BEIS has just published the Government's response to its March 2018 consultation on "Insolvency and Corporate Governance" reforms. The response identifies a number of proposals for reform, as summarised below:
Action to improve the insolvency framework in the cases of major failure
- sales of businesses in distress: the Government will introduce a measure so that a director of a holding company who does not give due consideration to the interests of the stakeholders of a financially distressed, large* subsidiary when it is sold, and who has no reasonable belief that the subsidiary's stakeholders would be no worse off as a result of the sale (as compared to administration or liquidation) may be disqualified if that subsidiary enters into administration or liquidation within 12 months
- reversal of value extraction schemes undertaken by connected parties: the Government will legislate to enhance existing recovery powers of insolvency practitioners in relation to value extraction schemes
- investigation into the actions of directors of dissolved companies: the Government will introduce a new power to investigate the conduct of the former directors of dissolved companies
Strengthening corporate governance in pre-insolvency situations
- group structures: the Government will pursue options to require groups to provide explanations of their corporate and subsidiary structures;
- shareholder responsibilities: the Government will look at ways to strengthen shareholder stewardship, including working with investors, the FRC and others to: (i) incorporate stewardship within the mandates given to asset managers by pension funds and other asset owners; and (ii) see whether and, if so, how, a new mechanism could be established to allow institutional investors to escalate concerns about a company or its directors;
- dividend reform: the Government will explore whether there is a case for the comprehensive review of the UK's dividend regime, as well as options for a proportionate strengthening of the existing framework. The Government will also consider whether to require listed companies to have an annual shareholder vote on dividend payments;
- directors' duties and professional advisers: the Government will: (i) strengthen access to training and guidance for directors, and will consider whether training should be mandatory for directors of large companies; (ii) invite ICSA to convene a group to identify ways of improving the quality and effectiveness of board evaluations; and
- protecting suppliers: the Government will increase the current cap on ring-fenced funds that can be paid over to unsecured creditors ahead of the usual order of priority under insolvency law. The Government also plans to publish a separate call for evidence on further ways to create a responsible payment culture.
The response also proposes changes to the package of measures designed to help companies in distress set out in the Government's "Review of the Corporate Insolvency Framework", published in May 2016.
Companies with a defined benefit ("DB") pension scheme should also be aware of proposed reforms put forward by the Department for Work and Pensions ("DWP"), which include the introduction of a civil penalty of up to £1 million for pension rules breaches, and new criminal offences aimed at directors and others. These are part of the Government's broader corporate governance reform agenda and discussed in more detail below.
Action to improve the insolvency framework in the cases of major failure
Sales of businesses in distress
Many respondents to the consultation were not in favour of the proposals to introduce new measures in this area and were concerned that they may deter legitimate business sales. As a result, the Government has confirmed that it will not take forward plans to introduce a new liquidator or administrator action for personal liability of a director where a company has been sold in a situation of distress in the last two years. Instead, it will introduce a measure so that a director of a holding company who does not give due consideration to the interests of the stakeholders of a financially distressed, large subsidiary when it is sold, and who has no reasonable belief that the subsidiary's stakeholders would be no worse off as a result of the sale (as compared to administration or liquidation) may be disqualified if that subsidiary enters into administration or liquidation within 12 months. Under existing legislation, a director who is disqualified can be required to pay an amount by way of compensation to creditors pursuant to a compensation order, so it will still be possible for a disqualified parent company director to be personally liable for loss caused to creditors of the relevant subsidiary.
The Government will provide a non-exhaustive list of matters which the court may take into account when assessing whether a director acted reasonably in relation to a sale, including:
- whether professional advice on the sale was considered;
- the extent to which the board of the holding company engaged and consulted with the major stakeholders of the subsidiary prior to the sale; and
- other steps taken by the director to ensure, as far as within their means, that the sale was no worse an option than formal insolvency.
It will also work with industry to develop guidance on the steps a director should take when considering the sale of an insolvent subsidiary. On the issue of a potential conflict of interest between the duties the director of the parent company owes to that company's shareholders, on the one hand, and the requirement to consider the interests of the subsidiary's stakeholders, on the other, the Government confirms that there will be no conflict issue because directors' duties are subject to the requirement to act within the law at all times, and it will be a legal requirement for the parent company director to consider the interests of the subsidiary's stakeholders.
Reversal of value extraction schemes undertaken by connected parties
The Government has listened to respondents who highlighted that the new powers proposed in the consultation would overlap with existing provisions and cause additional complexity and confusion. Accordingly, it will not take forward proposals to introduce a new power to reverse transactions and claw back money for other creditors where a connected party undertakes a "rescue" package in the two years leading up to liquidation or administration which does not add value to the company and ultimately results in unfairly putting a particular party in a better position on insolvency than other creditors.
