Published on 31 December 2010 by Tony Groom

Pre-pack Administration is a tool for saving struggling businesses that are in severe financial difficulties but are potentially sound.

Essentially it means “selling” the business to a new company immediately upon appointment of an Administrator, the preparation for sale being carried out prior to appointment. The sale requires additional scrutiny if the directors and shareholders of the new company are the same as in the previous company to prevent any abuse.

Insolvency practitioners use pre-pack administrations to achieve the swift sale of a business where it is not appropriate for them to trade the business as a company in administration. This way the business can continue to trade without disruption.

There are many reasons for not trading a company in administration including avoiding the administrators’ costs and the risks of trading a company in administration. It is often argued that key stakeholders such as customers, staff or suppliers will not remain loyal to a company in administration.

Administration involves the appointment of an insolvency practitioner as administrator to take control of an insolvent company (from its directors) with the objective of administering it in the best interests of creditors.

A pre-pack is only one form of administration. In normal administrations there are a number of possible outcomes including return of the company to the control of the directors, such as following a restructuring or a Company Voluntary Arrangement, or the administrator can sell the business and assets ahead of liquidation. In the prepack form assets are sold immediately on appointment of the administrator, who does not then trade the company

The liabilities remain with the old company and can include more than the outstanding debts such as onerous or unwanted lease agreements. It is also possible to terminate employment contracts prior to the sale leaving the liability behind although this is a specialist area as employees are also protected by legislation referred to as TUPE (transfer of undertaking protection of employment). Once the assets have been sold (liquidated) the old company is then normally wound up as a Creditors voluntary liquidation (CVL).

Pre-packs have huge advantages in allowing the new company to trade without the burden of the previous company’s debt, almost without disruption keeping valued staff and equipment, contracts, relationships and customers.

However, to prevent abuse, especially as the creditors do not get a chance to object, before a company can use this method it must show it has taken advice from an insolvency practitioner who must ensure the business and assets are not sold below their value. The business and assets must therefore be independently valued.

The administrator has a considerable of duty of care and must be able to account for any sale and this is scrutinised when a sale is to previous owners or directors. This duty of care is set out in an Insolvency Practitioners’ Guidelines known as SIP 16.

The opportunity to terminate contracts means that a pre-pack offers considerable scope for restructuring the business. That the company became insolvent indicates a need for change to the business model, normally to reduce costs to make it viable.

One problem with pre-packs is that the new company often fails shortly after the pre-pack if the opportunity to effect real change is not used.

Finally, funding pre-packs can be an issue. A pre-pack involves the purchase of business and assets which requires funds although much of the finance might be provided by the bank that is essentially funding the new company to buy out its loan to the old one. The new company will require funding, not just for purchase but also for working capital to trade when suppliers who as creditors of the old company are likely to be wary about providing credit to the new one.

Another funding issue is HMRC who are often left with a large unsecured claim in the old company. HMRC can demand a deposit against future PAYE and VAT liabilities, for up to six months of payments and increasingly are invoking this right when the directors of new and old companies are the same.

While a pre-pack is often regarded as controversial because the creditors are faced with a done deal, the counter argument is that a swift sale of the business assets is the best opportunity to preserve value and therefore ensure the best possible return for the creditors who might otherwise get nothing or very little.

Putting a failing business into administration without a pre-pack risks a dramatic drop in its value due to disruption and loss of sales during the administration.

Pre-packs allow a fundamentally good and viable business idea to be preserved, retaining customers, suppliers and goodwill, without all the start-up costs normally associated with a new business.