Business rescue: the challenges

6 October 2009 Author: Riza Moosa

Introduction

To start, it is helpful to consider any obvious benefits of these new provisions.

Firstly, business rescue is a substantively non-judicial, commercial process. Yes, the process is formalised following the filing of a board resolution (or application to court to commence the proceedings) and each significant step in the process may allow intervention of affected parties by application to the court. Yet this remains an engagement amongst the business rescue practitioner (who will be a qualified professional experienced in managing companies in difficulty), affected persons (being shareholders, creditors and employees (individually or through their representative trade unions) of the company in devising a business rescue plan to rescue the company.

Secondly, business rescue is a consultative and inclusive process involving all affected persons, in which each of these stakeholders is afforded an opportunity to participate and be consulted throughout the process.

Thirdly, there is a moratorium period where liquidation and legal proceedings are halted against the company.

Fourthly - and perhaps most significantly - is the outcome sought by the proposed legislation, namely, the ultimate rescue of the company and maximising the likelihood of the company’s continued existence on a solvent basis. Or if that is not possible, then to ensure an outcome which provides a better return for the creditors or shareholders than would result from the immediate liquidation of the company.

In certain respects the structured, formal process proposed in the Bill is not dissimilar to the typical negotiated rescue proceedings conducted informally when major creditors of a distressed company act together to reach a commercial solution to rescue the company.

Judging from the above there is clear utility in the broader notion of business rescue. Unfortunately, as is the case with most new legislation the devil lies in the detail. An assessment of some of these challenges forms the basis of this paper.

At the heart of these challenges lies the concept of a temporary moratorium on the rights of claimants against the company or property in its possession, and the effect of the business rescue on:

  • the protection of property interests of the company; and
  • on agreements entered into by the company and third parties; and
  • the incurral of further indebtedness and the ranking of claims of creditors providing such debt during business rescue proceedings.

What is Business Rescue and how does it work?

To weigh up these challenges we need to form a basic understanding of what business rescue is and how it will work.

Business rescue proceedings can commence in the following ways:

  • by the board of the company resolving to place the company under supervision; or
  • by an affected person applying to court; or
  • during liquidation proceedings or during proceedings to enforce any security against the company, the court may of its own accord make an order placing the company under supervision and commence business rescue proceedings.

The board of a company may resolve that the company voluntarily commences business rescue provisions if :

  • the board has reasonable grounds to believe that the company is "financially distressed"; and
  • there appears to be a reasonable prospect of rescuing the company.

The definition of "financially distressed" means:

  1. it appears to be reasonably unlikely that company will be able to pay all of its debts as they fall due and payable within the next six months; or
  2. it appears to be reasonably likely that the company will become insolvent within the next six months.

Interestingly if business rescue proceedings are commenced by application to court by an affected person the applicant does not suffer a similar reasonableness test (section 131). It is up to the court to be satisfied that that the company:

  • is financially distressed; or
  • the company has failed to pay any amount in terms of any employment-related payment obligation; or
  • it is otherwise just and equitable to do so for financial reasons;
  • provided that there is a reasonable prospect for rescuing the company.

Affected persons may object to the company resolution and apply to court to set aside the resolution on the grounds that:

  • there are no reasonable grounds for believing that the company is financially distressed;
  • there is no reasonable prospect of rescuing the company;
  • the company has failed to satisfy the procedural requirements for the commencement of business rescue proceedings (section 130(1)).

This objection may arise at any time after the adoption of the resolution in terms of section 129 until the business rescue plan is adopted.

An application to commence business rescue in terms of section 131 has the effect of suspending liquidation proceedings or any proceedings to enforce any security against the company even if these were commenced already, see section 131(6).

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How creditors' rights are affected once business rescue proceedings commence

The timing of the commencement of business rescue proceedings is crucial. In terms of section 132(1) business rescue proceedings begin when the company files a resolution with the Commission (the Companies and Intellectual Property Commission) to place itself under supervision. This timing is relevant for the following reasons: no time limit is set for the actual filing of the resolution, and many, if not all of the restrictions placed on creditors commence only once business rescue proceedings have begun.

Once appointed (which is within 5 business days after the filing of the resolution) the business rescue practitioner enjoys extensive powers including the full management control of the company in substitution for its board and existing management (section 140 (1)).

The business rescue practitioner has a number of duties imposed by the new legislation including the duty to investigate the company's affairs, business, property, and financial situation and make an assessment of whether there is any reasonable prospect of the company being rescued. If at any time during the proceedings in the business rescued practitioner is of the view that there is no reasonable prospect for the company to be rescued he or she must inform the company, all affected persons and the court and must apply to court to terminate the business rescue proceedings and to place the company into liquidation.

