A Review of the Corporate Insolvency Framework

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1 Mr Nicholas Blaney Policy Unit The Insolvency Service 4 Abbey Orchard Street London. SW1P 2HT 6 July 2016 Dear Mr Blaney, A Review of the Corporate Insolvency Framework FSB is the UK s leading business organisation. It exists to protect and promote the interests of the self-employed and all those who run their own business. FSB is non-party political, and is the largest organisation representing small and medium sized businesses in the UK. Small businesses make up 99.3 per cent of all businesses in the UK, and make a huge contribution to the UK economy. They contribute 51 per cent of the GDP and employ 58 per cent of the private sector workforce. We welcome the opportunity to respond to this consultation on corporate insolvency reform. The existing insolvency framework An insolvency regime is a vital part of the wider legal framework which underpins and enables economic activity. Specifically, the insolvency framework facilitates the process of creative destruction by regulating the death of businesses, the maintenance of assets and value in such circumstances, and the upholding of property rights. Therefore, an insolvency system has to balance the need to facilitate the winding up of businesses that are no longer viable in the least disruptive way possible and the returning to creditors of assets on the one hand, with the potential benefits that might accrue from trying to rescue businesses where there is a good chance that they can go on to thrive. The current corporate insolvency regime in the UK, on the whole, works well in both regards. The UK s framework is long established and widely respected based on a mixture of statute and common law principles. FSB does not want to see these key advantages diluted. That is not to suggest there are not ways in which the current framework cannot be improved. The UK s insolvency framework could be improved. It could: Be made more transparent with greater fairness for smaller unsecured creditors; and Deal more effectively with directors that act negligently or improperly. Such behaviour causes considerable problems, not only for those small businesses directly affected by such behaviour but it reduces the levels of trust between businesses, increasing the costs

2 of doing business and negatively impacts the reputation of business among the public more widely. The proposals in the consultation FSB considers that the proposals in the consultation are not measures which will enhance the existing insolvency framework in the ways that it needs to be improved. Little evidence has been offered about the extent of the failure of the current framework overall, to rescue sufficient businesses. It is not clear why the new moratorium system or the introduction of other an expanded essential supplier category and a cram down mechanism will deliver better outcomes i.e. be more effective at rescuing businesses than the current arrangements. The current domestic framework offers a number of opportunities for businesses who are insolvent to be rescued or for assets to be re-deployed in productive ways, while managing to avoid many of the problems of a US-style Chapter 11 system, which proposals like a moratorium seem to be moving the UK towards. Recently, the European Commission also proposed reforms which would, in effect, do something similar. This is not a shift FSB supports. Moving in this direction creates a number of risks, which could result in the UK regime s strengths being watered down for little demonstrable gain elsewhere. FSB considers that, at best, the proposals fail to deal with the most significant problems that negatively impact small businesses the most. At worst, they could make things more problematic for small businesses. The main focus of the consultation is on establishing a moratorium system. It is not evident as to why a new moratorium system is needed when one is already available for Company Voluntary Agreements (CVA) and which is infrequently used. The benefits of a new moratorium system have not been demonstrated. One of the biggest issues for small businesses is late payment and the abusive imposition of post facto credit terms (i.e. unilateral extensions mid contract term). Late payment has a significant impact on the cash-flow of small businesses. If a customer is already behind in their payment schedule, permitting it further time will be of little help to the creditor small business. As a result, a moratorium may just end up delaying the inevitable while putting creditor small businesses in more difficult situations. Delays in returning monies owed as a result of a moratorium could result in more small creditor businesses suffering to a greater degree than they already do. The wider economic implications could be more insolvencies rather than less from the spill-over effect through the supply chain. In addition, the costs of the moratorium will come out of the remaining assets in the business, further reducing the potential returns to creditors, if the attempted rescue fails. This could further compound the risks to the financial position of creditor businesses already created by the moratorium.

3 If the Government is determined to move ahead with the plan for a moratorium, no matter the risks, then the period which it can be in place for must be as short as possible. This will at least contain some of the risks (described above) associated with the policy. Widening the category of essential supplier is also fraught with risk. If small businesses have to continue supplying a larger business but which may still go out of business in the end, the financial position of those small business suppliers is more precarious, not less. This is not just a risk for one small business. An insolvent larger business in particular is likely to have numerous small business suppliers. In such circumstances the dangers of a domino effect are real. One result will no doubt be the need to increase the risk premium in suppliers pricing to take account of the new uncertainties such a law change would create. A third significant risk for small businesses in the proposals come from the suggested creation of binding rescue plans and the introduction of a cram-down mechanism. Implementing such measures are likely to put small business creditors (and unsecured ones in particular) in even more vulnerable positions. As with the moratorium and the proposal for a wider essential supplier list, the cumulative impact on small business creditors could be substantial, reducing rather than increasing the chances of receiving any assets back and putting creditor businesses in financial difficulty and. Rescue plans need to be supported by creditors and their development should be done through consent. It is only through such an approach that the negative spill-overs for creditor businesses can be avoided because each creditor is best placed to know if a rescue of the debtor business is likely to result in the best outcome for their own business. More widely, compulsion risks creating further distrust of the insolvency system among small businesses and increase levels of dis-engagement, which are already high. This would be a perverse consequence, when the objective should be to increase engagement where possible and practical. Many small businesses do not encounter liquidations of viable businesses who have been precipitated into insolvency by the acts of others or uncontrollable / unforeseeable circumstances. Rather, for most small businesses the reasons for the insolvency of a debtor (customer) business are more often perceived to be director greed, incompetence and in some circumstances criminal behaviour. In many of these types of cases, the directors and employees are readily able to work elsewhere and it is often planned that they do so, sometimes via a closely related phoenix company. Insolvencies that are a result of these kinds of actions should not be subject of delays as a result of the measures proposed in the consultation document. Neither should small creditors be forced to effectively collude in such actions. In such circumstances creditors need to be able to move quickly to preserve assets and secure material that might lead to civil responsibility on the part of the insolvent company s directors. Consequently, a further result of the proposals in the consultation could be more directors not being held accountable for the consequences of their actions. Finally, the suggestion in the consultation of greater involvement of the courts is counterproductive. They are likely to increase costs and potentially strain relations between parties rather than ease them. Procedures which involve creditor consensus rather than the cost of

