The Graham pre-pack review – Why is everyone cheering?

Theresa Graham’s report on pre-pack administrations has been out for a while now and the bit that we cannot understand is why the Insolvency Service and all the regulators seem to be saying how great it is. We’ll look at each recommendation in a moment, but the thing that jumped out for us first was that although the report trots out the same old platitudes about pre-packs being a good thing and that “all” that is needed is yet more transparency and disclosure, it appears to be overly reliant on a flawed assumption and some research that is arguably of limited use. 

The reason for several of the recommendations was that there was a close correlation between agents’ valuations of assets and the amounts realised in connected party sales. The assumption made in the report was that this was because agents were being presented with the connected party’s offer and asked to confirm that it was sufficient. From what we see in practice, this could not be further from the truth. From what we see on our visits to a wide range of smaller and medium-sized insolvency practices, the connected party usually offers a low figure, based on their knowledge of break-up values and depreciated cost values in their accounts, and that is then driven up because the IP instructs independent agents to conduct a formal valuation which results in a higher “in situ” value. The IP then tells the connected party that they need to increase their offer to get close to the higher “in situ” value. From what we see, in pre-packs involving the lower end of asset values, which is where the bulk of pre-packs to connected parties occur, it is nearly always only the connected party that is prepared to pay anything like the “in situ” value. In addition, in most cases, unless exceptionally good reasons are given and disclosed afterwards, a period of marketing is used to check that there really is no serious alternative interest. That was not always the case in the past, but SIP 16 has driven improved standards and it is now very rare to see a deal done without some significant attempts at marketing.

The research used to support much of the thinking in the report is based on a random sample of 500 pre-pack administrations from 2010. The first version of SIP 16 was effective from 1 January 2009 and was supplemented by Dear IP 42 in November 2009 after much-publicised problems with the way that the insolvency profession interpreted SIP 16, when compared to how the Insolvency Service considered that they should have interpreted it. Since that time the regulators, the insolvency profession and the odd compliance consultancy have all worked very hard to improve all aspects of pre-pack procedure and disclosure and it is somewhat galling to have recommendations passed down based on detailed analysis of how things used to be done. We knew that things were not done as well in 2009 and 2010 as they are now. That is why we have all worked so hard to make them better and we hardly needed a load of detailed research to state the blindingly obvious. Maybe next we could do research into a random sample of 1980s car engines and make some recommendations about how modern cars should improve emissions!

So, we have a series of recommendations to address some noisy complaints about one insolvency solution that represents a fraction of the total volume and value of insolvency appointments each year, based on arguable research and assumptions and supported by a public perception that pre-packs are wrong. Between the two versions of SIP 16 and the various investigations and reviews, we do start to wonder whether the changes brought in to address the criticism of pre-packs actually costs more than the benefit that any “improvements” might make in any event, even if you believe that they will really be improvements. Sorry if we sound a bit jaded, but isn’t it about time that someone recognised how good our insolvency system actually is, for all its foibles and unusual ways? There will always be losers in insolvency, it is the nature of the beast, but our system and the insolvency regulators and practitioners who constantly strive to make it work, results in millions of pounds being returned to creditors and thousands of jobs saved every year. Maybe, once the new rules are issued, someone will give the system a chance to settle so that we can see which of the myriad changes actually work in practice over the long term.

The Graham review made six recommendations and for the rest of this article we’ll comment on each one, in varying degrees of detail:

Key recommendation 1: Pre-pack Pool. On a voluntary basis, connected parties approach a ‘pre-pack pool’ before the sale and disclose details of the deal, for the pool member to opine on. (Just as a side note, shouldn’t any use of the word “opine” in a public document automatically result in the document being redacted for being pretentious?)

Although things may change in time, we currently hear that many of the organisations approached to work on the pool are not keen and there is a rumour that the only real interest is being shown by some of the larger law firms, which is likely to drive the cost up. The problem that we saw immediately is that those with enough knowledge of insolvency and pre-packs to “opine” on any such details are likely to be conflicted on many occasions because of their familiarity with the participants. Indeed, it has been made clear that IPs, and former IPs, need not bother applying for a job as a pool member. The alternative is to have the deal reviewed by someone with no direct knowledge of insolvency, leading to misunderstandings, further explanations, re-work and additional cost.

