European Funds Comment: Corporate Rescues and the Law of Unintended Consequences

18 May 2018
Issue 36

Imagine this scenario:  a struggling business is sold as a going concern; a year or so later, the business closes down and its employees get laid off; its creditors – perhaps including an under-funded pension scheme – can’t be paid.  There is a public outcry.  Would it have been better to liquidate the company rather than sell it?  Would an orderly wind-down have delivered a better outcome for stakeholders?  Politicians think so, and some are concerned that the seller did not have a formal legal responsibility to consider the interests of those stakeholders when deciding whether to sell.  They demand changes in the law. 

In March this year – almost exactly three years since Sir Philip Green sold iconic British retailer BHS for £1 – the UK government launched a consultation on some significant changes to the rules.  If enacted, one major reform would see the directors of a holding company that sells an insolvent subsidiary bearing some responsibility if the subsidiary goes bust within two years.  Liability could arise for the holding company’s directors if the position of creditors deteriorates after the company is sold and a court decides that, when they decided to sell the company, the holding company’s directors “could not have reasonably believed that the sale would lead to a better outcome for those creditors than placing it into administration or liquidation”.

In other words, if the court thinks that the directors ought to have known that selling the company, rather than putting it into liquidation, would not lead to a better outcome for the subsidiary’s creditors, the directors could be personally liable for any resulting loss, and they could face disqualification proceedings.  That is novel, because it would seem to breach the principle of limited liability and impose potential liability on shareholders who have done nothing more than decide to sell their shares.  It also sets up a potential conflict of interest for the holding company, whose directors have a duty to maximise value for their own stakeholders.    

But it gets worse.  In some other areas of company law, directors are given an important protection:  the question for a court is not whether the directors were right or wrong, but whether they acted in good faith.  But here, good faith is not enough.  The directors could be liable even if they thought a sale was better for creditors, but the court thinks that such a view was not reasonable. 

And, of course, the court will have the benefit of hindsight:  it will know that the business did in fact fail, and that creditors would have been better off if the company had been wound up earlier.  It will have to try to banish that knowledge from its mind, and put itself in the position of the directors at the time of the sale.  Judges are used to performing that trick, but that may not reassure a director facing the prospect of a hefty compensation order or a lengthy ban.

Directors of holding companies that are selling insolvent subsidiaries – a situation not unheard of in the private equity universe, even if it is not common – will justifiably worry about such after-the-fact scrutiny.  It is likely that they will be risk-averse, given that the possible sanctions are seriously career-limiting, and they will try to manage their risk.  They will worry that they will have no control over what is done to the business after they sell it, and will also be advised that putting the company into liquidation will not carry the converse risk:  there will be no duty to consider whether a sale could have facilitated a rescue and, therefore, led to a better outcome for creditors.  This worry will be heightened by the fact that, when quantifying the liability of the directors, there is no explicit requirement in the current proposals for the court to establish any direct link between the additional losses actually incurred and those that could have been reasonably anticipated at the time of the sale.

So, yes, the outcome will almost certainly be that more businesses will be put into liquidation rather than sold to a buyer with a rescue plan.  That might well satisfy the politicians appalled by the chain of events that led to the collapse of BHS in June 2016, but they should be careful what they wish for.  Corporate rescues do not always work but, in many situations, a sale to a turnaround investor is the best hope for a business and its employees.  Taking action to discourage such sales seems perverse.

The proposals themselves could probably be rescued by building in more robust safeguards for the directors of the selling company.  No doubt many respondents to the consultation, including the private equity industry itself, will make these points when the consultation closes in June.  The government should listen carefully (and take note of significant concerns with other proposals in the same consultation paper, which will be covered in a forthcoming edition of European Funds Comment). 

Otherwise, the ubiquitous law of unintended consequences is likely to strike again.