For most businesses, the next year or so will be a time of battening down the hatches as they see their profits squeezed, their cash flows under increasing pressure, and the banks not as 'profligate' as they were before.   The companies that manage to trade through this period will find most of the answers lying within, rather than outside, the business.  For them, cash will be 'King', all thoughts of growing market share or maintaining profitability will be sidelined as the focus is placed firmly on a survival of the (cash) fittest.  

• Cut out all non-essential expenditure.  Do it now, do not defer it for another day.  Be brutal, assume that the sector will not recover quickly, if at all.  If you have cut too deeply, you can probably repair things later on.  If you do not cut deeply enough, you could die 'a death of a thousand cuts' , others  on whom you may need to rely later for support will view your management skills as weak.
• Recognise where your commercial muscle lies, and then fully utilise it.  This can be on the supply side (typically) or sales side (less often).  Use your muscle to obtain longer payment terms from your suppliers.  They will not want to see you reduce your spend or go out of business.  Use your muscle to secure earlier payment from your customers.  They may need your prompt service or wish to see you reduce your prices to help them survive.  Be flexible, do what is necessary in the short to medium term.
• Reduce your fixed costs (those that you have to pay regardless of how busy you are) and increase the proportion of variable costs that you have.  Examples of this include taking on temporary rather than permanent staff.  Changing your cost base to one that is more resilient to unforeseen changes in activity levels will increase the chances of you surviving the battle of the fittest. 
• Keep on good terms with your bank and HM Revenue & Customs.  The bank's view is often that as the largest single investor in your business, you should have more regard to their interests than others'.  HMRC's view is that, as an 'involuntary' creditor, any ' investment' in your business is probably too much.  Don't rely on getting better terms from either, expect both to cut a hard bargain.  But be fair with them and recognise their views, and they will probably be fair with you.
• Cut your own outgoings.  You will not encourage others to work with you and support you if they do not see you hurting too.                     

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The credit crunch is hitting mainland Europe, raising insolvency rates, according to Legal Week's recent article NautaDutilh launches 20-strong Benelux team.

Most UK insolvency practitioners felt the economy starting to bite in midsummer and all the signs here are that, despite the oil price receding, corporate insolvency will loom for many this autumn.

For some thoughts on avoiding insolvency, try our earlier post Find a Business Angel.

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The number of companies facing insolvent liquidation rose by 15% during the second quarter of 2008, as compared to the same period last year, as the credit crunch continues to impact upon the UK economy.

Figures from The Insolvency Service published on 1 August 2008 revealed that there were 3,560 compulsory liquidations and creditors' voluntary liquidations (CVLs) in England and Wales during the second quarter of 2008. This was made up of 1,324 compulsory liquidations, an increase of 19.8% on the previous quarter, and 2,236 CVLs, an increase of 7.3%.

Further evidence of an economic slowdown was highlighted by 1,246 other corporate insolvencies, comprising 177 receiverships, 938 administrations and 131 company voluntary arrangements, an increase of 63% compared to the same period last year.

These numbers support the findings of a recent survey (July 2008) undertaken by R3, the trade body for insolvency practitioners, which showed that 90% of respondents believed that a rise in business insolvencies would hit the UK in 12 months’ time, indicating that the worse is still to come.

The Insolvency Service figures support this survey and highlight retail, construction, property, leisure and manufacturing among the worst affected sectors as consumers rein in spending in the face of rising inflation rates and a deteriorating property market.

Offering his reaction to the latest statistics, Steve Smith, Head of Insolvency at Mercer & Hole comments: “These are very worrying figures and do not bode well for the UK corporate sector - particularly for small to medium-sized businesses which suffer most in a downturn. Of particular note is the rise in compulsory liquidation numbers which suggests that creditors are now seeking to recover their debts more aggressively as other forms of recovery become less effective.” 

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The number of individuals becoming insolvent fell 8.3% to 24,553 in the second quarter, surprising analysts who expected to see an increase as evidence that higher living costs were impacting upon people's finances.

Individual insolvencies were made up of 15,297 bankruptcies (down 6% on the same quarter a year ago) and 9,256 Individual Voluntary Arrangements (IVAs) (down 12%). Interestingly there was a pronounced shift towards debtors' petitioning for their own bankruptcy as, in the second quarter of 2008, 84% of bankruptcy orders were made on a debtor’s petition.

