Corporate Law Update

This week we look at a consultation from the Government on corporate governance, particularly in the context of insolvent companies, the Government’s intention to amend the UK’s merger control thresholds for mergers in sensitive sectors and a case where the shareholders of a company were unable to recover loss in the value of their shares when the company’s directors were unsuccessfully prosecuted and the company folded.

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Government consults on insolvency and corporate governance

The Department for Business, Energy and Industrial Strategy (BEIS) has published a consultation on insolvency and corporate governance.

The consultation is aimed primarily at improving corporate governance in firms that are in or approaching insolvency. However, it also puts forward proposals for improving the wider framework of corporate governance.

The key proposals from the consultation are set out below.

BEIS has requested responses by 11 June 2018.

Liability for parent company directors

BEIS is proposing to impose penalties for directors of a holding company who approve the sale of an insolvent subsidiary. The proposed penalties include disqualification and liability to pay compensation.

Holding company directors would be liable only if four conditions are all met. These are:

  • The subsidiary was a large company and insolvent at the time of sale
  • It enters into administration or liquidation within two years of the sale
  • The interests of its creditors are adversely affected during that period
  • The directors could not reasonably have believed that the sale would lead to a better outcome than placing the subsidiary into administration or liquidation

The consultation suggests that holding company directors would need to consider (among other things) the buyer’s ability to support the subsidiary’s business for up to two years going forward.

This proposal would significantly broaden the scope of penalties for directors. Currently, penalties can only be applied to directors of the insolvent company itself, and not those of its shareholders.

The Government will need to balance the merits of this proposal with the potential difficulties it raises. For example, the proposal would seem to by-pass a cardinal principle of company law, namely that shareholders are entitled to act in their own interests when it comes to their investment in a company.

Also, holding company directors would need to balance their duties to the holding company (and the interests of its stakeholders) with the interests of the subsidiary’s stakeholders. If there is a conflict, they might feel that the need to dispose of a failing asset and protect the holding company prevails.

The proposed reform potentially raises particular considerations for the private equity and venture capital sectors. Sponsors will be concerned to ensure that their own directors, and directors appointed to vehicles within an investment structure or “stack”, will not be at risk of incurring personal liability on the secondary sale of a failed investment (particularly those directors who are not appointed at the portfolio company level).

Finally, it is worth noting that the proposal would only impose liability on the directors of a holding company. It would not encompass a situation where an individual sells an insolvent company, nor would it attach liability to a holding company itself.

Numerous other points arise from this particular proposal and we await the Government’s next steps to see whether it evolves any further than its current embryonic state.

Shareholder responsibilities

BEIS believes there is scope for shareholders and institutional investors to be more active in engaging with and stewarding companies.

The paper acknowledges that the Financial Reporting Council (FRC) is already consulting on changes to its Stewardship Code (as part of its larger consultation on the UK Corporate Governance Code). However, it asks for views on whether more can be done, as well as on concrete suggestions, such as:

  • establishing an “expert stewardship oversight group” comprising the Investor Forum, company chairmen, company secretaries, asset owners and the FRC; and
  • asking FTSE companies to commit to holding periodic “strategy and stewardship forum meetings” focussing on the company’s long-term strategic plans.


The Government is concerned about large companies paying dividends in the period immediately before they enter insolvency. More broadly, the paper raises the question of how and in what circumstances dividends are currently being declared and paid.

As a result, the paper is seeking views on whether the legal and technical framework for justifying and paying dividends should be reformed (and, if so, how) to make it clearer and more transparent to stakeholders.

In particular, the paper asks whether the current definition of “distributable profits” is fit for purpose.

As a matter of law, a company can pay a dividend only out of “profits available for the purpose”. The Companies Act 2006 defines these as accumulated, realised profits less accumulated, realised losses, but it provides no real guidance beyond this. Companies must look to their accountants to help them understand their level of profits and which profits are available to pay a dividend based on accepted accounting principles.

While adding clarity to the legislative framework would be useful, the Government will need to consider whether expanding the law in this area might intrude into the territory of accepted accounting regimes.

Directors’ duties

The paper notes that company directors often need to seek professional advice. It gives examples of accountants advising on the level of a company’s distributable profits, actuaries advising on pension-scheme deficits, and tax consultants advising on tax matters.

However, BEIS makes the point that, after obtaining advice, directors still need to make an evaluative judgment about whether to follow that advice and (if they choose to) how to apply it in practice.

In doing this, directors must comply with their duty under section 172 of the Companies Act 2006 to promote the company’s success. This may not mean following the advice wholesale. For example, they may feel they ought not to distribute all available profits and instead retain some to address business risks.

BEIS is worried directors may be following professional advice without full awareness of their duties. It is seeking views on whether this is likely to be the case and what can be done about it.

Other items

BEIS is also proposing the following:

  • New powers to reverse the extraction of value from companies in financial difficulties through complex structures put in place by investors as part of a “rescue” attempt.
  • New powers to investigate the conduct of directors of dissolved companies that do not go through formal insolvency proceedings.
  • Stronger corporate governance and transparency measures to enable third parties to understand the complex group structures of organisations with which they do business.
  • New measures to protect small and medium-sized enterprises (SMEs) in a supply chain where a large customer enters insolvency.

Government responds to national security merger control review

In October 2017, we reported that the UK Government had launched a consultation on various proposed changes to the UK’s merger control regime and beyond. The purpose of the proposed changes was to prevent investments and takeovers in the UK from raising national security concerns.

