In the second of a two-part series Leonard Curtis Director Phil Deyes looks at the zombie firm phenomenon, this time looking at how they affect the wider economy and what the future holds for all businesses navigating their way through Covid-19.
The term zombie company can apply to a wide spectrum of businesses. It covers the chronic to those only showing mild symptoms. It can be applied to the ‘can’t pay’ and ‘won’t pay’. It is the ‘won’t pay’ zombie companies that are the least deserving, but they have become difficult to identify in the midst of this pandemic.
Their growth and survival tend to be linked to wider economic strategy on both a macro and micro economic level.
At their most acute, a zombie company will be a drain on good capital, preventing that capital from flowing to a better and stronger business. It will also mask the strength of the balance sheet of those supporting the zombie company.
Allowing unrecoverable debt to accumulate prevents the need to crystallise a loss, which would inevitably ensue if the debt was enforced, or the zombie failed. Owing a little, gives the borrower a problem. Owing a lot, gives the lender a problem, the adage goes. Zombie companies are good at building up big, largely unrecoverable, debts.
Zombie companies do not invest
A zombie company will prevent the free flow of goods, services and labour which typifies a true market economy. Inefficiencies are allowed to accumulate and the free market becomes distorted. Good businesses can get sucked in as prices remain artificially low, with the zombie company chasing business solely on price, building up even more debt as they go.
In many instances, zombie companies do not invest, create anything, or foster a dynamic culture. Most importantly, they don’t create wealth for their shareholders. They become stagnated and bloated on the cash supplied to them by others, unlikely to ever be repaid.
Clearly, such companies can drag down GDP, stifle growth and amble on for years until someone, usually an external stakeholder, takes control and drives them into insolvency.
Creeping into zombie status after Covid-19
At the more benign end of the spectrum, a business may be showing signs of becoming a zombie, but this may be a result of a specific shock or event, Covid-19, for example.
These businesses were largely successful previously, but the existential shock has knocked them sideways, forcing them to make critical payments decisions, including the creation of debt to cover underperformance, even losses.
These are not fundamentally bad businesses. These are the ‘can’t pays’ in need of interim support until they can stabilise their financial affairs. Pre-pandemic, they were servicing debt, creating employment, generally creating wealth and accumulating reserves.
In my view, these previously successful companies, creeping into zombie status (as a result of a ‘shock’) should be supported. This sentiment seems to have resonated with the Government, whose intervention measures have been targeted to shield businesses from the extremes of this pandemic.
Insolvencies down thanks to state support
The criticism here is that the blanket approach (furlough, for example) has protected bad businesses as well as salvageable ones.
This could be why insolvencies are actually down, as businesses that would otherwise have failed have latched on to the cash life support provided by the Government. Couple that with a temporary restriction on the issuing of winding up petitions, plus political influence over HMRC to essentially close their collection teams, focussing on furlough fraud, and we have seen a fall in action being taken against bad companies. HMRC were previously a good cleanser of the business world, issuing winding up petitions against delinquent companies, failing to pay their taxes.
As the cost of pushing these businesses over was funded by the taxpayer, their motivation was more than just trying to get their money back. It was a mechanism to stop businesses from trading and creating yet more unrecoverable debt for the tax payer. This is presently not happening with the frequency it did, allowing poorer businesses to muddle on.
Limitations on enforcement of debt
The restrictions on the issuing of winding up petitions, FCA guidance to regulated lenders asking them to provide additional support rather than rein in facilities, and the limitations faced by landlords to recover rents (by essentially denying them rights of forfeiture), has meant virtually any business has been able to stave off, at least temporarily, insolvency.
It is interesting, that aside from furlough and some smaller, sector specific grants, the intervention measures have essentially provided access to debt and do not safeguard against the deterioration of the balance sheet of a business. The longer the crisis continues, the worse the balance sheet may become and the more prolonged the exit from zombie status will be.
Creditors cannot be expected to support a failing business in perpetuity, or be continually prevented from enforcement to recover their debt. Behind every creditor is a company or a Government needing to balance their own finances. This status quo cannot last forever and requires some strategic thinking and no doubt, collaboration, from all stakeholders.
What does the future hold?
The million dollar question, without doubt. The simple answer is that no one really knows, but businesses have to make plans and adapt to the ‘new normal’.