At the recent SESCA Conference we asked the Insolvency Service speaker what would happen if nobody will act in the pool. The answer given was that they will implement the proposed legislation to ban connected party pre-packs. So, we have a flawed solution being imposed on the profession based on flawed assumptions and research on how the profession used to work, that we have to make work. Furthermore, if we cannot find anyone mug enough to sit on the pool we will have failed to implement the solution so it will be our fault that the Insolvency Service then have to activate the legislation that they are already putting in place to outlaw pre-packs to connected parties!

In addition to practical concerns about the pool, our objections to this proposal are its costs, some significant questions about the liability attaching to it and our suspicion that it won’t address the problem anyway. Nobody yet knows what the cost of such an opinion will be, but we think that if this recommendation is followed through, then the connected party is unlikely to attempt to complete it themselves and will instead pay a professional to produce it. That may be the lawyer that they use for the purchase, an independent professional such as an accountant, or the IP intended as administrator. This will effectively mean the IP producing the SIP 16 statement early, but will the cost be covered by the connected party direct, presumably reducing the pot available to purchase the assets and business, or will it fit the definition of “pre-appointment costs” that can be authorised under the existing legislation, effectively just moving the cost from the post-appointment fees into the pre-appointment costs? We suspect that a “going rate” will develop, but we’d be surprised if it was under £2,000 and we would not be surprised to see some reports cost £5,000 or more, dependant as much on who produces it as the complexity of the deal itself. Whatever happens the losers will be the creditors as it will just reduce the funds available to them.

We are not sure whether anyone has considered the implications for anyone prepared to give an opinion on a pre-pack, but it seems to us that notwithstanding the comments in the report and elsewhere to the contrary, there are all sorts of potential liability issues attached to the connected party, anyone who helps them draft the report and anyone who acts on the pool. We are sure that a good lawyer will soon design wording to restrict the liability at each stage, but ultimately the effectiveness of any such clause will have to be established, probably through legal challenge. We suspect that it may be difficult to find a connected party, an advisor and enough people to form an opinion pool that are all prepared to risk the potential liability. Maybe they will be able to get some form of indemnity or insurance, but that would again have a cost impact.

Additionally on this point, which you may by now have noticed is one of our main causes for concern, we just don’t think that it will achieve what is intended, as it will not address the suspicion around pre-packs. We don’t think that those complaining about pre-packs will be satisfied with a report from the pre-pack pool, which will then mean them demanding something even more onerous and probably not stopping until pre-packs have been banned altogether.

Although it is clearly too late now, the die having been cast and the legislation drafted to enforce the recommendations, we have to say that we also don’t think it is a problem that needs addressing. The whole point of a pre-pack is that it obtains a premium for the business by conducting a quick sale without leaking damaging information to the marketplace and undermining the business. The closer the management and ownership of the purchaser is to the deal, the more they are likely to pay a premium to keep “their” business. As a small business ourselves, we know how protective business owners can be over their investment and we think that the majority of suspicions about pre-packs are unfounded. Even the review data was based on how pre-packs were operated over 3 years ago and we and the regulators have spent a lot of time educating and persuading IPs so that nearly every current case is accompanied by as much marketing as can reasonably be undertaken without damaging the pre-pack deal itself. If the current additional detail is still not enough to address the concerns of the small but vocal complainants, then we think that the time has come to recognise that pandering to their objections is costing the general body of creditors too much. We consider that a better solution would be to require all pre-packs to include a conditional clause, allowing the whole deal to be reversed in the unlikely event that the general body of creditors, including the secured, preferential and contingent creditors rather than just the noisy minority, vote against the proposals. This would allow the costs of the deal to be driven down, limit the disclosure to current SIP 16 levels and give the vocal minority the opportunity to vote, and be outvoted by those with a greater interest in the outcome. It would also ensure that the purchaser paid enough to ensure that nobody in their right mind would vote to overturn the deal

Key recommendation 2: Viability Review. On a voluntary basis, the connected party complete a ‘viability review’ on the new company.

We’ll keep our comments here to a minimum because they mirror many of our concerns about the pre-pack pool. We believe that the cost implications of this proposal will drive down returns to creditors. 

