Zombie companies go on the rampage – Catherine Feechan

Firms unable to repay debts racked up during the Covid crisis could face a reckoning soon, writes Catherine Feechan

The zombie apocalypse may be coming – but not in the form of the flesh-eating undead running riot (Picture: Greg Macvean)

The coronavirus struck, the UK was forced into lockdown and the government stepped up to fill the breach by providing unprecedented levels of support for businesses through grants, loans and furlough payments. It all seemed a sensible approach, aimed at safeguarding our longer term economic interests, but it may also have a negative impact due to the potential “zombie effect”.

Many businesses, even those which were previously in great financial shape, have racked up massive debts since March including bank or government loans which they were encouraged to take in an effort to survive. While trying to keep businesses alive is a natural instinct for most governments, the lasting impact of Covid-19 on many industry sectors means that a significant level of this debt is now held by so-called zombie companies which have little if any hope of ever repaying it.

Zombie companies are indebted businesses that, although generating cash, after covering running costs, fixed costs (wages, rates, rent etc) only have enough funds to service the interest on their debts, but not to repay them. They are kept alive only by continuing support from their funders.

Catherine Feechan, corporate partner at Davidson Chalmers Stewart LLP

Usually just one step away from insolvency, these companies have no capacity to invest or grow their business. Those companies which are not actually losing money on an operational basis and are able to service their debt, even if they can’t repay it, usually manage to stumble along but their position is always precarious. A small rise in interest rates or HMRC seeking to collect VAT and other deferred taxes could push many zombie companies over the edge.

The problem with such companies limping along is that they suck up economic resources that could be more effectively employed elsewhere. If government support results in companies being kept alive that would, or even should, have otherwise gone out of business, it affects the potential for economic growth, stifles productivity and slows the pace of recovery, and that impacts on us all.

Fear of reputational risk and a lack of potential buyers has also resulted in banks continuing to back zombie companies. The hope of being able to sell a customer’s assets at a better price in an improved economy to allow them to recover their loans has kept many such businesses on the banks’ books. While banks are not in a rush to start enforcing their rights to demand repayment just yet, that could change soon. We’ve already seen several massively increasing their bad debt provisions, a clear sign that they expect to see Covid-19 having a long-term impact on their own business as well as that of their customers.

While, for directors, their initial focus was understandably on keeping their business alive and, in many cases, taking on government support wherever it was available, they must now think about the longer-term implications. The explosion of debt incurred since lockdown will need to be addressed and many businesses will need to renegotiate with funders to write off an agreed proportion or extend payment terms. Where a workable solution is unachievable and the company then falls into zombie territory, directors must carefully consider whether continuing to trade is in the best interests of their stakeholders.

Currently wrongful trading provisions remain suspended but that may not continue for much longer. Directors could soon be open to personal liability if their company continues to trade when it’s likely that it will be unable to repay its debts.

You could argue that more due diligence should have been done on businesses prior to ploughing public money into them or that directors should have thought more about taking on such unprecedented levels of debt, but speed was of the essence when the pandemic struck in March.

At that point in the crisis, the blanket support provided was considered by both the government and directors as a risk worth taking. Economic pain down the line seemed preferable to the widespread collapse of businesses in the short term.

Time will tell, whether this was a sensible approach or a misguided one that has simply propped up legions of zombie companies which will drag down the UK economy over the longer term.

Catherine Feechan, corporate partner at Davidson Chalmers Stewart LLP