Update; The Corporate Insolvency and Governance Act 2020 commenced into effect on 26 June 2020. While the final provisions of the Act largely reflected the drafting of the original Bill, certain amendments were made including to: (i) improve the information available to certain pensions creditors in relation to a moratorium and restructuring plan; and (ii) prevent certain non-holidayed debts (including accelerated debts due under a financial services contract) from obtaining super priority in an insolvency process following within 12 weeks of the termination of a moratorium. The below update is based on the Bill’s original drafting. Our team will soon be publishing short videos considering each of the finalised Act’s reforms, as well as its likely impact on particular sectors.
The Government on 20 May 2020 published the Corporate Insolvency and Governance Bill, which contains the most far-reaching reforms to UK insolvency law for many years. The Bill has been introduced on an emergency basis in an attempt to ensure that otherwise financially viable companies survive during a period of unprecedented interruption and turmoil. However, it could upset the delicate balance between debtors and creditors under UK insolvency law.
Many of the proposed reforms could have been achieved with less radical amendments to the Insolvency Act 1986. Consultation with industry, practitioners or policy makers has been limited. Most fundamentally, the Bill introduces a debtor-in-possession insolvency procedure for the first time in English law. Introducing such sweeping reforms during a crisis risks unintended consequences. For landlords particularly, the legislation increases the risk that tenants will not make payments when due – the threat of serving a winding up petition has been weakened as has threatened forfeiture.
The focus of this briefing is what appears to be an unintended consequence of the new debtor-in-possession insolvency procedure, which could significantly impact the recovery for landlords. The draft legislation appears to grant super-priority to certain pre-moratorium unsecured debts (likely including unsecured banking and finance arrangements) which means that they will rank above other unsecured debts (including rent and other amounts due under a lease) where a company enters into administration or insolvent liquidation within 12 weeks of a moratorium ending.
In summary, the proposed reforms will have effect as follows:
New company moratorium: A novel, free-standing moratorium (unconnected to any other insolvency process) giving up to 40 business days of protection even without court or creditor approval during which a payment holiday will apply to all pre-moratorium debts except certain limited categories (principally for liabilities to employees and financiers). The moratorium prevents legal processes against the company, including commencing a claim, commencing insolvency proceedings, crystallising a floating charge and forfeiture. Directors retain management control. An insolvency practitioner will be appointed as moratorium monitor, responsible for ensuring that the moratorium is at all times likely to result in rescue of the company as a going concern. The monitor’s consent will be required for many company payments. Liabilities incurred during the moratorium will be payable as expenses, and therefore effectively prioritised. Fixed and floating charge assets will be capable of disposal subject to certain limitations.
Restructuring plan: Effectively an enhanced scheme of arrangement with similar broad scope, the reform allows the court to impose a compromise on a company's creditors and shareholders, including a cross-class cram-down. The compromise would need approval by the court and 75% of the creditors in each class (although the court can override rejection by one or more class).
Winding up petitions: Winding up petitions cannot be presented if based on statutory demands dated 1 March 2020 to 30 June 2020. Creditors will also be prevented from winding up a company unless the creditor has reasonable grounds to believe that coronavirus has not had a financial effect on the company or that the company would have become insolvent even absent coronavirus’ effect, which will be a significant hurdle for most creditors. Winding up will now commence from the date of the order, meaning that transactions entered into between the petition and the order will no longer be void unless validated by the court.
Ipso facto (termination) clauses: Contractual clauses permitting a supplier of most goods or services to terminate supply as a result of the customer’s entry into an insolvency procedure will cease to have effect. The supplier will not be able to exercise any pre-existing right to terminate either. Suppliers will also not be able to withhold supply to the company in insolvency until pre-insolvency debts are paid, preventing ransom payments being sought.
Suspension of wrongful trading: When determining what contribution, if any, a director should make to a company's assets following a finding of wrongful trading, the Court must assume that a director is not responsible for any worsening of the financial position between 1 March and 30 June 2020. While otherwise directors may feel compelled to cease trading so as to take every step to minimise loss to creditors once they believe that there is no reasonable prospect of avoiding insolvency, directors can now take some comfort that they will not be liable for any deterioration since 1 March 2020. This reform may allow directors to continue trading though other duties of directors will continue to apply, including the common law duty to have regard to creditors’ interests when a company is likely to become insolvent. Given the purpose behind the reforms is to ensure that companies continue to trade even when they are insolvent or in financial distress, the need for directors to consider these common law duties become ever more important to avoid personal liability.
