We recently assisted a client to rescue her business using a Pre-Pack insolvency arrangement. This month we are going to look at the “Pre-Pack” insolvency process by reviewing a case study that shows how de Jonge Read was able to provide an appropriate strategy recommendation that was preferable to a direct liquidation or voluntary administration in these circumstances.
Our client’s company operated three well-regarded beauty salons in Melbourne under one of the most respected business brands in the beauty industry. Clients book weeks in advance for an appointment.
As everyone knows, Melbourne endured the longest pandemic lockdown in the world and the severity of those lockdowns had a devastating effect on our client’s businesses. Our client borrowed heavily to keep the business afloat and retain employees during the pandemic. It wasn’t long before pressure started to mount in respect of loan repayments and the increasing debt owed to the ATO for PAYG and superannuation.
But for the onerous loan repayments, and the ATO debts, our client’s excellent reputation in the beauty industry and customer demand meant that the underlying businesses were still viable.
In the circumstances, our client had three (3) choices:
Voluntary Administration; or
A “Pre-Pack” arrangement.
Liquidation was out of the question. For a variety of reasons (discussed later), Voluntary Administration was not attractive, but mostly because of the considerable risk that the goodwill of the business would be damaged by the formal appointment of a Voluntary Administrator (VA).
Based on our analysis, the best option was a Pre- Pack arrangement.
What is a Pre-Pack?
A pre-pack is a procedure used for rescuing an insolvent business without having to appoint a VA. Essentially it is a sale process where the assets and goodwill of the insolvent company are formally sold to a new company, usually with the same directors in control. The employees of the insolvent company would typically be transferred to the new company which would assume responsibility for their accrued entitlements.
The amount equal to the assumed entitlements is adjusted from the purchase price. The insolvent company is then placed into liquidation. The result is the new company is able to continue with the business without pressure from the old company’s creditors.
At the risk of sounding cynical, if directors go directly to an insolvency practitioner (IP), in most cases the likely result would be a Voluntary Administration or a Small Business Restructure. It is a grey area as to what advice an IP is permitted to provide directors whose companies are under financial duress. The IP’s fiduciary duty is solely to the creditors, not the company or its directors. Therefore, it is rare that an informal insolvency arrangement such as a Pre-Pack is recommended by an IP.
In our client’s situation, by coming to de Jonge Read BEFORE approaching an IP, we were able to add substantial value in recommending and project managing a Pre-Pack.
Pre-Pack Vs VA
The value-adding in recommending a Pre-Pack becomes more obvious when you compare the two:
A Pre-Pack is much cheaper than a VA;
Pre-Pack ensures continuity of the business;
Directors remain in control of the business;
A Pre-Pack is much quicker than a VA (days compared to weeks);
Pre-Packs are quite common internationally. e.g. Similar versions have been part of the Canadian and U.K. insolvency landscape for several years. In the U.S.A they are used as part of a Chapter 11 filing;
In many cases it can allow for the preservation of goodwill and brand;
There can be more security for staff with a Pre-Pack;
Pre-Packs commonly have higher retention of customers and suppliers;
A VA can be invasive and detrimental to business;
There is no assurance that the VA will allow the business to go on given the personal risk exposure of the VA if the business suffers a short term loss;
Pre-Pack can often provide creditors with a better outcome compared to a sale under a VA.
If our client had initially gone to an IP instead of de Jonge Read, it is unlikely that the above factors would even be considered.
There is a risk in preparing a Pre-Pack and there is a need to proceed with caution in order to avoid a claim for illegal phoenix activity which can result in civil or criminal actions against directors who are involved in, or enable, such activity. Put simply, the buyer must pay commercial value for the assets being purchased.
The main difference between a legitimate phoenix business rescue and illegal phoenix activity is the director’s dishonest intent or recklessness. A good sign of illegal phoenix activity is where the transferring of assets for below market value occurs, and/or where the primary purpose in liquidating a company is to defeat creditors.
Independent valuation obtained.
New company registered.
Sale contract signed.
New company paid market value.
Staff transferred to the new company.
New company assumed responsibility for staff entitlement.
Assumed staff entitlements off set against the purchase price.
Business continued without any interruptions.
With our assistance, our client obtained independent valuations from a reputable valuer whose recommendation formed the basis of the sale price. This avoided any suggestion the transaction was designed to defeat creditors because the price paid was less than either the market value or, the best price reasonably attainable.
The determination of market value is crucial when the sale is not offered to the open market.
In cases where a fair market valuation is more difficult to obtain it may be more feasible to license the business first. The new company can then negotiate a price with the liquidator thus avoiding any suggestion of illegal phoenixing.
The truth is pre-packs serve a purpose and fill the void when administration cannot assist.