Opinion : Chancellor worries banks on insolvency

No creditor likes to have his existing rights diluted in any way
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The Independent Online
In his Budget speech, the Chancellor said the Government would be consulting on a proposed 28-day moratorium, "binding on all parties", to improve the company voluntary arrangement (CVA) procedure, and also on a proposal for debt-for-equity swaps.

These statements have started some alarm bells ringing.

We have known since a DTI Consultative Document in October 1993 that the Government favoured a 28-day stay, and that having considered everybody's views they would be issuing a further consultative document setting out their preferred option, which shou l d be available early in the New Year, when we can all presumably say what we think. Given this commitment to consultation, why the alarm bells?

Many insolvency practitioners have been saying for years that CVAs, accounting for less than 0.5 per cent of all corporate insolvencies, are structurally flawed. In particular, without something like a 28-day stay there is no breathing space in which rescue plans can be developed free from the threat of creditors taking steps which might destroy the business.

"The controversy has two foundations. First, no creditor likes to have his existing rights diluted in any way: he needs to be convinced that any process that suspends those rights offers a real prospect of a better outcome, ie, a rescued customer. Secon d , what safeguards will ensure that no mischief occurs during the stay? Banks are concerned that they could be prevented from appointing a receiver. It has been suggested that they should give seven days' notice of intention to appoint a receiver. This w o uld give the company the chance to start the CVA procedure, even if it were quite inappropriate.

No one could be obliged to give banking facilities to an insolvent company that had unilaterally imposed a stay, so the business would probably fall apart anyway. For commercial reasons banks must have the right to opt into any stay, and a better option would be to require the company to give senior creditors seven days' notice of its intention to commence the process (which could be shortened by agreement in urgent cases). All creditors could take comfort that at least one major creditor had bought in to the company's rescue plans, so it would be likely that those plans amounted to more than a delaying tactic.

This suggestion would effectively turn the senior creditors into the first line of defence against CVAs being used in hopeless cases. Junior creditors may think this is unfair, but senior creditors "own" the assets of an insolvent company, and have been given the right to decide under a contract freely entered into by the company. It would be unfair to retrospectively diminish the senior creditors' contractual rights in tens of thousands of companies, and could affect both the availability and also the cost of bank finance - for solvent companies, too.

Several more safeguards are needed during the stay. At a very early stage other major creditors need to be brought into the process. An insolvency practitioner must be appointed to ensure that decisions are not taken which could unduly prejudice any party. Some limits must be placed on the directors' powers in this period, with sanctions available if they exceed those limits. There must be a mechanism defining the rights and priorities of anybody who advances new credit during the stay. We need to know how the stay will affect creditors with special rights, such as landlords, finance companies, utilities, and creditors with contractual rights to recover for goods that have not been paid for.

Once a rescue plan is on the table, there must be clear voting rules setting out how any such plan may be approved. There has been plenty of litigation about voting rights under the existing law. There are also some very large issues to be considered, such as whether government debts should continue to be preferential, discouraging other creditors from voting for a rescue which might only offer them a minimal return. Until all of these questions are answered, it is impossible for anybody to judge whethe r the new procedure would be good, bad or just plain ugly.

More confusion arises from the Chancellor's statement that a debt-for-equity swap procedure is being considered. This flows from an interesting paper written by three eminent professors of economics. They have since carried out further research, includi n g some work with Coopers & Lybrand. The concept involves all creditors' debts being replaced by shares, recognising the different priorities between classes of creditors. The company then has its existing assets, no liabilities (so it is solvent), and n e w shareholders who should make whatever economic decisions are most rational for maximising their investments.

However, even the strongest advocates of this system (probably including its authors) would admit that we are a very long way indeed from turning an interesting theory into a fully-formed insolvency procedure which will work at the sharp end. Again, ban k s are sceptical. They can and do carry out debt-for-equity swaps when that is the right thing to do, but should such swaps be imposed on them against their will when they might see advantages in pursuing another route?

Will an ordinary trade creditor prefer holding shares in failed customers to dividend cheques (however modest), with all the problems of managing such an investment portfolio? Will government - nearly always a significant creditor - want equity stakes inthousands of private companies?

This particular scheme may need another year or so before it can be properly debated. No such system has ever been used anywhere in the world.

There was no need for the Chancellor to mention insolvency in the Budget. By doing so, when there are no detailed proposals available to debate, banks have been encouraged to expect the worst. If that makes them rather more cautious lenders for the next few months, nobody should be surprised.

Chris Hughes is head of insolvency at Coopers & Lybrand.