An example of the restrictions that may be placed on creditors’ rights is contained in section 132(1) which places a moratorium on any legal proceedings including any enforcement action against the company or its property or property lawfully in its possession unless:

  • the business rescue practitioner consents in writing;
  • with the leave of the court;
  • by way of set-off against any claim made by the company in legal proceedings irrespective of when those legal proceedings commenced; or
  • in any criminal proceedings against the company or its directors or officers; or
  • proceedings concerning any property over which the company exercises the powers of a trustee.

Section 133(2) suspends the calling of any guarantee or surety given by the company in favour of any other person except with the leave of the court.

The most invasive example of the impairment of creditors' rights is contained in section 136(2). Subject to section 35A and 35B of the Insolvency Act, 1936 (which provide for rights in favour of counterparties to derivative transactions), and despite any provision in any agreement to the contrary, during business rescue proceedings the practitioner may cancel or suspend entirely, partially or conditionally any provision of an agreement to which the company is a party at the commencement of the business rescue period, but not an agreement of employment.

For starters, this means that a typical non-variation clause would no longer have application since the business rescue practitioner now has rights to cancel or suspend entirely or conditionally any provision of that agreement. Nothing in the wording of this section refers to the business rescue practitioner (although then vested with full management control) acting on behalf of the company in exercising these rights to suspend or cancel agreements. It appears that this is an ability on the part of the practitioner derived from the legislation to exercise the rights in respect of an agreement to which the company is a party.

On the face of it the powers granted to the practitioner under this section deal a severe blow to the predictability of rights and obligations of contracting parties. However the business rescue practitioner must exercise this power in a reasonable manner. The question therefore arises what will amount to reasonable exercise of his or her discretion in those circumstances.

A creditor is likely to argue that any intervention in the established, predictable commercial arrangement and agreements that materially and adversely affects the rights of that creditor would amount to conduct which is not reasonable. On the other hand the practitioner could plausibly defend these actions on the basis that the practitioner's remit is to rescue the company and that any action which has the effect of facilitating the rehabilitation of the company would be reasonable in the context of the broader business rescue plan and particularly since that business rescue plan would involve the company and all affected persons.

Each action of this nature taken by the practitioner would have to be assessed on the prevailing facts and surrounding circumstances at that time. Section 136 only specifies that the business rescue practitioner may exercise its rights under that clause “during business rescue proceedings”.

Whether these rights can be exercised before the business rescue plan is adopted is uncertain. If these rights form part of the actions to be taken pursuant to an adopted business rescue plan then creditors receive some comfort that they would have been consulted on this by the business rescue practitioner (section 150(1)) and that they would have had an opportunity to vote to amend, approve or reject a proposed business rescue plan (section 145(2)). Creditors should bear in mind that in terms of section 145 (4) their voting interests in any decision where they are entitled to vote equals the value of the amount owing to that creditor by the company, irrespective of whether that amount is secured or unsecured.

Another interpretation is that the rights of the practitioner to suspend or cancel agreements exists before the approval of the business rescue plan - which may up to 30 business days after the commencement of the business rescue proceedings. This in accordance with the notion of a “freezing” of the business pending the workout pursuant to the business rescue proceedings and the business rescue plan. If this is correct then the creditors would not have an opportunity to vote in relation to the business rescue practitioner's ability to cancel or suspend any agreements. Again, this right would need to be exercised in a reasonable manner.

Conditional suspension is likely to amount to a variation of the terms and conditions of the agreement. Assuming the company is the debtor this would have the effect of binding the creditor to those altered terms.

A creditor who is adversely affected by any action to cancel or suspend agreements only recourse is a right to claim damages under section 136(3). In relation to such a damages claim by a creditor the question arises as to what cause of action would found a claim for damages. This is because one of the core elements of liability for damages, namely that of wrongfulness (in the delictual or contractual sense) would not be present. Where is the wrongfulness when business rescue practitioner is acting within the authority provided by legislation? Are we to imply that a wrongful suspension or cancellation remains wrongful despite this statutory authority?

It may be possible for the damages claim to be founded in the contract itself. This poses the question whether the aggrieved party actually has a damages claim based on the conventional principles of liability. If one were to conjure up a cause of action then the business rescue practitioner's action could arguably amount to an unlawful unilateral cancellation of the agreement (excepting that the act would be sanctioned by law). Using this as a premise, the damages claim would then seek to place the claimant in the same position had the cancellation or suspension and not occurred.

