CHANCERY DIVISION
Strand, London, WC2A 2LL | ||
Reissued: 15 January 2003 |
B e f o r e :
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In the matter of Colt Telecom Group plc | ||
- and - | ||
In the matter of the Insolvency Act 1986 |
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Richard Sheldon QC and Hilary Stonefrost (instructed by Slaughter & May) for the Respondent
Hearing dates : 6, 9, 10, 11, 12, 13, and 17 December 2002
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Crown Copyright ©
Mr Justice Jacob:
"Subject to this section, if the court –
(a) is satisfied that a company is or is likely to become unable to pay its debts (within the meaning given to that expression by section 123 of this Act), and
(b) considers that the making of an order under this section would be likely to achieve one or more of the purposes mentioned below,
the court may make an administration order in relation to the company".
"(1) A company is deemed unable to pay its debts -
(e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.
(2) A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.
"An application to the court for an administration order shall be by petition presented either by the company or the directors, or by a creditor or creditors (including any contingent or prospective creditor or creditors), […] or by all or any of those parties, together or separately."
"This petition is unusual in that Highberry claim that Colt is or is likely to become insolvent notwithstanding that Colt is a constituent member of the FTSE mid-250 index and has a market capitalisation of in excess of £550 million, that its latest balance sheet shows net assets of £977 million, and that the various series of Notes issued by Colt are not in default and do not fall due for repayment until the period 2005 to 2009. Against that, Highberry in their proposals to Colt have relied on the dramatic fall in its share price since the year 2000, and on its substantial operating losses and negative cash-flows."
"Having sought detailed analysis and advice from one of the "big four" accounting firms, Highberry Limited. believes it has legitimate concerns that even after the asset-write down announced on 27 September 2002, Colt Telecom's balance sheet does not properly reflect the true current value of Colt's business and in particular its network assets.
…
Highberry believes that insolvency is inevitable."
"We should add that our clients do not consider that the present conduct of the Company and its management can be in the best interests of the Company or its creditors. We are bound to remind you of your duties as a director and of the consequences that may result in the event the Company enters insolvency proceedings. In this context, directors may in appropriate circumstances be held personally accountable, and/or required to compensate creditors, if they permit a company to trade to the detriment of its creditors notwithstanding its insolvent position. Equally, a director will not be protected from personal liability simply because the Company has, for the time being, sufficient cash to meet its current obligations in circumstances where those cash reserves are evaporating, and where there is no realistic proposal for reversing the Company's fortunes before the time when it becomes unable to pay its debts as they fall due. You will of course understand that in the unfortunate event that our clients are obliged to procure that the Company be placed in some sort of insolvency regime, they will be constrained in the interests of creditors to ensure that the liquidator or other office-holder undertakes a thorough investigation of the conduct of the directors in the period leading up to the relevant insolvency order being made."
"5. Colt is the holding company of a group of companies ("the Group") whose trading operations are carried on by its subsidiaries. The Group's business was established in 1992 and Colt became the holding company in 1996. The business of the Group comprises the provision of advanced telecommunications services to business and government customers across Europe.
6. The Group employed just under 5,000 people as at the end of September 2002. Its annual turnover is in excess of £1 billion. Colt's balance sheet as at September 30, 2002 shows assets totalling £2.6 billion, creditors totalling £1.5 billion, net assets of £977 million and cash balances of £455 million. At that date, the Group had aggregate cash balances of £978 million.
7. Colt's assets consist primarily of cash held by it and investments in its subsidiaries comprising shareholdings in, and long term funding to, those subsidiaries. Colt's liabilities consist principally of its indebtedness on the nine series of Notes issued by it between 1996 and 1999. Colt's business has also been funded by raising equity capital totalling over £2 billion, the most recent being of about £500 million in December 2001.
8. Highberry Ltd is an English company which was incorporated in November 2001, and Highberry LLC is a Delaware corporation which was incorporated in September 2002. Colt says that the Petitioners are part of an American group called the Elliott Group, which is controlled by Mr Paul Singer, the father of Mr Gordon Singer, a director of Highberry Ltd and the person who verified the Petition. According to Colt, the Elliott Group is a "vulture fund," which specialises in the taking of "short" positions in shares of a company (in the expectation of a drop in their value) and acquiring debt securities at a discount (in the hope that their price will rise)."
9. Colt says that Highberry have acquired Notes in the market at various times as recently as September of this year at a discount from their initial principal value. There are no outstanding sums due on the Notes held by the Petitioners and the earliest date (in the absence of a declaration of default) on which the principal sum is due to be repaid on Notes held by the Petitioners is 2006. Colt says that it believes that the administration petition is part of the strategy of the Petitioners to make a speculative profit from its acquisition of Notes at a discounted price, and also from their (or their affiliated companies') short position on Colt's shares and that the Petitioners are seeking to achieve the profit by forcing an unjustified transfer of value from shareholders to noteholders".
