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If your company has difficulty meeting its financial obligations, it may be insolvent. While not all solvent companies can rescue themselves and avoid liquidation, the law does provide ways for companies to turn around their finances so they can begin trading as usual again. While not the only option, one of the most effective turnaround options is negotiating with your creditors and reaching a contract-based compromise. This article will explain what a contract-based compromise looks like in practice. It will also provide an overview of the essential practical considerations you may wish to consider.
Contract-Based Compromise
A contract-based compromise — also called a consensual agreement — is a private arrangement between you and your creditors to renegotiate the terms of your debt. This differs from court proceedings for insolvent companies, which are governed by a special set of laws. In other words, a contract-based compromise does not involve the courts. Instead, both parties agree to amend the terms of the outstanding financial liabilities so that the company can continue trading.
Before we examine some practical considerations, such as which kinds of insolvent companies best suit contract-based compromises, we will look at two hypothetical examples, involving a fictional company, Hard Times Co.
Examples
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Example One | Hard Times Co has had a bad trading year. Invoices sent by trade suppliers have piled up in the past month. In total, Hard Times Co owes £50,000 each to two suppliers of goods it uses to manufacture its products. As the director of Hard Times Co, you approach both suppliers separately and negotiate a payment plan. Rather than pay each supplier £50,000 up front, you will pay them each £10,000 for the next 12 months. This is effectively paying 20% in annual interest. |
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Example Two | Hard Times Co has an overdraft facility with its bank that it has drawn up to the maximum amount of £10,000. The bank is unwilling to extend the overdraft and is also demanding immediate payment. However, the company does not have £10,000 in cash. You go to a bank branch and speak with a client manager. Ultimately, you both agree that Hard Times Co will borrow money under a new debt facility. This is a revolving credit facility at 10% interest per year. You draw £10,000 under the facility to pay off the overdraft facility. The bank will also take security over your company’s assets and has to pay a £1,000 fee. |
Practical Considerations
Advantages
In most cases, contract-based compromises represent the best option available to companies facing insolvency or already insolvent. This is because they are cheaper, faster, and more flexible than non-contract-based compromises involving the court.
The only real disadvantage is that your company is at the mercy of its creditors.
Viability
Contract-based compromises are not for all insolvent companies. A contract-based compromise’s defining feature is that all relevant creditors agree to the proposal. Therefore, companies with numerous creditors of different classes, such as trade creditors (as in Example One) and bank lenders (as in Example Two), will have a more challenging time getting all to agree.
This is because where one creditor feels that they might have to compete against another in the event the company is liquidated, they are more likely to try and act in their own interests. Typically, this involves petitioning a court to initiate formal insolvency proceedings. When a court agrees to a petition, the chance of successfully negotiating a contract-based compromise diminishes.
As such, the more advanced a company is in the insolvency process, the less amenable its creditors will be to a compromise. Creditors tend to agree to arrangements with companies they think will be able to honour the arrangement.
Finally, businesses are unlikely to alter their position unless it is in their interest. Given that you are in an inferior negotiating position, your business should expect to have to pay for the privilege of your creditor waiving its legal right to bring proceedings. Commonly, this includes:
- paying more in interest;
- granting security over company assets;
- selling assets;
- making management changes; and
- granting your creditors shares in your company, known as debt for equity swaps.
Restructurings
You may hear certain creditors, especially financial creditors like bank lenders, refer to restructurings as consensual arrangements. Example Two was a simple example of a debt restructuring that was a contract-based compromise. At its most basic, a company with outstanding bank loans and other kinds of debt agrees to renegotiate the terms of the debt. For larger companies, restructurings can involve multiple banks and other lenders.
While restructuring can be a form of a contract-based compromise, more complex restructurings often require a court’s approval and are, therefore, not purely contract-based.
Overriding Directors’ Duties
When you realise your company is facing insolvency, as a company director, you have an overriding obligation to consider the interests of your creditors as a whole. Therefore, you cannot:
- continue to trade if it means that your company’s position will continue to deteriorate; and
- favour one creditor over another.
As this relates to contract-based compromises, this has specific practical implications. Here are some common scenarios where a director breaches their duties as a director for a company facing insolvency.
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Example Three | As in Example One, Hard Times Co cannot pay trade suppliers’ invoices when they are due. In this case, Hard Times also has bank loans with two separate banks. As its director, you negotiate with one supplier that you will repay it, knowing full well the agreement means you cannot pay the other supplier and the banks. By doing so, you have shown an unlawful preference for one creditor at the expense of others. |
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Example Four | Provided the facts were the same as in Example One, if you continue trading with the supplier you negotiated the compromise, you would be unlawfully trading. |
It is important to appreciate that, as a director of a company facing insolvency, you owe additional duties to the company’s creditors. This means you cannot make contract-based arrangements that unfairly prejudice other creditors. If you breach these obligations and insolvency proceedings escalate, the law may hold you personally liable for the company’s debts.
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Alternatives
In brief, alternatives to contract-based compromises include:
| Distressed sales | This is where you sell your interests in the business to a buyer, almost always at a discount. This is because of the inherent risk the buyer assumes with a distressed company. |
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Schemes of arrangement and Part 26A proceedings | Court proceedings that involve shareholders and creditors negotiating on an arrangement amongst each other that the court must then consent to. |
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Administration | Another kind of court proceeding where a court official (an administrator) is appointed by court order to manage the company’s affairs, and they remove the directors. In some cases, the business may continue, such as if the administrators sell the company. In other cases, they may sell the assets to pay back creditors. Either way, as a director or shareholder, you are out of the money and management of the company. Administrators have powers to order directors to personally contribute to the company’s assets where they have breached their duties. |
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Liquidation | The nuclear option — where either at the request of the shareholders or the creditors, a court agrees to appoint a court official (a liquidator) to sell all the assets and pay its creditors off. |
Key Takeaways
Contract-based compromises are usually the best option for companies facing financial distress. Provided all the relevant creditors agree to a proposal to renegotiate the terms of the debt, the court does not intervene. This makes it a private agreement, which saves all parties time and money. Companies with multiple creditors or which may struggle to survive in the future are less likely to successfully negotiate a contract-based compromise.
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Frequently Asked Questions
A contract-based compromise is where a distressed company agrees to modify the terms of any obligations owed to its creditors through private means rather than court proceedings.
The ability of your company to arrange a contract-based compromise largely depends on your position. A company with few creditors and a fighting chance of turning its business around is more likely to successfully negotiate a contract-based compromise with its creditors.
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