Transparency & Trust: a new era for directors’ disqualification?

In July 2013 the Department of Business, Innovation and Skills (DBIS) launched “Transparency and Trust” a discussion paper covering a wide range of company and business matters, including the directors’ disqualification regime in this country. The result was the introduction of the Government’s Small Business, Enterprise and Employment Bill into the House of Commons in July 2014.

Specialising in Director Disqualification as we do at NDP, it was clear that the Bill proposed significant  changes to the UK’s directors’ disqualification regime, and that a considered response was needed. So along with Barrister Donald Lilly, from 4 Stone Buildings, Neil Davies and Anne-Marie Chinnery (both of Neil Davies and Partners) summarised the Governments’ proposed amendments and provided their views on the Bill’s 6 broad categories, below*.

If you would like to talk in more detail about our response to this Bill, or you have a director disqualification problem, the contact us or call us on 0121 200 7040 for a free initial consultation.

(*The copyright of the full article is the property of Lexis Nexis).

  1. Targeting of individuals who “control” directors

DBIS in the original discussion document targeted what it called “nominee” directors. However, it abandoned that term after criticism, especially from the ICAEW, that there is no established meaning for a “nominee” director. In the Government Response, DBIS adopts another term that is new to the law – a “front” director. DBIS suggests that a lack of transparency is created in companies where the directors registered at Companies House are in fact a “front obscuring those who really exercise control”.[1]

The term “front” director is used throughout the Government Response, even though the individuals they describe at first blush appear to be what lawyers traditionally would consider to be shadow directors. The reason for this is that the shadow director concept, as presently defined, only extends to individuals who control the entirety of the board (or at least a majority of it), whereas the Government is considering extending that concept to an individual who controls a minority of the board, perhaps even just a sole director.[2]

Numerous proposals were suggested by DBIS to increase the accountability of “nominee” or “front” directors, many of which have been abandoned as a result of the consultation process. For the purposes of the disqualification regime, however, the present proposal is to extend the disqualification regime to “front” directors.[3]

It is of course already the case under s.6(3C) and s.8(1) of the Company Directors Disqualification Act 1986 (the “CDDA”) that a disqualification order may be made against not only an individual acting as a de jure director, but also as a shadow director. The meaning of “shadow director” under the CDDA is set out under s.22(5), which is in virtually identical terms as s.251 of the Companies Act 2006. This proposal, therefore, appears limited to the potential extension either of the meaning of a shadow director to an individual who is a puppet master in respect of a minority of de jure directors or the introduction of the new concept of a “front” director into the CDDA.

We have some concern with DBIS’s proposals in this area

The extension of the meaning of shadow director beyond that already determined by cases such as Re Unisoft and Ultraframe does not only impact upon the disqualification regime, but also company and insolvency law generally. The implications of such an extension, in particular in light of the fact that the concepts of de facto and shadow directors have to some extent merged[4], could be significant. For example, it is common in joint venture and similar structure for a particular shareholder to be able to nominate a director to the board of directors. That would not normally give rise to any possible implication of shadow directorship unless the nominations represented a majority control of the board.

If the concept of “front” directors is introduced that position changes, meaning that a joint venture participant who has a close relationship with a nominated director could be subject to the full panoply of directors’ duties, insolvency claims and disqualification. It seems to these authors that such an approach might well make UK companies unattractive for international business and joint ventures, a consequence DBIS is unlikely to desire. It is for that reason that we consider an extension of the shadow director concept – which should remain uniform, as it is now, across company, insolvency and disqualification legislation – should not be undertaken. Although we share the ICAEW’s view that novel concepts such as “nominee” or “front” directors should be avoided if possible, the alternative of extending the notion of a shadow director is less desirable.

Thus, if the notion of a “front” director is to be introduced into the disqualification regime, it should be done through the development of a new concept unique to disqualification. The Bill in fact adopts this approach. Whilst clause 79 of the Bill proposes amendments to the definition of “shadow director” under s.251(2) of the Companies Act 2006, those changes appear to reduce the scope of the concept by expressly carving out individuals who give instructions further to an enactment or as a Minister of the Crown.[5] Instead, the Bill introduces, by clause 93, a new concept to the disqualification regime, that of a “person instructing unfit directors”.

