of their security.)
A lack of accountability. The Insolvency Act 1986 (IA 1986) does not expressly provide for pre-packs. This means that administrators involved in pre-packs do not have to obtain prior approval for their actions from creditors or the court in the same way as they would in a normal administration.
Pre-packs do not maximise returns for unsecured creditors. The value of a business or its assets could be destroyed if its financial difficulties are leaked. As a result, it is impossible for an administrator to test the market fully. This means that businesses or assets which are sold by way of a pre-pack are usually sold with limited marketing compared with a normal administration.
Pre-packs are similar to the outlawed practice of creating "phoenix" companies. This practice involved a company being put into liquidation by its management, before the same business re-emerged trading as a new "phoenix" company, but without the debts of the old company. Creditors tend to be most suspicious about pre-packs when the business is sold back to the original owners. This is seen as allowing management to "asset strip" a company or "ditch" its debts. Under the pre-pack guidelines, administrators have to disclose to creditors the name of the buyer and whether there is any connection between the buyer and the company (see What are the pre-pack guidelines for administrators? below).
The proposed administrator has an inherent conflict of interest. The proposed administrator is often introduced to the company by its directors in the context of a proposal that the business or assets of the company be sold back to them. If he wants to be appointed as the company's administrator, he will have an inherent preference for the proposed pre-pack.
Writing-off liabilities using a pre-pack is a short-term fix. A pre-pack doesn't subject the company to a restructuring, which is often necessary if the business is to survive in the long term.
What are the benefits of a pre-pack strategy?
The benefits of a pre-pack strategy include the following:
Pre-packs can result in the quick and relatively smooth transfer of a business compared to a normal administration. This can reduce the costs of the administration process, which ultimately results in a better return for creditors.
Pre-packs can minimise the erosion of supplier, customer and employee confidence that is inevitably caused by insolvency proceedings (see How do pre-packs affect employees? below).
Pre-packs can save more jobs than a normal administration.
Often there is little choice. If there is no funding available, it may not be possible for the administrator to continue to trade the business through a normal administration. The alternative would be liquidation and the immediate cessation of the company's business.
Companies which are pre-packed are by definition insolvent so unsecured creditors are unlikely to recover all their money anyway. When unsecured creditors lose out in a pre-pack, it is not necessarily as a result of the pre-pack process but because of the company's underlying financial difficulties.
What is the approach of the courts to pre-packs?
The courts have recognised that a pre-pack deal is a legitimate restructuring tool in appropriate circumstances (see Legal update, Court considers pre-pack administration sale (www.practicallaw.com/3-386-1622)). The courts have also confirmed that administrators have the power to sell a company's business or assets without the prior approval of the court or creditors, if the circumstances justify it. For more detail, see Legal updates, Pre-pack administration supported by the High Court despite opposition by majority creditor (www.practicallaw.com/4-376-3683) and Administrators’ powers (www.practicallaw.com/8-102-8513).
In Re Hellas Telecommunications (Luxembourg) II SCA  EWHC 3199 (Ch), the High Court went further and expressly granted the administrators of a company liberty to complete a pre-pack of a company's assets. The judgment makes it clear that the courts will continue to assess the merits of any pre-pack sale where an administration order is sought. For further details, see Legal update, Pre-pack administration of Luxembourg company is approved by English court (www.practicallaw.com/8-501-4955).
The courts may assist with an administrator's appointment and a pre-pack sale outside ordinary court hours. For an example, see Article, DTZ's takeover process: M&A under the revised Code, PLC Magazine, 2012 (www.practicallaw.com/4-517-1594).
What are the pre-pack guidelines for administrators?
Administrators are subject to professional guidelines that relate specifically to pre-packs. The Insolvency Service's (IS) Statement of Insolvency Practice 16 (www.practicallaw.com/9-384-5059) (SIP 16) took effect on 1 January 2009. SIP 16 was introduced in response to creditor concerns about pre-packs. It sets out a detailed list of the information which the administrator should disclose to creditors where there has been a pre-pack. In practice, many firms of insolvency practitioners (www.practicallaw.com/5-107-6261) report to creditors within seven days of completing a pre-pack, setting out the required details of the transaction. Although SIP 16 is not legally binding, failure to comply with it could result in an administrator facing regulatory or disciplinary action. The IS monitors the reporting by insolvency practitioners of pre-packs to creditors, with a view to ensuring compliance with SIP 16.
In Clydesdale Financial Services Ltd and others v Smailes  EWHC 1745 (Ch), the High Court held that the failure of the administrators to comply with SIP 16 was not in itself a ground to remove them from office. For more information, see Legal update, A pre-pack sale and an application to replace administrators (www.practicallaw.com/7-500-2217).
For more information on SIP 16, see Legal update, Pre-packaged sales in administrations: Statement of Insolvency Practice 16 (www.practicallaw.com/7-384-5060) and Practice note, Statement of Insolvency Practice (SIP) 16 toolkit (www.practicallaw.com/9-520-7878). For more information on Statements of Insolvency Practice generally, see Practice note, A guide to Statements of Insolvency Practice (www.practicallaw.com/2-508-6851).