Nevertheless, we must look at these statistics with an element of caution as they may have been skewed by a rise in the number of people entering into informal debt management plans to try and head off insolvency.

Indeed, the decline in individual insolvencies is generally perceived to be a result of a reduction in the number of people entering into IVAs as lenders are more reluctant to accept IVAs and are imposing stricter terms. This has been fuelled by reports over the past year of banks raising their hurdle rates - the amount of money they are willing to accept from borrowers to settle their debts.

Steve Smith, Head of Insolvency at Mercer & Hole, comments: “Although the 'trickle down' effect of the credit crunch hasn’t truly hit personal insolvency figures, over the next 12 months the situation seems certain to deteriorate as consumers in the UK rein in their lifestyle borrowings. The downturn in the housing market, soaring commodity prices and the credit crunch will continue to take their toll.”

 

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The credit crunch has made it more important than ever for business owners to address
viability and solvency issues early. Delays in taking remedial steps now will only result in
more pain and fewer options, and will give you less time to act later on. 

Directors and managers concerned about their business should carry out an ongoing and in-depth assessment of the company, asking themselves the following five key questions:

1. Where can I improve cash generation or legitimately defer outgoings in order to
   improve the retention of cash in the company? 
2. Where are the main risks in the business? What would I do if I lost that valuable
   customer, or the bank were to withdraw its support? 
3. Are there any costs which can be moved from being ‘fixed’ to ‘variable’? 
4. Are there any areas of business that should be pruned back or sold? Is that
   person, department, service or product adding real value at this point in time? Can
   I afford to take a long term view without increasing risk? 
5. What can I do to cut my drawings from the business?

You need to be brutally honest with yourself. If you are at all unhappy with the
answers to these questions, you should re-assess all of your available options, which could
include restructuring the business using formal or informal routes. Now is not a good time to
defer that re-assessment.

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Experian reports a rise in UK corporate insolvency: up 8.5% in Q1 2008 compared to Q1 2007, in line with our last forecast here.

Business sectors identified as suffering include agriculture, banking, food retail and clothing (although some of the sample sizes are small), but 10% of the quarter's failures are in building and construction.

Regionally, the East Midlands is hardest hit with insolvencies up 53.6%.

Creditors' voluntary liquidations increased by 14.1% but compulsory liquidations fell by 2.2%, perhaps reinforcing concerns about confidence as debtors go for CVLs whilst fewer creditors are pursuing compulsory winding-up. The popularity of the procedures amenable to corporate rescue - administrations and company voluntary arrangements - continues with growth of 23.7% and 37.6% respectively.

My own experience is that more businesses are considering an insolvency procedure than either 3 or 12 months ago. Certainly, businesses cannot borrow their way out of trouble at the moment and the signs are that advice about facing insolvency is being sought earlier - offering more prospect of a constructive solution.

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Some say we are on the brink of a major slow down. Clearly the economy is not as strong as it has been, but surely the real questions are:

• just how sharp is the ‘adjustment’ likely to be;
• how long will it last; and
• where will it be felt most?

Let’s look back over some recent figures and at the same time consider what the future may hold:

• Currently GDP is growing at 2.9% pa and is expected to fall to under 2% over the next few months. Research has shown a 1% drop in GDP growth could lead to a 10% increase in corporate insolvencies (see our previous post). The economy has been incredibly resilient throughout the last decade, but the credit crunch has ended that period of stability.
• Whilst inflation is presently running just above the government’s target at just 2.2%, the Bank of England is forecasting a rise to over 3% in the near future giving rise to further pressures on disposable income. 
• House prices are weakening generally across the country, although less so in London. The recent reduction in loan to value ratios and income multiples on offer will restrict mortgage funding and reduce both demand and consumer confidence.
• Total personal debt levels, at £1.4 trillion, are huge and growing at £1 million every 5 minutes, more than three times the rate of inflation. The growth in personal debt may be slowing, but record numbers of personal insolvencies and a significant number of borrowers defaulting support the trend towards less excessive consumer spending.