By clause 93, a new s.8ZA of the CDDA has been proposed which gives the court a discretion to disqualify an individual (defined as “P”) who exercises a “requisite amount of influence” over a director in respect of which the court is satisfied a disqualification order should be made.[6] The required influence is itself defined as circumstances where the conduct which renders the director unfit was undertaken by him in accordance with directions or instructions from “P”.[7] There are then further consequential proposed amendments to the CDDA involving matters such as the procedure for such an application and the giving of disqualification undertakings.[8]

The breadth of this new provision is of concern to these authors. The new s.8ZA jurisdiction raises the same concerns as already outlined above in respect of joint venture participants who may be dissuaded from selecting the UK as a place to incorporate or trade if they could be disqualified in circumstances where the joint venture fails, and their representative director has conducted himself in a manner that renders him unfit. Moreover, there is a real question of whether the person behind a “front” director really has the necessary control or influence to warrant an extension of the disqualification regime simply by giving a direction or instruction. It is the director that owes duties to the company, not the person giving the instructions.

Directors have historically always been subject to demands from individuals who have the power to remove them (e.g. majority shareholders), but it has traditionally – and in our view properly – always been the director who must exercise the independent judgment as to whether the “instructions” from such persons should be followed. The proposed s.8ZA seems to undermine this fundamental rule of English Company Law in that a person – even a majority shareholder – expressing a firm wish or even a demand now must independently assess whether it would be a breach for the director to undertake the request, rather than rely on the director’s own judgment.

  1. Replacement of Schedule 1 to the CDDA with a “new, broader and more generic, provision”

The approach adopted by DBIS in the discussion paper was effectively to add four additional factors for the court to consider under the pre-existing Schedule 1 to the CDDA; namely (a) material breaches of sectoral regulation; (b) the wide social impacts of a failed company; (c) the nature of creditors and degree of loss suffered by them; and (d) the director’s previous failures.[9]

The general view received was that there was little support for simply adding to the existing Schedule 1. The view voiced by a senior counsel – and a view with which these authors fully agree – was that Schedule 1 could not and should not be seen as an exhaustive list.[10] As a consequence, factors such as material breaches of sectoral regulation and relevant social impact already might be taken into account by the courts. Concerns were also raised in respect of introducing the nature of creditors and directors’ previous failures as factors for the court to consider. We also share those concerns.

The concept of “vulnerable” creditors is not one that should be introduced into the disqualification regime. It would in our view be virtually impossible to adequately identify the characteristics of a “vulnerable” creditor with sufficient certainty. This factor has not been included within the new proposed Schedule 1 (dealt with in more detail below) and we agree with its exclusion.

We also share concerns about the introduction of a director’s previous conduct as a factor to take into account. There are at least two difficulties with this. The first is one of principle: conduct is either such as to warrant disqualification or it is not. A director is entitled to have the conduct about which the Insolvency Service complains set out in the claim made against him and the issue for the court to decide is whether that particular conduct warrants disqualification. Just as the fact that he may have previously conducted himself in an exemplary way should not weigh into whether the pleaded conduct warrants disqualification, it should also not weigh against a director.

If previous conduct itself warrants disqualification, it should be pleaded as such and considered as an allegation of unfitness by itself. The second concern is one of practicalities. Contested disqualification trials are an expensive endeavour already. Whilst it is of course in the public interest to disqualify directors who are unfit, it is also in the public interest to do so as efficiently as possible, not only to prevent undue strain upon public resources, but also to ensure that defendant directors are afforded a fair trial process. If the Insolvency Service could trawl through a directors previous conduct – which might span years or even decades – that raises the spectre of larger, longer and more expensive trials which might turn into a public examination of a director’s career, rather than focussing upon specifically alleged misconduct.

The proposal put forward by DBIS in the Government Response was to “recast a more generic set of factors that the court must take into account” [sic].[11] This then became the proposed new Schedule 1 to the CDDA, as set out under clause 94 of the Bill. Matters that must be taken into account in all cases are simply: (1) the extent to which the person was responsible for material contraventions by a company of applicable legislation or other requirements; (2) the extent to which the person was responsible for the company becoming insolvent; (3) the frequency of those breaches; and (4) the nature and extent of any loss or harm caused.[12] In these authors’ views, this amendment is to be welcomed simply because it makes clear what is already the practice of the courts – the factors to be taken into account (assuming they have been properly particularised) are broad and include any material breach by the director and the seriousness of the consequences of those breaches.

The Bill also includes specific provision for the court to take into account any misfeasance or breach of fiduciary duty by the director in relation to the company or material breach of legislative or other obligation of the director.[13] This appears to be an implementation of the proposal in respect of “previous conduct” as a factor. For the reasons we have already stated, we have concerns about the provision of this factor – although it is of course a matter of judicial practice the weight given to such conduct in deciding whether a director should be disqualified.

