The purpose of the consultation is described as "delivering a strong business environment…by seeking views on new proposals to improve the governance of companies when they are in or approaching insolvency."
To that end, the Paper considers the following four areas:-
- Sales of businesses in distress;
- Reversal of value extraction schemes;
- Investigation into the actions of directors of dissolved companies; and
- Strengthening corporate governance in pre-insolvency situations.
It is hard not to read the Paper as being a response to the BHS and Carillion insolvencies. In particular the Paper raises questions such as "should directors of a parent company that sells a subsidiary be obliged to take into account the interests of stakeholders in the subsidiary?", "what can be done to prevent (or at least challenge) "value extraction schemes" (e.g. management fees, high interest rates on loans, granting of securities and sale and leaseback arrangements)?", and "how can we protect supply chains in large insolvencies?"
In this article I will consider the proposals put forward in the paper to address the first two of these questions.
Should directors of a parent company that sells a subsidiary be obliged to take into account the interests of stakeholders in the subsidiary?
This one has a distinctly "BHS feel" about it. What is being considered is where a loss-making subsidiary is cut loose from a group such that the group need have no further concern about the funding of the subsidiary and the then directors of the subsidiary are relieved of their duties as directors.
As the law currently stands, the duties of the directors of the parent company are fully directed at the interests of that parent company. Unless they are shadow directors of the subsidiary (and the mere fact of being directors of the parent company will not make them so), those directors are under no duty to have regard to the interests of the creditors or other stakeholders of the subsidiary. Thus, they are perfectly at liberty to sell the subsidiary to whoever they want, with no regard to the interests of anyone other than the parent company itself. If that means selling the subsidiary into the hands of a novice owner with no credible turnaround plan and no access to financing; thereby leaving the creditors and stakeholders facing an inevitable insolvency, then so be it.
In the House of Commons Select Committee hearings into the BHS collapse, much play was made by the Committee that Sir Philip Green had sold BHS to a man (Dominic Chappell) who (it would seem with hindsight) had no realistic way of turning the business around and staving off formal insolvency. Criticism was thrown at the professional advisors of both the purchaser and seller for going along with it all and not asking the question "how is this purchaser going to sort all of this out?"
However, as the law stands, there was no obligation on the seller to have regard to any business plan that the purchaser may have had (if it indeed had one). Indeed one can even envisage a situation in which the directors of a parent company turned down a sale that would benefit the latter because they were concerned about the impact of that sale on the creditors of the subsidiary. The shareholders of the parent company could in turn accuse those directors of failing in their duties towards the parent company.
As for the professional advisors, it was suggested in the Select Committee that the parties had used reputable "City" firms to give an imprimatur of respectability to the transaction but that those firms did not do enough to check that the transaction was a "viable" one (in the sense that it would enable the subsidiary to be rescued and survive). That seems to me to fundamentally misunderstand the role of lawyers and accountants in these transactions. No doubt the seller told its professional advisors "get this loss-making subsidiary off our hands so that we do not have to fund it any more". Presumably the purchaser told its advisors "help me buy this thing".
I wonder what Sir Philip Green's reaction would have been if his lawyers had said "we would love to help you and the directors of the seller discharge their duties by getting rid of this loss-making subsidiary (and thus (presumably) strengthen the position of the seller) but we are not at all impressed with the individual behind the purchaser and we would have serious doubts about whether he has the wherewithal (or perhaps even an intention) to turn this around and so prevent an insolvency of the subsidiary down the line."
And I doubt if the purchaser asked its lawyers for a view on its own turnaround plan. Those lawyers were contracted to give advice on how to acquire the subsidiary - not on how to ensure its survival/turnaround thereafter.
For the avoidance of doubt I do accept (and indeed welcome) that lawyers have (and should continue to have) a wider role in society and in upholding and protecting the rule of law, but I struggle to see that role properly extending to a duty to look after the interests of all and sundry in every transaction they undertake, and neither the current law nor professional duties require them to.
