New credit decisions normally consider both the likelihood of failure of that potential client as well as the security provided by the underlying assets of the company concerned. As part of this process it is important to consider the potential client’s circumstances and adapt the risk assessment accordingly.
Whilst some lenders have a policy of not supporting businesses that have survived an insolvency event, perhaps through a pre-pack, those that do should ensure that their due diligence considers the particular risks that such a business presents. These risks not only include commercial risks around the supply chain, and customers but also the impact of losing key employees.Ownership and management for many SMEs is the same and frequently the directors undertake several key roles including sales, production, finance, IT, HR, etc. Whereas the lender risk of death or incapacity of a key person can be covered by insurance, where that person has experienced a previous failure there is an uninsured risk that they may be prevented from working as a director or manager (directly or indirectly) by a disqualification order.
Who in the business is key?
Frequently the reliance on a particular person within a company is overstated with many key roles capable of being undertaken through outsourcing or bringing additional expertise in.
Lenders should therefore consider in any pre-lend exercise whether there is a person that is practically irreplaceable be it due to relationships, cost etc. Understanding the impact on a business of a loss of a key man is important however this can often be difficult to quantify.
What is disqualification risk?
Where a company or partnership enters insolvent liquidation (voluntary and compulsory) or Administration an investigation is undertaken to establish whether the directors (those that acted within 3 years of the insolvency) acted appropriately and complied with relevant legislation. This investigation may eventually lead to the disqualification
If the director is disqualified he or she may not act as a director or be involved in the management of a company for a period of time defined by the disqualification order. This time period depends on how serious the offences are and ranges from 2 to 15 years.
A disqualification order would therefore effectively prevent a person from running a business in any substantial capacity. It is possible for the person to apply to court for a particular exception but this is rare.
How big a risk is it?
The financial and viability impact defines part of the risk to a funder – as highlighted above the financial risk to a funder of loss of a key person through illness or ill health can be insured but disqualification cannot.
The other element of the risk is the likelihood of disqualification….
Clearly every circumstance is different and there are many offences that could result in disqualification. The main 2 reasons for disqualification are:
- Non-payment of crown (HMRC); approximately 50% of disqualification orders relate to this and are typically made where HMRC has suffered disproportionately compared to other creditors; and
- Accounting records; poor accounting reports that have resulted in detriment to creditors is another common cause of disqualification.
A relatively low percentage of directors are disqualified. Taking 2011 as an example approximately 30,000 directors experienced either insolvent liquidation or administration that year. As at 14 August 2013 less than 500 (or 2%) of these directors have been disqualified. However as the disqualification process can take a considerable time (it has to be started within 2 years of insolvency) there is likely to be further disqualifications for this group of directors. As approximately 1,000 persons are disqualified each year the on-going rate of disqualification is likely to be around 3% of directors subject to an insolvency event.
Whilst in general terms the odds of being disqualified are low at approximately 1 in 30 it is important not to be complacent. The impact when it does happen can be material and affect client viability.
Can the risk of disqualification be assessed?
In general terms yes – a funder and their advisor can normally obtain information on the circumstances of any previous failure thought public documents and discussions with stakeholders. This information can highlight whether there appears to be a high or a low risk.