The Issues
(1) Must a petitioner prove that the company is "likely to be unable to pay its debts" on a balance of probabilities or is it sufficient for it to prove that that there is a real prospect of that being so?
(2) Is the ability to present a petition forbidden by a clause (the "no action" clause) in the terms of the Notes and their associated Indenture – a question of New York Law?
(3) Even if the no action clause is effective as a matter of New York Law, does English law public policy override its effect?
(4) Is Colt cash-flow insolvent?
(5) Is Colt balance sheet insolvent?
(6) If the answer to either (4) or (5) is yes, should I exercise the court's discretion to make an administration order?
Procedural matters
"The consideration of the issues is not intended to be done by way of a very detailed and protracted investigation as in a trial.
Issue 1 – The Jurisdictional threshold – "likely"
"Second, the section requires the court to be "satisfied" of the company's actual or likely insolvency but only to "consider" that the order will be likely to achieve one of the stated purposes. There must have been a reason for this change of language and I think it was to indicate that a lower threshold of persuasion was needed in the latter case than in the former."
"Paragraph (a) of s.8(1) sets out a condition that must be met before the court can enter into an inquiry as to whether an administration order would serve any useful purpose. The court must be satisfied that the company is or is likely to become unable to pay its debts. Clearly in this context, the test prescribed must be whether a company currently able to pay its debts as they fall due will probably be unable to pay them in the future. It would be unjust to a company's creditors to impose on them the regime of an administration order so as to improve and, perhaps expand the company's business if the probability is that the company will be able to pay its debts as they fall due."
Here Vinelott J is using the word "probability" in the sense of more likely than not.
"But the decisions on s.8(1)(b) of the 1986 Act to which we have referred illustrate the point – which may, perhaps, need no authority – that "likely" does not carry any necessary connotation of "more probable than not". It is a word which takes its meaning from context. And, where the context is a jurisdictional threshold to the exercise of a discretionary power, there may be good reason to suppose that the legislature – or the rule making body, as the case may be – intended a modest threshold of probability."
Issue 2: The no action clause
"Limitation on suits.
A holder may not pursue any remedy with respect to this Indenture or the Notes unless:
a. the Holder gives to the Trustee written notice of a continuing Event of Default;
b. the Holders of at least 25% in aggregate principal amount at maturity of Outstanding Notes make a written request to the Trustee to pursue the remedy;
c. such Holder or Holders offer the Trustee indemnity satisfactory to the Trustee against any costs, liability or expense (including the reasonable fees and expenses of its Counsel);
d. the Trustee does not comply with the request within 60 days after receipt of the request and the offer of indemnity; and
e. during such 60 day period, the Holders of a majority in principal amount at maturity of the Outstanding Notes do not give the Trustee a direction that is inconsistent with the request.
A Holder may not use this Indenture to prejudice the rights of another Holder or to obtain a preference or priority over such Holder".
"1. The no action clause only comes into play once there is an Event of Default;
2. It has no application prior to an Event of Default;
3. In any event the clause only applies to "contractual claims," i.e. claims based on the terms of the Indenture or Notes. It would not apply to claims such as for the appointment of a receiver, or a claim equivalent to this claim such as the appointment of an administrator.
"As interpreted by courts, the no-action clause also applies to most non-contractual claims (such as fraudulent conveyance claims, certain fraudulent misrepresentation claims, RICO violations, and actions to appoint a receiver or to impose a constructive trust; to suits brought by former bondholders; and to suits against defendants other than the company."
"The right cannot be modified without the holder's consent, but it can be enforced only by the trustee or by holders of 25% of the outstanding bonds if other requirements are satisfied. Most noncontractual rights, which fall under the purview of the no-action clause, are also in this category".
"Fifth, whatever the proper balance of individual and collective bondholder rights with respect to amendment, the balance with respect to enforcement should be tilted more towards individual rights."
"In other respects, however, the enforcement structure does not accord with the analysis; bondholder rights in the enforcement context are collecteive to a greater extent than in the amendment context; the enforcement regime does not take account of the fact that some bondholders may lack incentives to pursue violations of other holders' rights: and the enforcement regime imposes unreasonable barriers to the collective enforcement by bondholders."
"The structure of individual and collective enforcement rights established by typical bond indenture provisions and the courts' interpretation of these provisions is flawed in four ways …"
"Second, the broad interpretation courts have given to the no-action clause makes the enforcement system for some claims unworkable. Courts have held that holders must comply with the no-action clause to vindicate noncontractual rights. But a violation of these rights cannot result in a "Effect of Default" and compliance with the no action clause is therefore impossible. Moreover, courts have denied the trustee standing to assert noncontractual rights of bondholders. As a result, it would appear that neither bondholders nor the trustee can bring such noncontractual claims."
"the present structure of individual and collective enforcement rights is imprudent. The system places excessive reliance on enforcement by the trustee – a party that is not well suited to play the role accorded to it – and excessive limits on enforcement by bondholders."
