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18/06/2018

Corporate Governance & Insolvency – Problematic Proposals

Director responsibilities, corporate governance, and insolvency have been the subject of multiple Government consultations in recent years. The latest consultation, ‘Insolvency and Corporate Governance’, has just closed and ticked all three of those boxes.

The corporate governance consultation is, unfortunately, problematic for a number of reasons. Importantly, many of the proposals within the consultation could have significant negative consequences for the UK’s business and rescue culture. And, perhaps just as importantly from a policymaking perspective, while the consultation shares themes with other recent consultations, there is almost no attempt to tie all of the different policy proposals together – the absence of references to the 2016 corporate insolvency framework reform proposals is particularly glaring.

Fundamentally, the proposals in the consultation are designed to deal with specific behaviours or problems, but fail to address either the underlying factors which lead to these behaviours and problems, or the tools which already exist to tackle them. The underlying factors at play here are: the existing rescue options available to distressed companies; the existing powers available to office holders, and the effectiveness of the use of these powers; director skillsets and awareness of duties; and the funding of companies in financial distress.

The creation of new tools in isolation from existing powers and procedures or alternative reform projects will lead to confusion, inconsistency, unnecessary cost, and overlap. A more coherent approach to insolvency and corporate governance policy making across government would be welcome.

Rather than introduce these proposed reforms, the Government would be better off looking at two alternative options: it should review and, where necessary, improve the existing office holder powers to tackle director actions or to reverse transactions, and, secondly, the Government should introduce its 2016 reforms, which would help tackle the aforementioned underlying factors.

Corporate Governance & Insolvency – The Proposals

This consultation appears to be the Government’s reaction to a number of recent high-profile insolvencies and corporate governance failings. BHS, Carillion, Monarch, City Link and other cases spring to mind when reading the thinly disguised case studies in the consultation document. To address these, the Government is proposing to (in short):

  • Require directors of parent companies, which have sold a subsidiary, to make a contribution to the subsidiary’s creditors in the event that the subsidiary becomes insolvent within two years of the sale, where the subsidiary was insolvent at the time of the sale, and where the insolvency was reasonably foreseeable at the time of the sale;
  • Create new powers for office holders to reverse examples of ‘value extraction’ where, following fresh investment, investors or others have arranged restructurings or transactions to protect themselves against losses in the event that the company becomes insolvent, and where these have not added value to the company in receipt of the investment; and to
  • Expand the director disqualification regime to include directors of dissolved companies (in addition to directors of insolvent companies).

The consultation also includes questions about directors’ awareness of their responsibilities, the prescribed part, and the position of SMEs as creditors in large insolvencies.

Dissolutions and Disqualification

Taking the least controversial proposal first, extending the director disqualification regime to directors of dissolved companies is a sound idea. While there are plenty of legitimate reasons why a company might be dissolved without first going through an insolvency procedure, there are also plenty of illegitimate reasons. In the insolvency profession’s experience, it is all too common to come across directors who have attempted to avoid their creditors and the scrutiny involved in an insolvency procedure by allowing their company to be struck off from the Companies House register because of a failure to file accounts, or by paying the £10 dissolution fee and hoping nobody notices. In the past five years, there have been 280 court orders for the simultaneous restoration and liquidation of a dissolved company. That’s just the tip of the iceberg and represents 280 directors who have – deliberately or not – almost escaped scrutiny.

Bringing directors of dissolved companies within the scope of the disqualification regime is only part of the solution to the abuse of the dissolution process, however. While directors may be disqualified, creditors can still be left worse off as a result of an illegitimate dissolution because no distribution of dividends can be made by a dissolved company. To get any money back from a wrongly dissolved company, creditors have to be willing to go through the costly process of having the company restored via a court order and then liquidated. There is something of an asymmetry here: it costs just £10 or a failure to file accounts to have a company dissolved, but it costs much more to reverse this process. While there are fines and sanctions for incorrectly dissolving a company or for failing to file accounts, these appear to be often ignored. To help resolve this issue, it should be made much easier to restore a dissolved company. If companies can be dissolved administratively, an administrative process for restoring them might help.

Where there is a question mark over the ‘dissolved disqualifications’ proposal is whether the Insolvency Service has the resources to cover both insolvent company disqualifications and dissolved company liquidations. If investigations work for the additional directors brought within the scope of the regime comes at the expense of existing investigations then the reform would not improve corporate governance in the UK, but would simply shift scrutiny from one type of corporate governance failure to another.

Subsidiary Sales and Value Extraction

The two most problematic parts of the consultation proposals are the planned new rules on subsidiary sales and value extraction.

The first proposal, covering subsidiary sales, would dramatically expand director liabilities, pierce the ‘corporate veil’, and would make directors personally liable for the success of a former subsidiary in a way they would not be were their company to still own it. The scope of the power is simultaneously wide – with sales being judged for ‘unreasonableness’ or whether they cause ‘harm’ to stakeholders – yet hard to pin down: it may prove difficult to show that directors “could not have reasonably believed that the sale would lead to a better outcome for… creditors than placing [the subsidiary] into administration or liquidation.” This wouldn’t bode well for the attractiveness of the UK as a place to do business.