Section 136 must be read with section 134(1)(b) which provides that any person who has a result of an agreement made in the ordinary course of the company's business before business rescue proceedings have begun and who is in lawful possession of any property owned by the company may continue to exercise any right in respect of that property has contemplated in the agreement, but subject to the provisions of section 136. The wording of this section is wide enough to include the lawful possession of the company's assets by a creditor pursuant to an agreement of pledge. Giving effect to the plain meaning of the words, a creditor would be entitled to exercise its rights pursuant to the pledge, including the realisation of the asset, in accordance with the terms of the pledge agreement, but subject to any suspension or cancellation in accordance with section 136.

Two questions arise from these provisions:

  • Does the practitioner’s right to cancel or suspend agreements affect any action taken by a creditor pursuant to section 134(1)(b)? A purposive interpretation of section 136 could very well extend the business rescue practitioner's powers to the commencement of business rescue proceedings in such a way that results in any action taken pursuant to section 134(1)(b) being overturned. This approach would argue that no creditors should be allowed to exercise the rights that would be prejudicial to the company, its property or any other affected person without their consultation and involvement.
  • Does the general moratorium on legal proceedings against the company pursuant to section 133(1) prevent a creditor from summary execution (also known as self help or parate executie)? In pledge agreements it is very common that the creditor is given the rights to realise property secured under that pledge without having to go to court. Such provisions are valid provided that the debtor is not unduly prejudiced by the creditor's action. The wording of section 133(1) prevents any "legal proceeding, including enforcement action" during business rescue proceedings. Our case law and authorities suggest that the nature of summary execution is a non-legal process. It is however an enforcement action, but one which derives from the agreement between the debtor and creditor and not from legal proceedings. There is therefore a very good argument to be made that the plain meaning of section 133(1) as read with section 134(1)(b) would permit a creditor to take summary execution in accordance with agreements reached previously with the debtor. This interpretation must however take heed of a purposive approach in interpreting section 133(1) where a practitioner, or even other affected persons, may argue that the general moratorium on legal proceedings was intended to halt all enforcement action not only action taken through court processes.

Section 134(3) states that if during a company's business rescue proceedings the company wishes to dispose of any property over which another person has any security or title interest (this would include the reservation of ownership, and contracts such an instalment sale transactions) the company must:

  • obtain the prior consent of that other person, unless the proceeds of the disposal would be sufficient to fully discharge of indebtedness protected by that person's security or title interest; and
  • promptly pay to that other person to the sale proceeds attributable to that property up to the amount of the company's indebtedness to that other person; or
  • promptly provide security for the amount of the those proceeds to the reasonable satisfaction of that other person.

The effect is that any underlying transaction, could be repaid or discharged at any time before maturity of and while the company is in the process of, if the company chooses to dispose of the relevant asset and complies with the provisions of section 134(3).

While repayment in full of a creditor’s claim in circumstances where the company is financially distressed may not be the worst outcome, again the lack of predictability when businesses enter into agreements will increase. No longer is there an assured duration of the agreement with fixed consequences should the agreement terminate earlier than expected. Except that nothing seems to exclude from the amount of this indebtedness of the amount of any prepayment fees or penalties by virtue of this accelerated payment

A further example of the impairment of creditors’ rights, relates to the ranking of a claims against the debtor company in Section 135 of the Bill. This section creates a ranking in respect of claims against the company during the course of business rescue proceedings, by providing that claims by employees in respect of any remuneration or reimbursement for expenses related to employment and which are not paid during the course of business rescue proceedings are regarded as post-commencement financing advanced to the company (in other words loans advanced by those employment-related creditors to the company).

Section 135 contemplates that a company may obtain financing from third parties during the course of business rescue proceedings and that such funding may be secured to the lender utilising “any asset of the company” to the extent that it is not otherwise encumbered. Borrowings so raised will be paid in the preference set out in section 135(3)(b).

Section 135 ranks claims related to post-commencement financing as follows:

  • payment of the business rescue practitioner's remuneration and costs referred to in section 143 (being tariff-based remuneration of the practitioner and any other further remuneration agreed to, calculated on a contingency basis);
  • all other claims arising out of the costs of business rescue proceedings;
  • all claims for post-commencement financing obligations related to employment (as contemplated in section 135(1));
  • thereafter, all claims in respect of post-commencement financing raised from third-party lenders, which lending has been secured;
  • thereafter, all unsecured claims against the company.