"With respect to enforcement, the no-action clause requires bondholders to comply with its requirements before they can "pursue a remedy with respect to the Indenture or the Bonds". The only exception for which bond indentures provide is the individual right of holders to bring a "suit with enforcement of [payment of principal and interest], on or after [the] respective [due] dates" expressed in the bond. The no-action clause severely limits the ability of individual bondholders to enforce their rights. If the trustee is not on its own inclined to take enforcement measures, a bondholder would have to assemble a group holding at least 25% of the principal amount of bonds, request the trustee to pursue a remedy, and offer to the trustee indemnity against any loss, liability or expense. Even if this is done – or, for that matter, even if the trustee is willing to bring the claim – holders of a majority of the principal amount of bonds may direct the trustee not to pursue the claim. If so, the claim cannot be brought."
"The no action clauses as construed by the courts applies to a wide variety of claims. Some of these claims are contractual; others are rooted in statutory or common law, such as fraudulent conveyance law, state corporation law and the law of fraud".
"Since bond indentures do not incorporate into themselves provisions of fraudulent, conveyance law, state corporation law, blue-sky law or the law of fraud, violations of these laws do not result in an Event of Default. Similarly, violations of bondholder rights by persons other than the company generally will not result in a breach of the bond indenture, since these persons are not party to the indenture. With respect to these violations it is therefore impossible for bondholders to give the trustee the notice required by the no-action clause. Nevertheless, courts have on multiple occasions dismissed bondholder claims, asserting such violations for failure to comply with the no-action clause."
"Inasmuch as courts have interpreted the no-action clause to encompass noncontractual claims and claims against third parties, the enforcement mechanism envisioned by the clause is unworkable".
"To reduce the flaws in the present structure of bondholder rights, courts should accord a narrower scope to the no-action clauses which limits individual enforcement by bondholders. The broad interpretation courts have given to the clause is responsible for the unworkability of the enforcement regime in respect to certain claims".
Elliott Associates v Bio-Response [1989] Del.Ch. Lexis 63
"Plaintiffs argue that their remaining claims are not subject to the restrictions in the Indenture because they are non-contractual claims. Specifically, plaintiffs contend that the complaint alleges fraud, violation of the implied covenant of good faith and fair dealing, and a statutory claim for the appointment of a receiver pursuant to 8 Del. C. § 291. This Court has recognized that debenture holders may be able to seek relief outside of the indenture where there are "special circumstances which affect the rights of the debenture holders as creditors of the corporation, e.g., fraud, insolvency, or a violation of a statute [citations omitted]. However, the complaint does not adequately allege a fraud claim and I find that the other claims are subject to the restrictions in the Indenture, notwithstanding plaintiffs' arguments to the contrary. [p.4]
Finally, the plaintiffs argue that, by statute, they are entitled to seek the appointment of a receiver in light of Bio-Response's alleged insolvency and that this statutory claim is not impaired or restricted in any way by the Indenture. Pursuant to 8 Del. C § 291, any creditor or stockholder of an insolvent corporation may apply to this Court for the appointment of receivers for the corporation. The complaint adequately alleges insolvency and, although it is not free from doubt, plaintiffs are likely to be considered creditors for purposes of this statute. Cf. Noble v European Mortgage & Investment Corp., Del. Ch., 165 A. 157 (1933). However, I find that plaintiffs' statutory claim is restricted by the terms of the Indenture". [p.5]
Feldbaum v McCrory Corporation [1992] Del.Ch. Lexis 113
"Absent an allegation of fraud in the inducement of the purchase, clauses of this sort are generally applied to foreclose bondholder suits under the indenture, where the plaintiff has not complied [citations, including Elliott omitted]. Such clauses are bargained-for contractual provisions which inure, not only to the benefit of issuers, but also to the benefit of the investors in bonds. Such clauses need not prevent the prosecution of meritorious suits9. They do, however, make it difficult for individual bondholders to bring suits that are unpopular with their fellow bondholders. This, in fact, is their primary purpose. As the American Bar Foundation's Commentaries on Indentures, § 5.7, at 232 (1971), notes, regarding the Foundation's proposed model no-action clause.
The major purpose of this Section is to deter individual debentureholders from bringing independent law suits for unworthy or unjustifiable reasons, causing expense to the Company and diminishing its assets. The theory is that if the suit is worthwhile, [a significant percent] of the debentureholders would be willing to join in sponsoring it … An additional purpose is the expression of the principle of law that would otherwise be implied that all rights and remedies of the indenture are for the equal and rateable benefit of all holders".
"This, as a practical matter, is especially true of bonds of failing or bankrupt companies whose bonds tend to move into the hands of specialists, so-called vulture funds, for whom, given their small numbers and significant holdings, collective action problems do not present the obstacle to collective action that frequently accompanies wide-spread distribution of financial interests [citation omitted.]
