The government has published a consultation paper looking at ways to improve the framework surrounding companies in or approaching insolvency. The policy objective is to reduce the risk of major company failures and their impact on a wider range of stakeholders, including employees and company pension scheme beneficiaries.
The paper follows a number of recent high-profile cases which have highlighted potential shortcomings in the governance of businesses facing financial difficulties and the legal duties of business owners contemplating distressed sales.
The consultation forms part of the Government's wider corporate governance reforms, which we discuss here. In its introduction to the consultation paper, the Government comments that:
"We are already working to implement reforms to improve the corporate governance regime in relation to executive pay, strengthening the employee and wider stakeholder voice in the boardroom, and corporate governance in large privately held businesses. Our insolvency regime is another important part of the UK’s business environment and is well regarded internationally. The Government recognises however, that the regime must be continually improved to ensure it delivers the best possible outcomes now and in the future. The Government wants to take this work further to reduce the risk of major company failures occurring through shortcomings of governance or stewardship, and to strengthen the responsibilities of directors of firms when they are in or approaching insolvency."
The consultation closes on 11 June 2018.
The key proposals
The government is proposing to:
- introduce new potential liabilities for the directors of parent companies who sell an insolvent subsidiary, where there was no reasonable expectation that the sale would result in a better outcome for creditors than on an insolvent process and creditors suffer as a result
- expand insolvency officeholders' powers to unpick complex value extraction schemes
- improve the government’s investigatory powers in respect of dissolved companies which have avoided a formal insolvency process
- look at a range of measures to strengthen corporate governance in pre-insolvency situations.
Considering the future viability of a business on a distressed sale
The government is concerned that there are currently insufficient controls on the sale of an insolvent (or potentially insolvent) company. Echoing the events in the BHS case, in which the company was sold for £1 to a purchaser with no realistic prospect of being able to safeguard the viability of a company saddled with huge pension liabilities, the Government summarises the current state of the law:
"… there is currently no requirement in law for a seller to consider the future viability of a business after its sale. There is no formal requirement, for example, to review a purchaser’s credentials and proposals, and no duty of care on the part of a seller towards the company’s employees or future creditors. If a company that was sold subsequently fails, even if the sale contributed to that failure, or if the purchaser is found to have had no viable way to return the business to profitability, the seller cannot be held accountable for the consequences of the decision to sell the business. Existing company and insolvency law can address the conduct of the failed company’s directors and can attack certain transactions which have unfairly harmed creditors, but it does not readily allow for the conduct or actions of directors of another company (for example a parent company) to be addressed."
Strengthening the responsibilities of parent company directors on distressed sales
The consultation proposes changes to enable directors of a parent company to be held accountable for sales of subsidiaries where creditors have been adversely affected. The measures will apply in cases where the directors have sold a large company and the following criteria are satisfied:
- the company is either insolvent, or would be insolvent without guarantees provided by other companies in the group
- the company entered into administration or liquidation within two years of the sale
- the interests of the creditors have been adversely affected since the sale
- the director, at the point of sale, could not have reasonably believed that the sale would lead to a better outcome for the creditors than liquidation or administration.
There is no requirement for a causal link between the sale and the insolvency; it is sufficient that the director could not have reasonably believed that the transaction would be in the creditor’s interests. The penalties to the individual are likely to include disqualification from holding office as a director and seeking court orders for financial contributions from directors.
At present the proposed requirement focuses on a deterioration in outcome for creditors of the company – and not a broader consideration of stakeholder interests (for example, employees), but the Government is "keen to hear views" on whether new penalties should be introduced for directors who sell an insolvent company without any reasonable expectations that the sale is in the interests of the subsidiary's "stakeholders", and which subsequently fails.
Expanded review powers for inappropriate extractions of value
The government is considering extending the existing "antecedent recovery powers" of insolvency officeholders under the Insolvency Act 1986 – under which officeholders are able to challenge a range of pre-insolvency transactions which adversely affect creditors. These reviewable actions include transactions at an undervalue and transactions designed to engineer better outcomes for certain creditors, known as "preferences".
The government is concerned that the current framework is not sufficiently flexible "to counter all types of transactions which unfairly strip value from an ailing company in the modern world".
It is therefore proposing to give officeholders new powers to tackle complex value extraction schemes. It is proposed that these new powers would only apply where the company:
- received a new investment;
- had value extracted in a transaction or series of transactions designed for the benefit of the investor (e.g. excessive interest on loans or management fees) without adding value to the company; and
- subsequently enters liquidation or administration.
The new powers would enable scrutiny of transactions within a period of two years prior to formal insolvency, but, in contrast to existing antecedent recovery powers, it would not be necessary to show that the company was technically insolvent at the time, or as a result, of those transactions.
Establishing new investigatory powers in respect of dissolved companies
The current law gives powers to the Insolvency Service to investigate and sanction the directors of live and insolvent companies. However there are no investigatory powers to hold directors of dissolved companies to account. Some company directors are making use of this loophole to avoid accountability by allowing or causing their companies to be dissolved instead of complying with the formal insolvency process.
Whilst not impossible for directors of dissolved companies to be prosecuted, a court order is required to restore the company to the register, which means that current enforcement action is in practice reserved for situations where there is already strong evidence of misconduct.
The government is therefore proposing that the scope for investigation and sanction should be extended to include former directors of dissolved companies. They are also considering whether the Secretary of State should have the power to:
- require any person to provide information to investigate the conduct and actions of former directors of dissolved companies
- seek an order disqualifying a former director from holding a director’s office at another company
- seek an order for the former director to financially compensate creditors in situations where the director’s actions caused identifiable loss
- seek a prosecution where there is evidence of criminal conduct.
Strengthening corporate governance in pre-insolvency situations
The government is also exploring wider governance issues that can be relevant when companies experience financial difficulties:
- Group structures: what steps should be taken to improve governance and accountability within large and/or complex company group structures?
- Shareholder responsibilities: should shareholders be encouraged to actively steward and engage in the long term strategies of the companies in which they have investments?
- Payment of dividends: is the legal and technical framework for dividends still appropriate – the consultation paper highlights instances of large dividends being paid despite large pensions deficits?
- Directors’ duties: are directors are commissioning and using professional advice appropriately or are they doing so without fully turning their minds to their wider statutory duties?
- Protection for company supply chains: In insolvency situations, the likelihood of each company in the supply chain recovering what they are owed diminishes. Should supply chains and creditors should be better protected, and if so, how could this be achieved?
Osborne Clarke comment
The consultation clearly has laudable aims, particularly when considered against the backdrop of recent high profile insolvencies, the parallels with which are clear from the examples cited in the consultation.
In May 2016, the government launched a consultation, A Review of the Corporate Insolvency Framework, which made proposals, amongst other things, for a pre-insolvency moratorium, the development of a new flexible restructuring plan tool incorporating a cram-down mechanism, and options for rescue financing, to strengthen the rescue culture with the aim of improving the UK's World Bank rankings. That consultation has not progressed, which is understandable in light of its timing relative to the Brexit referendum, if not disappointing given its equally laudable aims.
The challenge the latest consultations pose is how to resolve the particular mischiefs flagged without doing serious harm to the turnaround and rescue culture which can be so important in preserving value and jobs. It may be that this can be achieved in a more balanced way by adapting the existing range of protections rather than through wholesale reform.
Should you wish to discuss any of the issues raised by this consultation or the other consultations referred to in this article please contact one of the following or your usual Osborne Clarke contact.