Avoiding insolvency during Covid crisis

Since its declaration by the World Health Organization as a global pandemic, Covid-19 has had devastating effects on businesses all over the world. Courts in many jurisdictions including the US have recognised the pandemic as a natural disaster with far reaching effects.

Parties to contracts have had to establish whether the Covid-19 pandemic falls within the scope of the force majeure clause; as well as whether the doctrine of frustration can be relied on for one to be relieved of their contractual obligations.

Locally, the government has put in place various legislative and policy measures to cushion both citizens and businesses from the ensuing economic hardships. Such include reduction of the Central Bank Rate to 7 percent to enable commercial banks lend to consumers at affordable interest rates, reduction of VAT rate from 16 to 14 percent leading to reduction on the price of vatable goods and services and reduction of Cash Revenue Ratio to 4.25percent. The reduction by the Central Bank is intended to increase liquidity among commercial banks. This will in turn avail more cash to the banks to continue advancing credit facilities to businesses and other consumers.

Despite the various measures, many businesses continue to experience reduced turnover. This has hampered many businesses’ ability to service their credit facilities timeously. This may in turn result in drastic measures by creditors such as commencement of insolvency proceedings which would negatively impact the ability of businesses to operate as going concerns in the long-term.

In this publication, we explore the various options available to both businesses and creditors for purposes of increasing capital flow so that the businesses can remain afloat while at the same time meeting their financial obligations to their creditors.

Insolvency is a financial position where a company is unable to meet its financial obligations as and when they become due. More likely than not, an insolvent company’s liabilities are more than its assets. Under the Insolvency Act, 2015, a business is insolvent if a demand to pay its debts has been issued and the notice period has lapsed without the company honouring the same. At this point, a creditor has the statutory right to lodge an insolvency petition in court for the assets of the company to be liquidated as a way of recovering its money.

It is important to note that Kenyan courts have ruled that insolvency is not a measure of last resort in debt recovery. Courts have also determined that where the debtor has made proposals to liquidate the debt, such proposals should not be taken as inability to pay the debt and therefore an insolvency petition presented where such proposals exist will be declined. Similarly, courts frown upon creditors who present insolvency petitions for the sole purpose of coercing debtors to pay. Consequently, it is important for both creditors and debtors to consider arrangements that provide for adequate capital to run the business while at the same time servicing the debts.

That notwithstanding, many companies may find themselves dealing with insolvency petitions during this pandemic. However, as discussed below, there are various options in law which both the debtor and the creditor may explore to achieve a win-win situation in the long-term instead of liquidation. A snippet of each of these options is outlined below.

Company voluntary arrangements (CVAs)

A Company CVA is a statutory insolvency procedure which sees a company and its creditors agree on repayment of the debts over a specified period of time. Usually, a CVA is proposed by the company in distress, through its directors. It may also be made by a company’s creditors or administrators. The objective of a CVA is to rescue a viable company in financial distress from liquidation.

A CVA has provisions on what happens in case of default. It is implemented in much the same way as a commercial contract between the parties and is binding upon the company and its creditors. During the negotiation and pendency of a CVA, the directors of the company may apply to court for a moratorium on payment of its debt(s). It is important for companies to review the terms of their loan agreements with various lenders to confirm whether entering into a CVA is one of the default events which may trigger liquidation proceedings. A company should also consider its existing contracts with third parties to avoid triggering termination as a result of such arrangements.

Schemes of arrangement and compromise

A scheme of arrangement is used by companies to give effect to a debt restructuring as it enables a company to agree with its creditors or a class of them in respect of its debts owed to creditors. It can also be used to effect a solvent reorganisation of a company in order to avoid insolvency.

A scheme of arrangement presents an opportunity to reach a compromise or arrangement with creditors, whether through a conversion of debt to equity or through any other genuine structure that will allow the company to focus on a return to profitability. As noted under CVAs, a company with multiple loan agreements should review the terms of such agreements to ensure that entering into a scheme of arrangement and compromise would not amount to a default event and therefore trigger liquidation proceedings.

Administration

The objectives of administration, as provided for under the Insolvency Act, are to maintain the company as a going concern, to achieve a better outcome for the company’s creditors as a whole than would likely to be if the company were liquidated without first being placed under administration and to realise the property of the company in order to make a distribution to one or more secured creditors.

The company or its creditors may apply to court for the company to be placed under administration so that it continues doing business while at the same time be protected from creditors through a statutory moratorium. Administration is undertaken under the supervision of an administrator and the High Court. The end goal is for the business to increase its turnover over a specified period, normally 12 months, upon whose completion a report is filed in court by the administrator as to the company’s ability to settle its debts in the long-term while remaining afloat.

Balance sheet reorganisation

Balance sheet reorganisation entails modifying the debt, operations or structure of a company as an attempt at eliminating financial harm, maintaining the business as a going concern and potentially improving its financial and business prospects. It is intended to assist companies in financial difficulties (or in danger of getting into financial difficulties) to re-organise their affairs. Indeed, the various modes of balance sheet restructuring may be utilized as part of a compromise/arrangement, a CVA, or, in case of a company under administration, the administrator’s proposals.

In the context of debt restructuring and corporate recovery, the various modes of balance sheet reorganisation may be in the form of: Modification/renegotiation of borrowing/lending terms; consolidation/ further lending; refinancing; equity injection;strategic divestures; job mergers or right sizing; and redundancies.

Equity injection would entail the company raising additional capital and issuing shares to investors in the company. The Companies Act, 2015 allows a company to alter its share capital by, inter alia, increasing its share capital by allotting new shares.

A company in financial distress may invite equity investors who will provide it with capital and in return allot new shares to them. Both private and public companies are at liberty to consider this when debts and losses increase depleting the company’s capital. Capital may be raised privately from specific investors or on the capital markets. Whenever a company is financially challenged the shareholders should always consider the option to re-organize its balance sheet and avoid possible demise through liquidation. However, the incoming investors may want to influence the management of the company through board representation. Consequently, equity investment is often accompanied by corporate governance restructuring of the investee company.

The writers are Nairobi-based advocates of the High Court of Kenya practising as such at Mboya Wangong’u & Waiyaki Advocates