Having regard to the breadth of the new Schedule 1 provisions and the discretion of the courts in giving weight to the various factors involved, these authors seriously question whether there is anything to be gained by the new draft Schedule 1.

  1. Accountability for misconduct overseas

Although the present disqualification regime permits the court to take into account foreign conduct for the purposes of determining unfitness, there must be a relevant insolvency event in respect of a company subject to winding-up in England and Wales[14] before disqualification proceedings may be commenced against such a director. There is no equivalent provision to s.2 of the CDDA (which provides for disqualification of a director in light of a UK criminal conviction) for foreign convictions. Thus, there is arguably a lacuna in respect of directors who have been subject to the equivalent of disqualification, criminal or similar orders and convictions in foreign jurisdictions, who then seek to become directors of UK companies.

The “overwhelming majority” of those who responded to the consultation process were of the view that overseas restrictions or convictions in connection with the management of companies should restrict an individual from being a director in the UK.[15] In principle, we agree; but we are also of the view that any such potential disqualification must be subject to court oversight and discretion. As already mentioned above, foreign jurisdictions might well have a system of corporate law or corporate culture quite different from that in England and Wales, and what might be considered abroad to be serious malpractice in respect of a company may not be considered serious in England and Wales (and indeed vice versa). We are therefore encouraged to see that the draft clause 92 of the Bill is framed so that the proposed new s.5A of the CDDA would provide that: (a) where a director has been convicted of a relevant offence, the power of the Secretary of State is limited to applying to the court for a disqualification order[16]; (b) the court has discretion to make a disqualification order[17]; and (c) a relevant foreign offence is only one for which there is a corresponding indictable offence in England and Wales[18].

DBIS also has suggested that further consideration be given to the interaction between UK and foreign disqualification regimes, particularly as to whether regulations should be made to permit the enforcement of foreign restriction orders within England and Wales.[19] We do not see that such an approach would have an appreciable benefit to the already proposed system of disqualification. For the reasons already stated, any form of automatic disqualification based upon a foreign conviction is not appropriate, given that foreign laws may well be in a constant state of flux and even if it is agreed now that the foreign law is consistent with English and Welsh law, that will not necessarily be the case in the future. Therefore, some form of judicial intervention is required to assess the nature and treatment of the foreign conviction or restriction. To allow for that effective judicial oversight, it appears to these authors that the better approach is to permit a disqualification application in England and Wales to be based upon a foreign conviction or restriction, rather than to enforce that foreign order itself in England and Wales. It is notable that this particular proposal has not made its way into the Bill.

  1. Increased cooperation through information sharing between sectoral regulators and the Insolvency Service

DBIS observes that the task of enforcing good corporate governance by directors often depends upon effective cooperation between different enforcement agencies, citing in particular, the Financial Conduct Authority (“FCA”).[20] DBIS also observes, however, that cooperation between sectoral regulators, such as the FCA, and the Insolvency Service could be inhibited if material in the regulators’ hands does not fall within the gateways provided by the CDDA for disclosure and use as “investigative material” for a disqualification claim.[21] The Government Response suggested that it intended to ‘remove the legislative barriers to the types of investigative material that can be provided by sectoral regulators or others for use by the Insolvency Service to pursue the disqualification of a director.’[22] Clause 97 gives effect to this intention. If this clause is implemented in its existing form, it will enable the Secretary of State to bring disqualification proceedings under s 8 of the CDDA based on any information he receives from any source whatsoever (including information received from a member of the public) provided he is satisfied that it is in the public interest to bring such proceedings.

DBIS invited views on whether sectoral regulators should be given additional power to disqualify directors themselves.

Views of those consulted were mixed about giving regulators the powers to disqualify directors. Concerns were voiced that sectoral regulators do not have the experience of disqualification proceedings as does the Insolvency Service and that the same could be achieved by simply taking regulatory breaches into account in the disqualification proceedings brought by the Insolvency Service.[23] Even of those who did believe such powers should be given, about half of them thought that such cases should always proceed to court (i.e. regulators could not accept undertakings, as the Insolvency Service can).[24]

In light of the consultation process, DBIS has decided not to seek the grant of disqualification powers to sectoral regulators.[25] We firmly agree. In addition to the concerns stated by the consultation participant, the giving of such power does not solve the fundamental problem, which is one of information. Whilst a regulator might have access to information that would not be available in the hands of the Insolvency Service, the same may be true whereby the Insolvency Service has information, particularly about the insolvency itself, which would not – or would not efficiently – find its way into the regulator’s hands.