That consultation was split out into:

  • short-term proposals, which contemplated changes to the UK’s merger control regime; and
  • longer-term proposals, which envisaged more significant powers for the Government to intervene in certain kinds of investment.

The Government has now published its response to the short-term proposals set out in the consultation. The key points are as follows:

  • Turnover test. At the moment, a merger is within the UK’s merger control regime if the UK turnover of the business being acquired (the target) exceeds £70 million.

    The Government has confirmed it will implement its proposal to reduce this threshold to £1 million for mergers of businesses within certain specified sectors.

  • Share of supply test. Currently, a merger is within the UK’s merger control regime if the combined share of supply of products or services by the target and the buyer would move to above 25%, or if the merger would increase a combined share that already sits above 25%.

    Again, the Government has confirmed it will implement its proposal to add an additional share of supply test for mergers in certain specified sectors, namely where the existing share of supply of the target alone is 25% or more. This will supplement (and not replace) the existing share of supply test.

  • Specified sectors. The new thresholds will apply only to mergers in particular sectors. These are military and “dual-use” products (as set out in certain lists included in the UK’s Strategic Export Control Lists), multi-purpose computing hardware and quantum-based technology.

The result is likely to be that a significant number of mergers in these sectors will now fall within the UK’s merger control regime and come under the scrutiny of the Competition and Markets Authority.

The Government has laid the order amending the “share of supply test” before Parliament. It intends to lay the order amending the “turnover test” in due course. Both orders will come into effect at the same time, which is likely to be 28 days after they are approved by Parliament.

The Government is considering responses to its longer-term proposals and will respond to them in due course.

Shareholders could not claim for loss in value of company

The High Court has held that two director-shareholders of a company who were unsuccessfully prosecuted for fraud could not claim back the drop in the value of their shares when the company’s business failed.

What happened?

Breeze and another v Chief Constable of Norfolk concerned two individuals who ran a company that provided mental health services to the National Health Service (NHS). Those individuals were also the company’s main shareholders.

Following a “tip-off” by a disgruntled former employee, local police arrested the two individuals on suspicion of over-charging. The individuals were tried two and a half years later but were emphatically exonerated by the judge, who said they could “leave court with [their] heads held high”.

However, during the period between arrest and trial, the individuals were unable to run the company. The company’s position deteriorated so badly it was ultimately placed into receivership and dissolved. The individuals consequently lost the value of their shareholdings in the company, which they estimated at a combined total of just over £30 million.

They subsequently claimed against the Chief Constable to recover the loss in value of their shares. They alleged malicious prosecution and misfeasance and said the Constable should have known that the prolonged investigation would cause the company’s business to fail.

The Constable argued the individuals could not claim damages due to the “reflective loss” principle.

The “reflective loss” principle states that, if a company suffers loss caused by someone else, it is the company that has the right to claim. Shareholders may suffer loss if the value of their shares goes down, but they cannot recover that loss unless they have their own, separate right of claim. If the loss in share value is merely “reflective” of the company’s own loss, it will not by itself give rise to a claim.

The principle can sound complex. However, in reality, it merely affirms the fact that a company is a person separate from its shareholders, with its own rights. This concept has been familiar to English law for over 150 years since the 19th century case of Foss v Harbottle.

What did the court say?

The court agreed with the Chief Constable. It said that the loss in the individuals’ shareholdings merely reflected a loss suffered by the company and so, at first glance, was irrecoverable.

However, the case raised two interesting points:

  • The individuals argued, based on historic case law that the “reflective loss” principle applies only where a company has the right to claim for breach of a duty owed to it. That was not the case here, and so they should be allowed to claim.

    The court rejected this, saying that the principle applied to any claim a company may have which results in a loss reflected in the value of its shares.

  • The individuals also argued that they should be allowed to claim despite the “reflective loss” principle, because the Constable’s actions had deprived the company of its management and so rendered it unable to claim itself. They said it would be unfair to allow the Constable to escape liability when it was his actions that caused the company to be unable to claim. This is a recognised exception to the “reflective loss” principle (known as the exception in Giles v Rhind).

    The court was not able to give a final view on this, as it did not have sufficient evidence before it. However, the master saw some merit in this argument and allowed the individuals to apply to amend their claim to provide more details.

Practical implications

The interesting element of the judgment in this case was the master’s willingness to “expand” the “reflective loss” principle to claims beyond breaches of duty owed to a company. Depending on how one approaches the principle, this is either a significant extension of the principle or (as the master suggested) not an extension at all.

The judgment was given in the context of an application to strike the individuals’ claim out. It does not therefore set any binding precedent for courts to follow, but the master’s decision was well-reasoned and future courts will probably follow a similar approach.

It will be interesting to see whether the individuals in question pursue their argument that the exception to the principle applies in this case.

The key point to remember is that a shareholder will usually have no right to claim for a loss in the value of its shares merely because the company itself suffers loss. If the shareholder wants to recover its loss value, it will need to examine whether it can launch an action some other way. These might include the following:

  • Bringing a derivative claim on behalf of the company (if the company’s claim is against its directors for breach of duty).
  • Using its voting rights in the company to replace the company’s board with directors who will be prepared to bring the claim.
  • Identifying and establishing some other duty owed directly to the shareholder and claiming on that basis. However, even then, a shareholder is unlikely to be able to recover any damages that merely reflect an underlying loss to the company itself.