4 court involvement are preferable, and such procedures inevitably increase insolvency practitioner costs as well. Effective reform The problems with the current insolvency framework are not found in its inability to rescue ailing businesses but in the system s: Lack of transparency; Cost and chequered performance in returning assets to unsecured creditors in particular (which is related to cost); and Inability to deal effectively with negligent or malfeasant directors. 1 The Government should focus its reform agenda on these aspects. Useful measures that would improve the framework in all of these areas include the following. Transparency and costs A simplified fee structure e.g. fixed fees for the statutory aspects of the insolvency process; Building on the recent changes with front-page disclosure of costs to ensure true transparency around costs and fees. This should include an overall estimate of what creditors can expect as a return from the insolvency e.g. nothing, a small return, a larger return etc. This kind of information upfront is what creditors want to know. It will help incentivise creditor involvement if there is the prospect of a return. It should also involve full itemised disclosure of costs. This does not have to be intimidating or confusing for small creditors. It can be presented in an understandable format, such as that used by Australian practitioners; 2 Clear industry guidance on how to allocate costs especially in grey areas e.g. where jobs might ordinarily be done by juniors or office administrators but for unexpected reasons may have to be done by partners; Creditors meetings should be re-instated as a standard part of the insolvency process. A further way of reducing the costs of insolvencies and enabling more returns to creditors would be to reduce the charges on compulsory liquidations and bankruptcies. How any shortfall in funds for the Insolvency Service might be made up would have to be thoroughly thought through. Therefore a review should be undertaken of such levies and whether alternative sources of income might be found e.g. other charges or general taxation, which could help share the burden. 1 While the term directors is used in this submission as a short-hand, The term director in this context is being used as shorthand to not only encompass directors of companies but negligent and malfeasant sole-traders and partners in general partnerships too. 2 Fully itemised disclosure should use the cost information that IPs already have to calculate within their practice in order to identify how much they will need to charge for a job. This should mean minimal additional administrative burden on IPs.

5 Protecting unsecured creditors The Insolvency Service should examine the case for a third party debt right. Such a right should (perhaps similar to the Contracts [Rights of Third Parties] Act right) be available in insolvency situations. It would help small contractors further down the supply chain to seek a proportionate payment direct from the paying client who has received the benefit of their work or goods provision often without having paid for them. There would be some complexities to be looked at in detail, and it may mean some exceptions to a general rule, which would need to be identified. Such a measure would help avoid knock on insolvencies in the supply chain; A review of the law on retention of title in insolvency situations, to see whether it might be strengthened, for example, to further help small creditors retain control over goods supplied to a business that had subsequently become insolvent which have not been paid for; More education targeted at small business owners about using credit control mechanisms and terms and conditions more effectively to better protect themselves. This is the kind of advice and information that could be made available jointly through the Insolvency Service and the Small Business Commissioner. Negligent/ malfeasant directors and director disqualification Despite recent changes there remain gaps in the effectiveness of the armoury of legal measures available to those trying to tackle negligent and malfeasant directors and reduce incidents of wrongful trading: The authorities who usually take disqualification action against directors are underresourced. They also tend to concentrate on the larger cases. Smaller company directors, who are sometimes serial director/liquidators and so-called phoenix merchants, tend to be tackled less effectively. FSB considers that the Insolvency Service would be benefit from more funding to help them take more action against such people; Creditors should be able to bring disqualification action against negligent/ malfeasant directors using a simplified or streamlined procedure which, if successful, would potentially trigger the compensation power under Section 110 of Small Business Enterprise and Employment Act (SBEEA). Such an approach would lead to more successful disqualifications and to valuable compensation for SMEs; Section 118 of the SBEEA 2015 created a right for causes of actions against directors to be assigned to creditors who might wish to fund and have control of such action. However, for this to be effective the assignee needs the authority, through a simple procedure, to access the key documentation held by the IP on which they can base any legal action. If this disclosure right is not put in place then Section 118 will be difficult for creditors to utilise; Further, even if a director is found guilty they can hide behind court rules because the liquidator is not party to the evidence the director has submitted on their net worth, because the liquidator is not the victim even though the liquidator is responsible for the victim and the creditors of the liquidated company. Therefore changes to the rules in this

6 regard would further improve the position of those wronged and enable more returns to creditors; The Insolvency Service, BIS and the Ministry of Justice should work together to identify ways of reducing the barriers to bringing actions against negligent/ malfeasant directors by IPs. These barriers include liquidators being held liable if a court action fails. The removal of the exemption from the Jackson restrictions on no-win, no-fee (which previously created a cost effective way of going after negligent or malfeasant directors) has created a significant barrier to bringing such actions; Create a rebuttable presumption of trading while insolvent when there are already one or more unsatisfied judgments against a company. That would help tackle the common problem of some businesses trading with minimal assets after they have been subject to such a judgment. The evidential burden of proving wrongful trading to establish director s personal liability would likely be considerably lessened by such a change with the result that more judgments would be settled or more directors held to account. We would be happy to talk in more detail about the points made in this response, if you would find that helpful. If you have any questions about this response please contact my colleague Richard Hyde on the following address: Richard.hyde@fsb.org.uk Yours sincerely, Martin McTague Policy Director Federation of Small Businesses