What are the issues for directors of a company that is pre-packed?
Section 214 of the IA 1986 imposes personal liability on directors for wrongful trading (www.practicallaw.com/0-107-7526). The directors of a company who are involved in a pre-pack need to make sure that they do everything they can to minimise loss to creditors. Directors should take independent legal advice, especially if they will acquire an interest in the company's business or its assets through the pre-pack (see the discussion of "phoenix" companies under Why are pre-packs controversial? above).
The IS has indicated that it will use its enforcement powers to penalise any directors who misuse the administration process to disadvantage creditors or to seek to obtain a benefit for themselves. For more information on section 214 of the IA 1986 and wrongful trading, see Practice note, Insolvency and considerations for directors: Wrongful trading (www.practicallaw.com/5-107-3984).
There are particular issues for directors if the insolvent company has an outstanding liability to a defined benefit (DB) pension scheme (www.practicallaw.com/0-107-7545). A pre-pack transfers the insolvent company's business and assets to the purchaser, but all liabilities (including any debts due to a pension scheme) remain with the insolvent company. If a company deliberately uses a pre-pack to avoid a pension scheme liability in this way, the Pensions Regulator (www.practicallaw.com/9-201-5137) can require anyone connected or associated with the insolvent company to contribute to the scheme in the company's place (see, for example, Legal update, Pensions Regulator imposes first contribution notice (www.practicallaw.com/9-502-6731)). For more information on who is connected or associated with an insolvent company in this context, see Practice note, Who is "connected" or "associated"? (www.practicallaw.com/9-422-3889).
How do pre-packs affect employees?
Pre-packs are frequently used to rescue companies which are "people" businesses, such as retail businesses. This is because much of the value in such a business lies with its employees. If the company is subject to a protracted administration process then key employees may lose confidence that the company can be saved and seek alternative employment.
It seems likely that, where a pre-pack takes place, the employees engaged in the business will transfer to the purchaser through the application of The Transfer of Undertakings (Protection of Employment) Regulations (SI 2006/246) (TUPE). However, the position is not clear and there are conflicting Employment Appeal Tribunal (EAT) (www.practicallaw.com/7-200-3201) decisions on the point. For more information, see Practice note, Buying the business and assets of an insolvent company: Employees (www.practicallaw.com/9-100-1853). For more information on TUPE and insolvency, see Practice notes, TUPE (7): insolvent businesses (www.practicallaw.com/8-380-7944) and TUPE: overview (www.practicallaw.com/8-202-1704).
Do unsecured creditors have any way to challenge a pre-pack?
Creditors have a statutory right to bring an action against an administrator under paragraphs 74 and 75 of Schedule B1 to the IA 1986. Paragraph 74 relates to conduct causing unfair harm to a creditor's interests and an administrator not performing his functions quickly and efficiently. Paragraph 75 relates to misfeasance. SIP 16 (www.practicallaw.com/9-384-5059) may help provide creditors with the information that they need to bring such an action (for more information on SIP 16, see What are the pre-pack guidelines for administrators? above).
A less formal and cheaper way of challenging a pre-pack is to contact the IS's pre-pack complaints hotline (see Legal update, The Insolvency Service sets up a pre-pack complaints hotline (www.practicallaw.com/6-385-0467)). Administrators could face regulatory or disciplinary action if they have failed to comply with SIP 16 and directors of a company that is pre-packed can be disqualified if their conduct in the period leading up to the pre-pack is considered to be unfit. For more information on the disqualification of directors where a company is insolvent, see Practice note, Insolvency and considerations for directors: Disqualification orders and insolvency (www.practicallaw.com/5-107-3984).
Are there any proposals for law reform in the area of pre-packs?
In 2010 the IS published a consultation that contained proposals for addressing some of the criticisms aimed at pre-packs, in particular the claim that the process lacks transparency and accountability (see Why are pre-packs controversial? above). For more information about the consultation, see Legal update, The Insolvency Service consults on reforms to the procedure for pre-pack administration sales (www.practicallaw.com/7-501-9133).
In 2011 the government proposed legislation to control the use of pre-packs. However, on 26 January 2012, the government announced a review of the existing regulatory regime (including SIP 16 (www.practicallaw.com/9-384-5059)), in place of new legislation. The review will attempt to identify ways in which the present regulatory framework could be used to encourage transparency and confidence in pre-packs. For more information, see Legal update, Government decides against new pre-pack legislation (www.practicallaw.com/9-517-5274).
On 12 March 2013, the Insolvency Service announced that an independent review of pre-packs would commence in late Spring 2013 (see Legal update, Insolvency Service announces review of pre-packs (www.practicallaw.com/3-525-1732)). This review began on 15 July 2013 with a final report expected to be published in Spring 2014 (see Legal update, Insolvency Service begins review of pre-packs (www.practicallaw.com/4-534-5783)).
Where can I find out more about pre-packs?
For more information on pre-packs, see Practice note, Buying the business and assets of an insolvent company: Pre-packaged administrations (www.practicallaw.com/9-100-1853).