A senior accountant charged with carrying out an independent review of pre-packaged administrations admitted she herself approached the much-maligned practice with negative perceptions.
So why did she end up concluding that pre-packs should not be banned, or even subject to legislative scrutiny?
Some 600 of the 2,365 UK firms that went into administration last year were subject to pre-packs, a practice that has at times enraged creditors and solvent competitors operating in the same market.
Pre-packing involves the failed business being sold by the administrator at or soon after its appointment, often to the existing directors, with negotiations taking place behind closed doors beforehand without creditors' knowledge (see bottom, for more details). The process is commonplace in the IT channel, with recent examples including the pre-packed acquisitions of Trinity and Norbain.
Opponents say pre-packing lacks transparency and does not result in the best value being achieved for businesses. But it can also be an important way of preserving value.
Commissioned by business secretary Vince Cable (pictured) last autumn and carried out by senior accountant Teresa Graham, the report concluded that pre-packs have a place in the UK's insolvency landscape. However, there "could - and should - be some major improvements to how they are administered", Graham said. She made six recommendations designed to address some of critics' worst concerns (see bottom) but stopped short of proposing legislative action.
"Should these measures fail to have the desired impact and they are not adopted as I would hope by the market, then government should consider legislating," she said.
Although pre-packs in general are controversial, those involving "connected parties" - normally the directors of the failed firm - have attracted particularly fierce criticism due to the perception that it allows "bad businesses" to resume trading shorn of their debts, but not their management.
Managing director of EP Credit Management & Consultancy and credit industry veteran Eddie Pacey said: "What I find unpalatable is when too many directors are frequently retained by the acquiring firm or may be related to those acquiring. If they screwed up the business, then they should have no role in the pre-pack moving forwards and any ‘role' should be restricted to six months."
Set up to fail?
Graham's report appears to add credence to the view that pre-packs involving connected parties deliver lower returns to creditors, and are more likely to go on to fail again.
Her report studied empirical research into 499 pre-packs from 2010, carried out by the University of Wolverhampton. Some 316 of these - or 65 per cent - involved a connected party.
More than a quarter of connected sales failed within 36 months, the research found, compared with just 18 per cent of companies that failed where the purchaser was not a connected party.
Pre-packs - and trading administrations more generally - are not known for delivering high returns to unsecured creditors but those involving connected parties performed particularly woefully on this front, the research found.
Of the 499 pre-packs studied, in the 121 cases where a distribution to unsecured creditors was made, the median payment was a paltry 4.3 pence in the pound, with the middle 50 per cent of cases spread between 1.5 pence and 12.9 pence.
But the research also found that a creditor is more likely to receive no distribution at all in connected pre-packs than unconnected ones.
Distributions paying more than five pence in the pound of the unsecured creditors' debts are also less likely in connected cases.
For the counterfactual 110 trading administration cases studied, where a known dividend was made, the median was 7.0 pence.
Graham outlined a number of allegations industry onlookers made against connected-party sales during her research, the most damning of which is that the practice is a "sham simply to ditch debt".
"It is easy to sympathise with the creditor who has lost a potentially large sum of money in the administration and then sees the director(s) of the old company operating the new company from the same premises," she said.
"With those directors, as was said to me on several occasions, still ‘driving the same Rolls-Royce through the factory gates'. In such situations creditors' perceptions of pre-packing, and indeed the whole insolvency regime, will not be positive."
But Graham argued that simply being a connected-party case does not make the pre-pack "bad".
"I cannot ignore what defenders of pre-packing, including those in favour of connected pre-packs told me," Graham said. "Often the connected party may be the only party willing to make the best or only offer for the business. They may see it as their livelihood and want to ‘have another go'."
The report also upheld some of the other key concerns cited by critics of pre-packs, including the lack of transparency around the process. The marketing of pre-pack companies for sale is "insufficient", Graham added, with her research's evidence showing that where no marketing is carried out, pre-packs return less money to creditors.
More must be done to explain the valuation methodology, Graham added. Independent valuations were conducted as part of the pre-pack process in 91 per cent of cases studied, however, these appear to be "desktop valuations" only, she said.
But based on the empirical evidence, Graham concluded that pre-packing can boost jobs, is cheaper than downstream insolvency methods and may bring "limited benefit" to the overall UK economy.
"My conclusion based on this evidence is that there is a place for pre-packs in the UK's insolvency landscape - I do not recommend the banning of pre-packs," she said.
Giles Frampton, president of insolvency trade body R3, welcomed Graham's findings, arguing that debate around pre-packs has long suffered from a lack of empirical evidence."
As the report says, pre-packs can help save jobs and do provide benefits for creditors too," it said. "The report will help dispel some of the myths that exist around the pre-pack procedure."
But Pacey argued that Graham's recommendations do not go far enough.
"There have been many attempts to clean up insolvency rules but the fact remains the UK is still a great place to fail with no real tangible penalty attached, either fiscal or reputational," he said.
Of the 20,000 businesses listed on Companies House that go through an insolvency procedure each year, about 600 to 700 of those are pre-packed administrations.
Although pre-packing is a well-known concept, nowhere in statute is it defined or referred to. However, case law has established that pre-packing is permissible by law.
It is also a widely understood concept, taken to refer to the sale of all or part of a company's undertaking before formal insolvency is entered, with the sale to be executed at or soon after the appointment of an administrator.
It is likely that pre-packing increased after the implementation of the Enterprise Act 2002's amendments to the 1986 Insolvency Act, Graham's report said. This is partly because the lower costs opened up administration
generally to smaller, owner-managed companies.
Graham proposed that a "pool" of experienced businesspeople should be formed to enable independent scrutiny of a connected party pre-pack deal. This should improve transparency. However, approaching the pool will be voluntary.
Connected parties should also complete a "viability review" on the new company, although this would again be on a voluntary basis. This is designed to address the criticism that pre-packs allow firms with unviable business models to return to the market shorn of their debts, only to fail again.
All pre-pack businesses should also have to comply with six principles of good marketing. Any deviation from these should be brought to creditors' attention, Graham recommended.
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