Instead, it will look to enhance existing recovery powers of insolvency practitioners in relation to value extraction schemes by, among others:
- working with stakeholders to see how it can improve the existing provision intended to allow insolvency practitioners to overturn investor loans with excessive interest rates, while paying due regard to the level of risk being taken by the investor providing the credit;
- aligning other existing provisions that deal with value extraction techniques. For example, some provisions contain conflicting requirements where the transaction involves a connected creditor and the Government aims to make the burden of proof on the insolvency practitioner consistent (i.e., that insolvency at the time of the transaction is presumed, rather than needing to be proven) so that it is easier for them to challenge preferential payments to connected creditors; and
- considering whether legislative amendment is required to clarify: (i) that the granting of security can be challenged as a transaction at undervalue, (ii) that shadow directors can be targeted under section 212 of the Insolvency Act as delinquent directors; and (iii) the rules regarding wrongful trading claims against directors.
Investigation into the actions of directors of dissolved companies
The Government will go ahead with plans to introduce a new power to investigate the conduct of the former directors of dissolved companies, and to take appropriate action where they have breached their legal obligations, without the need to restore the company to the register. The Government hopes that this will address concerns regarding the practice of "phoenixing", where a company is dissolved and another created, usually with a similar name, in order to avoid creditor liabilities.
Strengthening corporate governance in pre-insolvency situations
The Government will pursue options to require groups to provide explanations of their corporate and subsidiary structures. This may include a requirement for large groups to include an organogram of their corporate structures, along with an explanation of how corporate governance is maintained throughout the group, in their annual report. The Government will also consider whether the process for dissolving redundant companies and streamlining group corporate structures could be simplified.
The Government will look at ways to strengthen shareholder stewardship, including working with investors, the FRC and others to: (i) incorporate stewardship within the mandates given to asset managers by pension funds and other asset owners and (ii) see whether and, if so, how, a new mechanism could be established to allow institutional investors to escalate concerns about a company or its directors, including the discharge of their duties under section 172, CA 2006. The Government will consider the effectiveness of existing mechanisms, such as the ability of shareholders of listed companies to raise concerns with the Chair or the Senior Independent Director.
A majority of respondents to the consultation felt that the UK dividend regime could be improved, and there were a variety of suggestions as to how this could be achieved. Given the current debate over pension reforms (see "Pension Reforms" below), it was notable that the Government confirmed that it agreed with the strongly held views that there should be no automatic bar on companies paying dividends where the company's pension scheme is in significant deficit.
Taking respondents' views into account, the Government has decided that it will explore with the ICAEW, GC100, the Law Society and others whether there is a case for the comprehensive review of the UK's dividend regime, as well as options for a proportionate strengthening of the existing framework. This will include looking at: (i) whether directors could provide stronger reassurances for shareholders and stakeholders that proposed dividends will not affect the affordability of any deficit reduction payments agreed with pension fund trustees; (ii) whether companies should be required to disclose the audited figure for available reserves and distributable profits in their annual report; (iii) the ways in which the definition of "net assets" might be tightened, for example by a more critical look at "goodwill"; and (iv) whether any review should consider the case for more significant change, such as the merits of adopting a solvency based system as adopted in a number of non-EU countries, namely the US, Canada, Australia and New Zealand (though also bearing in mind that the current distributable profits system is a mandatory requirement for public companies under the EU Second Directive on Company Law and the broader economic impacts this may have if it led to listed UK companies reducing their dividend payments).
There was a warning, too, that if investor pressure and compliance with the new section 172 reporting requirements for large companies, bearing in mind the FRC's updated Guidance on the Strategic Report (see pages 57 to 62 for guidance on section 172 reporting, in particular), do not deliver sufficient progress on companies providing fuller disclosure of their capital allocation decisions, the Government will legislate to require companies to disclose and explain these decisions.
The Government will also consider whether to legislate, or take other measures to ensure that, for listed companies, there is at least one shareholder vote on dividend payments each year.
Directors' duties and professional advisers
The Government will: (i) strengthen access to training and guidance for directors, tailored to different sizes of company, and will consider whether some level of training should be mandatory for directors of large companies; (ii) invite ICSA: the Governance Institute to convene a group to identify ways of improving the quality and effectiveness of board evaluations, including the development of a code of practice for external board evaluations.
