Major U.K. Insolvency and Corporate Governance Reform Announced: What Private Equity Investors Need to Know

The U.K. government has announced major reforms to the insolvency and corporate governance framework, including:

  1. insolvency reforms targeting sales of subsidiaries in distress without due consideration for other stakeholders and "value extraction schemes";
  2. potential corporate governance reforms, including changes to the dividend framework and new requirements to disclose capital allocation decisions and group structures; and
  3. restructuring reforms, including a new flexible "restructuring plan" procedure, a new restructuring moratorium and measures to prevent suppliers from relying on insolvency event termination clauses.

Timing is uncertain: The government intends to bring forward legislation to implement the insolvency measures as soon as parliamentary time permits. Given competing pressures such as Brexit, this may not be for some time.

1. Reform of the insolvency framework

Sales of businesses in distress: The government intends to adopt a highly controversial measure impacting holdco directors selling subsidiaries in financial distress by imposing a risk of disqualification and personal liability of directors on the sale of a distressed company.  

Specifically, a director of a holdco who does not give “due consideration” to the interests of the stakeholders of a financially distressed subsidiary when it is sold may be subject to disqualification action, and possible personal liability under a compensation order1, if that subsidiary enters insolvent liquidation or administration within 12 months of the sale. A director will not be exposed to liability if he or she had a “reasonable belief” that the sale would deliver no worse an outcome for stakeholders than if the subsidiary had entered formal insolvency proceedings.  

The government has recognized market concerns that the new measures should not disincentivize rescues or unnecessarily hold directors liable for the conduct of others over which they have no control.2 However, the new rules potentially expose sellers (and their directors) to greater risk than in, say, a pre-pack administration sale and could impact the prospects of rescuing businesses as a going concern.

It remains unclear how the proposed measures will work in the context of a multinational group where there is a non-U.K. holdco or a non-U.K. subsidiary.

Value extraction schemes: The government will legislate to enhance existing recovery powers of insolvency practitioners in relation to value extraction schemes designed to remove value from a financially distressed company at the expense of its creditors, particularly where other creditors are unfairly disadvantaged by credit transactions (such as “excessive” interest on loans from an investor). Reassuringly, the government acknowledges the need to have regard for the risk taken by the credit provider.

Dissolved companies: The government will give the Insolvency Service powers to investigate directors of dissolved companies where they are suspected of having acted in breach of their legal obligations. This responds to calls for the government to act against the practice of “phoenixing,” where a company is dissolved and another is created soon after (usually with a similar but slightly different name); this practice is often used to avoid liabilities.

2. Potential corporate governance reforms

The government is considering the following corporate governance reforms, subject to further consultation and review of whether investor pressure and/or market changes are sufficient to deliver progress without the need for legislation.

Dividends: The government is considering the case for a comprehensive review of the U.K.’s dividend regime, including:  

  • requiring U.K. companies to disclose their distributable profits in their audited accounts;
  • ways in which the definition of net assets (for U.K. public companies) might be tightened, such as a more critical look at the valuation of goodwill;
  • whether there is a case for moving toward a solvency-based framework for the payment of dividends, as in the U.S. and Canada3; and
  • the practice of some companies consistently paying interim dividends, rather than final dividends, so as to avoid the need for shareholder approval.

Capital allocation decisions:
The government may legislate to require U.K. companies to disclose and explain their capital allocation decisions. There is a particular focus on dividend payments where the company has a pension scheme deficit.

Group structure transparency and streamlining: Proposed reforms would require U.K. companies of a significant size to publicly disclose their corporate governance arrangements and possibly group structure charts. It will also consider simplifying the process for dissolving redundant companies within a group.

Shareholder stewardship: The government intends to work with the investment community, regulators and other interested parties to discuss how investment mandates can make explicit reference to stewardship, and to provide a new mechanism through which institutional investors can escalate concerns about a company or its directors.

Board evaluations and guidance: The government has asked the Governance Institute to explore ways to improve the quality and effectiveness of independent board evaluations4, including the development of a code of practice for external board evaluations. The government also aims to strengthen training and guidance for directors.

3. Restructuring reforms

Restructuring plan: The new “restructuring plan” procedure represents a potentially seismic change to the U.K.’s restructuring and insolvency framework and offers the possibility of a full financial and operational restructuring, akin to that possible within U.S. Chapter 11 proceedings. The possibility of cross-class cram-down sounds caution for stakeholders seeking to employ hold-out strategies.

New moratorium: A stand-alone moratorium will be available to “pre-insolvent” companies to encourage companies to engage with creditors early in cases of financial distress. The moratorium will affect both secured and unsecured creditors but — critically — will not affect the enforceability of financial collateral arrangements (which leaves open the possibility of enforcement of security over shares in an English company, for example). All creditors must receive notice of the moratorium, raising the prospect of negative publicity from a sponsor’s perspective.   

Insolvency event termination clauses: New rules will restrict the enforcement of insolvency event termination clauses in certain contracts for the supply of goods and services. The idea is that this will help stabilize distressed businesses to maximize value for stakeholders. However, suppliers will retain the right to terminate a contract on other grounds (such as non-payment or non-performance).

To learn more on the restructuring reforms, see our prior Kirkland Alert and the government’s paper.

1. Under current legislation, individuals may be disqualified from acting as directors, based on their conduct; to avoid court action, directors may offer a disqualification undertaking instead. A disqualified director can potentially also be the subject of a compensation order, requiring them to pay compensation to the company’s creditors. This possibility of personal liability will remain following these reforms, should the court find that a disqualified parent company director has caused loss to one or more creditors of the subsidiary.

2. The new measure is somewhat more limited than that originally proposed. For example: (a) the government will not take forward the proposed measure of enabling a liquidator or administrator to bring personal actions against holdco directors; (b) the original “look-back” period has been reduced from two years to 12 months; and (c) the measures will be limited to sales of large subsidiary companies (i.e. those which do not qualify as small- or medium-sized companies under the Companies Act 2006).

3. Under such a system, dividends could be paid only where the board is satisfied (and makes a solvency statement to that effect) that, post-dividend, the company will still be able to pay its debts as they fall due. This is usually allied with a net asset test (requiring that, post-dividend, the company’s assets will remain greater than its liabilities). This would constitute a shift away from the U.K.’s current “distributable profits” framework.

4. The U.K. Corporate Governance Code already requires a company within its scope (i.e. those with a premium listing on the LSE’s Main Market, whether incorporated in the U.K. or elsewhere) to undertake an annual assessment of its board’s effectiveness, and for an independent evaluation to be undertaken at least once every three years.

This publication is distributed with the understanding that the author, publisher and distributor of this publication and/or any linked publication are not rendering legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. Pursuant to applicable rules of professional conduct, portions of this publication may constitute Attorney Advertising.

© 2018 KIRKLAND & ELLIS LLP. All rights reserved.