"The primary purpose of a no-action clause is thus to protect issuers from the expense involved in defending lawsuits that are either frivolous or otherwise not in the economic interest of the corporation and its creditors. In protecting the issuer such clauses protect bondholders. They protect against the exercise of poor judgment by a single bondholder or a small group of bondholders, who might otherwise bring a suit against the issuer that most bondholders would consider not to be in their collective economic interest. In addition to providing protection against improvident litigation decisions, a no-action clause also protects against the risk of strike suits. Obviously the class features of any such suits make that prospect somewhat more likely and somewhat more risky to the issuer than it would otherwise be.
No-action clauses address these twin problems by delegating the right to bring a suit enforcing rights of bondholders to the trustee, or to the holders of a substantial amount of bonds, and by delegating to the trustee the right to prosecute such a suit in the first instance. These clauses also ensure that the proceeds of any litigation actually prosecuted will be shared rateably by all bondholders11.
"No-action" clauses are thus consistent with, if not central to, the indentures in which they are found, for the primary purpose of such indentures is to centralize enforcement powers by vesting legal title to the securities in one trustee. See George. G Bogert & George T. Bogert, The Law of Trusts and Trustees, § 250, at 280 (rev.2d.ed. 1992) ("In the case of debenture bonds, … the issue is often made payable to a trustee in order that the powers of enforcement may be centralized.")."
"Plaintiffs have not alleged that the trustees have engaged in any impropriety or are otherwise incapable of performing their duties."
This he thought was critical.
(1) Unlike the Professor, Mr Brownwood had very considerable practical experience of the issue of bonds. His feeling for how they worked and were meant to work in practice was borne of many years of experience;
(2) The suggestion that the clause did not apply to pre-Event of Default situations produces an illogicality – freedom for all to act at a time when the situation is not so serious as a default, but a restriction when there is a default. That makes no commercial sense, notwithstanding Mr Brisby's manful attempt to suggest otherwise. It is the Professor's underlying assumption that either the individual or the Trustee must be able to act at any one time. But that need not be so. Mr Brownwood's concept of the "deal" makes immense commercial sense if one bears in mind the policy articulated in the cases. In this connection the Professor told me that New York law, like ours, construes contracts purposively. I can see no rational purpose for individual bondolders being able to rock the boat before default but not after.
(3) Likewise I can see no rational purpose in limiting the bar to "contractual claims". If it were so limited then individuals could undermine the policy by applying for a receiver or the sort of action taken in this case.
"Except as otherwise provided with respect to the replacement or payment of mutilated, destroyed, lost or wrongfully taken Notes in Section 2.11, no right or remedy herein conferred upon or reserved to the Trustee or to the Holders is intended to be exclusive of any other right or remedy, and every right and remedy shall, to the extent permitted by law, be cumulative and in addition to every other right and remedy given hereunder or now or hereafter existing at law or in equity or otherwise."
Issue 3: English public policy
"Any article contrary to these [i.e. the winding up] sections - any article which says that the company is formed on the condition that its life shall not be terminated when any of the circumstances mentioned in s.79 exist, or which limits the right of a contributory under s.82 to petition for a winding up, would be an attempt to enforce on all the shareholders that which is at variance with the statutory conditions and is invalid. It is no answer to say that the right to petition may be waived by any contributory personally. I do not intend to decide whether a valid contract may or may not be made between the company and an individual shareholder that he shall not petition for the winding up of the company. That point does not arise now. But to say that a company is formed on the condition that its existence shall not be terminated under the circumstances, or on the application of the persons, mentioned in the Act is to say that it isformed contrary to the provisions of the Act, and upon conditions which the Court is bound to ignore."
"In my opinion this condition is annexed to the incorporation of the company with limited liability - that the company may be wound up under the circumstances, and at the instance of the persons, prescribed by the Act, and the articles of association cannot validly provide that the shareholders, who are entitled under s.82 to petition for a winding up, shall not do so except on certain conditions.
…..
In the present case, the clause only imposes a limitation; but, if we were to hold this limitation to be valid, we could not stop short of saying that the statutory condition may be dispensed with altogether."
"Whether the principle of this decision would extend to a similar provision in a contract between a company and a creditor, is a question which has never been judicially considered, but there is little reason for doubting that this, too, would offend against the policy of the Act [p.46]"
"Of course, individual shareholders may deal with their own interests by contract in such way as they may think fit. But such contracts, whether made by all or some only of the shareholders, would created personal obligations, or an exceptio personalis against themselves only, and would not become a regulation of the company, or be binding on the transferees of the parties to it, or upon new or non-assenting shareholders. There is no suggestion here of any such private arrangement outside the machinery of the Companies Acts."
"A petition presented by a person who is contractually bound not to present a petition will be struck out"
"The application of a rule of the law of any country specified by Rules 173 to 179 may be refused only if such application is manifestly incompatible with public policy ("ordre public") of English law."
The expert witnesses
(1) There may be prepared, with a view to its being exhibited to the affidavit in support of the petition, a report by an independent person to the effect that the appointment of an administrator for the company is expedient.
(2) The report may be by the person proposed as administrator, or by any other person having adequate knowledge of the company's affairs, not being a director, secretary, manager, member or employee of the company.
