Open any business publication and the same bells ring: recession in the UK seems all but guaranteed this year. From the Confederation of British Industry to the Bank of England, any institution worth its salt seems to be preparing for the worst. A recession is a simple economic phenomenon, often defined as a significant downturn in economic activity lasting anywhere from a few months to potentially years, however its impacts can be complicated. This article aims to explore one of those key impacts, corporate insolvency, and what this means for commercial law firms.
What is insolvency? Why do companies become insolvent?
Much like a recession, the concept of insolvency is also very simple. In the case of corporate insolvency, this occurs when a financially distressed company can no longer meet their financial obligations as debtors to their creditors. One important distinction to make at this point is that an insolvent company is not the same as a bankrupt company. Bankruptcy is a legal order given to individuals or corporations that provides a remedy, whereas insolvency is a state of financial being. For example, under the US Bankruptcy Code, an insolvent company can file for Chapter 11 Bankruptcy that allows them to stay in business while, under judicial supervision, restructuring their obligations in an attempt to satisfy their creditors. One recent example of a company attempting to do this is the cryptoexchange platform FTX, following a liquidity crisis and failed acquisition deal from Binance.
In England and Wales, our equivalent of Chapter 11 Bankruptcy is known as going into ‘administration’. Here, an insolvency practitioner is appointed as the administrator and the company is protected from legal action brought by its creditors. The goal in these cases is to prevent the company being wound up, known as being liquidated, and allow the company to continue running. Going into administration is a scary time for businesses, and only approximately 10% of businesses survived the process in 2016.
Beyond administrations, there are three other potential outcomes of an insolvency worth keeping in mind. First, there are compulsory liquidations. These are orders given by the High Court following the submission of a winding-up petition by a creditor. In these cases, an Official Receiver or Insolvency Practioner is appointed to liquidate the company and satisfy the creditors as best as possible. This is done in accordance with the principle of pari passu, effectively meaning each unsecured creditor has an equal claim to the wound up assets. Next, there are creditors’ voluntary liquidations. In practice, these function identically to compulsory liquidations with one important caveat: the directors wind up the company voluntarily. In these cases, the directors can appoint their own liquidators (assuming 75% of shareholders by value agree) to pass a ‘winding-up resolution’. Finally, there are company voluntary arrangements. These arrangements allow the company to pay the creditors, assuming they agree to it, over a fixed period in the hope they can discharge their obligations.
One major aggravating factor for insolvencies is a recession. Indeed, many of the factors that contribute to a company going insolvent such as excessive borrowing or loss of key customers are exacerbated by the overall slowdown in economic activity. Recessions are reflective of lessening consumer demand, meaning it can be harder for companies to generate adequate cash flow to satisfy their creditors. We can expect companies specialising in non-essential goods and services to be hit hardest by this, as consumers are forced to make hard choices in the wake of soaring food (up 13.3% annually in December) and energy prices. When these factors are coupled with consistently rising interest rates (meaning debt is more expensive), it’s easy to see why the number of registered corporate insolvencies in Q3 2022 were up 40% year-on-year.
Being insolvent, or nearing it, does not necessarily mean the end of the company. These examples aim to illustrate some alternatives to bankruptcy for an insolvent organisation.
One notable example of an actual insolvency case is that of upmarket country lifestyle brand Joules, which was recently brought out of administration following the acquisition of a 74% stake by Next plc for £34mn. The remaining 26% stake remains with the retailer’s founder, Tom Joule.
Joules is one of the many luxury brands that is suffering from a lack of consumer demand in the wake of a soaring cost of living crisis. With a net debt of £25.7mn and significant amounts of inaccessible capital, the brand was unable to pay its creditors and fell into administration. Here, Next was able to capitalise on the massively reduced share price of Joules. Prior to this arrangement, Joules had entered into talks with Next but these fell through. As shares dropped even further to just 9p (compared to its 160p price in 2016), Next was able to enter what they hope to be a massively profitable agreement. In these cases, the law is ordinarily very simple, and firms will advise merely on the acquisition of the company. This of course brings with it all the usual requirements of an M&A such as due diligence and post-completion checks with the Competition and Markets Authority (‘CMA’).
Facilitating an acquisition is not the only role law firms can play in the wake of actual or potential insolvency cases. Commercial law firms play a pivotal role in restructuring, which ultimately aims to reduce the liabilities of a company by modifying its financial and operational aspects. One recent example of this involved Freshfields Bruckhaus Deringer (‘Freshfields’) advising on the restructuring of MAB Leasing (‘MABL’), the primary aircraft leasing entity of the Malaysia Aviation Group (‘Malaysia Airlines’). Faced with falling consumer demand spurred on by Covid-19 lockdowns and economic headwinds, Malaysia Airlines needed financial structuring to survive as they neared insolvency. In that restructuring, Freshfields advised on an unprecedented conceptualisation of a UK court-based restructuring known as a scheme of arrangement, which allows a compromise between the company and certain creditors. When a majority in number and 75% in value of each class of creditors approves the scheme and it is sanctioned by the court, it then becomes binding on all creditors. As Freshfields notes, the UK scheme had several benefits: it allowed the company directors to remain in control (unlike a Chapter 11); it was quicker and more cost-effective than a Chapter 11 and it avoided having to deal with each lessor individually which would be more time consuming. The scheme was ultimately successful, placing Malaysia Airlines in a more financially secure position by allowing them to reduce their aircraft liabilities. This is a key example of how law firms can advise insolvent companies.
What does an increase in corporate insolvency mean for law firms?
As we have seen, law firms play a key role in helping companies escape insolvency. However, like all changes in the economy, an increase in insolvencies brings with it winners and losers.
First, we are especially likely to see an increase in general litigation claims, particularly in professional negligence cases. Following the 2008 financial crisis, there was a considerable increase in professional negligence claims against auditors who audited insolvent companies, with litigants arguing auditors failed to flag issues to shareholders and investors. As more companies become insolvent, more investors will be looking to recoup their investments by any means possible. Therefore, commercial law firms with particularly strong litigation teams such as Herbert Smith Freehills and Slaughter and May (both ranked Band 1 by Chambers UK for their dispute resolution offerings) may benefit from a rise in corporate insolvency.
Equally firms that are particularly well known for their restructuring work, such as Kirkland & Ellis and Latham & Watkins (both ranked Band 1 by Chambers UK for their Restructuring/Insolvency departments), will stand to benefit from this increase. As we have seen, restructuring is both exceptionally complex and very involved from a legal perspective. This will lead to more high-value deals, allowing restructuring heavy firms to turn a greater revenue per lawyer. As revenue per lawyer is ultimately the driving metric behind law firm success, these firms will embrace this opening in the market.
More corporate insolvencies are reflective of a general slowdown in the market, which means we will also see less complex M&A work. As debt becomes more expensive due to rising interest rates, less companies will be looking to take on particularly ambitious M&A work and instead look for safer options. These safer options are more precedent-driven, or commoditised, meaning lower ranked – and cheaper – firms will be picked to complete them. Firms such as Skadden, Arps, Slate, Meagher & Flom, which are particularly driven by their M&A work, will suffer in this respect. Notably, Skadden may be able to mitigate some of this impact given its stronger counter-cyclical offering than other M&A heavy firms, such as Davis Polk & Wardwell, that do not offer a similar variety of practice areas in their London office.