4
Corporate failure
This chapter looks at what constitutes corporate failure, who decides that a company has failed and why some companies fail. From the insolvency lawyer’s point of view it is important to understand the nature and causes of corporate decline so that the potential of insolvency law to prevent or process failure can be assessed and so that insolvency law can be shaped in a way that, so far as possible, does not contribute to undesirable failures or prove deficient (substantively or procedurally) in processing failed companies.
The purpose of insolvency law is not, however, to save all companies from failure.1 The economy is made up of a vast number of firms, each engaged in marketing and product innovations that are designed to improve competitive positions and each being challenged in the market by other firms. Business life involves taking risks and dealing with crises, and the price of progress is that only those able to compete successfully for custom will survive.2 An efficient, competitive marketplace will thus drive some companies to the wall because those companies should not be in business: they may be operated in a lazy, uncompetitive manner, their products may no longer be wanted by consumers and managerial weaknesses may be placing their creditors’ interests at unacceptable risk. The role of insolvency law in such cases is not to take the place of the market’s selective functions but to give troubled companies the opportunity to turn their affairs around where it is probable that this will produce overall benefits or, where this is not probable, to end the life of the company efficiently, expertly, accountably and fairly.
It can also be argued, however, that insolvency laws and processes should be able to look beyond the immediate position of the company
1Where companies enter insolvency procedures orientated towards rescue (e.g. administration and Company Voluntary Arrangement) 79 per cent of cases result in some sort of rescue and, in 62 per cent of these, the rescue is of the entire business: see the R3 Twelfth Survey of Corporate Insolvency in the UK (2004) (‘R3 Twelfth Survey’) p. 30.
2See M. White, ‘The Corporate Bankruptcy Decision’ (1989) 3 Journal of Economic Perspectives 129.
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and should be sufficiently accessible to democratic influence to allow consideration of factors beyond the narrow confines of the firm or the strictly economic. Corporate failures may lead to the breaking up of teams with experience and expertise; to wasted resources and to run-on effects such as the unemployment of staff; harm to customers and suppliers; general impoverishment of communities and losses of con- fidence in commercial, financial, banking and political systems. A large corporate insolvency may, for instance, not only produce job losses and harm to the community, but also prejudice the availability of commercial credit as banks are shocked into newly restrictive lending policies. An insolvency often spreads ripples that extend considerably beyond the troubled firm.
What is failure?
Companies routinely encounter difficult times and survive them.3 Some firms, however, undergo formal or informal rescue procedures before regaining health and others may end up in liquidation. R3 reported in 2004 that 21 per cent of businesses survived insolvency and continued to operate in one form or another and administration procedures resulted in 66 per cent job preservation.4 In 2005 the number of companies liquidated per quarter ran at between 3,000 and 3,400.5 To talk of ‘troubled’ or ‘failing’ companies is accordingly to refer in a broadbrush fashion to companies encountering a variety of problems and in different stages of decline or regeneration. More precision can be brought to such discussions by distinguishing between companies that are in distress and companies that are insolvent.
3Of new companies, 80 per cent of VAT-registered businesses are still going after two years, falling to 70 per cent after three years: see J. Guthrie, ‘How the Old Corporate Tortoise Wins the Race’, Financial Times, 15 February 2007.
4R3 Twelfth Survey, p. 4.
5BERR Statistics and Analysis Directorate figures. Insolvencies in the recession of the early 1990s peaked at just under 25,000 per annum in 1992. The corporate restructuring company Begbies Traynor reported in October 2008 that stricter lending criteria and the inability to secure funding meant that a ‘staggering’ 4,566 companies faced critical problems: see J. Grant, ‘Businesses in Distress Double’, Financial Times, 20 October 2008. After a poll of 2,073 of its members in October 2008, R3 was reported as predicting that small and medium-sized company insolvencies were set to rise by a ‘catastrophic’ 41 per cent by the end of 2009 compared with where they were at the end of 2007: see J. Grant, ‘Insolvency Rate to Rise 41% by End of 2009’, Financial Times, 4 November 2008.