"The CPR, the practice and procedure of the High Court …apply to insolvency proceedings in the High Court .. with any necessary modifications, except so far as inconsistent with the Rules.
"In providing a report experts:
(c) where there is a range of opinion in the matters deal with in the report [must] give
(i) a summary of the range of opinion; and
(ii) the reasons for his own opinion
(e) if such opinion was not formed independently should make clear the source of the opinion"
he could not have prepared the report which he did. I regret to say that I conclude, without hesitation however, that Mr Heis failed in his duties to the court. Unconsciously I think he espoused his clients' cause. Moreover I think he was prepared to act for Highberry when there was a clear conflict between his firm and that of a client, namely Colt. Of course I do not say these things lightly and must give detailed reasons. Some of these emerge in my detailed consideration of the allegations of insolvency. But some matters stand out particularly so I set these out now:
(1) Mr Heis and his firm were prepared to act for Highberry even though his firm had acted for Colt recently. A key question in these proceedings is Colt's WACC (current weighted average cost of capital). KPMG had recently given tax advice concerning transfer pricing. That advice involved the WACC for an important Colt asset, namely its long distance network. Mr Heis did not, I will allow, know that when he wrote his initial rule 2.2 report. But that is because neither he nor anyone at KPMG concerned with possible conflict of interest made any specific inquiries as to what was involved in the tax advice. Evidence from Mr Akin of the company was given on this point. It was to the effect that the WACC, on KPMG's advice, was 8.5%, - to be contrasted with Mr Heis's figure of 24.67% for the assets as a whole. Mr Heis sought to brush that aside on the basis that he did not have access to the advice given by KPMG. He said "I would not expect the WACC calculations for the purpose of agreeing tax computations with the Inland Revenue and tax authorities in other countries to be equivalent to FRS11 [Impairment of Fixed Assets and Goodwill] calculations." He does not set out how those calculations would be done. He added, , that "Mr Akins' report makes it clear that they are not equivalent." I do not think it does. That is the wrong question in any event: the real question is whether KPMG's tax advice concerning WACC is relevant to these proceedings. It could be relevant either as an exact equivalent or as a comparable (if there were differences between WACC for FRS11, and WACC for tax purposes - a matter which remains unresolved). Mr Heis should not have been entering any such dispute as a partner in KPMG - they were potentially speaking with forked tongues.
In relation to this point I do not blame Mr Heis. For Colt complained to KPMG about both a conflict of interest and the risk of improper use of confidential materials. The reply was not from Mr Heis but from another partner in KPMG, a Mr Lerner. It can fairly be termed a "brush off". It in no way considered the fact that KPMG were espousing two widely different WACCs. It did not consider the fact that Mr Heis was giving expert evidence in which KPMG had an interest in the result. It solely addressed the questions of whether there would be a conflict if KPMG were appointed administrators and whether there would be a breach of confidence.
(2) Mr Heis' firm stood to make a lot of money if his expert evidence was accepted. Yet he did not bring this out in his Rule 2.2. report. All that contained was the routine statement that he and another partner were prepared to act as administrators. This is not a case where the expert had an indirect or subordinate interest in the result. Or a case where KPMG was merely carrying out a detailed investigation of facts. On the contrary KPMG had a very great direct interest in the court accepting Mr Heis's expert opinion as to insolvency. He should never have offered to be the administrator. It astonishes me that the possibility of a problem in this regard never crossed Mr Heis's mind (or that of anyone else at KPMG) until Mr Heis was asked about it. Only then did he offer to stand down.
I hasten to add that what I have said has only marginal application to a routine, run- of-the mill, petition for administration in which the insolvency practitioner routinely offers to act as administrator. Petitions are generally presented in uncontroversial cases, normally initiated by the directors. Even in those cases an insolvency practitioner has a bit of a conflict of interest and must be particularly careful to be objective in giving his advice to the directors as to the need for and purpose of an administration order. Contested petitions are significantly different. They are rare birds. I think that an insolvency practitioner asked to give expert evidence to support such a case should not propose himself as the administrator. Otherwise the Court is faced with an expert giving highly contested evidence in a case where he has a direct interest in his evidence being accepted. Mr Sheldon did not go so far as to submit that such a conflict made the evidence inadmissible. I think he was right about that (for instance employees of a company quite often give expert evidence for their company). But the fact of such a conflict clearly goes to weight. And it is also obvious that the fact of the interest should be explicitly and fully brought out in the expert's report under Rule 2.2.
(3) The key area in relation to balance sheet solvency relates to the valuation of the company's assets. FRS 11 relates to this. It applies when "fixed assets need to reviewed for impairment when there is some indication that impairment has occurred." In other words when there is reason for looking again at an earlier valuation of fixed assets, a revaluation job should be done. No one suggests that the job is easy. It is not to be done on a forced sale basis - the general idea is to value the assets on a going concern basis. FRS 11 impairment reviews are carried out by specialist accountants. They involve a considerable degree of judgment and experience. It is common ground that a small difference in initial assumptions can make a great difference to the result (a point not mentioned in Mr Heis's initial evidence as it should have been).
