Insolvency Oracle

Developments in UK insolvency by Michelle Butler


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The Perilous Neglect of the Fragile Insolvency Service Enforcement Directorate

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“Trust is essential to every commercial transaction. We neglect its fragility at our peril”, says Vince Cable in his foreword to the “Transparency & Trust” Government Response. Having read the Government’s proposals, I am inclined to repeat the often-cried warning that we neglect the ever-decreasing resources of the Insolvency Service at our peril. Although some of the Government’s proposals have the veneer of reducing the costs of disqualifying directors, whatever small gains are achieved will be wiped out by the hidden burdens that look to be added the Directorate.

It’s not all about the Insolvency Service, however. The Government has tagged on what appear as afterthoughts some ideas that will impact on IPs’ approaches to antecedent transaction challenges. These ideas are poorly covered in the Government Response – they escape all the Impact Assessments – and thus it is not surprising that R3 immediately commented on its “specific concerns” regarding these proposals (http://www.r3.org.uk/index.cfm?page=1114&element=19780).

The key objective of Cable’s “Transparency & Trust” drive is the creation of a public register of beneficial owners, but in this post I have summarise the more material plans that will affect insolvency work. The Government’s full response can be found at https://www.gov.uk/government/consultations/company-ownership-transparency-and-trust-discussion-paper.

Changes to the CDDA

The original proposals suggested that Schedule 1 of the CDDA, Matters for Determining Unfitness of Directors, might be added to in order to ensure that the following are taking into account in relation to disqualification orders and undertakings:

• Material breaches of “sectoral” regulation (especially the banking sector);
• The “wider social impacts” of a failure;
• Whether vulnerable creditors or those who had paid deposits had lost out in particular; and
• The director’s previous failures, possibly with a finite number of failures being allowed before unfitness is presumed.

The Government response accepts that simply adding to the Schedule 1 is not the solution, as directors might conclude that any factor not explicitly listed will not be taken into account. The response states: “we will recast a more generic set of factors that the court must take into account” (paragraph 222), although it also lists pretty-much the items described above, but with the exception of the X strikes and then you’re out idea, which does not appear to have made it through.

However, the paper does state that the court (or the Insolvency Service) will need to take into account “any previous positions as director of a company that has become insolvent and any relevant aspect of the director’s track record in running these companies… We are sympathetic to concerns we heard about the possible unwanted effect the inclusion of a ‘track record’ could have on those involved with early stage companies, or in rescuing companies that are in difficulties”, although I wonder at the depth of their sympathy: “We are clear that a director will, of course, be able to present any argument he or she might have (for instance as a business rescue professional or that the insolvency was not due to any element of unfit conduct on the director’s behalf)” (paragraph 225).

The consultation also sought views on whether – in fact, the consultation asked which – other “sectoral” regulators (again, looking mainly at the banking sector) should have the power to apply to court, or accept an undertaking direct, to disqualify a director. Although the ICAEW felt that this was appropriate, the Government’s response aligns more closely with R3’s response: disqualifications will remain with the Service, but the CDDA and gateways will be amended so that information might be exchanged more effectively, and there might be greater collaboration, between regulators. It has also suggested that expertise might be shared between regulators, which might include secondments.

The consultation proposed that the time period within which disqualification proceedings need to be commenced be increased from two years to five. The response explains that “views were mixed” (paragraph 279). However, I note that there was no support for any extension of the time period from R3, ICAEW or ICAS (the IPA did not respond – well, not the Insolvency Practitioners Association, but the Institute of Practitioners in Advertising did) – all three bodies noted that the BIS consultation document had stated that the two year timescale did not pose a barrier in the vast majority of cases and that the court can consider extensions. R3 also observed that five years would be a long time for an investigation to ‘hang’ over an individual and the ICAEW noted the potential difficulties if office holders needed to keep a case open for a long period. Despite these views, the Government proposes to increase the time limit to three years.

“Better Compensating Creditors for Director Misconduct”

The Transparency & Trust paper runs to 283 paragraphs, but this section, which contains the meaty proposed changes for IPs, runs to only 17 paragraphs! I don’t like that heading either…

The Government has expressed dissatisfaction with the fact that so few actions have been taken to challenge antecedent transactions. “Since 1986, there have only been

• around 30 reported wrongful trading cases;
• around 50 preference claims; and
• around 80 reported cases arising from undervalue transactions” (paragraph 260).

However, the response does not acknowledge that, as R3 pointed out in its response, many more cases are settled out of court. Neither does it acknowledge in any meaningful way that, in a great deal of other cases, the disqualified director simply has no money!

The Government’s proposed remedies are:

• To allow such causes of action to be sold or assigned to a third party “to increase the chances of action being taken against miscreant directors for the benefit of creditors” (paragraph 272); and
• To empower the Secretary of State to apply to court for a compensation order against, or to accept a compensation undertaking from, a director who has been disqualified.