Section 135(3)(b) goes further to state that all claims for post-commencement financing raised from third parties will have preference in the order in which they were incurred over all unsecured claims against the company. This seems to indicate that those post-commencement financing claims (other than claims related to employment) have preference irrespective of whether or not they are secured. Although silent on the ranking of pre-commencement financing claims that are secured, in our view on these claims must remain unaffected (save to the extent changed during the course of business rescue proceedings), including during any superseding liquidation proceedings.

Moreover, according to section 135(4), this statutory ranking of claims will remain in force if business rescue proceedings are superseded by a liquidation order. This means reordering of the ranking of claims against the company during business rescue proceedings as well as in any liquidation proceedings to the extent that those liquidation proceedings occurred during the course of business rescue proceedings. In short preference is given to a unpaid post rescue salaries and other employment related payments (in this regard, the broad strokes reference to “any remuneration, reimbursement for expenses or other amount of money relating to employment” becoming due and payable must be carefully monitored to ensure that only the normal course emoluments are afforded this preference. Business creditors would be well advised to consider any provisions in employment agreements of management of the company which provide for any accelerated claims or bonuses etc to happen during business rescue proceedings.

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What can be done to mitigate effects of the potential impairment of rights

Let us assume that the business rescue provisions in the Bill will be enacted in their present form. This carries with it a real prospect that creditor's rights under agreements, guarantees, sureties and this other security documents may be materially impaired or extinguished once business rescue proceedings commence.

Assess transactions and creditors wisely: Credit assessments of borrowers and counterparties to commercial agreements would then necessarily need to take into account the possibility of this impairment. Any additional risk perceived to be assumed could be catered for in the pricing of commercial arrangements.

Look for more recourse: When security is being taken the net, should be cast as wide as possible and preferably include individuals, trusts and other entities that will not be bound by this legislation. This would improve avenues of recourse available to the creditor should be the primary debtor undergo business rescue proceedings and the creditors' rights are impaired pursuant thereto.

Be informed, act fast: Commercial agreements, and specifically lending arrangements, should allow for constant information to flow to the creditor in order for the creditor to have constant monitoring of the situation. Specifically the intention of voluntary business rescue proceedings should be notified to the creditor prior to that decision being taken. Once filed that resolution commences business rescue proceedings. Therefore when directors are contemplating rescue proceedings, whether this is placed in a board briefing or board pack any notice of a meeting of the directors at which business rescue proceedings will be mooted needs to be notified to the creditor. Any such act should constitute an event of default or trigger event, described in the relevant underlying documents. These events should then be constructed to allow the creditor early termination or acceleration rights prior to the actual commencement of business rescue proceedings. It should be recognised that provisions of that nature giving creditors rights in a manner which is seen to subvert a business rescue process may be capable of being impeached on that basis.

Indulgences for breaches of agreements should also be given with great circumspection. Any rights of creditors exercised before business rescue proceedings commence are likely not to fall within the purview of the business rescue practitioner if these have been contractually agreed. This means that creditors should be able to (and ready) exercise their rights as soon as they are aware of any event of default all breaches of agreements. Events of default should also be crafted with shortened grace periods. Security documents should be clear in respect of permissible summary execution so as to avoid the sanction of the court where possible. Participate in appointment of practitioner: even though business rescue proceedings may have commenced, the appointment of the business rescue practitioner should be a matter for consultation with the relevant creditor. This right can be provided for in the underlying document.

Ensure rights not permanently affected if proceedings terminate: Agreements that may be cancelled or suspended during business rescue proceedings by the practitioner must be capable of being revived should those business rescue proceedings fail. In fact the revival should be automatic notwithstanding these suspensions. If cancelled a revival is likely to amount to a novation of the existing agreement, but nevertheless it is possible to provide for this automatic reinstatement. In other words the agreement should provide that if for any reason it is suspended or perhaps even cancelled during business rescue proceedings and of those business rescue proceedings and then terminate, that the agreement will be reinstated on the same terms automatically upon the termination of the business rescue proceedings. Given that the wording in the Bill is silent on if an when suspended or cancelled contracts revert to their status prior to the cancellation or suspension, provisions of this nature would at least provide creditors with contractual claims in a liquidation scenario rather than the possibility of entering into liquidation with only a damages claim.

Ensure appropriate intercreditor arrangements: In lending transactions, since unsecured and secured creditors will have equal voting rights calculated with reference to their outstandings, where possible intercreditor arrangements amongst lenders should attempt to rebalance the ranking amongst secured and unsecured creditors by agreeing voting strategies or by turn-over provisions by lower ranked lenders to the extent that the effect of the business rescue proceedings and rescheduling of indebtedness is that those lower ranked lenders receive more than they would have had business rescue proceedings not commenced.

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