Now Mr Heis was an insolvency practitioner. So far as the value of fixed assets are concerned insolvency practitioners normally turn to expert valuers in the relevant field. If the asset is a factory then they go to a factory valuer and so on. But in this case Mr Heis set himself up as the relevant expert valuer. It turned out that he had no expertise in FRS 11. He was essentially giving evidence second-hand. He said he had spoken to experts on FRS11 in KPMG who knew about FRS 11 and he understood the exercise. That is far from being an expert in the field himself. Saying, "I know a man who knows and he has explained it to me" is not expert evidence. So at the outset I would reject his evidence on FRS11 simply on the ground that he is not an expert on that subject.
The approach of Colt's experts was very different. They called two, both partners in another of the "big four" accountants, Ernst & Young. One was on FRS11 (Mr Halkes), a man with great experience of the standard from its introduction in 1998. He was also particularly experienced in auditing telecom companies. The other (Mr Hughes) was an insolvency practitioner (Mr Heis's expertise) who gave evidence on cash-flow insolvency. Of course in both cases the experts checked with other members of the firm, and, in some cases, got them to do some of the "donkey work", namely ascertainment and checking of detail. Moreover, at least in the case of Mr Halkes, he checked his opinion with another partner expert in FRS11. But the big difference was this: Mr Heis was giving the opinion of others who could not be cross-examined and who had not, so far as I know, read the CPR or its Practice Direction or the Code of Guidance. Colt's experts were true experts in their respective fields.
(4) Quite extraordinarily Mr Heis thought that even if a case were made out for it, no administration order would be made. It was a point he volunteered at the end of his evidence:
A. I thought the chance of an administration order necessarily arising even if the court were minded to make one, would be tempered. As Mr Hughes quite rightly pointed out, some form of solvent scheme or whatever, which presumably would not involve us, would be an answer if the court were minded to make that administration order anyway. So I think our view of the chances of our being appointed were probably quite low.
MR JUSTICE JACOB: Sorry, you put the 2.2 report in and you thought the chances of an administration order being made were low?
A. Because my conjecture was that the company would suggest some form of alternative procedure such as a scheme as Mr Hughes has made the point --
MR JUSTICE JACOB: In advance of the court hearing?
A. No, on the basis that the court signified that it was minded to grant an order.
I was amazed by this: I cannot imagine why Mr Heis did not say in his 2.2 report that he thought the prospects of an order being made were low even if the court was minded to make it.
(5) In his reply, Mr Brisby drew my attention to a number of passages in the Rule 2.2 report where Mr Heis expressed reservations or caution. The general theme was that he only had limited public information available and was doing the best he could with that. I reject that "excuse". If the information was not good enough to use, then there should have been no report. There would have been nothing wrong in Mr Heis saying "I do not have enough to form a reliable conclusion"
Q. The last bullet point: "Highberry believes that insolvency is inevitable." You are not suggesting that, are you, Mr Heis?
A. No, I am not.
Q. So you knew when you signed the 2.2 report that it was going to get into the press and be relied upon by Highberry to make allegations of insolvency against the company?
A. Yes, that was not the principal purpose of the report. [The rest of the answer does not matter]
Issue 4: Cash flow insolvency
Q. Your conclusion is as follows: "As can be seen above, based on publicly available information, it is reasonable to conclude that the company will not be able to meet its bond redemptions in 2006 without a re-financing. Given its current share price, bond prices and financial position, it is unclear how this can be achieved. It therefore appears reasonable to conclude, on the basis of publicly available information, that the company is likely to become unable to pay its debts as they fall due in 2006." The first point, Mr Heis, is you are not making any allegation of cashflow solvency prior to 2006, are you?
A. No.
Q. In your second report, I think you state that uncertainty as to future events prevents you from forming a definitive conclusion?
A. That is right.
Q. You say that brokers reports are speculative?
A. I have quoted the word used by Mr Hughes but "speculative", I think, is a word that can be used on any uncertain prediction into the future. I think we are both speculating as are the brokers.
Q. So you accept your view is also speculative?
A. It is based on the brokers' reports, which are in themselves speculative.
Q. Do you still maintain that it is your view that it is more likely than not that this company will be cashflow insolvent in 2006?
A. It is my view, but I accept that that view is not necessarily definitive or all that reliable.
Q. I will put it to you, Mr Heis, that it is simply untenable?
A. Well, I would not say it is untenable but because the cashflow issue is something that is a feature of 2.2 reports I have dealt with it, but obviously I accept that there are limitations in the way I have dealt with it.
Q. You are in no [obviously missing from the transcript] different position from the brokers on this point, are you not, whatever the position may be on other matters, you are clearly in no different position from the brokers?
