The COVID-19 pandemic will mean that investors are more likely to find themselves with a financially distressed company in their portfolio, and possibly in unfamiliar territory. Investors and, in particular, investor directors should be mindful of the implications of insolvency and their duties as directors.
Below are some areas which investors and investor directors may want to bear in mind when considering approach/strategy to a portfolio company experiencing financial difficulties during this challenging time and throughout any portfolio company insolvency process.
Managing investor director conflicts
When a company is performing well, the interests of the company and of the investor are generally aligned. When things take a turn for the worse, however, interests can diverge. Nowhere is this more acutely felt than for the investor director who, in addition to being as exposed as all other directors to possible claims of misfeasance or wrongful trading, also has to balance duties to the investor as well as to the company.
There are some guidelines which can be followed to try and minimise potential challenge to the investor director's conduct. A few examples include ensuring (where possible) that:
- a clear separation is maintained between shareholder/debtholder matters on one hand and board matters on the other, with the investor director remaining on the board side and (ideally) not being directly involved in decisions made by the investor in relation to the company
- any decision made by the investor in relation to the company is relayed to the board at the same time or shortly after the investor director is made aware of the decision
- the investor and the board (including the investor director) receive separate legal advice, and instructions on behalf of the investor (and advice given to the investor) do not come to/from the investor director
- the company, the board and the investor should take care to protect any applicable legal professional privilege. Correspondence by the board with company counsel should not be shared with investors who are not serving on the board, and correspondence by legal counsel to the investors should not be shared with other directors or the company, and
- the board (including the investor directors) should ensure that they follow proper procedures and maintain accurate records of their decision making – see below.
Directors' duties and governance – a reminder
To the extent COVID-19 results in a company becoming (even temporarily) insolvent or directors consider that a period of insolvency is likely, all directors (including investor directors) should be:
- acting in the best interest of creditors – this includes unsecured creditors (employees, HMRC, landlords, suppliers) not just secured creditors. Directors should be prioritising the short term cash position of the company not long term returns for shareholders
- mindful of their risk of personal liability in relation to wrongful trading – this is a technical test but broadly bites where a director knows (or ought to know) there is no reasonable prospect of avoiding an insolvency process and does not take every step to minimise losses to creditors
- giving careful thought to transactions that the company is entering into – especially intragroup transactions / transactions with connected parties. Grounds on which transactions can be challenged subsequently include where those transactions constitute preferences or transactions at an undervalue, and
- documenting all decisions carefully so they have clear contemporaneous records should the company ultimately be placed into a formal insolvency process and those decisions subsequently scrutinised.
Acting quickly
As part of a portfolio company's business continuity planning around COVID-19, investors need to be particularly alert to any signs of financial distress or weakness to the business model. Directors should be acting quickly to explore Government financial support measures or seeking further investment / financing alongside dealing with the inevitable and significant business disruption that will result from COVID-19.
Involving insolvency practitioners early is sometimes perceived as admitting defeat (given that they will often also be appointed as administrators, should that become necessary). However, that perception is not necessarily the reality and their involvement does not indicate the certain demise of the company. Indeed, they can add significant value in assisting management deal with the ramifications of such extreme disruption. In any event, while a formal insolvency process may be a last resort, a well-planned and managed administration will render a far better return than a last-minute frenzy.
Control
If a formal insolvency becomes unavoidable, the extent to which a private equity sponsor can control an insolvency process will depend largely on: (i) whether or not they hold secured debt; (ii) whether or not their security is second ranking (sitting behind, say, a bank or other financial institution); and/or (iii) their contractual relationship with the senior secured creditor.
The taking of secured loan notes, while, for various reasons, not universal, generally provides the "qualifying floating charge" which is necessary in order to exercise any control in an insolvency scenario.
Assuming the investor holds the only security granted by the company, then it can largely control the timing of appointment of administrators and the identity of those administrators. If the investor holds second ranking security then the circumstances in which enforcement action can be taken will depend on the terms of the agreement with the senior lender, varying from simply a "consultation" requirement to a situation where the investor can take no enforcement steps (including making a demand) until the senior lender has been repaid in full or has consented to such action.
Timings
Negotiating the sale of a business out of administration (which could be through a "pre-pack" sale which occurs immediately following appointment of administrators), while generally quicker than standard M&A transactions, still takes time.
Administrators have a duty to creditors to achieve the best price reasonably obtainable for assets of the company and will require a robust marketing process. If one has not been recently undertaken on which they can rely, they will need time to do their own.
Buying from administrators
If you are considering acquiring the business out of administration, either through a credit bid (i.e. using a reduction of secured debt as part of the consideration) or a cash acquisition, it is worth remembering that administrators sell without any warranties or indemnities and on an "as is and where is" basis. This may not be too significant a concern given the involvement of the sponsor during the life of the company, however, if there are any particular areas of risk, consider seeking a retention mechanism which may be more palatable to the administrators.
Summary
We are all facing an uncertain few weeks and months. In any distressed situation, being mindful of early warning signs and initiating contingency planning options sooner rather than later will assist in navigating what can sometimes seem like a minefield of issues which arise on an insolvency. Understanding from the outset an investor director's duties in a distressed situation will also assist in formulating an appropriate strategy.
If you have any questions or concerns, please do not hesitate to contact any member of the Private Equity team or Restructuring & Insolvency team at Taylor Wessing.
