The law of unintended consequences: How a simple change threatens business rescue in the UK

After a few false dawns, it seems that the UK may now, at last, be getting to grips with the pandemic.

This is a time when viable businesses should be allowed, with the consent and support of their creditors, to reshape, continue profitable relationships, retain and recruit staff and generally keep the wheels of commerce turning.

However, a key tool that would enable companies to achieve this, the Company Voluntary Arrangement (CVA), has essentially become redundant due to government changes to insolvency law.

What is a Company Voluntary Arrangement?

CVAs are a consensual insolvency process. The directors of the company propose to its creditors a resolution of the financial difficulty in which it finds itself. This can take any shape but frequently involves the introduction of more equity, in return for which creditors agree to receive less than they are entitled to in full and final satisfaction of their claims.

If more than 75 percent by value of unsecured creditors agree to the proposal, it can bind the dissenting 25 percent. There are saving provisions for secured creditors (who cannot be affected without their consent), and preferential creditors (who must be paid in full before unsecured creditors receive anything, again unless they consent).

As a large majority of creditors need to approve a CVA, it is a useful consensual tool for companies.

Given many have found themselves in distressed situations through no fault of their own during the pandemic, it is reasonable to expect CVAs would be widely used as the economy emerges from Covid-19 restrictions and businesses grapple with changes brought by Brexit.

The return of Crown Preference

But a decision made by the HM Treasury in 2018 has effectively rendered CVAs impossible. In the October 2018 budget, it was announced that certain tax debts would be moved to preferential status (known as Crown Preference).

The government’s own calculations suggested this shift would increase recovery to the Treasury by £185mper year – a figure that pales into insignificance compared to the sums the government has paid in Covid-19 support packages.

However, this small change has been hugely consequential for CVAs. Its effects are exacerbated by the government’s decision to allow VAT payments to be deferred.

This means that if a hospitality company, for instance, wishes to propose a CVA, its proposal will need to include payment in full of all employee NICs and (potentially accumulated) VAT before unsecured creditors receive anything.

The only circumstances in which this would not be necessary, is if HMRC votes to receive less than full payment for these sums, which to date it has been unwilling to do.

Three quarters of unsecured creditors are unlikely to approve a proposal in which they receive virtually nothing, because the Crown must be paid in full first.

It also seems improbable that directors of insolvent companies will volunteer to work hard on low wages for a significant period of time to be able to pay tax debts in full.

The majority of companies will have little option but to enter administration or liquidation.

Crowning folly?

The suggestion to reintroduce Crown Preference occurred prior to the pandemic. While it is understandable that the Treasury might be dismissive of the insolvency industry’s discontent with Crown Preference’s impact on business rescue, the government could have postponed its reintroduction until the economy had returned to health.

Instead, the government has decided it will effectively prevent CVAs from being implemented.

While this is clearly detrimental to unsecured creditors, it also has unintended negative consequences for the government.

A large proportion of these businesses will have obtained bounce back or CBILS loans. If they find themselves in financial difficulty, but perceive a CVA is not possible, they will simply enter an administration or liquidation process in which creditors will receive very little.

This effectively means government lending for bounce back loans and CBILS it is unlikely to be repaid, as a consequence of its own actions.

Statistics for insolvencies throughout 2021 were released on January 18, 2022. They show only 115 CVAs were implemented last year, 0.8 percent of the total corporate insolvencies. This compares to 278 in 2020 and 355 in 2019, both at about two percent of total corporate insolvencies.

It is difficult to think of cases in which a CVA will be a realistic option for companies with significant Crown debt.

If Crown Preference is not scrapped, or at least postponed for the next year or two to allow for pandemic-related company rescues, it will be not for the want of consistent lobbying and evidence gathering by company directors and the insolvency industry.

This article is by Stewart Perry, restructuring and insolvency partner at European law firm Fieldfisher.