A. No, probably a slightly worse position.
Q. Let me just slightly rephrase the question. When I use the phrase "more likely than not", I mean more probable than not. Is it your view that it is more probable than not that the company is going to be cashflow insolvent in year 2006?
10 MR JUSTICE JACOB: Or [the transcript wrongly says "why"] are you unable to say?
A. I think if I can deal with that and answer it, Mr Sheldon, you could say that it is not possible to form a conclusion. I would certainly say it is not my view that it is more likely than not that the company will be able to re-finance successfully because the objective evidence does not support that. But if you are saying is my opinion valid at all, then I would say that there are significant limitations and you may query whether that is a worthwhile opinion to form. My view is that it is, but obviously I have made the point that it is limited, it is of limited reliance that one can place on it.
Issue 5: Balance Sheet insolvency
"Financial Reporting Standard 11 'Impairment of Fixed Assets and Goodwill' sets out the principles and methodology for accounting for impairments of fixed assets and goodwill"
….
"It would be unnecessarily onerous for all fixed assets and goodwill to be tested for impairment every year. In general, fixed assets and goodwill need to be reviewed for impairment only if there is some indication that impairment has occurred. (Requirements for additional impairment reviews of goodwill and intangible assets in certain circumstances are included in frs 10 'Goodwill and Intangible Assets').
Where possible, individual fixed assets should be tested for impairment. However, impairment can often be tested only for groups of assets because the cash flows upon which the calculation is based do not arise from the use of a single asset. In these cases, impairment is measured for the smallest group of assets (the income-generating unit) that produces a largely independent income stream, subject to constraints of practicability and materiality.
Impairment is measured by comparing the carrying value of the fixed asset or income-generating unit with its recoverable amount. The recoverable amount is the higher of the amounts that can be obtained from selling the fixed asset or income-generating unit (net realisable value) or using the fixed asset or income-generating unit (value in use).
Net realisable value is the expected proceeds of selling the fixed asset or income-generating unit less any direct selling costs. Value in use is calculated by discounting the expected cash flows arising from the use of the fixed asset or assets in the income-generating unit at the rate of return that the market would expect from an equally risky investment."
….
"Cash flows
36 The expected future cash flows of the income-generating unit, including any allocation of central overheads but excluding cash flows relating to financing and tax, should be based on reasonable and supportable assumptions. The cash flows should be consistent with the most up-to-date budgets and plans that have been formally approved by management. Cash flows for the period beyond that covered by formal budgets and plans should assume a steady or declining growth rate. Only in exceptional circumstances should:
(a) the period before the steady or declining growth rate is assumed extend to more than five years; or
(b) the steady or declining growth rate exceed the long-term average growth rate for the country or countries in which the business operates."
…
"Discount Rate
"41. The present value of the income-generating unit under review should be calculated by discounting the expected future cash flows of the unit. The discount rate used should be an estimate of the rate that the market would expect on an equally risky investment. It should exclude the effects of any risk for which the cash flows have been adjusted and should be calculated on a pre-tax basis.
"Estimates of this market rate may be made by a variety of means including reference to:
(a) the rate implicit in market transactions of similar assets;
(b) the current weighted average cost of capital (WACC) of a listed company whose cash flows have similar risk profiles to those of the income-generating unit; or
(c) the WACC for the entity but only if adjusted for the particular risks associated with the income-generating unit.
43 If method (c) is used the following matters are of note.
· Where the cash flow forecasts assume a real growth rate that exceeds the long-term average growth rate for more than five years, it is likely that the discount rate will be increased to reflect a higher level of risk.
· The discount rates applied to individual income-generating units will always be estimated such that, were they to be calculated for every unit, the weighted average discount rate would equal the entity's overall WACC.
44. The WACC will be a post-tax rate from the entity's point of view, whereas the required discount rate will be a pre-tax rate. Some of the issues that need to be considered in adjusting from a post-tax rate to a pre-tax rate are discussed in Appendix I.
45. Using a discount rate equal to the rate of return that the market would expect on an equally risky investment is a method of reflecting the risk associated with the cash flows in the value in use measurement. It is likely that this method will be the easiest method of reflecting risk. However, an acceptable alternative is to adjust the cash flows for risk and to discount them using a risk-free rate (e.g. a government bond rate). Whichever method of reflecting risk is adopted, care must be taken that the effect of risk is not double-counted by inclusion in both the cash flows and the discount rate."
…..
"Appendix I – Determining pre-tax discount rates
The discount rate reflects the rate of return required on the assets being reviewed, not the way in which they have been financed. Hence it is not affected by any tax relief available on the cost of financing the asset or by any tax paid by the provider of finance."
"On 27 September 2002, the Company also announced that given the recent downturn in the telecommunications industry and in the overall economic environment that it was prudent to take further action to ensure that its asset base remained aligned with the realities of the market. As a result, the operating exceptional items of £508.0m. shown under network depreciation and £43.0m. under other depreciation and amortisation in the three and nine months ended 30 September 2002 represent a non-cash impairment charge to write down the book value of fixed assets. This charge resulted from a review covering all of the Group's tangible fixed assets and goodwill and was computed in accordance with the requirements of FRS 11 'Impairment of fixed assets and goodwill'.
