Alan Meek considers how 'connected party' debt is treated in insolvencies and whether there is a general case for treating such debt less favourably than other debt.
I have recently discovered a thing called the 'internet'. It bombards me with information from all over the world. It is interesting of course to know 24:7 what people called Kim and Kanye are doing but I have also found that it gives me access to legal thinking in different jurisdictions on an almost daily basis.
In this regard, my fancy was taken by a report I read of an American insolvency court decision where a debt owed by a bankrupt was 're-characterised' as equity. I won’t claim to be fully conversant with the facts of the case (it is an unreported case) but from what I can glean, the court appears to have come to the view that this particular debt should be treated less favourably than any other ordinary debt.
There were a number of relevant factors (the debt arose from a prior 'settlement' and had been bought and sold) but I believe that key to the decision of the court to relegate the ranking of this debt in the insolvency process was the connection between the debtor and the 'lender'. That got me thinking, so reluctantly I dragged myself away from MailOnline.
It occurred to me that in a number of CVA cases, I had seen circumstances where debt had initially been owed to the owners of the debtor company but where, by a combination of sale of shares and sale of the debt at a discount, what had at one point been connected party debt had ceased to be connected party debt.
It had thus become debt which, on its own, carried enough voting power to force through a CVA. Had the debt continued to be connected party debt, the voting rules in CVAs would have meant that the votes of unconnected parties would also have been necessary to pass the CVA. The effect of those debt and share sales was that ordinary third party creditors were effectively disenfranchised and a CVA that would not otherwise have been passed, was approved.
In my view the intention to subsequently propose a CVA was already there when the sales were being effected and those sales would not have occurred but for the intended subsequent CVA. So, the new owners of debt and equity were united in purpose with the old owners, but were not connected parties for the Insolvency Act.
My thought process went a bit like this:
In CVAs, for voting purposes, we already treat connected party debts differently from debts owed to other parties. We treat postponed debts differently from ordinary debts in liquidations.
There is a current discussion about treating consumer debts as preferential in insolvencies. Some employee debt is preferential. So, the idea that we might treat one class of unsecured debts differently from others is not a new one. Is there therefore a more general case for treating connected party debts less favourably than other debts?
That may mean creating a ranking of “inferior ordinary claims” or “super equity” - something somewhere below ordinary external creditors and above shareholders.
I can see pros and cons. Often the 'connected parties' are those who have to be lenders of last resort to a business - a typical family company, for example, may require funding on what would otherwise be its deathbed.
Who is most likely to provide that funding? Mostly likely it will be those with most to lose if the company fails - and that often means the family directors and shareholders. Should we discourage them from putting money in at that point?
On the other hand, it is precisely those 'insiders' parties who are best placed to form a view on the financial position of the company. Insiders should not be able to take advantage of that knowledge to manipulate the situation to their own benefit.
Of course we already have remedies such as unfair preference and wrongful trading. But of course any remedies that may be available require litigation and funding for that litigation.
We live in a rescue culture apparently. Anything that might imperil businesses on the verge of insolvency may be considered to be not quite cricket. However a strategy aimed primarily at preserving equity value for 'insiders' should surely not be designed and carried out by those very insiders at the risk of losses being sustained by external creditors. As always it’s a policy balancing act.
Anyway, I wonder what the Beckhams are up to now.
The views expressed in this article are the views of the author and do not necessarily represent the views, policies or regulatory approach of ICAS.