The 'Preserve or Break Up' Decision

A well-designed insolvency regime seeks to sift insolvent companies which are economically distressed from those which are merely financially distressed.

Economic Distress and Financial Distress

A company is economically distressed if the total value realised from its constituent assets — land, labour, capital, and entrepreneurship — would be higher if such assets were removed from its business and disposed of piecemeal. The proposition underlying an economically distressed business is no longer viable: the business creates goods or services that are no longer in sufficient demand in the relevant market, or is doing so based on technology which no longer pays for itself. In relation to an economically distressed business, all of its stakeholders as a group (including society as a whole) are better off if the business’s constituent assets are split off from it and recycled to more promising, higher value uses.

By contrast, a company which is merely financially distressed is unable to generate sufficient value to meet its liabilities as they fall due (in which case the company is cashflow insolvent). It may even be the case that the total value of the constituent assets of its business is exceeded by the quantum of its liabilities (i.e., the company is balance-sheet insolvent). Nevertheless, some or all of those constituent assets generate more value in their present use than they would if split up and disposed of piecemeal. In the jargon, there is a going concern surplus, a positive difference between the assets constituting the going concern and their piecemeal value. By hypothesis, therefore, all of the company’s stakeholders as well as society as a whole are better off preserving the (relevant part of the) company’s going concern, rather than breaking up the business and realising the assets piecemeal.

Costs of Inadequate Sifting

The sifting of economically from merely financially distressed companies is, definitionally, a precondition to the achievement of insolvency law’s value-maximisation purpose: preserving the going concern of an economically distressed company and failing to preserve the going concern of a merely financially distressed company each produces a pro tanto worse outcome for stakeholders as a group than would otherwise be the case.

Either of these outcomes is also antithetical to insolvency law's distributive purpose: those entitled to the going concern surplus, or those who would have benefited from piecemeal disposal of the company’s assets, are deprived of this value.

A failure accurately to ascertain whether the company is economically or merely financially distressed may also impede achievement of insolvency law's investigative purpose. Errant decisionmakers of the debtor may not duly be held to account for having permitted the company to become economically distressed; alternatively, honest but unfortunate decision makers may wrongly be targeted and may be required to incur time, attention, and expense in order to defend themselves even though they were not in fact culpable for their company’s economic distress.

It is also worth highlighting the particular costs of preserving the business of an economically distressed company (OldCo) by permitting that business to be sold to a new entity (NewCo). Permitting such a business to survive does not merely deprive OldCo’s creditors (in the way described above) of some of the value to which they were entitled. It also creates competition for NewCo’s competitors which is unfair because it results from the subsidisation of the continuation of NewCo’s business at the expense of OldCo’s creditors.

There are, in general, only three mechanisms for distinguishing economic from merely financial distress (referred to below as 'filters').

Market Exposure

First, OldCo’s business and its constituent assets may be exposed to the relevant segments of the relevant markets for a suitably long period and then sold to the highest bidder(s), be it for the business as a going concern or for its constituent assets. We refer to this as the 'market exposure filter'. In principle, such exposure can elicit bids which reveal whether there is a market for the business (in whole or part) as a going concern and, if so, whether there is a going concern surplus. Due exposure to the market in this way can be conceptualised as reducing the coordination costs involved in those seeking to realise the best value for the insolvency estate being able to locate the best buyers for the estate’s constituent assets. In practice, however, such bids may not always yield fundamental values for the business and/or its constituent assets.

Creditor Decision

The second filter, the 'creditor decision filter', entails vesting the decision as to whether to preserve the going concern in creditors as a group.

In relation to insolvent companies, shareholders are underwater, are not entitled to be paid anything until creditors have been repaid in full, and may have perverse incentives effectively to ‘gamble’ with the company’s assets by maintaining the business as a going concern. This is because shareholders have asymmetric incentives. They may have nothing further to lose from running the business of the insolvent company into the ground, such as by converting tangible assets which may have been realised to benefit creditors into intangible assets such as employee hours which have a net benefit for the estate only if the business is not economically distressed. Shareholders may prefer this course since it would give them at least some prospect (no matter how unrealistic) that the business would recover and they would thereby regain an equity stake in the company. ?

