Business rescue

Business rescue follows failed management-led correction and failed informal creditor workout as a formal process within the legislative framework.  If successful, liquidation is avoided.

Conceptually, the purpose of business rescue is to preserve the going concern value a distressed firm, that is or is going insolvent but potentially viable, through a legal process enabling turnaround, inclusive of refinancing and financial restructuring, or keeping it afloat and selling it as a going concern (for turnaround and refinancing by the buyer).

A firm that enters business rescue and emerges intact may satisfy creditors' claims more effectively than a firm that is liquidated.  If eventually liquidated, the outcome may be more favourable to stakeholders if a business rescue attempt has not been made.

Business rescue allows a distressed firm to:

• Satisfy claims of creditors.
• Continue in the economic stream.
• Preserve jobs and create employment (see the imperative of job preservation).
• Pay taxes.

Business rescue law therefore reflects two requirements of a modern commercial economy:

• A method for the orderly payment of debts owed to multiple creditors.
• A  means to ensure that individual debtors retain sufficient assets and rights to maintain a dignified or at least non-penurious existence.

View the position of business rescue in the timeline of financial distress.

Click on Timeline of financial distress table for a popup table explaining the four stages.

View the restoration of corporate value at different levels of company health.

Compromises in terms of Section 311 of the Companies Act

"311 offers of compromise to creditors are complex."

In this business rescue procedure creditors voluntarily agree to waive or reduce their claims to allow a business to continue as a going concern. 

The eventual compromise must be sanctioned by both the creditors and the court. 

The case law dealing with it is complex.

Judicial management (Sections 427 - 440 of the Companies Act)

"Judicial management has been a failure."

The intention is for a company experiencing a temporary financial setback as a result of mismanagement or other special circumstances, to be restored to profitability by replacing existing management with a judicial manager. 

However, as a business rescue regime, judicial management has been a dismal failure ever since its introduction in 1926. 

The main problem is that it cannot bind suppliers and creditors to continue to trade with the company and deal with the existing directors of the company in restructuring, rationalising and reorganising such company for the benefit of creditors and shareholders.  

Consequently, judicial management is, in practice, merely a forerunner to liquidation.

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View the timeline of financial distress cost and failure diagram.

It has been established in the timeline of financial distress that costs increase and equity value is less preserved as processes follow the sequence of Management-led correction ->Informal creditor workout -> Business Rescue -> Liquidation.

The failure rate follows the same sequence (with liquidation representing 100% failure).

"New business rescue legislation is not a silver bullet for South Africa's distressed companies."

Business rescue is expensive, albeit less so than liquidation.

Moreover, judging by international experience with modern business rescue regimes, it can be expected that after the replacement of judicial management with the proposed debtor-friendly new business rescue legislation, less than 50% of business rescue attempts in South Africa will still be successful.

One should therefore guard against viewing new business rescue legislation as a panacea for South Africa's unemployment and liquidation problems, since less than 50% of company liquidations will be avoided.

The best time to turn around a company is and remains earlier than business rescue, using upstream processes of management-led correction and informal creditor workout.

Like other court-driven processes, business rescue is more expensive than processes that take place outside of the legal framework (management-led correction and informal creditor workout).

Direct costs include the legal, accounting and management consulting fees associated with the supervisor and advisors used to develop the business rescue plan and interface with affected parties and the courts.

Indirect costs refer to additional management time and lost sales, customers, employees and suppliers.

Costs of reorganizing under chapter 11: some evidence from the 1980s (see box on the right)

"From a sample of 101 successfully reorganized publicly traded firms:

• The direct costs of bankruptcy (formal USA business rescue procedure) averaged 23.5 percent of the book value of the firm on exiting Chapter 11.
• The median value was 8.8 percent.
• If measured on the basis of entering book value, the direct costs averaged 5.4 percent.
• These costs were incurred over 1,87 years, the average time these firms spent in reorganisation.

The business rescue experience in the USA is that most companies do not survive Chapter 11.

Baker A. Smith, President of Morris-Anderson & Ass., a leading US turnaround firm (2002)

"Since over 85% of businesses never successfully emerge with a confirmed plan of reorganisation, the cure must be worse than the illness.  Most companies die in Chapter 11.  Unless a company’s underlying problems are addressed with a turnaround plan or sale, Chapter 11 can’t ultimately save them."