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Distressed companies are those that encounter financial crises that cannot be resolved without a sizeable recasting of the firm’s operations or structures.6 Such distress may be seen in terms of default, where the company has failed to make a significant payment of principal or interest to a creditor.7 Alternatively, distress can be seen in terms of financial ratios. Thus, calculations based on a company’s accounts can be used to reveal profitability ratios, liquidity ratios and longer-term solvency ratios.8 Assessing whether a company is in distress may involve reference to these ratios individually or collectively, but the central issue is whether the company is revealed to be in such a state of crisis that drastic action is required.9
A company is insolvent for the purpose of the law if it is unable to pay its debts.10 No legal consequences attach to a firm, however, simply by virtue of its insolvent state. Such consequences only follow the institution of a formal proceeding such as a winding up or the appointment of an administrator or administrative receiver. There is, moreover, no single
6C. Foster, Financial Statement Analysis (2nd edn, Prentice-Hall, Englewood Cliffs, N.J., 1986) p. 61; A. Belcher, Corporate Rescue (Sweet & Maxwell, London, 1997) ch. 3. The R3 Twelfth Survey (p. 30) revealed that 21 per cent of businesses entering a rescue procedure experienced a break-up sale of assets. For a spectrum of potential indicators of distress see R. Morris, Early Warning Indicators of Corporate Failure (Ashgate/ICCA, London 1997); see also J. Day and P. Taylor, ‘Financial Distress in Small Firms: The Role Played by Debt Covenants and Other Monitoring Devices’ [2001] Ins. Law. 97.
7In Belcher’s terms a ‘default proper’ as opposed to a ‘technical default’ of a loan term, which relates not to principal and interest payments but to other issues, e.g. retention by the firm of a minimum level of net worth.
8Profitability ratios address the firm’s effectiveness using available resources, liquidity ratios speak to its capacity to pay its debts in the short term and longer term, solvency ratios consider the firm’s capital structure and its ability to meet longer-term financial commitments (see Belcher, Corporate Rescue, p. 40). Ratios are often used in attempts to predict insolvency: on which see ibid., ch. 4; E. I. Altman, ‘Financial Ratios, Discriminant Analysis and the Prediction of Corporate Failure’ (1968) 23 Journal of Finance 589; J. Pesse and D. Wood, ‘Issues in Assessing MDA Models of Corporate Failure: A Research Note’ (1992) 24 British Accounting Review 33; R. Taffler, ‘Forecasting Company Failure in the UK Using Discriminant Analysis and Financial Ratio Data’ (1982) Journal of Royal Statistical Society, Series A, 342.
9Wruck defines financial distress as ‘a situation where cash flow is insufficient to cover current obligations. These obligations can include unpaid debts to suppliers and employees, actual or potential damages from litigation and missed principal or interest payments’: K. Wruck, ‘Financial Distress, Reorganisation and Organisational Efficiency’ (1990) 27 Journal of Financial Economics 419 at 421.
10See R. M. Goode, Principles of Corporate Insolvency Law (3nd edn, Sweet & Maxwell,
London, 2005) ch. 4; Boyle and Birds’ Company Law (6th edn, Jordans, Bristol, 2007) pp. 846–8; A. Keay and P. Walton, Insolvency Law: Corporate and Personal (2nd edn, Jordans, Bristol, 2008) ch. 2.
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legal definition of inability to pay debts. Within the Insolvency Act 1986 and other insolvency-related statutes there are a number of tests of insolvency and these relate to the purposes of different legislative provisions. The two main reference points regarding the inability to pay debts are the ‘cash flow’ and the ‘balance sheet’ tests.11 The cash flow test is set out in section 123(1)(e) of the Insolvency Act 1986 and, according to this, a company is insolvent when it is unable to pay its debts as they fall due.12 (The fact that the firm’s assets exceed its liabilities is irrelevant.)13 The courts, moreover, will pay regard to the firm’s actual conduct so that insolvency will be assumed if the company is not in fact paying its debts as they fall due.14 A further issue is whether future debts can be considered as part of the cash flow test. This was discussed in the Cheyne Finance decision15 in which Briggs J said that, although Parliament had removed the requirement to include contingent and prospective liabilities in framing what is now section 123(1)(e), it had added the words ‘as they fall due’ which merely replaced ‘one futurity requirement with
another’ and, accordingly, future debts could play a role in the cash flow test.16
Insolvency under this test is a ground for a winding-up order17 or an administration order18 or for setting aside transactions at undervalue, preferences and floating charges given other than for specified forms of new value.19
The balance sheet or asset test of section 123(2) of the Insolvency Act 1986 considers whether the company’s assets are insufficient to discharge its liabilities, ‘taking into account its contingent and prospective
11See Goode, Principles of Corporate Insolvency Law, pp. 85–9. Note that the Insolvency Act 1986 s. 123(1)(a) and (b) provides two specific alternative methods of establishing inability to pay debts to facilitate the proof of insolvency (i.e. for creditors) for the purposes of winding up or administration proceedings.
12The difficulty with the cash flow test is that ‘its meaning is vague and imprecise and determining whether a person or company is, on a particular day, insolvent, is often difficult’. Keay and Walton, Insolvency Law, p. 16.
13See Cornhill Insurance plc v. Improvement Services Ltd [1986] 1 WLR 114.
14Ibid. 15 Re Cheyne Finance plc [2008] BCC 199.
16See K. Baird and P. Sidle, ‘Cash Flow Insolvency’ (2008) 21 Insolvency Intelligence 40; T. Bugg, ‘Cheyne Finance’ (2008) Recovery (Spring) 10. The Cheyne Finance case concerned the contractual drafting of an insolvency event of default clause, not a petition presented on grounds of cash flow insolvency, and Briggs J’s comments are, strictly, obiter. It is arguable, however, that the courts are likely to apply common approaches to the cash flow test when deciding either petition or default clause cases: see Baird and Sidle at p. 41.
17Insolvency Act 1986 s. 122(1)(f). 18 Insolvency Act 1986 Sch. B1, paras. 11, 111(1).
19Insolvency Act 1986 ss. 238–42 and 245, especially ss. 240(2) and 245(4).
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liabilities’. This may involve assessing the value of assets and judging the amount the asset would raise in the market; though a difficulty arises through the Act’s failure to indicate whether valuations should be made on the basis of a ‘going concern’ or ‘break-up’ sale. Particular difficulties may arise where there is no established market value for the commodity. The test, furthermore, gives rise to potential problems in so far as there is no statutory definition of prospective liabilities. Standard accounting practice treats contingent liabilities more subtly than section 123(2) and that section does not include any particular basis for measuring assets and liabilities.20 The balance sheet test is also one of the tests prescribed for the purpose of grounds for winding up,21 administration22 or the avoidance of transactions at undervalue,23 preferences24 and certain floating charges.25 It is also a test relevant in considering the disqualification of directors26 and is the one test used in identifying insolvent liquidation for the purposes of assessing directorial liabilities for wrongful trading.27
Defining insolvency at law is further complicated by the use of further tests in statutes other than the Insolvency Act 1986. Thus, under the Company Directors’ Disqualification Act 1986, a company becomes insolvent for the purposes of potential directorial disqualification if its assets are insufficient for the payment of its debts and other liabilities together with the expenses of winding up, or when it goes into liquidation or when an administration order is made or an administrative receiver is appointed.28 Under the Employment Rights Act 1996, and for purposes concerning employee rights to payment from the National Insurance Fund on an employer’s insolvency and the employee’s job termination, the employer is deemed insolvent when a winding-up order or administration order has been made; a resolution for voluntary winding up has been passed with respect to the company; a receiver or manager has been appointed; possession has been taken by holders of debentures secured by floating charges; or any property that is the subject
20See Belcher, Corporate Rescue, pp. 46–7. Prospective and contingent liabilities must be taken into account according to Re A Company (No. 006794 of 1983) [1986] BCC 261.
21Inability to pay debts for the purposes of winding-up orders can also be assessed in ways independent of insolvency: see Goode, Principles of Corporate Insolvency Law, p. 90.
22Insolvency Act 1986 Sch. B1, paras. 11, 111(1).
23 Ibid., ss. 238, 240(2). 24 Ibid., ss. 239, 240(2). 25 Ibid., ss. 245, 245(4).
26Company Directors’ Disqualification Act (CDDA) 1986 s. 6(2).
27Insolvency Act 1986 s. 214. 28 CDDA 1986 s. 6(2).
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of a charge and a voluntary arrangement has been approved under Part I of the Insolvency Act 1986.29
Finally, for the purposes of a member’s voluntary winding up under section 89 of the Insolvency Act 1986, the company’s directors must make a declaration of solvency but reference is not made to the cash flow or balance sheet tests. The issue is whether the company will be able to pay its debts in full, together with interest at the official rate, within such period (not exceeding twelve months from the commencement of the winding up) to be stipulated in the declaration.