The Government response barely makes a passing comment at some of the objections to these proposals raised by R3, the ICAEW, and ICAS, such as:

• Insolvency practitioners already have the means – and the duty and expertise – to pursue monies from errant directors, although the future of these is at risk when the insolvency exemption from the Jackson reforms ends.
• Why would a third party be any better equipped to take action than a liquidator?
• The possibility of a liquidator assigning their right to a claim already exists in Scotland.
• IPs are also limited in what they can achieve, as too few cases are being passed to IPs from the OR.
• Creditors’ returns may end up being lower, because a third party would only buy a claim in the expectation of making a profit.
• Third parties will not have the same investigative powers as liquidators.
• It would be impossible to prevent directors – or a friend etc. – from acquiring a claim with the intention of quashing it.
• It is difficult to see how assigning claims away from a liquidator to a third party intent on making a profit would increase confidence in the insolvency regime.
• It is difficult to see how compensation might be paid to anyone other than the company’s creditors via the office holder.
• If the Service were to distribute monies to creditors, it could duplicate the work done by the IP in adjudicating on claims, and the costs to the Service would be prohibitive. “The Insolvency Service would be better focusing its resources on disqualifying more directors rather than seeking to take on new activities such as distributing monies, which is already performed efficiently by insolvency practitioners” (R3).
• A compensatory award could prejudice civil claims being brought by the office holder (and, in my personal view, I could see a race develop between the IP and the Secretary of State, to see who gets their hands on the director’s limited purse first).
• “We do not think that the Insolvency Service has the resource to provide the evidence required to ensure a fair compensatory award upon which the Court can rule” (R3).
• The Service’s costs for bringing disqualification actions likely will increase substantially, and with fewer undertakings offered, given that directors will risk being pursued for compensation.

Despite these concerns, the Government is going to bring in these two remedies “when Parliamentary time allows”. Sales or assignments will be allowed of the following causes of action: fraudulent and wrongful trading – both of which will be extended to administrators to pursue (per the Red Tape Challenge outcomes); transactions at an undervalue; preferences; and extortionate credit transactions. The compensation awards/undertakings will be allowed by the court or the Secretary of State “to a particular creditor or group or class of creditors, or the creditors as a whole” (paragraph 274), although there is no mention as to how this may work in practice.

I shall leave the final word to the ICAEW, which, in its response to the consultation question on whether the proposal would improve confidence in the insolvency regime, stated: “We consider that confidence would be more likely to be improved if the Insolvency Service were resourced adequately to take disqualification action in every case where it appears to be justified.”


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What will “Transparency & Trust” mean for IPs?

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My thanks to Mr Cable for re-appearing in the headlines and making this two month old consultation suddenly seem current again. The proposal in his “Transparency & Trust” paper that got everyone talking was the attempt to curb future excesses of the banks and demand by legislation that their directors take care to be socially responsible, but is there anything in the paper for IPs..?

The consultation can be found at https://www.gov.uk/government/consultations/company-ownership-transparency-and-trust-discussion-paper, although regrettably it closed to responses yesterday. Well, it’s been a busy summer!

Identifying Beneficial Owners

I’ve been doing a bit of work recently on compliance with the Money Laundering Regs and it has reminded me of the rigmarole around identifying, and verifying the identities of, an insolvent company’s beneficial owners. Identifying the >25% shareholders is the easy bit (although, of course, it gets a bit more complicated where the shareholders are corporate entities), but how, on day minus-one of an insolvency appointment, are you supposed to identify other beneficial owners, those who “otherwise exercise control over the management of the company”? People don’t often stand up and introduce themselves as shadow directors. The consultation describes other complications to identifying the beneficial owners, such as where a number of shareholders have agreed to act in concert.

BIS’ suggested solution: let’s make it a requirement for companies to disclose their beneficial owners. The consultation considers the details of such a system: when companies would be required to make such disclosure; to which companies it would apply; what about trusts; what powers would need to be granted and to whom to ensure compliance; whether such a registry would be publicly available or restricted only to law enforcement and tax authorities… but what I cannot help asking myself is: if a company is being misused for illegal purposes by some hidden beneficial owner, would the company really have complied with the legislation and disclosed him/her? Or is it more likely that such requirements would just put more burden on law-abiding companies in ensuring that their registers of beneficial owners, in which no one is really interested (the information only really has any value if money laundering has taken place, doesn’t it?), are kept up-to-date?

Although, personally, I cannot see such a system doing anything much to help prevent illegal activity, at least if IPs are able to see information on companies’ beneficial owners, it might help in their Anti-Money Laundering checks, and I think that anything that helps with that chore would be a bonus. So how likely is it that the information would be made public? It seems from the consultation that it is the Government’s preference and, even if that doesn’t happen, the second option is that it might be accessible to “regulated entities”, i.e. anyone who is required to make MLR checks.