There are several problems. Under the proposals, directors would find themselves caught between their responsibilities to parent company creditors (whose position may be worsened by a failure to sell) and the current and future stakeholders of a subsidiary. Rather than seek to sell a subsidiary, directors may find it easier to simply close them down (complete with job and creditor losses), or to not even set them up in the first place. This would stifle innovation and investment.

It’s not clear what positive impact the proposal might have either. On the one hand, the new risks involved with selling a subsidiary may prevent valid subsidiary sales outside of insolvency procedures; on the other, the difficulty in showing directors should have known better may mean that the new power brings very little money back to creditors. While the insolvency and restructuring profession is well aware of the importance of insolvency procedures in business and job rescue, it’s also true that forcing all business sales through an insolvency procedure – one way to avoid the new liabilities – would not be a positive development. Insolvency procedures can involve value-loss, and, besides, a sale through an insolvency procedure wouldn’t actually require any consideration of the future viability of a subsidiary. The proposal contains a lot of downsides, but few, if any, positives.

The value extraction proposal has similar problems: new risks for one group – in this case, investors, who may consequently become less willing to invest or rescue businesses – but little benefit to show for it in return. The Government is right to identify that ‘value extraction’ is not positive, but the proposals would undermine the appetite for genuine investment, too.

Alternatives

As highlighted above, the two best alternatives for the Government would be to review and update existing office holder powers, and to introduce its 2016 reform proposals. These might tackle the underlying problems with corporate governance and insolvency in a way the proposals in the consultation document would not.

If, for example, the Government is concerned about sales, restructurings or investments which can be perceived as ‘unfair’ then, rather than introducing reforms which could put companies off from sales, restructurings and investments, introducing tools which can improve transparency and third party oversight of the restructuring process could help. The 2016 reform proposals include plans for a court-based restructuring tool and business rescue moratorium which would allow for structured, transparent and, in the case of the proposed restructuring tool, court-sanctioned sales or restructurings. The success of these tools would depend, in part, on them not being perceived as ‘insolvency’ procedures but as restructuring processes, thereby avoiding the value loss which can be associated with administration and other existing insolvency options.

Similarly, improving UK rescue funding – one of the key parts of 2016 reforms – would provide more options for companies in financial distress and could lessen the chances that a company might expose itself to a ‘value extraction’ scheme. It would also make it easier for companies to trade during an administration, increasing rescue options and transparency (that said, the specific 2016 rescue funding proposals are not necessarily the right ones for the Government to proceed with).

The Government should also consider why the existing tools available to office holders have failed to reverse examples of ‘value extraction’. After all, a transaction at an under value, preferential treatment, or misfeasance following an investment are still a transaction at an under value, preferential treatment, or misfeasance whether they follow an investment or not. Simply creating new versions of existing tools to deal with specific circumstances won’t circumvent all of the problems which prevent the use of existing tools, and may well alienate the few sources of rescue funding which are currently available. Creating specific tools for specific circumstances would also be a missed opportunity to improve things in all cases and for all creditors and stakeholders.

There are several factors which affect the use of the existing tools:

  • The ‘insolvency test’ for pursuing certain claims, where it applies, can be too high a barrier to overcome, while time limits and ‘look back’ periods can nullify claims even when this test is passed;
  • There can be a lack of funding available for making claims, particularly when there are no assets left in an insolvent company to pay for litigation;
  • Case law has limited the scope of existing powers;
  • It can be difficult to apply existing provisions to ‘new’ features of the business landscape which have emerged since 1986; and
  • The willingness and resources of the office holder to litigate can have a big impact on whether a claim is made (including where the office holder is the Official Receiver; the appointment of insolvency practitioners in more cases could help increase the resources available for pursuing claims in compulsory liquidations).

The Government’s ‘value extraction’ proposal does contain plans to scrap the ‘insolvency test’ in certain circumstances. This is an interesting idea, but it’s not clear why it should apply to only some situations and not others; it wouldn’t necessarily deal with an inability to fund claims either. Entirely scrapping the test would, however, constitute a significant change to how the insolvency and restructuring framework operates and much more consultation would be needed before such a reform is introduced. A wholesale review of the full set of existing office holder powers might be more worthwhile instead.

Finally, significant parts of the consultation focus on sanctioning directors after a breach of their duties (as do the recent Treasury consultation on tax abuse and insolvency, and the recent White Paper on defined benefit pensions), but there are little concrete proposals for improving the skills of the UK’s directors in the first place. A focus on prevention rather than cure would see less damage done to UK corporate governance than waiting to act until breaches of duties have occurred.

While the Government’s attention to corporate governance challenges is timely, the solutions on offer are not the right ones. Hopefully the Government will listen to the feedback from R3 and others and reconsider its proposals.

Notes to editors:

  • R3 is the trade body for Insolvency Professionals and represents the UK’s Insolvency Practitioners.

  • R3 comments on a wide variety of personal and corporate insolvency issues. Contact the press office, or see www.r3.org.uk for further information.

  • R3 promotes best practice for professionals working with financially troubled individuals and businesses; all R3 members are regulated by recognised professional bodies
     
  • R3 stands for 'Rescue, Recovery, and Renewal' and is also known as the Association of Business Recovery Professionals.