Insolvency law thus defines ‘insolvency’ in different ways for different purposes.30 Legal definitions, moreover, are not the only measures for corporate failure. If economic criteria are employed, a company might be said to be failing if it cannot realise a rate of return on invested capital that, bearing in mind the risks involved, is significantly greater than prevailing market rates on similar investments. Such failure would not necessarily lead to ‘legal’ insolvency but, if lasting in nature, this is a possibility. Alternatively, a failure to produce appropriate financial returns might result in corporate financial distress or investor-driven changes in the company’s staffing and strategies.
Who defines insolvency?
A corporate insolvency can involve a number of concerned parties. These include creditors, shareholders, group subsidiaries,31 directors and managers of the company, employees, suppliers and customers. A host of professional advisers will also have a role to play and these may include financial and management consultants, lawyers, bankers and accountants.
As seen above, there is no simple objective point in corporate affairs when the law states that the company is insolvent. The law creates opportunities for action rather than laying down consequences for stipulated states of affairs. Different tests are applied for different purposes and there are judgements involved in assessing each test. Thus, the question of whether a firm fails on the cash flow test of ability to pay debts depends on a set of constructions. As Miller and Power have put it: ‘Corporate
29See Goode, Principles of Corporate Insolvency Law, p. 92.
30Thus we have seen that the Insolvency Act 1986 confines the term ‘insolvency’ to a formal insolvency proceeding: Insolvency Act 1986 ss. 240(3), 247(1). The phrase ‘unable to pay its debts’ embodies the concept of a state of insolvency: see Goode,
Principles of Corporate Insolvency Law, p. 84.
31See ch. 13 below.
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failure is itself constituted out of an assemblage of calculative technologies, expert claims and modes of judgment.’32 Not only different parties but also different professionals will possess distinctive ways of perceiving and constructing corporate events and of deciding how to respond to these. Accountants invariably have a choice of ways to portray a company’s performance in both healthy and troubled times.33 There is a variety of ways, moreover, to deal with financial challenges and distress so that insolvency becomes as much a negotiable or technical issue for the accountant as an objective one.34 The law, on this view, can be seen as overlaid on the facts as established by the accountants, so that ‘the calculative technologies of accountancy trigger legal processes and provide the knowledge of those processes that law comes to administer after the event’.35 The accountants can thus be seen as straddling the corporate process and not only providing auditing, consultancy and other services for healthy companies, but also dominating the legally created market for insolvency administration and the extra-legal market for corporate rescue. In these roles, the accountants carry out regulatory, advisory and managerial functions. The law says little in detail about the economic substance of corporate failure (it prefers to set down procedures for dealing with vaguely defined circumstances) and, because this is the case, it creates a ‘legal space in which such matters can be negotiated’.36 The legal process thus becomes highly dependent on extra-legal expertise: on the portrayals of corporate affairs that are presented by the accountancy and economic professionals who appear before the courts and pull the triggers created by the insolvency legislation.37 Central to such endeavours are the ratio analyses that have ‘transformed the nature of corporate failure and opened it up to a new regime of judgment and assessment’.38 The conception of
32P. Miller and M. Power, ‘Calculating Corporate Failure’ in Y. Dezalay and D. Sugarman (eds.), Professional Competition and Professional Power: Lawyers, Accountants and the Social Construction of Markets (Routledge, London, 1995).
33On the weak role of accountants and auditors in securing information for assessing corporate health, from an Australian perspective, see F. Clarke, G. Dean and K. Oliver,
Corporate Collapse: Accounting, Regulatory and Ethical Failure (rev. edn, Cambridge University Press, Cambridge, 2003) ch. 17.
34Miller and Power, ‘Calculating Corporate Failure’, p. 54. 35 Ibid., p. 56.
36Ibid., p. 58; though see the portrayals of insolvency practitioner work as obfuscatory rather than negotiatory in S. Wheeler, Reservation of Title Clauses (Oxford University Press, Oxford, 1991).
37On the role of insolvency professionals in shaping insolvency processes see ch. 5 below.
38Miller and Power, ‘Calculating Corporate Failure’, p. 59. For a classic multi-variant analysis looking at the ratios of working capital to total assets; retained earnings to total assets; earnings before interest and losses to total assets; market value of equity to book