Europe’s Insolvency Storm – Why the Clouds have Parted but not Disappeared

At the heart of the proposals is an effort to shift the focus of insolvency away from the liquidation and winding up of failing companies to instead encourage struggling businesses to restructure at an early stage.

Insolvency tourism?

The gulf between the insolvency regimes in EU countries is best illustrated by the practice of “forum shopping” – in which a company or individual moves their centre of main interest (“COMI”) to another country in order to benefit from that country’s insolvency regime.

This has been particularly prevalent in personal insolvency – with the UK being seen as a destination of choice. Britain currently allows bankrupts to obtain discharge from bankruptcy after one year; whereas the wait is much longer in several other EU countries – five years in Italy, seven years in Germany and 12 years in Ireland. This discrepancy has not gone unnoticed and reform is now in the offing.

Jobs at Stake

Across Europe, there are about 200,000 businesses facing insolvency every year and it is estimated that 1.7 million people lose their jobs as a result. Seen in this light, the European Commission’s plan to shift the focus of insolvency from liquidations to restructuring is an attempt to reduce these figures and harmonise the approach across Europe.

As well as the obvious benefits of reducing failures, the new mechanism is an attempt to reduce the stigma of failure and to allow honest entrepreneurs whose failure is down to misfortune to start again relatively easily. Statistics have shown that failed entrepreneurs learn by their mistakes and are generally more successful second time around.

There are also attempts to deal with unemployment as Europe’s leaders have promised a youth guarantee scheme under which young Europeans will be offered a job, apprenticeship or education place within four months of becoming unemployed or leaving formal education.

This is all very promising for the future, but what about the current level of insolvency? Surprisingly, the recession has not led to uniformly rising levels of business failure across Europe.

North / South Divide

In the UK, corporate insolvencies have fallen steadily since 2009. There are several unique factors behind this. Firstly the tax authority, HM Revenue and Customs (“HMRC”), launched a time to pay (“TTP”) scheme allowing businesses to spread payment of their outstanding tax. As HMRC is the instigator of most court-led winding-ups, this has reduced the number of failures.

In addition, interest rates have been kept artificially low for an extended period (the Bank of England base rate has been at a record low of 0.5% for more than five years). With some of Britain’s main banks still part-owned by the government following their bailout during the financial crisis, many lenders have shown great forbearance when dealing with businesses falling into loan arrears and breaching of loan covenants.

The recession has also put creditors off the idea of spending more money on legal costs pursuing a business to wind itself up, as assets values have been so depressed and the prospects of getting even their legal costs back are remote.

Across Northern Europe there is a similar story with governments and banks keen to avoid the knock-on effect of major failures on the supply chain. The insolvency figures for France and Germany show a similar reduction, post-2009.

In the countries hardest hit by the recession, there was little that could be done to mitigate the fallout. In Italy, Spain and Portugal, corporate failures are on average 50% up on the 2009 figures and unemployment levels are significantly higher than in the rest of Europe.

Across Europe the construction sector in particular has been hit hard, accounting for over 20% of all insolvencies. Spain has been the hardest hit in this sector with over 30% of failures being construction-related businesses.

Construction sector feels more pain than most

Government austerity measures led to the failure of several large construction companies that had come to rely on public sector contracts – and this triggered a ripple down effect along the supply chain that affected many dependent businesses.

The construction companies that have survived are those that tightened their belts and cut costs where possible. The reduction of public spending has also led to many construction projects being delayed or cancelled, so with less work around larger firms have been pitching for smaller projects – which in turn puts pressure on the smaller construction firms through increased competition.

In the short term, these larger firms generally have the financial stability to take on low margin work in order to keep staff employed and provide a contribution to overheads but for smaller firms, this pressure quickly becomes unsustainable.

There is no doubt that there has been an overall reduction in profitability in the sector as competition has increased and there is also a concern that low-balling (tendering either at a loss or at substantially reduced margins) tenders leave the successful bidder potentially in a precarious position, especially as labour and raw material costs are now increasing. Indeed, the lack of liquidity in the market can result in a business having inadequate access to funding and result in over-trading which ironically can result in the insolvency of the business.

As mentioned earlier in this article, the banks and other lenders have been keen to avoid large-scale failures. Property related businesses have caused the banks more of a problem than many other sectors as the inflated property market at the start of the recession resulted in banks’ lending at high property valuations and therefore they are themselves sitting on a potential loss if the business were to fail and the properties and/or business had to be sold.

The lenders’ approach has therefore been to try to work with management and to ignore any breaches in lending covenants. Whilst this “hands-off” approach has resulted in many businesses surviving, the banks have generally been reluctant to lend further monies to these poorly performing businesses – as is logical in a distressed market – leaving many so-called Zombie companies which are working hard just to tread water.

Another sector hit hard by the recession is retail. The reduction in consumer spending power and job uncertainty has had a devastating effect on some high streets and shopping centres. The move towards online retail has also not been without problems as some online retailers report that the only way to generate turnover is to have permanent price reductions and discount sales in order to generate turnover but at the cost of reduced profit margins. The best-placed retailers are those who have identified their niche market and worked hard through advertising and promotions to maintain and increase their market share.

The good news is that a wave of alternative finance providers – such as peer-to-peer lenders – has emerged to fill the lending gap. The interest rates are generally more expensive than those of conventional normal bank lending, but at least they have unblocked the credit pipeline for businesses.

The Storm is Not Past

The pace of economic recovery in much of the Eurozone is proving painfully slow. The bloc’s GDP grew by just 0.2% in the first quarter of 2014, and while German growth is robust, the group’s second and third largest economies – France and Italy – stagnated and contracted respectively.

With such a fragile recovery, the risk of further surges in insolvencies cannot be ruled out. But at least the European Central Bank is determined to keep interest rates at their current rock-bottom levels.

In the UK, the picture is very different, with the OECD predicting that Britain’s economy will be the fastest growing of all the G7 nations this year. So the question here is of when, not if, interest rates rise. The current economic consensus is for early 2015.

Combined with the banks’ increasing reluctance to show forbearance, such a rate rise could push many of the struggling businesses that have survived thanks only to low interest rates into insolvency.

Europe’s insolvency problem has abated, but the continent is far from out of the woods.


Related reading