The Government has published its response and action plan following its consultation in March this year on reforming the UK’s corporate governance landscape in the context of insolvent companies.
In its original consultation, the Government put forward various proposals to deal with perceived deficiencies in the management of troubled companies that may be leading to poorer outcomes for creditors, employees and other stakeholders.
One of the core proposals was to attach personal liability to the directors of a holding company that sells an insolvent subsidiary where that subsidiary later goes bust. This would mean that it is not only the directors managing a failing business who could be in the line of fire, but also the directors of the company’s parent.
Under the original proposal, holding company directors could incur personal liability if four conditions are all met:
- the subsidiary was both large and insolvent at the time it was sold;
- the subsidiary enters into liquidation or administration within a specific “hardening period” after completion of the sale;
- the interests of creditors are adversely affected during that period of time; and
- the holding company's directors could not have reasonably believed that the sale would lead to a better outcome for creditors than the administration or liquidation of the subsidiary.
No more hiding
Unsurprisingly, this proposal has met a significant degree of resistance and objection from various stakeholder groups.
It is not difficult to understand the reasons behind the Government’s desire to do more to prevent damage to creditors and other stakeholders in the wake of high-profile cases such as BHS and Carillion.
However, exposing directors of parent companies to personal liability on the insolvency of former subsidiaries threatens to compromise one of the cardinal principles of English company law – that a company and its members are different persons and members (including parent companies) are entitled to act with their own interests in mind and not those of their company. To adopt the common legal terminology, it looks to “pierce the corporate veil”.
A problem for investors
An important question is to what extent the proposals could cause particular issues for investors in the private equity, venture capital and other alternative asset management sectors.
Sponsor investments in private businesses are normally structured through a “stack” of up to four holding companies, with each company taking on a different type of financing (from institutional debt at the bottom of the stack, through mezzanine and other subordinated financing, up to equity at the top).
It is usual for a sponsor to appoint directors (normally chosen from their own personnel) to the boards of some or all of the companies in the stack (particularly the top company), although rarely to the boards of operating companies in the group structure below. These “stack” companies will all be “holding companies” of the underlying investee business, with the result that, under the new proposal, the sponsor-appointed directors could be exposed to personal liability.
This potential personal liability for investor directors could also further highlight the potential tension between actions which might have to be taken by those directors to protect their own position and the regulatory, contractual and fiduciary duties that the sponsor who they represent will owe to the limited partners in their funds. Those duties are generally focussed on maximising returns to the limited partners and one could imagine a situation in which it may be best for the sponsor (and its limited partner investors) to “cut and run” from an investment that has gone badly, but doing so could expose their own personnel who are investor directors on the holding company boards to personal liability.
Some fund documents may already address this, by having limited partners acknowledge that sponsor-nominated directors may have to act in accordance with their directors' duties and that any such course of action may not be in the interests of the fund. However, the sponsor's duties will always remain to the fund, so there will be a balancing act, where the sponsor will have to weigh the benefit of having directors on the relevant boards against the potential financial loss to the fund.
In addition, depending on how an investment is structured and on the final regulations when introduced, sponsors will also need to understand whether liability for directors of holding companies stops at the top of the investment stack, or in fact reaches higher up into the sponsor’s own group.
A softer approach..?
Despite the objections raised, the Government has confirmed in its response that it intends to press ahead with this proposal. It says it recognises the concerns raised by respondents to the consultation, and it will ensure that any new legislation is “properly targeted” at directors who had “no reasonable belief” that stakeholders would be left no worse off by a sale.
To this end, the Government has decided to reduce the “hardening period” from the original proposal of two years to the shorter period of 12 months.
It has also confirmed that holding company directors would not be susceptible to actions by liquidators or administrators seeking damages or compensation. Directors would still, however, be subject to potential disqualification proceedings (and accompanying financial penalties) brought by the Insolvency Service.
But, apart from this, the wording of the formal response suggests little change from the Government’s original proposal and will therefore do little to assuage the concerns that have already been voiced.
If anything, the response has created further uncertainty. In particular, if administrators and liquidators of insolvent subsidiaries will not be able to bring proceedings directly against the directors of holding companies, whether in their own name or through the subsidiary itself, it is not clear what the nature of their personal liability will be and who will be able to enforce that liability against them.
The concern is that, rather than serve to protect creditors and other stakeholders, the new measures will make directors of holding companies more likely to put troubled subsidiaries into administration or liquidation straightaway than to give someone else a chance to turn them around by selling them, if doing so could expose those directors to liability if the attempted turnaround is unsuccessful.
We must wait to see the detail of the final proposals to understand how they will pan out and what measures the directors of holding companies can put in place to guard against the associated risks. Some will say that difficult times call for difficult measures. Time will tell whether the benefits of the new regime justify disrobing the corporate veil.