In response to suggestions from respondents that it should consider introducing stronger enforcement measures to ensure compliance with directors' duties, the Government confirmed that it believes the current enforcement mechanisms work, and that it will assess the impact of the new section 172 reporting requirements for large companies, as well as any recommendations from Sir John Kingman's review of the Financial Reporting Council (FRC) before considering further action.
The Government will increase (from £600,000 to approximately £800,000, based on inflation since the cap's introduction in 2003) the current cap on ring-fenced funds that can be paid over to unsecured creditors ahead of the usual order of priority under insolvency law. The Government is also monitoring the impact of the first year of mandatory payment practices' reporting (introduced in April 2017 in order to combat a culture of late payment practices). It plans to publish a separate call for evidence on further ways to create a responsible payment culture soon, as well as its findings from two consultations on construction payments.
The Review of the Corporate Insolvency Framework (May 2016)
The Government also took the opportunity to set out a number of changes to the previously announced package of measures designed to give financially-viable companies more time to rescue their business. They include:
- the introduction of a new moratorium to help business rescue. This will give those financially distressed companies which are ultimately viable, a period of time when creditors (including secured creditors) cannot take action against the company, allowing it to make preparations to restructure or seek new investment;
- the prohibition of enforcement by a supplier of termination clauses in contracts for supply of goods and services on the grounds that a party has entered a formal insolvency procedure, the new moratorium or the new restructuring plan; and
- the creation of a new restructuring vehicle that would include the ability to bind dissenting classes of creditors who vote against it.
The DWP has published the latest details of its proposed reforms in a consultation paper, "Protecting defined benefit pension schemes – a stronger Pensions Regulator", published in June.
These proposals include plans for a new power for the Pensions Regulator to issue a civil penalty of up to £1 million for more serious breaches of the pension rules and new criminal offences (targeted at all of those with responsibility for the pension scheme, including directors of the relevant companies and any associated or connected persons) to punish wilful or grossly reckless behaviour in relation to a DB pension scheme, non-compliance with a contribution notice and failure to comply with an expanded notifiable events framework. The DWP proposes expanding the current list of notifiable events to include, among others: (i) the sale of a material proportion of the business, or assets, of a company which has funding responsibility for at least 20% of a DB pension scheme's liabilities; (ii) the granting of security on a debt to give a creditor priority over debt to a DB pension scheme; and (iii) significant restructuring of a relevant company's board of directors and certain senior management appointments (for example, changes to at least two out of three of the Chairman, CEO and CFO (or their equivalents) within the previous six months). Although some commentators had also called for dividend payments to be considered a notifiable event, the DWP refers to the work that BEIS is doing in reviewing this area (referred to above), so this is unlikely to be included.
The DWP also proposes bringing the timing for notification of certain notifiable events forward to no later than when negotiations have led to agreement in principle of the relevant transaction's main terms (i.e., the signing of heads of terms), rather than the current requirement for notification "as soon as reasonably practicable after the event has occurred", and extending the reporting obligation to other parties (for example, to directors of a parent company who are planning a transaction that will have an impact on a DB pension scheme in the group). For some notifiable events, there will be a new requirement for a transaction's corporate planners (they state that this is "usually the board of a company", but don't specify which company) to prepare a declaration of intent for the pension trustees and the Pensions Regulator setting out: (i) the nature of the planned transaction; (ii) that they have consulted on its terms with the trustees and whether the trustees agree (or not); and (iii) explaining any detriment to the pension scheme and how this is will be mitigated. This will be required at a later point than the notifiable event notification. Notably, in an M&A context, they have suggested that this will be after the parties have completed due diligence and transaction financing has been finalised, but before signing of the SPA.
In the accompanying press release entitled, New Crackdown on Reckless Directors, the Government indicated that its proposals will be set out in further detail in the autumn.
It will be interesting to see whether the Government decides to go ahead with a comprehensive review and shake up of the UK dividend regime, particularly as it may, at that point, have a freer hand (post Brexit) to move away from the distributable profits model. The proposal to consider mandatory training for directors of large companies is also noteworthy, and could be a significant additional burden for companies depending upon how it is implemented (for example, if it had to be provided by an accredited body and repeated on a regular basis). In the meantime, the Government seems to expect that the new section 172 reporting requirement for large companies will have a significant impact, though it remains to be seen whether that will be borne out in practice. For those thinking about how to draft their section 172 statements for 2019, there is a clear steer that companies should disclose and explain their capital allocation decisions, and a warning that if disclosures do not improve, further legislation will follow to require this.
Overall, while the responses that the Government received to the consultation suggest that reform in this area will be welcomed, it remains to be seen whether any measures introduced will really be effective in reducing further large UK corporate failures and, where companies do fail, holding those responsible to account.