Business rescue key success factors

In a previous post Draft business rescue legislation - main features the main characteristics of new business rescue law was summarised.

This post is a follow-up dealing with key success factors for business rescue in South Africa.

When to rescue which businesses

Avoid the need for business rescue

The earlier each stage in the sequence of management-led correction - informal creditor workout - business rescue starts on the timeline of financial distress, the better the chances of successful business rescue should the first two processes fail, or the better the chance that formal business rescue can be avoided in the first place.

In practice, however, management-led correction and informal creditor workouts already suffer from late starts, or they take too long before taking the shape of a serious turnaround intervention.

Expedite business rescue if the need for it cannot be avoided

The reason for the unnecessary high failure rate of business rescue internationally is that it is deemed to be a measure of last resort - often postponed until the company is in an advanced stage of distress.  Directors and managers may resist business rescue since they fall under the supervision of a third party (the Supervisor in terms of Chapter 6 of the Companies Bill, 2007 in South Africa) in charge of business rescue, and they fear the negative impact on the business of the stigma of insolvency.  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. This may lead to reckless or insolvent trading.  Moreover, the cost of formal business rescue is such that management-led correction and informal credit workout, which are attempted first, may be prolonged too much before placing the business under supervision.  The late timing of business rescue commencement represents a major obstacle to its viability.

Rigorous application of laws against reckless / insolvent trading

Although the current Companies Act provides for personal liability of directors in certain limited cases, section 93 of the new Bill goes all the way by making directors personally liable to companies and others who suffered losses because of misleading financial statements, untrue annual reports and reckless carrying on of a company’s business.

In addition to personal liability, section 215 of the Bill makes reckless management and failure to comply criminal offences subject to 10 years imprisonment and high fines.

Pre-packaged business rescue rather than free fall business rescue

If business rescue is left too late, it will present the supervisor with the most difficult scenario possible - that of free fall business rescue. 

Free fall business rescue refers to placing a company under supervision as a last resort when it has run out of cash and cannot meet its creditor obligations anymore.

Such cases are normally dead on arrival.  By this time the situation has deteriorated so far that the realm of the "deep turnaround" has been entered into:

• No borrowing capacity.
• Banks will not lend even if there is borrowing capacity - making it difficult to get post-commencement finance.
• Difficult, if not impossible, to obtain private equity funding.
• Suppliers stopped supplying, tightened up on credit terms and/or asked for up front payment.
• Key clients stopped buying or hedged their bets by shifting their purchases to more stable competitors.
• Key staff is long gone to better situations or preparing to move.

Overseas experience shows that business rescue attempts once already insolvent and out of cash has a lower success rate than those that started earlier.

In the USA the free fall approach to Chapter 11 of old is more and more replaced by pre-packaged Chapter 11.  The same trend is evident in the UK.

Pre-packaged business rescue involves timeously devising a sale, or a business rescue plan inclusive of financial restructuring and agreements for post-commencement finance, as well as agreements with all affected persons, when it is clear that there is not enough time to turn the company around before insolvency has set in. 

This takes place prior to the company being placed under supervision when it still has borrowing capacity, and intact management, systems, and supplier and customer relations.

The company is then placed under supervision before or when insolvency has set in to obtain the legal benefits such as the moratorium on the rights of claimants against the company or in respect of property in its possession. 

The resultant business rescue cost and total cost of the overall exercise is much cheaper, business rescue takes shorter, and the success rate and claim holder recovery rate is higher than free fall business rescue.

Since the supervisor must be independent of the company, and cannot appoint advisors to the supervisor or to the company that are not independent of the supervisor and the company, it would seem that advisors involved in preparing the pre-packaged business rescue cannot become the supervisor, nor can they be appointed by the supervisor (but they can be appointed by management).

It seems that statutory recognition to translate out-of-court practice into the legal business rescue framework in terms of pre-packages solutions and recognition of the workout advisors as "independent advisors" will be beneficial to business rescue outcomes.

Avoid attempting the business rescue of lost cases

In statistical terms, the purpose of business rescue is to avoid making a Type 1 error, which is liquidating potentially viable businesses that should be rescued.

Conversely, Type 2 error refers to attempting to rescue lost cases that should be liquidated.

The cost of Type 2 error is the cost associated with the unsuccessful rescue attempt plus the cost of subsequent liquidation.

Supervisors need to be trained and educated to recognise hopeless cases early on during the business rescue process to enable them to speedily terminate business rescue proceedings allowing liquidation to proceed without delay.

An effective business rescue legal framework and judicial infrastructure

South Africa has the ideal opportunity to craft and formalise the most suitable modern business rescue regime.