Despite all of that I have just said, I would certainly agree that it is not satisfactory that an insolvent (or soon to be insolvent) subsidiary can be passed on to someone who is not fit to look after it and its stakeholders, just so that that person (and not the previous owners) will be the one at the steering wheel when it inevitably careers over the edge. Having someone else purchase the subsidiary puts an element of distance, and therefore an element of deniability, between the previous owner and the collapse. The new directors may well be just as exposed to issues, such as wrongful trading, as the old ones would have been had they remained in office but crucially they may be substantially less worth suing. The new directors may not care as much as the old ones about any reputational issues. In short, they may just be convenient fall guys for the previous owners.
The Paper's proposal in this area is to render the parent company directors "accountable" if they sell a subsidiary in a sale which is harmful to the interests of the subsidiary's stakeholders and that harm was reasonably foreseeable. Accountability here might entail disqualification or personal liability.
Four preconditions to such accountability are proposed:
- The subsidiary must be insolvent (the effect of group support guarantees is to be ignored for this analysis) at the time of the sale;
- Formal insolvency must follow within 2 years;
- The position of creditors must get worse after the sale; and
- At the time of the sale, the directors could not have reasonably believed that the sale would lead to a better outcome than an immediate liquidation or administration.
To me, this looks a bit like extending the wrongful trading provisions so that they apply to directors of parent companies in these limited circumstances. Unfortunately the enforcement of those provisions is far from straightforward and one of the great difficulties is in proving what someone "knew or ought to have known" at a given time. I can't help but think that proving that someone "could not have reasonably believed that the sale would lead to a better outcome" would be similarly challenging.
If one were to be radical, one might wish to consider whether the kind of circumstances being considered here might even merit the loss of limited liability. In these circumstances should the parent company be rendered liable for the debts of the subsidiary? After all, when times have been good, the parent company will have benefitted. It is of course the very concept of limited liability that allows an insolvent subsidiary company to be dumped. There are very few situations currently where limited liability is taken away. I would not consider it a huge moral stretch to suggest that what happened in BHS may be an example of a situation that might merit such an outcome.
Reversal of value extraction schemes
But even a fall guy might want something out of it for putting his/her head above the parapet and being the immediate public face of shame when the inevitable collapse ensues. And that is what this section is about - "value extraction schemes". So in our imaginary situation, a subsidiary ("SubCo") is heading for the buffers (and its parent company can see this coming years off). So the parent finds a willing purchaser and sells SubCo to purchaser (usually for a negligible sum). Some nice PR is generated, "best for long-term interests of everyone", "challenging market, but investment promised", "fresh management team with experience in turnaround" etc and for the moment the heat is off as the deal is done. The purchaser now has a few years grace before the wheels will fall off during which time the purchaser is in full control of SubCo. So what does the purchaser do to recompense himself/herself for the inevitable public opprobrium and no doubt large legal costs associated with being at the helm when formal insolvency does happen?
The answer is of course to make hay while the sun shines. So one might see arrangements put in place between purchaser (or parties related to the purchaser) and the (now purchaser-controlled) SubCo. These arrangements may take an almost infinite number of forms. The Paper gives the following examples:-
- Management fees;
- Excessive interest on loans;
- Securities being granted by SubCo in favour of purchaser;
- Excessive remuneration packages; and
- Sale and leaseback of assets.
But in practice, anything whereby value moves away from SubCo (and its creditors) to purchaser (and its connected parties) would fall under this heading.
The Paper suggests that the existing suite of remedies available in a subsequent insolvency (e.g. unfair preference, gratuitous alienation/transaction at undervalue and wrongful trading actions) may not be wholly adequate to address the mischief.
Here is an example. The new directors of SubCo have a very good idea that SubCo will avoid insolvency for approximately 3 years from today but that insolvency is nonetheless inevitable. They award themselves contracts that provide for enhanced remuneration if certain targets/milestones are met. They arrange for one of their associated companies to advance a secured loan of £X million to SubCo for a term of two years at a high rate of interest. Finding finance for SubCo is one of the milestones in the directors' contracts and entitles them all to a bonus. By the end of the two years the lender has taken a considerable amount out of SubCo. One year later, SubCo goes into administration. It is not immediately obvious that the existing challengeable transactions remedies can easily be used to recover what has been paid out in that two year period.
Of course my example looks very clear and was meant to suggest that the directors were simply looking for ways to extract money from a failing business. In reality the directors will no doubt contend that "normal finance" was not available, that only a connected party would have taken the risk of lending to a distressed business like this and of course trying to turn around a failing business is very difficult, highly skilled and should be adequately remunerated (even if it fails).
