Banks could lose the killer instinct: The insolvency debate may change the way smaller companies are financed. John Willcock reports

BANKS have been the villains of the recession, seen as the people who pull the plug just when a company is reaching breaking point. Hardly surprisingly, a furious debate is under way into whether insolvency laws should be reformed so that banks lose some of their rights when businesses are wound up.

Predictably, this has horrified the banks. Last week Eddie George, Governor of the Bank of England, gave a qualified approval to the banks' treatment of small business clients. But he warned that there were still problems, and the insolvency debate could prod the clearing banks into a serious rethink in their approach to funding small businesses.

One of the main proposals put forward by the Department of Trade and Industry is a 28-day stay of execution for companies facing administration or voluntary liquidation. This is broadly accepted by the banks and insolvency practitioners. The more controversial proposals include requiring banks to give seven days' notice of appointing a receiver.

Receivership is a fundamental weapon in the banks' armoury. It is quite different from the various forms of liquidation and administration, which are initiated by and on behalf of combinations of directors, creditors and the courts. The receiver is appointed by a bank literally to 'receive' the bank's oustanding loans, and the bank stands first in line before other creditors.

The moment a receiver is appointed he has to go to the business premises, secure them and change the locks if necessary. Teams of security guards are often used for this work. Bank accounts are frozen, contracts held in abeyance, and the entire running of the business handed over to the receiver.

The banks fear that directors could play havoc with assets in seven days. Any Arthur Daley worth his salt would have removed anything worth taking in that time.

The DTI paper also suggests reducing banks' ranking in a payout to that of other creditors. This would dramatically reduce the amounts banks would recover in company collapses.

Another proposal is to abolish receiverships completely. All creditors would then be taken into account in company collapses. This is anathema to the banks. The draft proposals were published by the DTI before Christmas in a paper titled 'Company Voluntary Arrangements and Administration Orders.' They have been broadly welcomed by the insolvency practitioners who would have to implement them. But the receivers echo the banks' opposition to the more controversial ideas.

Views on the proposals have to be received by the DTI by March, and the banks' response is being co- ordinated through the British Bankers Association.

Already clearing banks have voiced their fears. If they can no longer rely on being able to call in the collateral pledged as security for their loans, they will cease to lend to risky businesses, or put up their prices for lending. Either way small businesses will be hit hard.

What was meant to be a consultative document to fine tune insolvency legislation has instead had the effect of questioning how banks finance small businesses.

Small businesses make up the vast majority of business failure statistics. In the past three years there have been 66,000 liquidations, 21,600 receiverships, 447 administration orders and 296 company voluntary liquidations, according to the accountants Coopers & Lybrand.

The DTI paper suggests that many of these could have been saved with improved legislation. But the way these companies were financed when they were set up must bear some responsibility for the scale of failures.

Eddie George warned last week that British businesses' reliance on overdrafts to finance their operations was a serious problem for the UK economy. Overdrafts are repayable on demand, yet act as risk capital for the majority of small start- ups in the UK.

Overdrafts comprise 58 per cent of all UK company debt, compared with 14 per cent in Germany. With long-term loans the position is reversed. Only 11 per cent of UK business loans are long term, compared with 31 per cent in Germany.

Mr George pointed out that the main obstacle to switching to long- term funding was expense. Small businesses pay interest only on the overdraft outstanding, and term loans are always more expensive. But term loans cannot be withdrawn on demand, giving businesses vital shelter from receivership when things get tough.

At the moment, a limited company can be started with two pounds 1 shareholders. The capital of the company is formed by borrowing from the bank. So when the directors are facing hard times, avoiding insolvency is seen as a problem for the bank as much as for themselves.

But banks usually take personal guarantees and mortgages when they provide business overdrafts. The slip of paper a director signs when he launches the company can come back to haunt him when things go wrong.

The alternative of a term loan to the directors to invest as equity in the company would make them aware right from the start that their equity holding was directly related to the health of the company.

People tend to cast their eyes enviously towards Germany, where banks hold large chunks of their clients' equity. But Midland Bank warned against simply adopting the 'German solution' in a research paper from its corporate finance department in 1993. It was adamant, however, that banks and their customers need to change the way finance is put together.

It quoted Admiral Beatty when German ships showed their superior construction at the Battle of Jutland in the First World War: 'There's something wrong with our bloody ships today.' Will the clearing banks take a similarly urgent attitude to reforming finance for small businesses?

(Photograph and graphs omitted)