There’s a sting in the tail, however. Slipped into the consultation is: “If they were given access to the registry, regulated entities would incur additional costs if they were required to check and report any inconsistencies between their own data and that held on the register” (paragraph 2.74). Can you imagine? Would they seriously require office holders to inform whoever that a defunct company’s register of beneficial owners was not up to date? My perception is that IPs do not really feature as a separate group in the minds of those who oversee the MLR, so I doubt that they would see the pointlessness of such a task.

Changing Directors’ Duties

Okay, this proposal won’t directly affect IPs, but I couldn’t help passing a quick comment. As no doubt you’ve heard, the proposal is to amend the directors’ duties in the CA06 “to create a primary duty to promote financial stability over the interests of shareholders” (page 61). It is noticeable that more consultation space is taken up listing the potential drawbacks of the proposal than its advantages. In addition to the described issues of how to enforce such a duty, how shareholders would react, how UK corporate banks would fare competing against banks not caught by the CA06, I was wondering how you could measure promoting financial stability: it seems to me that it would depend on whether you were to ask Vince Cable or George Osborne.

The consultation includes many other proposals, which would affect the disqualification regime – some of these are:

• whether the regime should be tougher on directors where vulnerable people have suffered loss (is the absence of a jubilant Christmas for a Farepak customer a more worthy cause than that for a redundant employee who’d worked hard up to the end of an insolvent company’s life?)
• whether the courts should take greater account of previous failures, even if no action has been taken on them (surely the just and socially-responsible solution would be to fund the Service adequately to tackle any misconduct of the first failure?)
• whether to extend the time limit for disqualification proceedings from two to five years (what about the Service’s method of prioritising cases? I appreciate that this is a gross simplification, but don’t they hold a big pile of potentials and progress those that they feel are in the public’s greatest interest, leaving the rest in the pile until it gets to the critical time when they have to make a decision one way or the other? Won’t the extension to five years simply mean that their potential pile holds four years’ worth of cases, rather than one year’s? Again, unless the Service is granted more resources, I cannot see that this measure would really help. I also object to the consultation’s comment that “it can quite easily be several months before the relevant insolvency practitioner reports to the Secretary of State detailing the areas of misconduct that may require investigation. In such cases, the limitation period might mean that misconduct is not addressed” (paragraph 12.2))
• whether “sectoral regulators”, such as the Pensions Regulator, FCA and PRA, should be granted the ability to ban people from acting as a director in any sector.
• whether directors who had been convicted/restricted/disqualified overseas should be prevented from being a director in the UK.

“Improving Financial Redress for Creditors”

The Government anticipates that, if liquidators and administrators (as the Red Tape Challenge outcome proposes to extend the power to take S213/4 actions to administrators) were entitled to sell or assign fraudulent and wrongful trading actions, a market for them would develop. Do you think so..?

BIS has thought about the possibility that directors (or someone connected to them) might bid for the action and, although they suggest an, albeit not water-tight, safeguard, they also point out that, if the director did buy the right of action, at least the estate would benefit from the sale consideration. Although, personally, I’d feel uncomfortable with that – and I’m not sure what the creditors would say (but, of course, the office holder could ask them, and maybe that would be a better safeguard?) – I guess it makes commercial sense.

The consultation also proposes to give the court the power to make a compensatory award against a director at the time it makes a disqualification order. The consultation states: “This measure could potentially affect the timeliness of obtaining disqualifications if it deterred directors from offering a disqualification undertaking and therefore resulted in more disqualification cases needing to be taken to court” (paragraph 11.16), but personally, I would have thought that this measure would increase exponentially the number of director undertakings, as there seems to be no suggestion that an undertaking would expose a director to the risk of an award.

It is envisaged that the award would not be used to cover the general expenses of the liquidation and “there is a question as to who should benefit from any compensatory award. This could be creditors generally or it could be left to the court to determine based on the facts of the case” (paragraph 11.14), although I assume that, if it were for the general body of creditors, the office holder would be expected to pay the dividend. I wonder how the office holder’s fees and costs would be viewed, if he had to keep the case open purely for the purposes of seeing through the outcome of any such action.

The consultation also states that “Liquidators would still be expected to consider whether there are any actions they could bring themselves, as they ought to now” (paragraph 11.15). Could liquidators be criticised for taking actions, the proceeds of which would settle first their costs, when, if it were left to the court on the back of a disqualification order, the creditors would see the full amount? It is a liquidator’s function to get in and realise the assets, so probably not, but administrators..?

The same paragraph states: “If by the time the disqualification action comes before the court, liquidators have successfully recovered monies from the directors, that is something the court would be expected to take into account when deciding whether or not to make a compensatory award (or in setting the amount of it)” – it could get fun if the actions were running in parallel.

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Despite my quibbles, generally I think the proposals are a step in the right direction. However, I wonder how those in the Service’s Intelligence and Enforcement Directorate feel about the proposals, which would lead to so much more work and high expectations laid upon them. Let’s hope that these proposals give them a sound case for increasing their access to funds and people.