Today’s SMEs are tomorrow’s business giants, but most are being smothered by bankrupt clients and irresponsible bankers. Prem Sikka writes.

Two things have dominated recent headlines – the fallout from the Carillion liquidation and the abuse of small and medium-sized enterprises (SMEs) by banks.

The common factor is the legal privileges enjoyed by banks which need to be challenged if any government is to create the necessary conditions for survival of SMEs.

Carillion collapsed with nearly £7bn of liabilities. Its liquidation is in progress and chances are that most the proceeds from the sale of the assets will go to banks, Carillion’s secured creditors.

The unsecured creditors, which include thousands of supply change creditors, will get little. The losses to unsecured creditors are also drivers of new insolvencies as the cash flows of creditor businesses are squeezed. A domino effect has already set-in and many other businesses are facing closure.

In 2017, due to Carillion and other bankruptcies unsecured creditors suffered losses of £4.2bn. The first half of 2018 has inflicted another loss of £2.7bn. The hit from the bankruptcies of Maplin, Toys R’ Us and Palmer & Harvey are yet to work through the system.

Many SMEs will take a financial hit

SMEs are frequently not diversified and cannot easily absorb the losses. They don’t have sufficient economic clout to impose covenants on companies to safeguard their interests. They do not have sufficient resources to take out credit insurance. They are left to bear a disproportionate part of cost of client liquidation whilst banks walk away with most of the liquidation proceeds. The risk sharing, as prescribed by law, is highly inequitable.

The second thing dominating the headlines is the fallout from the leaked Turnbull Report.

The Turnbull Report shows that many viable businesses have been unnecessarily and deliberately placed in liquidation. And the Treasury Committee said that “small businesses have been subject to some appalling treatment by banks”.

This pattern of abuses has also been documented in the Tomlinson Report and a report on RBS’ treatment of small business customers in its Global Restructuring Group (GRG).

A key reason for the abuses is to increase bank profits and executive bonuses. These are assured because banks, as secured creditors, are able to grab almost all of the assets and leave others to absorb almost all of the losses.

A common factor in the above two stories is the interests of banks and their capacity to destroy viable businesses. There is no reason why the banks and other secured creditors should not bear a greater proportion of the losses arising from bankruptcies.

Possible solutions

Unlike SMEs, banks and other financial institutions hold diversified portfolios and thus have a greater capacity to absorb losses. Their overall losses are likely to be a small proportion of their total investment whereas the losses to SMEs are substantial.

The very concept of a secured creditor could be abolished and all creditors, after payment of any priority creditors, could rank equally for claims on the proceeds of liquidation.

Such a rapid change may be too much for some and no doubt privileged interests would agitate against any change.

Another possibility could be to reform Section 176A of The Insolvency Act 1986 and the Enterprise Act 2002, and ensure that a substantial part of the proceeds of liquidation are ring-fenced for payment to unsecured creditors.

Currently, up to £600,000 can be ring-fenced to pay unsecured creditors and is totally inadequate.

This could be changed to ring-fence say 30% of the proceeds of liquidation, thus ensuring that SMEs and other unsecured creditors receive something after the bankruptcy of a Carillion-like customer. It could be a life saver for many.

The proposed change in the distribution of assets would also give SMEs and other unsecured creditors incentive to watch over and invigilate the bankruptcy proceedings.

The proposed 30% ring-fencing still gives banks privileges – i.e. they will still get majority of the proceeds of liquidation but not all of it. The change would make risk sharing more equitable and SMEs and unsecured creditors would not bear most of the cost. Secured creditors would still be able to obtain charges on assets, but wouldn’t be able to walk away with all of the proceeds.

Of course, banks are likely to oppose any change as they have got used to having their ways regardless of the social consequences. They would try to frighten governments and others by saying that if the proposed change goes through they would deny credit to SMEs even though SMEs are poorly treated.

The alternative is to permit the current state of affairs and abuses to continue and let the weakest bear the biggest share of the cost of bankruptcies.

Today’s SMEs are tomorrow’s business giants, but too many are being strangled by unfair distribution of assets from bankrupt customers. This is facilitated by inappropriate laws.

It is time that parliament rebalanced the privileges of banks and secured creditors with more equitable distribution of the proceeds of liquidations.

If we want to solve this crisis and put our national economy back on its feet something must be done. But so far we’re standing still.

Prem Sikka is Professor of Accounting at University of Sheffield and Emeritus Professor of Accounting at University of Essex. He tweets here.

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