We do, however, have an additional point, in that this recommendation seems to show a lack of emphasis on where the duty of an administrator lies. The administrator’s duty is to maximise returns for the creditors in the proceedings that he is responsible for. While he should not be blind to the longer term effects of his decisions, he has to give priority to those who have already lost money. The future viability of the new company is a matter for anyone who deals with that company. Why should the existing creditors of the old company, who have already lost a significant proportion of their debt, suffer additional cost to check out the viability of a new company that, if they have any sense, they will only deal with on more cautious terms anyway? If you were, say, the paper supplier to a print company and lost a load of money, then you received a detailed pre-pack disclosure telling you the name of Newco, surely you will think long and hard before deciding what terms to deal with the new company on. How is that going to be helped by a report from the connected party telling you that they think that the new company will do things better going forward? In reality, you know that in all likelihood they are starting with a reduced working capital and cashflow position because of purchasing the old business and you will only extend limited credit if you deal with them at all.  

Recommendation 3: SIP 16: that the Joint Insolvency Committee considers, at the earliest opportunity, the redrafted SIP16 in Annex A.

This should be, to anyone remotely connected with the regulation of the insolvency profession, one of the silliest recommendations. While we have no objection to SIP 16 being revised to implement one or more of the review’s recommendations, the thought that a single individual’s opinion of how the SIP should be worded would ever be acceptable is madness! The original SIP 16 was produced by some of the brightest minds in insolvency and was then revised by the combined might of the Insolvency Service and the JIC. What on earth possessed an individual to think that they could do better? By all means make recommendations and invite the JIC to consider revisions to the SIP, but please remember that the SIPs carry almost as much weight within the regulatory system as the legislation itself and it would be foolish in the extreme to change the regulatory framework based on the drafting skills of an individual, however well-intentioned.

Recommendation 4: Marketing: that all marketing of businesses that pre-pack comply with six principles of good marketing and that any deviation from these principles be brought to creditors’ attention.

Seems to be a good recommendation. ‘Nuff said.

Recommendation 5: Valuations: SIP16 be amended to the effect that valuations must be carried out by a valuer who holds professional indemnity insurance.

Likewise, a good recommendation, although we are not sure how significant it is because we’d have expected most agents to have PII anyway.

Recommendation 6: SIP 16: that the Insolvency Service withdraws from monitoring SIP16 statements and that monitoring be picked up by the Recognised Professional Bodies.

The drama that has blown up around this is all a bit over-the-top, in our opinion. The regulators already monitor SIP 16 statements. They do so in an appropriately-weighted fashion within the bounds of their existing monitoring procedures, if anything giving them more attention than they deserve because the regulators perceive a greater risk as a result of the relentless attention that pre-packs have received since 2009. The recent farce around the Insolvency Service withdrawing from SIP 16 monitoring via Dear IP, then initially using a different database to notify only some of the original recipients that they had changed their minds and wanted to continue receiving SIP 16 statements for now, just shows how silly the whole thing is. It appears that the Insolvency Service is going to keep receiving a copy of every SIP 16 statement, despite the review saying that it is unnecessary, while someone designs an official system to show that the regulators are doing what they have been doing anyway for the last 5 years.  

So, by way of a conclusion and probably a much needed apology to Theresa Graham and those that think that the review deserves more respect than we are giving it, we admit that we have been a bit harsh to make a point. This is insolvency and there is rarely a single definitive approach to a problem, especially when that problem only exists in the perceptions of a vocal minority. If the review’s recommendations were being used as a starting point from which to consider improvements to SIP 16, legislation and industry practice generally, we would not need to be so hostile. Unfortunately, however, they are being held up as universal truths and some form of Holy Grail, backed up by the threat to use “reserve powers” (see our forthcoming article about this iniquitous abuse of legislation). We disagree and think that this will be a costly and ineffective waste, and with everyone else professing undying love for the review, we thought somebody had to speak up in opposition.

Just a reminder – our day job is helping IPs comply with the rules and regulations imposed by others. Despite our opinion, we will, of course, continue to help IPs do what they have to and we have no intention of leading a rebellion or advising IPs to do anything that will not fully comply with the word and spirit of any revised SIP or legislation.