Instead, DBIS focuses in its conclusions upon information sharing between regulators and the Insolvency Service, along with an express provision that sectoral breaches should be a factor in determining unfitness.[26] The latter point has already been addressed above. Regarding information sharing, these authors take the view that it is to be welcomed. We also agree with DBIS’s suggestion that regulators should have the power to report directors suspected of unfit conduct to the Insolvency Service. As DBIS’s own comments suggest, however, this appears to be more of an internal issue for those government agencies through training and secondment, rather than a judicialor even a legislative matter.

The Bill does not address any information sharing as set out in the Government Response, but instead, under clause 95, heightens the obligations of Office-Holders to prepare reports[27] on the conduct of directors of insolvent companies and keep the Secretary of State informed of “new information” that comes to light (“new information” being defined as information that would have been included in the report had it been known to the Office-Holder at the time of preparing the report).[28] These provisions are to be welcomed, as Office-Holders who have information relevant to the disqualification of directors ought to, in our views, ensure that information is provided to the Secretary of State and such should be an ongoing obligation. The Bill also removes, by s.97, the requirement that an application under s.8 of the CDDA be based upon “investigative material” or the “report, information or documents” – this amendment is also to be welcomed. If material is available to demonstrate a directors’ unfitness, an application for unfitness should not be constrained by artificial barriers for use of evidence obtained outside the scope of an investigation.

  1. The introduction of compensation orders against disqualified directors

It is of course correct that the disqualification regime presently does not afford any compensatory relief to creditors or shareholders or other persons who have been adversely affected financially by the conduct that ultimately is found to have rendered him unfit to act as a director. In its discussion paper, DBIS suggested two potential reforms that might provide a degree of such compensation: (a) to allow liquidators to assign fraudulent and wrongful trading actions; and (b) to give the court the power to make compensation orders against directors that have been disqualified.

The first of these suggestions falls outside the scope of this article. Regarding compensation orders, a sizeable two thirds of consultation participants broadly supported the concept of compensation orders.[29] The devil appears to have been in the detail however, as there were differing views spread widely across those consulted as to how they would operate.[30] The approach in the Bill, under clause 98, is to make a compensation order solely based upon causation – a compensation order can be made where a person is disqualified and the conduct giving rise to that disqualification as “caused loss”.[31]

Whilst we of course agree that directors guilty of misconduct should, so far as they are able, compensate those who have been adversely affected by that conduct, we have some difficulty seeing how a “compensation order” will operate in practice.

First, DBIS suggests that the sort of behaviour that would amount to misconduct for the purposes of s.212 would also give rise to a compensation claim.[32] That view is at odds with the wording of the proposed s.15A of the CDDA, which only requires the Secretary of State to establish a causal link between the unfit conduct and the loss. Therefore, conduct that might warrant disqualification, but which does not amount to misfeasance under s.212, could give rise to a compensation order even though not a claim under s.212.

Second, further clarification should be provided in the statute by what is meant by “causing” loss. For example, if a director is disqualified on the basis of failing to maintain proper books and records, is it possible for the Secretary of State to argue that had proper books and records been maintained, the company would have succeeded, or perhaps the director would have ceased trading sooner? It is arguable that such minor “unfit conduct” could have wide causal ramifications and thus prima facie given rise to substantial compensatory claims under the new s.15A. In these authors’ views, if compensation orders are to be enacted, the concept of “causing” should be more clearly defined and restricted to conduct with a direct causal link to the loss in question.

Third, there are issues about whether a creditor or class of creditors is bound by compensation claim litigation. If a compensation claim on the application of the Secretary of State failed, would that mean the subject-matter of that claim was res judicata for a claim by a liquidator or a creditor, in particular one who was specifically named in the claim, as envisioned by the proposed s.15B(1)(a)? If the Secretary of State accepted a compensation undertaking from a director, would a liquidator or creditor nonetheless be entitled to bring a s.212 claim for any losses they suffered above and beyond the compensation undertaking? These are difficult questions that remain unanswered in the Government’s Response[33] and have no specific answer within the proposed Bill. It appears to us that the costs and efficiency benefits of a compensation order could only be achieved if the outcome bound the company, its creditors and members; but that would raise issues in respect of claims where the victim wished to litigate the matter itself, or more probably, was not satisfied with a compensation undertaking.