By contrast, creditors as a group are the insolvent company’s residual claimants: their claims to repayment effectively entitle them to the value of the company’s business, and they possess incentives to get the ‘preserve or break up’ decision right since they stand to gain or lose from that decision. In this crucial sense, creditors as a group constitute the principal in insolvency proceedings for whose benefit the proceedings and those running them must operate. Creditors as a group are also likely to have interacted with the company, including over the course of its decline, and would therefore be likely to have the best information (compared to any other entity or stakeholder group other than the company’s management) about the company’s business, its management, its customers, competitors, and counterparties, the market in which it operates, the reasons for its decline, and its prospects.

Taken together, these considerations show that creditors as a group are better placed compared to anyone else — including the court, any insolvency practitioner (IP), and any other expert, none of whom has the same knowledge of the debtor, its business and decisionmakers, or the same direct incentives — to make the ‘preserve or break up’ decision. Vesting this decision in creditors as a group is an obvious and often effective way of reducing both the coordination costs of identifying any going concern surplus in the business and how best to preserve, as well as the motivation costs of the IP in particular and the insolvency process more broadly.

It is for this reason that modern insolvency regimes vest primarily in creditors as a group the decision whether or not to permit the business to continue as a going concern. This is characteristically done through putting one or more restructuring plans to creditors (and perhaps shareholders, whose vote is effectively treated as subordinate to that of creditors). A plan typically proposes which creditors would be paid and how much; whether some or all of the business would be kept as a going concern; whether it would be retained by OldCo or transferred to NewCo; by whom it would be managed; and who would have an equity stake in the owner entity. By voting to accept or reject one or more plans, the creditors (and, where permitted, shareholders) make the ‘preserve or break up decision’.

However, there are inherent informational asymmetries between the IP, secured creditors and the debtor’s directors on one hand, and unsecured creditors on the other. ?Further, often creditors may be rationally disengaged from such decision-making since they may have individual stakes in the outcome that are too small to justify the requisite investment of time and attention. At the same time, their involvement may slow down the decision-making process, which may be particularly problematic if the value of the business is in freefall and a speedy response is required.

Independent Assessment

The third filter, the 'independent assessment' filter, vests in an independent decision maker either the making or the assessment of the decision whether or not to preserve the going concern, including, in particular, through a sale of OldCo’s business to NewCo.

The court is the paradigm: in principle, it can receive evidence and arguments in an adversarial setting in order to decide whether to permit the business to continue as a going concern. This tends to reduce coordination costs in incentivising the IP to accumulate sufficient information as to the appropriate course of action, and to minimise motivation costs by holding the IP to account.

As already noted, however, the court would not usually have any prior knowledge of the company, its business, circumstances, or prospects, and there is no guarantee that the forensic process would arrive at the correct decision. Such a process also tends to be time- and resource-heavy, which may not be appropriate to the circumstances of the distressed company and its stakeholders. Such costs may be particularly onerous in a pre-pack given that the procedure is frequently used by small and medium-sized enterprises.

Further, and crucially for our purposes, it matters greatly who bears the burden of justification and what test the court applies.

It is one thing for the party advocating the going concern sale of OldCo’s business to NewCo to satisfy the court — on the balance of probabilities, or on a ‘real as opposed to remote prospect’ basis, or to some other appropriate standard — that this course would maximise the value in OldCo’s estate.

It is an entirely different matter for someone seeking to challenge such a sale to be required to show that (say) the person proposing the sale — or, even more demandingly, the person who oversaw the sale — acted so unreasonably in committing OldCo to the sale that no reasonable person in their shoes would have thus acted (the unreasonableness test), or that to commit the company to the pre-pack would be an obvious abuse of the administrator’s powers (the obvious abuse test), or that they acted so as to harm unfairly the person bringing the challenge (the unfair harm test).

Given the practical realities of litigation and the significant latitude courts afford to regulated professionals such as IPs, a challenge subject to any of these tests or another similar one would be particularly difficult to sustain even if there were significant concerns about the advisability and even the propriety of the sale on an ordinary commercial view.

Conclusion

This analysis derives from 'Rehabilitating the UK Pre-Pack: A Critical Analysis and Proposals for Reform', co-written by Alfonso Nocilla and me and published in (2024) 40.2 Banking & Finance Law Review 207-243. The paper uses this analysis as part of a set of arguments to the effect that the UK pre-pack is structurally flawed and in need of reform.

The final pre-publication draft of the paper is available at the SSRN: https://dx.doi.org/10.2139/ssrn.4565561.