We summarise the key legislative changes planned by government relating to insolvency and corporate governance and focus on what they mean for investors, including the private equity community
On 26 August 2018, the Department for Business, Energy and Industrial Strategy (BEIS) published its Insolvency and Corporate Governance – Government Response in which it sets out new legislation that will be introduced with the aim of reducing the risk of company failures occurring through poor governance or stewardship, improving the insolvency framework and increasing protections for creditors.
The government's response originates from the 2016 Review of the Corporate Insolvency Framework and the 2018 Consultation on Insolvency and Corporate Governance and comes in the context of the high profile collapse of two industry behemoths, Carillion and BHS.
BEIS has stated that these significant reforms 'will help ensure the UK's business environment continues to be open, fair and attractive, and that the actions of a few do not undermine the broader reputation of British business'. In this article, we summarise the key reforms and consider the potential impact on investors, including the private equity community.
The government’s proposed legislative changes
- An inflationary increase to the cap on the prescribed part from £600,000 to £800,000.
- The introduction of director disqualification action in cases where directors of holding companies (including, for example, investor directors) do not give due consideration to the interests of the stakeholders of a financially distressed subsidiary when it is sold and the subsidiary enters insolvent liquidation/administration within 12 months of such sale.
- Updates to the existing antecedent transaction framework to improve office-holders' powers to challenge antecedent transactions ('unfair value extraction').
- An extension of the current investigation regime under the Company Director Disqualification Act 1986 to include former directors of dissolved companies.
- The introduction of a new optional 28 day moratorium (which may be extended) and a new role of monitor to act during the moratorium.
- A prohibition of 'ipso facto' clauses.
- The introduction of a new flexible restructuring plan to allow cross-class cram down onto both secured and unsecured creditors.
The government has also confirmed that it will further consider a range of measures to strengthen corporate governance in pre-insolvency situations.
What does the Government Response mean for investors and private equity?
The government considered that no legislative actions are necessary at this point to improve corporate governance and transparency in relation to complex group structures and has instead chosen to place trust on the new Corporate Governance Code (CGC) which comes into effect on 1 January 2019. This is good news for investors, which already place great importance on robust corporate governance and transparency arrangements as the very essence of a successful investment is predicated on effective management of the target company and clear investment agreements. However, the government did highlight that it would continue to consider whether further changes would be 'proportionate, business-friendly and beneficial' so firms should continue to keep an eye on this area of law.
Another key topic for investors to monitor is the government’s questioning regarding the possible strengthening of shareholder responsibilities. Again, no legislative changes have been confirmed at this stage but the government has indicated that this remains an area of focus and concern.
The most significant issue for investors who commonly appoint investor directors to consider is the introduction of director disqualification action in cases where directors of holding companies do not give due consideration to the interests of the stakeholders of a financially distressed subsidiary when it is sold and the subsidiary enters insolvent liquidation/administration within 12 months of such sale. This aspect of the government’s consultation received much criticism for the following reasons:
- It could lead to a conflict between the duties owed to the holding company's shareholders and the stakeholders of the financially distressed subsidiary.
- It has the potential to undermine limited liability.
- It could deter legitimate business sales and lead to more insolvencies and, if this happens, then it would lead to fewer rescues and restructures (which is at odds with the government's stated aim of 're-invigorating [the UK's insolvency regime's] rescue culture').
The government has sought to reassure the public by confirming that its intention is that 'the measures introduced will enable directors to remain confident that a sale would not expose them to liability or sanction if they had a reasonable belief at the time of the sale that the sale would likely deliver a no worse outcome for the stakeholders of the subsidiary than placing it into formal insolvency'. Although this raises key questions regarding valuation. The government intends to limit the measures to sales of large subsidiary companies; i.e. not those that qualify as small or medium sized companies under the Companies Act 2006. The government has also confirmed that it will provide a non-exhaustive list of matters which the court may take into account when considering whether a director acted reasonably in relation to the sale. The government has explained that such 'matters may include:
- 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'.
The government’s pledge to legislate these measures 'as soon as parliamentary time permits' raises some very significant questions, particularly for the private equity community and their advisors. The impact of the changes on investor directors and the management of risk and conflicts in distressed situations requires particular consideration. Amidst the uncertainty of the fast approaching Brexit deadline and in the context of the government’s stated aim of 're-invigorating [the UK's insolvency regime's] rescue culture', it seems strange that the government has settled on introducing a measure that could result in fewer rescues and the withdrawal of inward investments into UK businesses. However, time will tell whether the advantages of the new debtor friendly moratorium and flexible restructuring plan will counter the potential disadvantages of the extension of duties to directors of holding companies on the sale of distressed subsidiaries.