03/09/2008

Financial assistance: living with its legacy

For most professionals in practice today, the financial assistance rules have been a fixture on the transactional landscape throughout their career. But from 1 October 2008 the rules will disappear other than for public companies and their subsidiaries.

What were the rules for?

The financial assistance rules were, in essence, creditor protection laws. A company could only do something to assist its own takeover involving the reduction of its net assets, or exposure to liabilities such as upstream guarantees, if the directors could say that despite doing so, they believed the company would still have sufficient funds to pay its creditors for at least a year into the future (the whitewash). As a way of preventing reckless whitewashing by the directors, their statement of belief had to be reported on by the auditors.

How have things turned out?

People have often questioned how much protection has really been afforded to unsecured creditors under the financial assistance laws. For example, how often have unsecured creditors challenged the reasonableness of a directors’ whitewash where the company has subsequently become insolvent? Very rarely. But there have certainly been cases where the need for a whitewash has prevented companies in a weak financial position from carrying out a financial assistance step which could have prejudiced their unsecured creditors.

The interpretation of the rules, the policing of the rules, and the conduct of the whitewash process, have all (for understandable reasons) been dominated by secured lenders (banks) and their lawyers. This is because the rules have more importance to the banks whose security would be in jeopardy if they were not complied with, than to the unsecured creditors they were meant to protect.

Missing the point

Most of the professional effort which has been devoted to financial assistance whitewashes over the years has been in arguing about what steps do or do not constitute assistance, about how to present those steps on the necessary forms for public filing, and about how to construct board minutes and other documents designed to demonstrate proper compliance. This sometimes shifts the emphasis away from the key question of whether the company can really afford to borrow the money and service the debt.

Where do we go now?

There is a happy coincidence of timing here. The removal of the financial assistance rules has come along just as the credit crunch is seriously affecting banks’ attitudes to lending, and the Chancellor is advocating a return to ‘good old fashioned banking’. Banks will need to review their approach, and in our view, provided they focus on how sensible the underlying lending proposition is, they should be able to wave goodbye to the whitewash process and the compliance paper trail without feeling its repeal leaves them in a more vulnerable position. After all, early financial due diligence should eliminate concerns about net assets and cashflow viability in most cases.

It would be a shame if banks tried to re-create the whitewash as a private requirement outside of the original statutory framework, because it would involve money and time being spent without a clear purpose. It is possible that the auditors’ non-statutory letter, which banks have become accustomed to requiring, will remain in existence adapted to reflect a non-statutory process, but in reality it would be nothing more than a due diligence reporting requirement. It might be more useful for banks to take a fresh look at their financial due diligence requirements and restructure those to focus on the borrower’s net asset strength and its ability to service and repay the debt, rather than on the old whitewash procedure, even if this new approach involves some form of review by an accountancy firm at the company’s expense.

In essence, banks should try to seek the protections that the financial assistance framework gave them, but move away from the shackles of assessing what is or is not financial assistance.

The spirit lives on

The law as a whole may not have changed as much as people imagine. There are several areas of law which look to police the decision making of companies, particularly in order to protect shareholders and creditors. These include the newly enacted laws on fiduciary duties of directors, insolvency, and those regarding maintenance of capital. We expect to see a lot more emphasis on some of these areas of law after September 2008.

To take one example, the rules on transactions at an undervalue (section 238 of the Insolvency Act 1986) remain unchanged, and if you look at the implications of these laws you soon realise that some of the fundamental elements of the old financial assistance rules live on. These provisions enable the liquidator of a company to ask a court to set aside anything which the company may have done (within certain timescales) which benefits someone else significantly more than it benefits the company.

An interesting development in recent years, which focuses on a specific creditor class and has brought about real change, has been the protection afforded to defined benefit pension schemes in the context of a leveraged transaction. The impact has been something of a shock to sellers of businesses with a scheme deficit, but the need to satisfy the Pensions Regulator has given real teeth to the law and resulted in very significant improvement to the financial position of defined benefit schemes. This specifically focussed law, enacted in the light of some fairly shameful examples of ignoring the interests of pension schemes, has probably produced more concrete and visible results than the much wider financial assistance rules.

Whilst there may be some teething problems, in general terms and in particular in the leveraged transactions arena, there is no reason why the repeal of the financial assistance laws should not save both time and money for all concerned.