Navigating the post-COVID ‘perfect storm’

It may not surprise you that there is a general expectation amongst insolvency practitioners (and beyond) that a significant rise in corporate financial distress and, therefore, formal insolvencies are on the horizon. Many commentators, though, have used the phrase ‘perfect storm’ to describe the potential severity of the situation we may all be facing. Current historically low failure rates may mask the growing number of factors that could converge to make 2021 the toughest trading year in living memory. Why might there be such choppy waters ahead?

The (more obvious) factors include:

The end of government support

The raft of measures, including CBILS & BBLS, the furlough scheme and VAT deferrals, clearly cannot go on forever and will need to be repaid. Sectors such as hospitality and leisure have suffered significantly and, without wishing to state the obvious, the damage will take a toll on many. Within the insolvency profession, there has been much talk about ‘kicking the can down the road’ each time support is extended. While the availability of support is to be commended, there is a growing sense of saving up problems for another day.

Catch-up

Official figures show that UK insolvencies in 2020 were at their lowest since 1989 and 40% down on 2019. Clearly, this isn’t because more businesses are thriving than in the previous 30 or so years. Rather, it suggests some of the measures introduced to help otherwise good and profitable business have also served to artificially prop up those businesses that were already doomed and would have failed. Measures such as the prohibition on winding up petitions, unless the reason for non-payment was non-COVID related (good luck proving that!), have held the number of business failures artificially low for the last 12 months. It cannot be the case that the injection of ‘COVID cash’ and creditor forbearance have turned these otherwise failing businesses into profitable entities. Aside from the unlucky casualties of the pandemic, a spike in insolvencies just to return us to where we would have otherwise been should be expected.

Other important factors:

The return of Crown Preference

For those old enough to have been in business before 2002, you might remember that HMRC used to be able to claim ‘preferential status’ (i.e. would be repaid before other unsecured creditors) in formal insolvencies.

From December 2020, HMRC became a (second-ranking, behind former employees) preferential creditor again regarding some taxes, most notably VAT, PAYE and National Insurance. This places the Crown back ahead of banks and funders with floating charges, making those lenders more vulnerable when a company enters an insolvency process. Read more on the return of Crown preference here.  

The Enterprise Act introduced the concept of the ‘prescribed part’ – where some of the cash otherwise due to a floating charge holder was instead paid to unsecured creditors. The ‘quid pro quo’ for this change was that HMRC’s preferential status would stop, and they would be repaid the same proportion as other unsecured creditors, such as trade suppliers. The new Crown Preference provisions come with no such counterbalance to ensure the banks are no worse off in an insolvency situation.

The proposed reintroduction of HMRC preferential status attracted much criticism when announced (even in the good old pre-pandemic days). I was one of many that suggested that the likely damage to the UK’s rescue culture would far outweigh any potential benefits to the Treasury. With all the government assistance afforded to businesses in the last few months, it seems incredible that HMRC’s proposed bump up the pecking order was not postponed at least.

For example, preferential creditors cannot be bound by a Company Voluntary Arrangement (CVA) without their consent. As such, unless the company hoping to enter a CVA to trade its way out of difficulties is confident of repaying crown debts in full, HMRC now effectively hold a veto on the entire process. Moreover, even if HMRC can be repaid, it is very common in the current climate for businesses to have large tax arrears from taking advantage of the option to defer VAT and PAYE payments. The need to find these amounts in full, ahead of all unsecured creditors, is likely to make many proposals simply unworkable, meaning that ‘terminal’ rather than ‘rescue’ proceedings may be the only possible option.

The banks

Barclays recently reported a 30% fall in pre-tax profits for 2020 and has set aside £4.8 billion for loan defaults due to the economic fallout of the pandemic.

A change in accountancy regulations brought about by IFRS 9 (stay with me!) means that the way the banks recognise these losses will change. Previously they would have only been recognised once the loss incurred. The movement to an ‘expected’ loss model, meaning that these lenders must fully recognise anticipated credit losses in the financial year relating to any loan default. Simply put, the banks’ balance sheets will take a bigger hit all the sooner.

The implication of this and the reintroduction of HMRC’s preferential status is that would-be lenders are likely to become less willing to advance new cash. Unless a company has significant assets, access to finance – especially in a rescue context – is expected to become more difficult.

Lenders might also seek tighter covenants around HMRC payments and greater control of book debts to maintain a fixed charge claim over such debts. In some instances, this might limit directors’ ability to manage immediate cash flow difficulties, removing an often important lever to defer HMRC payments in the short-term.

Pre-pack bashing

They don’t have the best of reputations, driven in no small part by media misreporting, but pre-packaged administration sales (where a buyer is found before a company entering administration and the business and assets are sold with little or no notice to creditors) are an important part of the UK rescue culture.

Numerous government attempts to ‘clean up’ the use of this procedure and improve ‘stakeholder confidence’ have been introduced, the latest of which seeks to make it mandatory for management looking to buy-back a business to employ an independent (but unlicensed) Evaluator. Whilst it can never be a bad thing to increase scrutiny and transparency of such a process, I have little doubt that the criticism of pre-packs has been somewhat overstated. Any IP entering into a pre-pack already has a staggering amount of hoops to jump through to agree and justify the outcome to creditors. The introduction of another barrier seems unlikely to provide any party with any real comfort but will further increase the costs of the process.

Crisis or opportunity?

I don’t wish to paint an unnecessarily pessimistic picture here. It is a common misconception that all insolvencies are bad (and far be it from me to suggest to anyone losing their business or their job to ‘cheer up & look on the bright side’). On an individual level, it is a tough and emotionally draining process for business owners to wind up a company’s affairs after many years and one I never take lightly.

On a more macro-economic level, however, insolvencies serve a vital function for the economy. At best, rescuing viable businesses and preserving jobs is often misunderstood and undervalued (I would say that, I suppose). Even at the lower end of the scale, terminal liquidation procedures, where a business often cannot be saved, serve to recycle assets into the economy and provide opportunities and new growth.

New legislation under the Corporate Insolvency and Governance Act 2020 or ‘CIGA’ (more on that another day perhaps!) has sought to improve the rescue landscape within the UK. My concern, however, is that many factors are potentially conspiring to make the use of tried and tested rescue procedures such as Administrations and CVAs less viable.

Focussing on the positive, the seemingly inevitable rise in insolvency rates affords those well-run, agile businesses with cash reserves and/or quick access to finance many new opportunities for acquisition and growth in the coming months and years. If you look hard enough and plan your journey carefully, perhaps there are some calmer waters to be found and some sunlight poking through the storm clouds ahead.

This article was written by Stuart Morton, Insolvency and Recovery Director at Price Bailey. If there is anything in this article that you would like to discuss or find out more about, please contact Stuart on the form below.

 

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

 

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