Overview
This book examines the impact of financial distress and insolvency on corporate governance. Whilst the book is written from a predominantly legal position, the review and analysis has been expanded to cover broader issues of business and strategic management that overlay director decision-making in such circumstances. It seeks to avoid normative prescription, choosing instead to illustrate its arguments with an empirical analysis of specific director decisions, revealed by a systematic review of five different case studies of large public companies that have experienced financial distress and ultimately insolvency.
In the UK, the law related to financial distress and insolvency focuses on specific director responsibilities, setting out how directors are expected to implement their legal duties in such circumstances to companies, shareholders and creditors. These duties have been established in common law and in statute, most notably through the Companies Act 2006, and the Insolvency Act 1986. In parallel, largely in response to prominent examples of business failure, codes of practice have been established to prescribe how public companies should behave in a range of different areas including determining the composition of the board of directors and ensuring its independence, financial reporting and the remuneration of senior executives—so-called governance codes. This latter development is a response to a perceived need for those charged with running a company to be more accountable and transparent in their decision-making.
This book examines the impact of financial distress and insolvency on governance structures and processes, taking a dual perspective that includes an investigation of the way in which directors discharge their legal responsibilities and the way in which they implement governance codes. This is a rapidly evolving agenda and the synthesis of these two areas in an approach that combines doctrinal, theoretical and empirical analysis should be of value to those responsible for interpreting, applying and developing statutory legislation and formulating and implementing appropriate codes.
Financial Distress: A Challenge for Governance
Most companies experience periods of financial distress, reflecting external environmental challenges such as new competition, changes in product technology, problems with labour supply or increasing capital costs—all of which have the potential to put pressure on the company’s overall financial and economic viability. Companies can adjust to such problems in a variety of different ways including entry into new markets, new product development or diversification into new areas of business. Each of these business development options is likely to create a demand for more finance, at least in the short term, to successfully implement the business plan, putting pressure on cash flow in circumstances where resources may already be constrained. Alternatively (and potentially simultaneously) focus may be primarily placed on improving the flow of funds from existing business operations. In either situation, companies are likely to apply a range of different strategies to business financing and the management of cash flow, including cost reduction, equity/share issue, asset sale and/or new debt financing/debt renegotiation. Whilst such approaches to improving cash flow may resolve financial problems in the short term, ultimately the directors may run out of options and the company fails.
Business failure is an unfortunate but recurring corollary of business life. Table 1.1 shows that between 2013 and 2017, the number of new company insolvencies in England and Wales ranged from 14,658 to 17,243. The table also shows the relative frequency of different types of insolvency. Creditors’ voluntary liquidations have been the most frequent, followed by compulsory liquidations, administrations, company voluntary arrangements and receiverships. There are no definitive statistics to indicate the number of companies that are experiencing financial distress at any particular moment; however, it would be reasonable to assume that the number is significantly higher than the number of company insolvencies.
Table 1.1
New company insolvencies in England and Walesa
Number of insolvencies | % change—2016 to 2017 | |||||
|---|---|---|---|---|---|---|
2013 | 2014 | 2015 | 2016 | 2017e | ||
Total new company insolvencies | 17,682 | 16,319 | 14,658 | 16,545 | 17,243 | 4.2 |
Underlying total insolvencies | 17,682 | 16,319 | 14,658 | 14,749 | 15,112 | 2.5 |
Compulsory liquidations | 3632 | 3755 | 2889 | 2930 | 2799 | −4.5 |
Creditors’ voluntary liquidations (CVL) | 11,453 | 10,401 | 9992 | 11,890 | 12,861 | 8.2 |
Underlying CVLs | 11,453 | 10,401 | 9992 | 10,094 | 10,730 | 6.3 |
Administrations | 2009 | 1587 | 1402 | 1374 | 1289 | −6.2 |
Company voluntary arrangements | 571 | 554 | 364 | 346 | 292 | −15.6 |
Receiverships | 17 | 22 | 11 | 5 | 2 | −60.0 |
Whilst Table 1.1 indicates the overall scale of the problem, over the last decade a series of high-profile business failures in the UK including JJB Sports plc, Waterford Wedgwood Group plc, Woolworths Group plc, Comet plc, HMV Group plc, British Home Stores Limited (BHS) and Carillion plc have created an increasing awareness of some of the key issues that business insolvency can create. The heightened attention paid to such failures is not difficult to understand. Large public companies are amongst the most influential economic players in developed countries. Changes in the value of their assets and liquidity have a major impact on capital markets and they make major contributions in terms of employment and investment. Some employ large numbers of service sub-contractors or have a large number of suppliers that have extended credit to the company in different forms. Banks and other lenders may also have provided financial support through loans and other securities. Major institutional investment and pension funds may have significant shareholdings. Such companies may also have employee pension schemes that require continual funding. Where such prominent companies have failed, attention has increasingly been focused on corporate governance—specifically the way in which the directors of the company have met their responsibilities to shareholders, employees, creditors and the general public.
UK law has chosen to remain largely silent about the commercial decisions that are taken by the board of directors and the impact of such decisions on creditors and shareholders when the company enters a period of financial distress. The responsibility is typically left to the directors of such companies to resolve the debt problem before the company enters a formal insolvency regime. This informal rescue stage may frequently involve decisions that require approval by creditors and institutional shareholders. Once a formal regime is invoked directors see their control eroded as decisions are made by insolvency practitioners who maintain an independent role and do not necessarily require creditor or shareholder approval for such decisions. The governance pattern that takes shape during this stage is frequently vague and ill-defined from a legal perspective, partly due to a lack of detailed disclosure rules that would identify the influence of third parties (principally creditors). The precise nature of governance is also unclear. Governance codes do not directly address issues arising from financial distress and insolvency. It is not clear what impact financial distress or insolvency may have on the practical implementation of such codes.
This is a comparatively neglected area of research and analysis. The author has not found any systematic empirical research into the effects of financial distress and insolvency on corporate governance, that maps the evolving responsibilities and liabilities of each of the parties involved (directors, creditors, shareholders and ultimately insolvency practitioners) against the context of statute and common law responsibilities and governance codes. However, it is clear that this topic is becoming increasingly important in emerging doctrinal and empirical research in business, law and management. This is the gap that this book seeks to address.
Scope and Contribution
In summary this book focuses on:
- how UK law approaches financial distress and insolvency and the extent to which statutory legislation and current codes of governance acknowledge and accommodate both situations; the work should assist policy formulation by creating an increased awareness of the role of other key players—specifically creditors and institutional shareholders in the governance of financially distressed companies.
- the extent to which boards of directors continue to exercise their general duty to their company through effective business/commercial judgment during periods of financial distress, and how far their approach in such circumstances is consistent with statutory responsibilities and governance codes;
- the influence of shareholders and creditors on the board’s choice of informal business rescue options and their subsequent success or failure;
- the influences of the decisions made by insolvency practitioners on creditor claims and the distribution of assets. The outcomes should provide further context for proposals to regulate for greater disclosure of secured creditor influence during administration, and the provision of more support for unsecured creditors.
Narrative
Chapter 2 of this book examines the emergence of codes of corporate governance and the scope of directors’ legal duties to the company. It also considers the role of external markets and credit rating agencies as indirect governance mechanisms. C...