Strategy & Operations » Governance » The changing insolvency landscape

On 20 March 2018, the Department for Business, Energy and Industrial Strategy (BEIS) published a consultation document on insolvency and corporate governance, which sought views on proposals “to improve the governance of companies when they are in or approaching insolvency.”

The consultation document went on to explain that the intention is “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, which closed on 11 June, focussed on four principle areas:

* Sales of businesses in distress, where it was proposed that, in order to deter directors of a parent company from the sale of an insolvent subsidiary without having proper regard to the interests of that subsidiary’s stakeholders , the parent company directors should be liable “where the sale of an insolvent subsidiary causes harm to creditors and this was foreseeable at the time of the sale”;

* Reversal of value extraction schemes, where transactions undertaken by investors to “strip [a company] of its assets to lessen their loss, or protect their profits, should the company eventually become insolvent” might be reversed if they were held to have been designed to avoid existing creditor protections;

* Investigation into the actions of directors of dissolved companies, extending the powers of the Insolvency Service to cover companies currently beyond their scope; and

* Strengthening corporate governance in pre-insolvency situations to prevent a number of perceived issues, for example the use of complex group structures, the role of shareholders, the rules around payment of dividends, the balance between directors duties and their use of professional advisers, and protection for company supply chains in the event of insolvency.

Some aspects of these proposals make good sense. For example, extending the powers of the Insolvency Service to take action against the former directors of a dissolved company will help to end the abuse of a small minority of directors using insolvency as a means to avoid debts.

As the consultation notes, “the director in many cases continues running the same business using a new company which can often have a very similar name to a previous company” and in some cases there can be a trail of successive company failures. Similarly, there can be little objection to the reversal of value extraction schemes designed to favour one group over another.

Perhaps less helpful is the proposal that directors of a parent company be held liable if a former subsidiary enters administration or liquidation within two years of that subsidiary company being sold. This raises two concerns: firstly that this strikes at the heart of entrepreneurial risk-taking and, just as important, that the risks that the proposed liability would create for directors might lead them to prefer putting a business into insolvency rather than selling it for turnaround.

It is the nature of entrepreneurial businesses that some succeed whilst others fail. Any such success or failure is very often the result of one or more decisions taken by the directors, but the ramifications of those decisions are not always immediately apparent.

Once a business is sold, the previous directors no longer have any control over the company and cannot direct its operations. Management of the company is then entirely under the control of the new owners. Moreover, the proposed period of two years from date when a business is sold does not match the normal 12-month basis of assessment of a business as a ‘going concern’.

The proposal therefore creates substantial risks to the directors of a company by making them liable for the actions of the new owner(s) and new management. They would be liable for circumstances outside their control.

As if that were not enough, there is a strong element in the proposal of the reassessment of directors’ decisions with benefit of hindsight. As the consultation states, “the proposal does not require there be any causal link between the sale and the failure”. It will be established that “the director could not reasonably have believed that the sale was in the interests of creditors … by a worsening position followed by formal insolvency”.

How can directors know what might be viewed by an external party, with hindsight, as something that “could have been reasonably foreseen at the time of the sale” that “would have led to a better outcome for creditors”?

These are serious risks, which many directors are unlikely to take. If they do not, then potentially viable companies may be wound up, rather than being sold to new owners prepared to invest in the business and attempt to return it to profitability.

This outcome may very well be to the detriment of creditors, employees and other stakeholders. There is a long track record of successful turnaround investment and management in the UK which would be imperilled.

Finally, it is not proven that recent instances of high-profile corporate failures have been due to weaknesses in the legal and regulatory environment rather than to the actions or inactions of individual directors.

The responsibilities of directors to all stakeholders are clearly set out in current legislation and additional legislation will not necessarily lead to better behaviour and corporate responsibility.

Robust enforcement of current regulations would, however, send a clear signal that inappropriate behaviour will not be tolerated and individuals will be held to account.