So the Paper proposes that a new power could be given to insolvency practitioners that would allow them to "tackle complex transactions that strip companies of their value prior to an insolvency". The suggestion is made that the following preconditions would have to be met for a challenge to be made:-
- There must have been new investment into the company;
- Value must have been extracted in a transaction (or series of transactions) designed to the benefit of that investor (or connected parties), without adding value to the company; and
- The company must subsequently enter liquidation or administration.
I am not entirely sure why the first requirement is there. No doubt most of the arrangements entered into in an attempt to extract value will have new investment of some sort as "window-dressing" but the mischief being struck at is "value extraction" not "value extraction after new investment" - after all, "value extraction" is "value extraction" regardless of what precedes it.
It is the second requirement that is the heart of the whole matter:-
- "value" must have been extracted (incidentally, "value" is not defined but presumably cash, other assets or any benefit would qualify);
- "designed to the benefit of…" - that would imply that there must have been an intention to benefit (perhaps akin to the discussions about " an intention to prefer" in preference case law); and
- "without adding value to the company" - again, what is "value"? It feels as though it is being used in a slightly different sense than in (i) (although maybe not - and if it is not, are we looking at something akin to gratuitous alienation/transaction at undervalue?).
Taken together what this has the feel of is "we know the kind of thing that we want to challenge, but it is very hard to define it, so we are going to leave it in nebulous terms" (for the moment at least). An analogy can perhaps be drawn with the way tax law seeks to attack schemes and arrangements that are designed to avoid/evade tax. Is there merit in simply looking at the outcome and deciding whether that outcome is a prohibited outcome?
Admittedly, for those of us who are involved in giving advice, this kind of thing gives us a fairly large problem. I can tell a client that selling 100,000 euros for £100 at a time when the client is balance sheet insolvent will almost certainly be challenged as a gratuitous alienation if the client goes into insolvency in the next two years. I can advise that granting a security in favour of a director in respect of a loan made by that director last year has all the hallmarks of an unfair preference. However, if I am asked, "how much can I charge by way of interest on the loan I have made to the company I have just acquired with a view to turning it around, and how much can the company pay me so that I cannot be caught by the "value extraction" provisions?" that is much more difficult question to answer.
Actions have consequences. Some courses of action will almost certainly lead to certain outcomes. Where the course of action taken by relevant parties leads to a predictable outcome and that outcome is disastrous for creditors, then the relevant parties are properly to be held responsible for that outcome.
No doubt "something must be done!" and "this kind of thing cannot be allowed to happen again!" and similar sentiments are laudable. After all, these large insolvencies will have damaged a very significant number of people and also have the potential to damage the whole economy and the essential infrastructure of the country. It is right that things like this lead us to reappraise from time to time whether we have the balance right between freedom to conduct corporate affairs and a more interventionist approach.
For my own part, I am beginning to think that these abuses cannot be sufficiently dealt with as part of insolvency law reform alone. To my mind, other issues are equally relevant such as:-
- The role of auditors and the extent of their duties. Far too often it seems we see situations where auditors routinely sign off on their audits only for a company to catastrophically fail shortly thereafter. We see auditors being fined time after time for failures in their audits and we see little change in the corporate cultures that permit such failures. If thought is being given to extending the duties of directors, perhaps thought needs to be given to considering whether in certain cases a reporting accountant should be required to report on the viability of a purchaser business plan;
- Whether company law needs to differentiate to a far greater degree between small owner managed companies (where an insolvency would be unfortunate but not seismic) and those companies/groups that have an economic importance (locally, regionally or nationally) where an insolvency will cause material damage to the economy (or sector);
- A new role for independent advisors in certain circumstances (I am thinking about whether something akin to the "pre-pack pool" might be of use in the sale of any distressed business of the type considered in the Paper) (albeit I have my own doubts about the current efficacy of the pre-pack pool procedure);
- Properly independent non-executives (and by this I mean not chosen by the very people who they then sit beside on the board, and often on other boards); and
- Is limited liability to be considered a right or a privilege.
The pessimist in me thinks that whatever we do, however we legislate, clever people will continue to develop new ways of doing things that they know they really should not be doing; but the lawyer in me knows that it is our duty to society to do our best to try to stop them anyway.