In summary, the main aspects of the economy are less volatile than, say, the 1980s to early '90s when huge swings could be expected. The economy has certainly become more unstable during the last 6 months, but overall, I expect the ‘adjustment’ to be relatively shallow and short-lived, with the pain being suffered more in particular regions or sectors :

• Retailers who enjoy a strong market position and are well organised and managed are likely to fare better than their weaker competitors. Suppliers of ‘growth support services’ into retailers, such as shopfitters, can expect a further deterioration in both sales volumes and margins, causing viability and solvency issues (see previous post).
• Pubs and restaurants have already seen their takings fall as a result of consumers’ reduced free cash, the smoking ban, and cheap supermarket alcohol. Fixed costs remain high, and leisure outlets with poor procedures and low staff morale are at risk.
• Confidence is low in the construction industry, despite the Olympics Effect and government housing requirements. Many construction related companies will not be able to cope with any further reduction in prices or any deferral of work or payment by the major employers(see previous post).

The slow down in these parts of the economy will no doubt create added opportunities for Insolvency Practitioners to bring their turnaround skills to bear to rescue ailing but viable businesses, as well as to assist in close down scenarios. As always, early attention to potential problems increases the likelihood that a turnaround will be achievable.

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We reported in our earlier blog 'Retail Insolvency News', that the New Year is a time when retail insolvencies tend to come to the fore. 

Some British retailers, hit by poor Christmas trading, may struggle to pay their December rent bills, forcing them into insolvency or a debt restructuring in the New Year.  Experts are predicting that the most likely to run into trouble are 'big ticket' retailers selling discretionary products.  

So noted Credit Today recently.  As one of those whose view they sought I think there are systemic risks and that big-ticket, discretionary-spend retailers are in the front line.

But so far 2008's prominent retail insolvencies have been in shoes (Stead & Simpson and Dolcis), books (The Works) and fashion (Elvi and Base Menswear).

The common thread is undistinguished chains at the low end of the middle market being most  at risk, with the credit crunch affecting future levels of retail spending and spending on non-essential delayable purchases. Differentiation and a nose for fickle customer demand remain the key factors for survival.

The Financial Times observes (here) that the tally of retail failures is lower than it might have been. Restructuring takes longer because of the more complex stakeholder structures found now compared to 5 years ago, and some of the weaker players saw the New Year's problems coming. Together these factors encouraged some retailers to start taking advice and acting early enough to avoid administration.

 

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The cash flow or commercial insolvency test contains a flexible and fact sensitive futurity requirement in the phrase “as they fall due”, according to Briggs J in Cheyne Finance Plc (in receivership) [2007] EWHC 2402 (Ch).

Cheyne was a structured investment vehicle (“SIV”). It was one of the first SIVs to go into receivership as a result of the credit crunch. The receivers sought the court's directions as they had to identify whether an “Insolvency Event”, which was defined by reference to the cash flow test in s123 Insolvency Act 1986, had occurred.

s123(1)(e) provides that a company is deemed unable to pay its debts:

“if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due”

The wider implications of the Cheyne decision, which is the first time the court has considered this section, are that technical insolvency may be triggered earlier in some cases than might have been expected.

The judge gave the following example:

“The company has £1,000 ready cash and a very valuable but very illiquid asset worth £250,000 which cannot be sold for 2 years. It has present debts of £500, but a future debt of £100,000 due in 6 months. On any commercial view the company clearly cannot pay its debts as they fall due, but it is, or would be balance sheet solvent”.

In other words, if the company can continue to pay its present debts, but it cannot pay a known future debt, it is insolvent. 

Consider a company with positive net assets but limited cash, say £100,000, which it is burning at a rate of £50,000 per month. In one month’s time it has to pay a wages bill of £60,000. Provided that on the balance of probability it will continue to burn cash at £50,000 per month, it is insolvent now, not just in a month’s time when it no longer has the cash to pay its present debts.

This decision seems especially relevant during the current credit crunch when companies may have positive net assets but insufficient liquidity. It emphasises the need to take specialist advice early.

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Headlines and commentary abound, but the real thing (181 pages) is here (pdf) or  here (html).

It stretches from mention of previous bank runs (Overend, Gurney & Co., 1866;  City of Glasgow Bank, 1878), Barings' liquidity crisis and the liquidation of BCCI to a detailed analysis of the development of the Northern Rock crisis in August and September 2007.

