Anyone for Dominoes?

No, not pizza or the game, but what is often referred to as the Domino Effect, the cumulative effect produced when one event sets off a chain of similar events. In some ways not dissimilar to the “R number” referred to by epidemiologists when talking about the spread of the Coronavirus. As the UK economy struggles with the impact of the COVID-19 virus there has already been much talk and despair at the prospect of many businesses going bust. By that I mean filing for some form of formal insolvency process. 

A study by R3 in 2018 concluded that some 25% of business insolvencies were caused by the insolvency of a customer or supplier. If you assume those in the 25% will cause a further 25% to go under, you end up with around 33% of all insolvencies being caused by other insolvencies. In the current high stress situation of the COVID-19 crisis it seems highly likely that those figures could be very significantly higher as many more businesses are not able to survive the loss of customers, the bad debts that goes with them and the disruption from loss of key suppliers.

Bad businesses need to fail for the stronger, viable ones to thrive. That is the capitalist system and Insolvency has its place. But is it appropriate across the board in the current crisis where many businesses would not be in distress but for the Coronavirus lockdown? In the UK we have a system where most business that get into serious trouble and cannot pay their debts as they fall due, appoint an Administrator. A Licensed Insolvency Practitioner (IP) takes over the running of the business from the directors and looks to create value for the creditors by either selling the business as a going concern or selling the goodwill and assets or liquidating the business. Most Administrations end up with a sale of the goodwill and assets and the rump company is then liquidated.

A long time ago IP’s would commonly run the business for a while and attempt to sort some of the underlying problems in order to maximise the sale proceeds. The changes to the law in the Enterprise Act 2002 and most importantly, the fear of personal liability has all but stopped that and most asset sales take place very quickly. At the extreme is the pre-pack where the sale is lined up prior to the insolvency and goes through immediately the Administrator is appointed. It has all become a transaction-based process that just re-cycles assets as fast as possible with the least possible risk and no change to the underlying business operations. A whole generation of Insolvency Practitioners have little or no experience of actually trading or improving a business.

The transactional approach to insolvency relies on there being a willing pool of buyers for the assets with cheap finance to support them. That has always been the case up until now, with only the most hopeless of cases unable to be sold. Sales of assets out of Administration processes are normally without the normal levels of due diligence and few, if any, representations and warranties by the seller. Fire sale prices are low to allow for the risk and there have been plenty of financial and trade buyers willing to purchase at attractive prices. The COVID-19 crisis has brought that to a grinding halt. Who will buy amid such uncertainty, how would they do any due diligence and who would fund the transaction? Yes, there are funds that have lots of money, but they have their own agenda and are normally only active at the top end of the market. It isn’t going to happen on the scale required and that will just lead to businesses being liquidated.

Studies have shown that insolvencies produce some return for secured creditors, normally banks and other types of lenders, but unsecured creditors such as suppliers get close to zero. That is why the Domino effect occurs and why the COVID-19 situation is potentially disastrous for UK businesses.

The UK government is proposing altering insolvency laws to help businesses impacted by the crisis. Many countries have already amended their laws. So far, the government’s response has been to relax the laws around wrongful trading. It also says it will bring in major changes debated and consulted on from 2014 to 2018 but which never made it to the statute book. Those proposals aim to create a “Chapter 11 lite” regime. There are several thrusts to that proposed legislation but the one of most relevance to the current situation is a moratorium period where creditors cannot take any action, thus giving a business time to create a recovery plan and agree it with creditors.

All very laudable but there will be practical problems. The moratorium, as proposed in 2018, has to be supervised by an IP who will ensure the conditions for the moratorium are satisfied and who will presumably advise the business in its attempt to turnaround and restructure. Those with little other than transactional experience will struggle to identify the underlying strategic and operational problems and help it get back on track. If the only tool you have in your tool-bag is a hammer, then every problem looks like a nail. Will they all too quickly see the only answer as an insolvency process? If so then the objectives of the new legislation will fail.

Forecasts of how many businesses are going to face potential insolvency are as high as half a million. If these are remotely accurate there will be a severe resource problem. Recent years have seen corporate insolvencies of less than 20,000 p.a. so an increase to six figures would be huge. There are only about 1,250 IP’s active in the country. In a recent article in the Times, one senior IP who spoke on condition of anonymity said “there are probably 10% or 20% of partners who can actually do proper restructuring. Not many have that turnaround skill any more”. Recognised Turnaround Practitioners who are not IP’s and who work to resolve a company’s difficulties outside of formal insolvency number no more, maybe another 150-200, a small number compared to the forecast demand.

Something needs to be done to ensure we don’t see huge numbers of good businesses failing and recognising the role Turnaround Professionals can play is an important part. IP’s are already experimenting with so called “light touch administrations” where the management remain in place supervised by the IP. But these are only likely to work for larger cases. Management in most cases won’t have sufficient expertise and IP’s won’t take the risk unless they are very confident in management’s ability.

So how do we avoid being overwhelmed. Capacity could be increased by the new legislation recognising turnaround managers who do have extensive experience running and turning companies around as suitable professionals to act as supervisors. That was in the original government proposal in 2016 but not in the last version in 2018. Turnaround Professionals are used to working with management rather than taking over and can run light touch engagements in most cases, especially for smaller businesses. But that will still leave a huge gap that can only be closed by reducing demand. We have to find a way of helping the many good businesses hit by this crisis to survive.

Government actions are helping but aren’t fast enough and aren’t reaching all businesses. There is also a big question mark over whether loans, VAT deferments etc. are the answer when many businesses may never be able to pay them back. The government will be making announcements this week on business assistance as the lockdown is relaxed and we will await the detail before offering further thoughts on how we might avoid a tsunami of insolvencies and the resultant domino effect across the economy.