Pre-Packs save financially distressed companies

By December 18, 2019 December 20th, 2019 3 Comments

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1.   What is Pre-packaged administration?
A pre-packaged administration is a pre-planned insolvency procedure wherein a company arranges to sell its assets to a buyer prior to filing for insolvency to facilitate the sale and the creditors and shareholders approach a bankruptcy court with a pre-negotiated corporate reorganization plan (the “Pre-pack”). This sort of company rescue procedure significantly reduces the time taken in lengthy court proceedings for businesses undergoing financial distress.
Alternatively, the business or material assets can also be sold to the existing directors/promoters operating under a new company, which is usually resorted to if the business is facing serious problems and creditor threats. The director/promoter of a failed business may wish to purchase its assets or business in order to form a new company.
2.     Why Pre-packs?
Among various advantages of Pre-pack, the one which is the most important is that it is debtor focused and not creditor focused. The Pre-pack procedure aims at saving the business, its value, IP value and ensuring business continuity and at the same time works towards bringing the company out of the financial distress it is facing. Following are the other advantages of Pre-pack:
(a)          Business continuity: In most industries a break in the company process will inevitably have a detrimental effect on the business. However, carrying out business during insolvency may not be an option if, for example, no funding is available, or if it is not possible to comply with regulatory requirements. Pre-packs facilitate a quick and relatively smooth transfer of a business, allowing the business to continue uninterrupted.
(b)          Value protection: News of insolvency or financial difficulty can result in a reduction in the value of a business, as customers, suppliers and employees lose confidence in the business. The risk of value diminution can be avoided by completing a Pre-pack before the news of the insolvency reaches the marketplace.
(c)          Job preservation: Cost-cutting and reduced operations during insolvency can result in job losses. Job preservation is often one of the main reasons for using Pre-pack. Avoiding redundancies and securing continued employment for the employees of the business is not only of benefit to the economy generally, but also to the creditors, as it reduces the number and value of preferential and unsecured claims in the insolvency.
(d)          Reduced costs: The costs associated with trading a business in insolvency can be significant. As control of the business and the risks and costs associated with it are transferred to the purchaser immediately or shortly after the appointment, the administrators can avoid incurring trading costs. Consequently, the costs of Pre-pack should be lower and result in greater return to creditors.
3.     Issues in Insolvency in the Indian context
There are few gaps in the Indian insolvency law that merit due attention. Firstly, value destruction – the debt companies entering the formal insolvency process under the Insolvency and Bankruptcy Code, 2016 (the “Code”) often experience avoidable value destruction (as it becomes difficult to preserve the value of an insolvent company). This is because the insolvent companies with viable business, upon their entry into the formal insolvency process are inadvertently pushed into liquidation, instead of being successfully restructured or their businesses being sold as a going concern.
It is imperative to note that by delaying initiation of restructuring, which is a procedure meant to realize the enterprise value of the company by reorganizing its capital structure, the insolvency law in India also causes further value destruction. The earlier the restructuring procedure is initiated, the higher are the chances of preservation of value of the business and its (remaining) enterprise value. If the debts are not restructured early, the corporate debtor may enter formal insolvency procedure, which may further depress the enterprise value.
Secondly, the law employs the committee of creditors (the “COC”) to be comprised with a super-majority of financial creditors and entrusts the decision about future of a corporate debtor with this COC (the COC may by 66% (sixty six percent) vote decide on the future of the corporate debtor). It is these financial creditors in the COC whose payoffs may not be necessarily affected by the outcome of the decision and they may not have the right incentive to preserve the value of the business of the corporate debtor. This results in discrimination against the financial and operational creditors as the latter do not have any representation or vote on the COC. Further, under the ‘creditor protection rules’, the resolution professional has to examine and confirm that the plan should provide repayment of the debt of the operational creditors which shall not be less than the amount to be paid to the operational creditors in the event the company was liquidated.
While empowering the majority financial creditors (with at least 66% (sixty six percent) vote by value) to impose a restructuring plan on operational creditors as well as dissenting financial creditors – the ‘cramdown’ provision, it facilitates restructuring but simultaneously also raises the possibility of abuse and the law does not provide for judicial supervision to ensure fairness in a resolution plan adopted by cramming down the minority financial creditors.
Insolvency law versus Corporate Restructuring under the Companies Act, 2013:
Unlike the Indian insolvency law, the restructuring provisions under the Companies Act, 2013 (the “Companies Act”) is much less potent since it does not allow a cross-class cramp-down provision. Additionally, unlike Section 14 of the Code, wherein a moratorium is declared on individual recovery action against the assets of the corporate debtor, the Companies Act does not provide for an automatic statutory moratorium. These hurdles make debt restructuring through the Companies Act far more difficult than through the Code.
The Code is still work in progress, but in all probability, it could prove to be the key to solving India’s bad loans mess.  
4.     How Pre-pack solves the above issues
The Pre-pack set up helps in preserving the organizational capital of the corporate debtor as the process helps in facilitating creation of a platform for negotiation between creditors and external financiers. Consequently, the Pre-pack can seek to facilitate going concern sale of the business of the corporate debtor at ‘fair value’ during the insolvency resolution process and not merely break-up ‘liquidation value’. Fair value means the estimated realizable value of the assets of the corporate debtor, if they were to be exchanged on the insolvency commencement date between a willing buyer and a willing seller in an arm’s length transaction. However, liquidation value on the other hand means the estimated realizable value of the assets of the corporate debtor, if the corporate debtor were to be liquidated on the insolvency commencement date.  
Further, Pre-packs can significantly reduce the time taken in the insolvency process as most ground work involved in negotiating the resolution plan and obtaining approval of creditors can be achieved before commencement of the insolvency process. The promoter and management of the debtor will have greater incentives to co-operate as it will allow them to negotiate directly with creditors and investors to achieve a plan that maximizes the value of assets of the debtor, while balancing the interest of all stakeholders.
5.     Pre-packs in Indian Context
In Indian context, if the Pre-packs were to be introduced in the Code, it would offer additional benefits. It would enhance the certainty of the resolution process. Often, the resolution process can be unpredictable on account of suspense over availability of prospective resolution applicants, continuation of business of debtor, availability of interim finance, disagreement over valuations, potential litigation and delays. Pre-packs would offer additional benefits, such as, it would enable the corporate debtors and financial creditors to negotiate and agree on a plan to resolve the insolvency of the corporate debtor with a prospective resolution applicant, without first commencing the insolvency resolution process under the Code. Once the plan is agreed upon by the financial creditors holding 66% (sixty six percent) of the debt of a corporate debtor, insolvency proceedings may be initiated under the Code to get the resolution plan formally approved by the COC and confirmed by the National Company Law Tribunal (the “NCLT”). The plan approved by the NCLT will become binding on creditors, members of the company, guarantors, employees and other stakeholders.
In cases where such a pre-negotiated plan is submitted, the corporate debtor is allowed to remain in possession of the business, under the oversight of an independent insolvency professional, appointed as chairman of board of directors, which helps in prevention of disruption in cases, where there is no trust deficit between the creditors and the debtor. However, in cases where no such pre-negotiated plan is submitted, the debtor is to be displaced from the business and a way is made for an independent insolvency professional to run the enterprise as a going concern and invite plans from the market.


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