Finally, the Bill envisions that the compensation payable – whether by order or undertaking – would be paid either to the company or, alternatively, to a creditor or class of creditors specified by the order or undertaking. A matter that is not addressed in the Government Response or in the Bill is how the Secretary of State will (or Court should) decide whether to contribute the compensation to the company as a whole or to a specified creditor and, if the latter, which creditor or creditors should be so specified. There are problems with both approaches. If the compensation returns to the company as a whole, then there is a possibility that creditors who cannot establish a causal link under s.15A(3) will nonetheless benefit from the order, because they will receive their pro rata share of the company’s assets which have been increased by the compensation order. If a specified creditor is compensated (e.g. one who can show causal loss), there is the problem that the Secretary of State might be aware of all creditors who could show such loss at the time he makes the application for a compensation order, and thus some creditors will benefit from the scheme, whilst others will not. It is notable that the proposed limitation period under the new s.15A(5) of two years from the disqualification order is not subject to any qualification on discoverability.

In those circumstances, these authors presently take the view that compensation should be left as a private matter to be litigated by liquidators or individual creditors and members.

  1. Extension of the time limit for instituting disqualification proceedings

The final matter considered as part of the discussion paper was that of the present time period for bringing disqualification proceedings under s.6, which stands at two years. Less than one third of those consulted stated a view at all, and of those who did, views were mixed. Half agreed that the limit should be raised to 5 years, the other half considered the present time period should be retained or increased to only 3 years.[34]

DBIS has concluded that the time period should be increased to 3 years. This proposed extension is found at clause 96 of the Bill, which amends s.7(2) of the CDDA to read “3 years” instead of “2 years and we support this amendment. Whilst the 2 year time limit is appropriate for many, if not most, disqualification proceedings, large and complex insolvencies may require a longer investigative period. Indeed, it is in directors’ interests as well that investigations are not undertaken too quickly, and expensive claims commenced precipitously. Although the IoD suggested that it was important that the threat of disqualification does not “hang over directors too long”, 3 years is not a particularly long time period in the company context, especially where directors could be subject to equitable claims for breach of fiduciary duty far after a 3 year period has elapsed.

Having said that, these authors would also encourage better communication (though much improved from a few years ago) to directors who are likely to have proceedings launched against them, so that they are not informed only a matter of weeks or even days before the two (or three) year deadline that proceedings are to be commenced against them. Given that the deadline is to be extended, that hopefully will accommodate a better pre-action procedure so that directors have the opportunity to comment on draft evidence or a form of pre-action letter prior to the commencement of proceedings against them.

Notes:

[1]         Government Response, at [158].

[2]         Government Response, at [197]. Also see Re Unisoft Group Limited (No. 2) [1994] 1 BCLC 709, at 620g-h per Harman J and Ultraframe (UK) Ltd v Fielding [2005] EWHC 1638 (Ch), at [1272] per Lewison J (as he then was).

[3]         Government Response, at [201] & [202].

[4]         Holland v Commissioners for Her Majesty’s Revenue and Customs [2010] UKSC 51.

[5]         The proposed new s.251(b) & (c) of the Companies Act 2006.

[6]         The proposed new s.8ZA(1) of the CDDA.

[7]         The proposed new s.8ZA(2) of the CDDA.

[8]         The proposed new s.8ZB to s.8ZE.

[9]         Government Response, at [207].[10]        Government Response, at [208].[11]        Government Response, at [222].[12]        The new proposed paras. 1 to 4 of Schedule 1 to the CDDA.[13]        The new proposed paras. 5 to 7 of Schedule 1 to the CDDA.[14]        This of course extends to certain foreign incorporated companies: see Mithani: Directors’ Disqualification at para III[66] et seq.[15]        Government Response, at [229].[16]        Proposed s.5A(1) of the CDDA.[17]        Proposed s.5A(2) of the CDDA.[18]        Proposed s.5A(3) of the CDDA.[19]        Government Response, at [236].[20]        Government Response, at [238].[21]        Government Response, at [239].[22]        Government Response, at pg 63.[23]        Government Response, at [246] & [247].[24]        Government Response, at [245].[25]        Government Response, at [256].[26]        Government Response, at [252] to [256].[27]        The proposed new s.7A(1) & (3) of the CDDA.[28]        The proposed new s.7A(5) & (6) of the CDDA.[29]        Government Response, at [267].[30]        Government Response, at [269].[31]        The proposed new s.15A(3) of the CDDA.[32]        Government Response, at [269].[33]        Government Response, at [273] to [275].[34]        Government Response, at [280].

 

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