It is the Group's accounting policy to review its tangible and intangible fixed assets for impairment whenever events or changes in circumstances indicate that carrying amounts may not be recoverable. An impairment loss is recognised to the extent that the carrying amount of an asset exceeds its recoverable amount, being the higher of its value in use and net realisable value. In computing the impairment charge fescribed above in accordance with this policy and the requirements of FRS11, the carrying amounts of the relevant assets were compared to recoverable amount, represented by the present value of discounted cash flows projected to arise from their use."
Q. Now, you do not suggest anywhere in your 2.2 report or in your second report that PricewaterhouseCoopers have been in any way negligent. Is that correct?
A. I think that's correct, but I would draw your attention to the fact that the 2.2 report was submitted before the PwC statement was issued.
Q. But that was submitted on the basis, amongst other things, of the December 2001 results, which were audited.
A. Yes, that's right.
Q. And there is no suggestion that PricewaterhouseCoopers were negligent in connection with that audit?
A. I clearly did not have the information about the nature of the audit they did, nor the personal expertise to say that, although, in my report, I have drawn very heavily on the relevant specialisms within the firm on both FRS and the application of it. So, I would not like to make any comment in relation to PwC.
Q. So, you are not suggesting that PwC have been negligent?
Q. No. The only things I know about PwC's involvement are: one, there was an audit which was done last year; secondly, there was a statement which was issued after the submission of the 2.2 report; and thirdly, it has emerged that the discount rate was 13.7 percent. Those three factors I don't think allow one to pass judgement.
I said "his view" but really it is the view of others as the following passage shows:
MR JUSTICE JACOB: So, you are not saying there is anything wrong with what PwC did?
A. Because there is no information to enable one to do so. But what I --
Q. Just help me with that. And if they got it right, then this company is not insolvent on a balance sheet basis, is that right?
A If they got it right, that's certainly true.
Q. So, you are saying something is wrong with PwC?
Q. We're saying that we have done the analysis on the public information and that leads to a different conclusion.
Q. When you say 'we', what do you mean 'we'? You mean you or somebody else?
A. I mean myself and the relevant colleagues with whom I've consulted extensively.
Q. Do you mean some of your report is not your own?
A. I have taken advice from other experts, which is necessary. There are a number of factors that need to be considered in a report such as this, and I have not all of those pieces of expertise myself, as indeed I wouldn't have thought anybody has. I have made sure that all of the advice that I have received I have completely understood, at length through meetings and discussions.
Q. Am I right that you have not even named the people who gave you that advice?
A. I haven't named them in the report. There are quite a large number.
Q. Mr Heis, you say that you refer to the £2 billion figure, but why didn't you give the company the benefit of the doubt and put that figure into your calculations?
A. Because it wouldn't have made any difference.
A. So, Mr Heis, you selected a figure of £217 million, even though you have projected that the company is going to spend an average of £327 million in the preceding five years leading up to what you say will then result in a disposal of only £217 million. That is absurd, is it not, Mr Heis?
A. It's one range of £217 to £2026 million. I mean I've pretty much -- I mean I worked out the number myself. I broadly conceded that £2 billion is a fair number, as opposed to £217 million. The whole thing depends on the discount rate.
Q. Can I move on from there because you have accepted FRS11 says nothing in terms about eliminating default risk from the cost of debt?
A. FRS11 only talks about eliminating the effects of financial structure.
Q. Exactly. In fact, eliminating default risk from the cost of debt, I suggest, is contrary to the whole point behind FRS11 because you run the risk of ending up with a cost of debt that is wholly unrelated to the risk that the market would actually attribute to financing the assets in question?
A. No, there I would take issue with you. Because FRS11 is applied to accounts that are prepared on the going concern basis. To use a discount rate that includes a default risk is counter-intuitive because you are using a rate that says this company is going bankrupt, and if you think the company is going bankrupt then you should not be preparing the accounts on a going-concern basis anyhow; you should be preparing the accounts on a break-up basis.
Issue 6: Discretion
(a) The making of an administration order would be an event of default under the terms of the Indenture - that would mean all the debt was repayable now. That could well destroy the entire business rather than serve the statutory purpose of the survival of the company and the whole or part of its undertaking.
(b) The Petition has very little support - no bondholder other than Highberry (holding just 7% of the notes) supports it. Mr Brisby suggested there might be silent supporters. I reject that - I can see no reason why a supporter, if there were one, could not have written a letter of support.
(c) It is premature - there is not even a suggestion of urgency given that is conceded that creditors will be paid until at least 2006.
(d) There is no indication that an administrator with no knowledge of the telecoms business could improve the current specialised management - it would almost certainly stop the business in its tracks. Normal corporate governance would be suspended for no clear or useful purpose.
(e) An administration order would simply add to the company's costs (if its business survived).
Conclusion