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corporate clips

bargain hunt: minimising the risk when buying assets from insolvent companies

april 2009

Overview

Recent figures from the Insolvency Service show that in excess of 4,600 companies in England and Wales went into insolvency during the fourth quarter of 2008. This represents a 51 per cent increase on figures for the same period in 2007 - the biggest increase since the recession of the early 1990’s. In addition, over 2,000 businesses went into administration in the same three months, up 250 per cent from last year (although this includes 729 separate managed service companies for which BDO Stoy Hayward was appointed administrator, which were approved in September 2008, but registered in October, pushing up Q4 figures).

However, not all companies on these lists are worthless. In the current economic climate, a business may be forced into insolvency because it has been unable to raise funds or obtain credit, despite having some valuable assets. Companies who are able to weather the current financial storm may be able to pick up these assets at a highly reduced “fire-sale” price; but is such bargain-hunting without risk?

This edition of Corporate Clips considers some of the key issues for purchasers to consider when deciding to buy assets from an insolvent company.

Particular Concerns for a Purchaser

In a normal acquisition from a solvent company, the buyer will have based the purchase price on a number of assumptions about the business, supported by a number of warranties given by the seller. This in turn leads to the seller disclosing information about the company against the warranties. If any of the warranty statements turn out to be untrue (or the disclosures made are inaccurate), the buyer has a mechanism for retrospective price adjustment.

A purchase from an insolvent business is very different – the insolvency practitioner will not have been involved in the business and so will generally refuse to give any warranty protection in respect of the assets being purchased. Timing is also hugely important – the longer the assets remain with the insolvent company, the greater the risk of deterioration in value of those assets or the risk of losing valuable customers or employees.

The buyer will therefore have a limited time period in which to conduct a due diligence review of the assets it is buying. It is for this reason that the price paid for assets from an insolvent company is usually exceptionally low – the buyer assumes significantly more risk, and may not (given time constraints) be in a position to mitigate that risk in any meaningful way.

Key issues for the buyer to consider are typically:

Title to the assets - the main concern for the purchaser will be to ensure that the company owns the business and assets it is looking to sell (and such assets are free from any charges or mortgages). This is particularly important in a group context, where the assets of an insolvent subsidiary are being sold.
Retention of title - it may be the case that certain assets of the insolvent company were provided subject to retention of title provisions (ie that title does not pass until the goods have been paid for in full). In reality, knowledge of such provisions and an according adjustment of purchase price may be the only way to deal with this.
Employees - contracts of employment will usually transfer to the buyer without variation on an asset sale. Having the seller sack employees before the sale will not get around employment legislation.
Contracts - typically, customers and suppliers will have a right to terminate when the company became insolvent; continuing relationships may need to be renegotiated.
Pension schemes - if a buyer takes over the existing pension scheme of the seller, it could end up being liable to make good all losses arising under the scheme.
Cash consideration - insolvency practitioners are mainly concerned with obtaining the best tangible offer which enables swift distribution of cash to creditors; they will not usually consider deferred consideration or shares in the purchaser as part-payment.

Phoenix Companies

Many businesses do not succeed at the first attempt. According to research by BERR, over a third of small businesses close within the first three years. In some cases, though, a company unable to trade out of its difficulties may be able to continue operating and retain staff by transferring the profitable elements of the failed business to another legal entity. Such resurrected “phoenix” companies may be perfectly legitimate – the former directors doing all they can to get the business up and running again.

However, this regime can easily be abused – unscrupulous directors may seek to deliberately put their debt-ridden business (AshCo) into insolvency, set up a separate legal entity with the same or similar sounding name (PhoenixCo) and have PhoenixCo buy the assets of AshCo at a vastly reduced price. PhoenixCo continues the business of AshCo in a similar manner but without its liabilities and creditors.

Insolvency legislation looks to punish such directors and to safeguard the creditors of PhoenixCo, many of whom are likely to have suffered losses as a result of the insolvency of AshCo (unsurprisingly, phoenix companies tend to have very poor trading records - they are, after all, for the most part replicating a failed business model). However, it can also have an effect on a legitimate business which purchased the brand and assets of an insolvent company but which seeks to utilise the knowledge of former directors.

A person who was a director or shadow director of AshCo within 12 months of its going into insolvent liquidation is generally prohibited from becoming a director of any phoenix company with a prohibited name at any time during the next five years (unless he is granted leave to do so by the courts or has notified creditors of AshCo within a strict time period prior to joining PhoenixCo). A name is deemed to be “prohibited” if it is a name by which AshCo was known in the 12-month period before its liquidation or if it is a name which is so similar as to suggest an association with AshCo.

Breach of this prohibition is a criminal offence, and the offending director may also find himself personally liable for the debts of PhoenixCo. He would also face criminal and civil liability if he was involved with the promotion, management or formation of PhoenixCo even if he was not actually appointed as a director of PhoenixCo.

This can be problematic if the legitimate buyer of assets from AshCo when using a similar name to AshCo seeks advice from former directors of the insolvent business or – for example – looks to engage them as consultants or employees to PhoenixCo. Whilst this may make good business sense – involving those who are best placed to make the most of the assets purchased from AshCo – it can open the former directors up to criminal and civil liability (and whether they knew they were breaching insolvency legislation is irrelevant - the liability is imposed regardless of knowledge or intention).

In addition, the new directors of PhoenixCo, together with PhoenixCo itself, may also be liable for the payment of PhoenixCo’s debts if they have acted or have been willing to act on the instructions of the former directors, knowing them to be in breach of the general prohibition.

Clearly, liability (whether civil or criminal and for any of the parties involved) is extremely undesirable. Any purchasers of assets from insolvent companies in this situation should look to obtain leave from the court to enable former directors to act for PhoenixCo or ensure that the relevant notifications of the former directors’ appointments have been given to creditors within the necessary time scales. Until such time as the court order is obtained, PhoenixCo should look to minimise risk by ensuring that all debts of PhoenixCo are paid on time.

Conclusion

Given the lack of meaningful warranty or indemnity protection given by the insolvency practitioner, a careful due diligence operation in the time available will be the purchaser’s only real protection.
A buyer looking to exploit the brand of an insolvent company should also be wary of engaging former directors of the business without first taking proper advice.

If you have any questions or would like to discuss anything in this article in more detail, please contact Andy Moseby at Kemp Little LLP on 020 7600 8080.