Consultation

This far the dti distributed the draft legislation for comment and held a business rescue panel discussion at the Companies Bill Conference 19 - 20 March 2006.

"The Department of Trade and Industry has started a consultation process with industry.  In the period leading up to the adoption of the draft business rescue legislation, there will be intensive engagement with all stakeholders.  This will include the evaluation of public comments, the redrafting of difficult sections of the law, amendments to the technical omissions and the resubmission to key stakeholders for further input."

The rest of the promised consultation process has not been clarified yet, but industry wish to engage with government with regard to its questions, clarifications sought and contributions made.

Promotion of debtor-friendly legislation

The debtor-friendly nature of the draft legislation is foreign the creditor-friendly culture and experience of South Africa, with vested interests in a creditor-friendly approach.

The dti needs to produce an Explanatory Memorandum and launch further initiatives to sell the merits of debtor-friendly legislation to industry.

Alignment of debtor-friendly company business rescue legislation with creditor friendly insolvency legislation

To make Chapter 6 work, legal convergence and uniformity are required between the debtor-friendly Companies Act and creditor-friendly insolvency legislation.

An effective court system, including a specialised statutory tribunal for business rescue

Experience commercial judges must be available at short notice.

The normal court system is unlikely to be appropriate for business rescue. What is required is a specialised statutory tribunal in which creditors will have confidence.

Availability of experienced commercial judges

Experience commercial judges must be available at short notice.

Regulation of supervisors - ABASA

ABASA - Association of Business Administrators of South Africa was established as in industry proposed business rescue regulatory body in 2004, and has applied to government for official recognition.

ABASA has set appropriate admission criteria for supervisors as discussed under "Need for regulation of supervisors" on the business rescue legislation page, and will ensure that its members carry out their duties in a professional and ethical manner.

Effective business rescue industry support

Organised turnaround industry - TMA-SA for networking, knowledge, education and promotion

The Turnaround Management Association - Southern Africa (TMA-SA) promotes the turnaround industry, and serves as forum for turnaround professionals of all disciplines to associate for purposes of information exchange, networking, education, and raising standards in the turnaround industry.

The members of TMA-SA are active in management correction, informal creditor workout and business rescue (the first 3 stages timeline of financial distress).

TMA-SA has accepted the challenge to make new business rescue legislation work in South Africa. 

TMA-SA will participate in the consultation with government about the draft business rescue legislation, will educate its members about business rescue and will collect and disseminate information about business rescue.

Education of supervisors

Based on the Certified Turnaround Practitioner example, a supervisor should pass an exam consisting of 3 modules:

• Turnaround management.
• Financial, managerial and tax accounting.
• Insolvency and business rescue law.

As discussed as discussed under "Supervisor exam " on the business rescue legislation page, TMA-SA can assist in setting up such an exam, either as a customised South African version of the international CTP exam, or as a home-grown initiative.

Turnaround finance

Companies entering business rescue proceedings do so because they have or will run out of cash.

Post-commencement finance as envisaged in Section 138 of the Companies Bill, 2007 is unlikely to be of much practical value in free fall business rescue, since by that time the distressed company will invariably already be without borrowing capacity.

Even troubled companies which enter pre-packaged business rescue early enough in the process may find it hard to find lenders.

Accordingly, there remains a strong need for a more active turnaround private equity industry in South Africa that not only invests in underperforming businesses and businesses requiring financial restructuring, but also invests in distressed businesses too.

It is envisaged that the business rescue legislation will stimulate the market for distressed situation private equity.

Government can also play a role through the establishment of a turnaround fund via the National Empowerment Fund for instance.

Business rescue scorecard

Whilst it is very difficult to find statistics in this regard, the success rate of business rescue overseas is lower than may be expected - less than 47% in the UK for instance (see business rescue).

Whilst its new business rescue legislation will make a major impact on successfully rescuing troubled companies, South Africa runs the risk of creating false expectations of new business rescue legislation being a panacea for its liquidation problems.

Moreover, there is a need to learn more about business rescue outcomes to enable lawmakers and turnaround practitioners to devise new and improved approaches and methodologies to increase the success rate of business rescue in future.

We therefore call for a scorecard to measure and the track the success of all business rescue attempts:

• Number and turnover of businesses that enter and survive business rescue.
• Percentage of jobs retained as a result of business rescue.
• Claim holder recovery as a result of business rescue.
• Cost of business rescue.
• Duration of business rescue.
• Business rescue success outcome – turnaround or sale.
• Pre-packaged or free fall.

For more information read Key success factors for business rescue in South Africa.

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This turnaround news flash was brought to you by CRS Turnaround - turnaround management consulting firm rescuing distressed companies and improving results of underperforming companies in South Africa.