At the macro-economic level, the Government will play a key role, especially for the most affected sectors of the economy. This could be via taxation, grants, state aid or continued wage contribution support.
More generally, we have seen several extensions of some of the temporary measures contained with the Corporate Insolvency and Governance Act 2020 (CIGA), such as the restrictions on the issuing of winding up proceedings and limitations on landlords executing rights of forfeiture for non-payment of rents.
There are also permanent changes within CIGA, aimed at business rescue and survival, such as the new ‘debtor in possession’ moratorium procedures, restraints on termination of supplier contracts on entering an insolvency regime, and the more complex opportunities via the restructuring plan.
HMRC also continue to show leniency in the payment of all taxes, saving otherwise huge cash outflows from a business. Their continued support will be essential to recovery.
Rebalancing the UK books
Commentators have talked about the need for a huge Government spending stimulus, to re-start the economy via an expansionary fiscal policy, where the economy is finding it difficult to return naturally to its pre Covid-19 equilibrium state.
Others have talked about introducing negative interest rates and other monetary stimuli to promote growth, by altering liquidity preferences. Supply side economic theorists look to reductions in taxes and regulation. A multi-faceted approach is no doubt required.
But, to re-balance the books of this country, it seems taxes will inevitably rise at some point in the future, which may hinder a supply side recovery. Talk is already afoot about changes in capital gains tax, which will be unpopular across many SME businesses, sucking out more of the risk capital a business may hold. Politics will clearly play a key role.
HMRC higher up pecking order from 1st December
On a smaller scale, but still vital for business recovery decisions, is the partial (re) introduction of secondary preferential status of HMRC for direct taxes of a company through the Finance Act 2020.
From 1 December 2020 HMRC’s claim will sit ahead of floating charge holders and unsecured creditors reducing the monies available for distribution to both, when a corporate enters insolvency.
While HMRC’s claim is limited to claims for unpaid employer NIC, PAYE and VAT, those liabilities, given the deferral options I have alluded to above, will be significant. It will no doubt influence future lending decisions, and not for the better as far as the borrower is concerned.
A debt is a debt and still needs repaying
There is already talk about treating CBIL and BBL debts in different ways, including the morphing of such debt into redeemable preference shares or other debt instruments. This may solve the timings of repayment, aligning them to profits, (pay as you grow!) but it’s still debt and it still needs repaying.
SME owner sentiment will no doubt play a part. Will business owners, faced with a mountain of debt to repay post-Covid, decide to pull the plug themselves, rather than wait for a creditor to do so? Will they take the view that there is so much pre-existing debt they will not see a dividend for decades and so why carry on? In a recovering market, they may decide to fold and re-start, especially if there is funding to do so. Will there be a rise in pre-pack administrations as we move out of this pandemic?
As soon as the intervention and support measures fall away, an increase in insolvencies is expected and perhaps inevitable. For those employees sadly losing their jobs, should the focus of the Government shift from funding the job they once had, via furlough, to funding the individual and funding them directly, to help them find new employment or give them new skills?
Will there be a Covid bounce? A turbo-boosted eat out to help out equivalent? A vaccine may facilitate this as we move out of lockdown permanently. But is this likely? Will we keep coming out and going back in to lockdown?
Businesses to control their own destiny
On the micro-economic side, it’s each individual business and business owner that needs to face the challenges ahead and adapt. Moving more online from offline. Using existing processes to make new products. Working remotely, rather than in an office. It may need to engage with customers differently, win business differently, or even develop new products and technologies to move to where demand has gone.
Engaging with all stakeholders within your business is as important as it’s ever been. Explaining your plan and why ‘bearing with you’ is better than enforcement. Knowing your options is also vitally important. Don’t be afraid of considering insolvency as an option under review, along with a host of other measures.
At Leonard Curtis, we have been having an increasing number of ‘what if’ conversations with SME business owners, many of which have never experienced an insolvency before. By speaking to us early, we have been able to advise on a whole host of matters.
By engaging early, we can often avoid insolvency altogether. Where insolvency is perhaps inevitable, we can manage the process in an efficient and compassionate way, guiding directors through a difficult process and managing both their own and creditors expectations of outcome.
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