Study on bankruptcy case confirmation rates (see box on the right)

The Poughkeepsie Study, as reported in Bankruptcy Court Decisions 17 December 1992, records that only 17% of Chapter 11 cases (in the Poughkeepsie District of New York) result in confirmed plans of which only 58% are consummated, nearly a quarter of which are liquidating plans.  This is reported as resulting in a 6.5% chance of the debtor emerging from bankruptcy as a reorganised operating business. 

Another US survey reported in the Spring 1996 edition of the ABI Law Review points to a similarly low plan confirmation rate. It is not clear to what extent US statistics are tainted by inclusion of “dead on arrival” cases.

The US Department of Justice in 1998 found that the success rate of Chapter 11 bankruptcy cases, as measured by the percentage of cases confirmed each year, has doubled since the early 1980s.

It found, on average, a 27% confirmation rate of Chapter 11 cases files between 1989 and 1995, compared to statistics for prior years that showed that only 17% of Chapter 11 cases were confirmed. A case is "confirmed" if the court approves of the company's plan to repay its debt.

Note that if a case is confirmed it does not necessarily follow that the business will survive.  The survival rate of businesses that enter Chapter 11 is therefore obviously less than the 27% confirmation rate.

Note on the above USA business rescue success rate studies

Firstly, these studies are dated and were conducted in the free fall business rescue days.  The trend has been towards pre-packaged business rescue, which has a higher success rate.  The actual failure rate for Chapter rate may therefore be lower than the figures from these studies.

Secondly, many Chapter 11 cases have eventual liquidation rather than reorganisation in mind i.e. the intent is not always business rescue, which pollutes the success rate statistics.

(See Key success factors for business rescue in South Africa for a description of free fall vs. pre-packaged business rescue).

Other USA business rescue success rate studies

• Many firms increase their investment expenditures only by very little in the first two years after a debt restructuring (James 1995).
• In each of the first five years after emerging from business rescue, between 35 percent and 41 percent of all firms have negative operating income (Hotchkiss 1995).

General advantages of business rescue

• Avoiding liquidation in almost 50% of cases (using the UK as a reference).
• Can trade while insolvent.
• A temporary moratorium on the rights of claimants against the company or in respect of property in its possession.
• Cram-down of dissenting creditors and avoiding creditor hold-out compared to informal creditor workout.

Advantages to directors and shareholders

Can appoint the supervisor itself (albeit that the appointment can be challenged in court by creditors).

Advantages to directors and management

Remain in control, albeit under supervision and subject to the instructions and veto power of the supervisor.

Advantages to consultants

Consultants (turnaround, legal, financial etc.) acting as advisors to the supervisor rather to the company during business rescue will, in the event of a liquidation, have their outstanding fees ranking above those of employees, secured, post-commencement finance, and unsecured claims.

General disadvantages

• Much more expensive than informal creditor workout.
• Reluctance of directors and management to hand over power to the business rescue supervisor, thereby admitting failure, and their attempts to avoid the stigma of insolvency.

This leads to delays in placing a troubled company under supervision, whether done so by directors, creditors or employees - thereby:

i) Missing out on the opportunity for pre-packaged business rescue (more successful).

ii) Leaving free fall business rescue (less successful) as the only option.

(See Key success factors for business rescue in South Africa for a description of free fall vs. pre-packaged business rescue).

• Danger of the company appointing a "friendly" supervisor

From the 070319 MoneyWeb article: Investment insights

"Nedbank takes issue with distressed companies appointing the supervisor for several reasons:

In certain cases, existing management may be the cause of the company's demise and may thus not be best placed to decide who the supervisor should be.

Further, a number of the large corporate collapses recently have involved wrongdoing on the part of management.

It is unlikely that management which brought about the downfall of a business through fraud or reckless trading would be willing to appoint an effective supervisor to expose and undo the effects of that wrongdoing.

It will be possible for management to appoint a friendly supervisor who may be less effective in exposing their mismanagement or wrongdoing and slower to rectify these in order to rescue the business.

The only remedy open to creditors and employees who object to the supervisor appointed by management is to apply to the High Court to have the supervisor removed or replaced.

This is both expensive and time-consuming.

Timing is critical when rescuing a distressed business and lengthy court proceedings in the initial stages can only be counter-productive."

In countries with a legacy of English law like SA, business rescue taking place under laws carries the stigma of insolvency, leading to loss of prestige, staff and customers.

As stated by Rudolf Gouws, chief economist at Rand Merchant Bank, in a Business Day article in October 2005: