Consider the situation where a company begins to struggle in a harsh economic climate. It finds it harder and harder to pay its suppliers as promptly as usual. However, the suppliers are struggling themselves, and allow the additional credit that is being taken as they are desperate for sales. Eventually after a few months, with huge debts mounting up, the directors of the company decide to fold. They transfer the business to another with a similar name and inform all its customers of the changes. A “phoenix” company arises out of the ashes without the burden of its previous debts and continues to trade successfully. This is the basis for many a fraud that has been investigated over the years but it is astonishing to discover that there is also a completely legal process that, if carefully followed, can allow this very course of action!
Around fifteen years ago a colleague and friend of mine started his own business growing mussels in the west coast of Scotland. The early years of such a business venture can be more fraught with problems than others. Dealing with livestock and the vagrancies of the Scottish climate meant that he faced one major problem after another. He had to deal with difficulties in obtaining the young mussels to grow on, attacks by predators wanting to eat his crop, solving design problems with his equipment, problems with security and trouble with harvesting the final product. Solving each of these problems in turn cost a great deal of money, which he borrowed from various sources including the bank, from his family and from the government. He managed to find solutions to all his problems and eventually after two or three years had a healthy core business up and running. However, by this time his debts had grown to such a level that the business was no longer viable. He sought insolvency advice and ended up having a receiver appointed over his business. He was then able to buy back his business assets from the insolvent estate and continue his business debt free. He currently runs a successful business, yet the original unsecured creditors were never paid.
This was well over a decade ago, and was always an area of the insolvency process that raised criticism with its commentators. However, the Enterprise Act 2002 introduced an even faster process known as “administration” that was easier and cheaper to implement. Unlike the process used by my friend, it did not need the approval of the courts to ensure any deal being done was fair. The process has been termed a “pre-pack” and allows a phoenix company to arise using the assets of a failing company and trade, often using the same or similar name as before and the same directors to run it.
The way in which a pre-pack works in practice involves a secured creditor, the directors or owners of the company arranging with an insolvency practitioner to sell the assets of the business before it is placed into administration. Then, when the administrator is officially appointed, the sale of the business is a “done deal”. There is no requirement for the business to be marketed externally and only a reasonable expectation that a fair price is received. The unsecured creditors may receive nothing after those having security are paid.
There is a great deal of criticism surrounding pre-packs because they allow an administrator to wipe the debts of a distressed business and sell it on quickly to the previous owners. The Insolvency Service, the government agency that is supposed to ensure that administration procedures operate within the legislative framework of the Insolvency Act 1986 and Enterprise Act 2002, has recognised the vulnerability of the system to abuse and introduced additional guidelines in January 2009 by way of Statement of Insolvency Practice 16 to force insolvency practitioners to disclose more information to all creditors. Even so, figures they released recently show that in the first 6 months of 2009 some 35% of the 572 pre-pack processes commenced showed compliance failures and of these 17 cases are currently being investigated for serious anomalies.
Clothing retailer USC was bought back by its owner Sir Tom Hunter out of administration, by purchasing 43 of the 58 outlets. Chief executive of the Officers Club David Charlton bought 118 of the 150 failing menswear stores. The coffee dealership chain Wittard and furniture retailer MFI were also both recent subjects of pre-pack buy backs. It is true to say that the previous owners or directors are allowed to cherry pick the best bits and start again debt free. However, in support of the process the object of finding the best way of realising the value of an insolvent and failed business without negative publicity is often achieved. The goodwill and jobs of the workers are preserved and the whole process of the insolvency is usually quick and efficient.
The insolvency arena will always be a rich picking ground for the fraud investigator. In many cases it is simply because that is the time when the inner workings of a company y are laid bare for external scrutiny. However, in the case of the pre-pack process there may be a fine line between it being the best rescue package for a failing business and fraudulent trading to remove the full value of business assets from the hands of the disadvantaged creditors. It is likely that this process will throw up a number of incidents of fraudulent behaviour for the investigators over the coming months and years.