The conclusions (quick link here) highlight firmly the responsibility of Northern Rock's directors for the reckless business model - borrowing short and lending long - which collapsed with the credit crunch, for failing to ensure that the bank remained liquid as well as solvent, and for failing to provide against the risks they were taking.

But they are also highly critical of the FSA:

• "substantial failure of regulation."
• "it was wrong of the FSA to allow Northern Rock to weaken its balance sheet at a time when the FSA was itself concerned about problems of liquidity that could affect the financial sector."
• "The current regulatory regime for the liquidity of United Kingdom banks is flawed."
• "It was the responsibility of the Financial Services Authority to ensure that the work of the Board of Northern Rock was sufficient to the task. The Financial Services Authority failed in its duty to do this."
• "The Financial Services Authority should not have allowed nor ever again allow the two appointments of a Chairman and a Chief Executive to a "high-impact" financial institution where both candidates lack relevant financial qualifications"
• "The FSA did not supervise Northern Rock properly. It did not allocate sufficient resources or time to monitoring a bank whose business model was so clearly an outlier; its procedures were inadequate to supervise a bank whose business grew so rapidly. We are concerned about the lack of resources within the Financial Services Authority solely charged to the direct supervision of Northern Rock. The failure of Northern Rock, while a failure of its own Board, was also a failure of its regulator."
• "In the case of Northern Rock, the FSA appears to have systematically failed in its duty as a regulator to ensure Northern Rock would not pose such a systemic risk, and this failure contributed significantly to the difficulties, and risks to the public purse, that have followed."

The Bank of England gets off relatively lightly with recommendations as to its response but few direct criticisms:

• "We are unconvinced that the Bank of England's focus on moral hazard was appropriate for the circumstances in August. In our view, the lack of confidence in the money markets was a practical problem and the Bank of England should have adopted a more proactive response."
• "we have concluded that the Bank of England should have broadened the range of acceptable collateral at an earlier stage in the turmoil."

The report's conclusions about the Chancellor's role are somewhat more opaque:

•  "State support for Northern Rock has involved the Government entering into contingent liabilities on a very large scale. It is important that the Treasury discharges its obligations to the House of Commons—and through the House of Commons to the taxpayer—promptly and fully to report on the extent of such liabilities."
• "We cannot accept, as some witnesses have suggested, that the Tripartite system operated "well" in this crisis. In terms of information exchange between the Tripartite authorities, the system might have ensured that all the Tripartite authorities were fully informed. However, for a run on a bank to have occurred in the United Kingdom is unacceptable, and represents a significant failure of the Tripartite system. If the system worked so "well", the Tripartite authorities should take a closer look at the people side of the operation."
• "While we welcome the Chancellor's admission that he was ultimately in charge of the decision making process relating to Northern Rock, we are concerned that, to outside observers, the Tripartite authorities did not seem to have a clear leadership structure."
• It is unacceptable, that the terms of the guarantee to depositors had not been agreed in advance in order to allow a timely announcement in the event of an adverse reaction to the Bank of England support facility."
• "We are also concerned that it did not prove possible to announce the guarantee that was decided upon that day before the markets opened the following day. The cumulative effect of these failures was to delay the guarantee until the evening of the fourth day after the run started and thus to make the run on the deposits of Northern Rock more prolonged, and more damaging to the health of the company, than might otherwise have been the case."
• "In view of the role that fears of a leak of a support operation had played in the decision on Tuesday 11 September that a covert operation was not possible, the Tripartite authorities were unwise initially to accede to Northern Rock's request for the announcement of the support operation to be delayed until Monday 17 September. In the light of subsequent events, it seems evident that the Tripartite authorities and Northern Rock ought to have strained every sinew to finalise the support operation and announce it within hours rather than days of the decision to proceed with the operation."
• "In failing either to make an announcement earlier in the week or to put in place adequate plans for handling press and public interest in the support operation, the Tripartite authorities and the Board of Northern Rock ended up with the worst of both worlds."

It will be interesting to see whether the Committee's recommendations for regulatory reform are followed, given the Chancellor's slightly different proposals aired last week.

