A question of balance in insolvency
The perennial dilemma in insolvency is how best to balance the diametrically opposed interests of debtors and creditors. Anthony Harrington reviews recent consultations that seek to solve the issue.
A modern, entrepreneurial economy needs to make it possible for people to fail, and then get back on their feet to come up with a second - and even third or fourth - genuinely innovative venture.
A fair society also needs to have some measure of debt relief so individuals who find themselves with an impossible debt burden can see light at the end of the tunnel.
Insolvency legislation is necessary, but is it ideal? A number of people - including creditors, insolvency practitioners, debtors and even HMRC - argue that much could be improved to make the law work better and, in some cases, create a fairer balance.
One has to applaud the fact that these green papers address significant questions in straightforward language.
The UK Government and HMRC have both recently issued consultations on Insolvency and corporate governance and Tax abuse and insolvency respectively. Perhaps the key thrust of the Government’s proposals is the wish to address the current spate of high-profile corporate insolvencies and identify who might be to blame.
The astonishing thing about these two consultative documents is that, for a change, they are written in plain English, noted Yvonne Brady, a Partner in Shepherd and Wedderburn’s corporate recovery and restructuring team.
“One has to applaud the fact that these green papers address significant questions in straightforward language, for this has certainly not always been the case,” she said.
However, and it is a very big “however”, there is an inherent fallacy in the idea that really complex issues lend themselves easily to simple treatments.
Onus of responsibility
The corporate governance paper floats the idea of making parent groups that sell an ailing subsidiary responsible beyond the sale.
This is an astonishing proposition. The essence of a sale is that the seller sells something and departs, leaving it in the hands of the buyer. How could you make a seller responsible for an outcome after the sale, when he/she has no say in, or veto over, the buyer’s decision?
Is the Government paper suggesting it is the vendor that should be careful about whom they sell to?
Otherwise, the paper goes on, the Government could intercede and make the directors responsible for the sale personally liable to make good on creditor losses. One has to wonder how this could work legally in practice as a credible scenario?
As Yvonne pointed out: “Every sale of a distressed subsidiary is a bespoke sale, with its own special, unique dynamics and circumstances.”
This being the case, one can only wish the Government the best of luck drafting legislation that can capture all of this variation, across all possible sales, and craft a prescribed ‘right way’ that will stand the test of legal scrutiny.
The last thing you want as a director is to find that someone can come along after the sale and second guess your decision.
Moreover, Yvonne continued, even if a civil service drafting team did produce workable legislation, the outcome would very probably be convoluted.
She explained: “Parent company boards look at all the circumstances around the sale of a subsidiary and make a judgement about whether a sale will be better for all stakeholders than a formal insolvency.
“The last thing you want as a director is to find that someone can come along some time after the sale and second guess you on the decision, and bring civil and criminal penalties to bear if their judgement disagrees with yours.”
The argument against suggests that, if this happened, it would paralyse entrepreneurial judgements. Directors would have no option but to minimise risk and put everything that looked wobbly into formal insolvency instead of trying to find a willing buyer to continue running the company.
However, if they did put everything into insolvency, that too could lay them open to attack on the grounds that they acted hastily and did not fulfil their “due care” obligations. So, directors would find themselves in a “damned if you do, damned if you don’t” scenario and UK enterprise would be severely damaged.
Knee-jerk reaction
Now let us look at the individual insolvency paper, courtesy of HMRC. As Donald McNaught, Partner and Head of Restructuring with Johnston Carmichael, explained, this paper in effect seeks to curtail possible director abuses by piercing the corporate veil.
HMRC’s motivation for producing the paper is pretty straightforward: “There is a minority who artificially and unfairly seek to reduce their tax bill through the misuse of insolvency of companies.”
Some folk, it seems, make a practice of “running up tax liabilities in a limited liability entity, then avoiding paying them by making the company insolvent - and setting up a new company to carry out the same practice again.”
The danger is not just that these “phoenix” companies (the new rising from the ashes of the old, as it were) cheat the taxman, they could also, according to the paper, “force out those businesses that act responsibly and contribute to society and the economy by paying the taxes due”.
Once you start allowing HMRC to pierce the corporate veil, you run the risk of chilling entrepreneurial behaviour.
The danger in all this is that these two documents are quite clearly a knee-jerk reaction on the part of the Government to recent high-profile insolvencies. However, Donald argued that the problems the consultative documents set out are not as widespread as the politicians seem to think.
“No one wants to see abuses, but the HMRC document in particular looks like HMRC want to put themselves in an enhanced position, as against other creditors, which goes against the principle of pari passu, or all creditors being on an equal footing," he explained. "Once you start allowing HMRC to pierce the corporate veil, you run the risk of chilling entrepreneurial behaviour as every director is going to be worried that a particular decision could jeopardise their assets and possibly land them with criminal charges."
On the corporate governance consultative paper, Donald pointed out that what the Government seems to be trying to do is to initiate the kind of obligation that was recently introduced regarding the sale of major football clubs.
“With these sales, the Football Association now has a rule that any sale of a football club has to be to a 'fit and proper' person, so there is an onus on clubs to properly vet the party it wants to sell to, and to stand responsible, post the sale, if things go horribly wrong.
“The politicians and HMRC like these consultative papers because they set out to target abusers of the system. However, the cure could well be worse than the disease. What I would like to see is HMRC working much more closely with insolvency practitioners."