Impact of the new measures on landlords
By preventing landlords from issuing statutory demands and winding-up petitions and by allowing companies to enter a pre-insolvency moratorium, this Bill may make it more difficult to recover unpaid rent arrears and other debts due under a lease.
The temporary prohibition on landlords exercising the right of forfeiture, announced in late April (see our briefing), has now been supplemented by the new moratorium.
During a moratorium, a tenant will benefit from a “payment holiday” in respect of pre-moratorium rent. It is not entirely clear from the legislation what a “payment holiday” is, nor the precise debts which benefit from such a holiday.
In relation to pre-moratorium rent, a landlord is not permitted to exercise its right of forfeiture absent permission of the court. Further, the landlord will not be able to commence legal proceedings to recover the rent, nor will it be able to present a winding up petition against the company. The draft legislation does not specify what impact the payment holiday has on the debt itself, including for example whether interest accrues during the payment holiday. If the company nevertheless wishes to pay pre-moratorium rent and the amount of such rent exceeds the greater of £5,000 or 1% of the company’s unsecured debts when the moratorium began, it will require consent from the moratorium monitor or a court order to do so. The monitor is permitted to consent only if he or she considers the payment of rent to support the rescue of the company as a going concern.
In relation to rent which arises during the moratorium, it appears that there will not be a payment holiday but that a landlord will nevertheless be prevented from exercising the right of forfeiture to recover it and from commencing proceedings absent permission of the court.
Unintended consequences of the new moratorium?
The Bill introduces a new Part A1 into the Insolvency Act 1986. Chapter 4 of that Part imposes “restrictions on the enforcement or payment of” certain pre-moratorium debts but is not clear whether those restrictions constitute the “payment holiday”.
It is nevertheless clear that certain pre-moratorium debts, including most significantly those owed in respect of wages and salary arising under a contract of employment and those owed under contracts involving financial services are excluded from the payment holiday.
In any winding up or administration that occurs within 12 weeks of a moratorium, any moratorium debts and pre-moratorium debts for which the company did not have a payment holiday during the moratorium are to be paid in priority to liquidation/administration expenses. This would mean that moratorium and pre-moratorium debts would rank ahead of the administrator or liquidator’s fees, preferential creditors, floating charge creditors and the claims of (other) unsecured creditors.
For landlords whose pre-moratorium rent is holidayed, those creditors who are not subject to the payment holiday will rank ahead of the pre-moratorium rent, potentially reducing the amount which landlords recover in any administration or liquidation.
However, it is not all bad news for landlords. For rent which relates to the period of the moratorium itself, there is no payment holiday. This rent will therefore gain priority although, given that the moratorium is intended to last for only a short period, may be low in amount relative to pre-moratorium rent which is outstanding.
Which debts could overtake landlords? The most significant category is of debts or other liabilities arising under a contract or instrument involving financial services. This is broad enough to capture most debts owed to banks and, because bank debt it not caught by the introduction of the ipso facto rule, banks would be free to accelerate debt which is not yet repayable or demand debt which is repayable on demand (including overdrafts) during the moratorium.
But it is much broader than that, because a contract involving financial services is defined not by the nature of the counterparty (i.e. a bank or financial institution) but the nature of the contract itself. It will therefore include all lending to the company, including intra-group, shareholder or related party lending (much of which is on demand).
We may also see that other counterparties seek to introduce lending structures into their contracts so as to benefit from the financial services contracts priority. For example, suppliers might seek to modify their terms so that where invoices are not paid on time, the balance is converted into a loan. Landlords might consider doing the same though it is more difficult to amend leases than it is for a supplier to revise its standard terms and conditions.
If all lending ranks ahead of pre-moratorium (but not moratorium) rent, landlords are likely to see the amount that they recover in any administration or liquidation which follows a moratorium greatly reduced, all the more so where landlords rank behind employees too.
The alteration of the ranking could also affect the incentives of other creditors. Creditors who benefit from the “super priority” created in respect of debts which are not subject to a payment holiday may be encouraging the company to enter administration or liquidation quickly after a moratorium which has not been successful in rescuing the company precisely so as to obtain this “super priority” status.
We intend to publish more detailed analysis of each of the proposed reforms in the coming weeks, including more on the potential unintended consequences that might arise. We are aware that representations are being made to Government concerning the “super priority” consequence so it is possible that this will not be carried through to the Bill once enacted.
Our restructuring and insolvency team’s initial analysis of the proposed reforms when they were first announced at the end of March can be found here.
We strongly advise landlords to be aware of the proposed changes to the UK insolvency regime and to understand how they may impact their tenants. If you wish to discuss these changes further please contact our experts below or speak to your usual Herbert Smith Freehills contact.