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For those of you who are not accountants - or don't read Accountancy Age - the quotes below are from its article "Retailers protected from impact of Trident ruling" published on 10 January 2008.

We reported the UK government's decision to exempt companies in administration from empty property rates in an earlier post.

President of R3 Patricia Godfrey says the decision couldn’t have been better timed for retailers: ‘With the effects of the credit crunch increasingly likely to be felt in the New Year, this move will help administrators save business and jobs.’

Mercer & Hole business recovery partner Chris Laughton agrees, highlighting the credit crunch as likely to lead to more retail insolvencies. Removing the preferential treatment on business rates for unoccupied properties would save businesses.

‘The decision will help what will be a higher number of retail insolvencies than last year,’ Laughton says.

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The credit crunch of August-September 2007 has disturbed the economic equilibrium - and may continue for a while yet. Debates about illiquidity or insolvency abound, but are we really facing a swing from boom to bust?

The underlying UK economy is strong, but we now have corporate transactions stalling through lack of funding, hedge fund failures, a sub-prime lender in administration and the Northern Rock bailout. What many considered a strange US phenomenon (had many people heard of sub-prime before this summer?) has become a real domestic issue. No wonder business and consumer sentiment is waning:

• the ICAEW UK Business Confidence Monitor (BCM) has moderated in Q3 2007 from a Q2 peak of +11.5 to a relatively weak +4.8;
• the BDO Optimism Index shows a sharp fall in August, from 101.9 to 101.2, confirming the impact of the US sub-prime crisis on UK businesses. This drop takes the Index to its lowest score since November 2005 and whilst business optimism has been decreasing slowly since July 2006, it appears that the impact of the turbulent financial markets has accelerated this trend; and
• the Nationwide Consumer Confidence Index fell back in August reflecting the impact of five interest rate rises over the past year. The main Index fell by two points, but it was not alone. All indices fell in August, the first time since December 2006 that all four measures of confidence showed a downturn in the same month.

For a reminder of how the credit crunch derived from the US sub-prime contagion via risk reappraisal amongst lenders and hedge funds, how CDOs, CLOs and SIV-lites were ideal vectors to spread the disease around the world, and the impact on bank lending, read "While you were away - fear and loathing in the markets" from The Times.

Other recent indications of the state and direction of the economy are:

• US business bankruptcies are on the rise, reports Bob Eisenbach, quoting Euler Hermes, who continued to forecast a small rise in the UK. After we reported Euler's November '06 forecast in a previous post, Geoff Swire commented when the UK's June insolvency figures became available that the forecast had been pessimistic. I suspect it was a timing issue and that corporate insolvency statistics in Q3 will rise in the UK, albeit by less than in the US.
• The world has changed dramatically: Germany’s Chamber of Industry has been flooded with distress calls from family Mittlestand firms unable to roll over credit lines and in Canada and Australia, junior mining finance has dried up almost entirely, according to Ambrose Evans-Pritchard on his Telegraph blog post "Brace yourself for the insolvency crunch".
• If the liquidity crisis continues it will will become an insolvency crisis and the banking industry will be hardest hit, according to Panmure Gordon.
• Insolvency firms are likely to be busy dismantling failed investment vehicles, with the most likely suspects being the quantitative hedge funds and funds focused on CDOs that have fallen foul of market conditions, writes Antonia Rawlinson "Uncertain times call for certain measures" in The Lawyer.
• "The M&A boom is over and law firms must adapt" agrees James Rossiter in The Times - restructuring is now the hottest game in town.

So what does all this mean? Yes the capital markets are in turmoil, banks are lending much more cautiously and some high risk investment vehicles are failing, but essentially this is only a liquidity problem. Its effect though is that stressed businesses will no longer be able to borrow their way out of trouble as they have become hard-wired to do over the last 3 years.

Crisis cash management and operational and corporate restructuring will come back into vogue as refinancing becomes passé. Only if stressed businesses fail to seek appropriate and timely assistance will the business insolvency statistics really start to rise.

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Credit crunch - market volatility - insolvency - where next?

Nouriel Roubini is a professor of economics at New York University and he is not optimistic about what will happen in the US: The Forthcoming Fed Rate Cuts May Not Prevent a US Hard Landing .

If there is a hard landing in the US, then Europe and the UK will feel the bump.

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