Background of Insolvency Service’s powers under Company Directors Disqualification Act 1986
Prior to The Ratings (Coronavirus) and Directors Disqualification (Dissolved Companies) Act 2021 (“the Act”), the Insolvency Service (on behalf of the Secretary of State) only had the power to investigate the conduct of directors of companies that have entered into an insolvency process. The Insolvency Service cannot make a disqualification action against former directors of disqualified companies under section 6 of the Company Directors Disqualification Act 1986 (“CDDA”) without first restoring that company to the register at Companies House. This is a critical and necessary step.
Before the Act took effect, The Insolvency Service followed a three-stage approach under s. 6 CDDA:
- Application to the Court to restore the dissolved company to the register;
- Once the company has been restored to the register, The Insolvency Service would use the power conferred under Companies Act 1985 to obtain information and documents from the company to investigate the director’s conduct; and
- Where appropriate, The Insolvency Service would seek a disqualification order under CDDA.
That restoration process is both a costly and time-consuming hurdle, causing delays in investigations and increasing the burden on public wallets to pay for those restorations.
Historically, creditors have been particularly concerned that unscrupulous directors are using and abusing the company dissolution process to avoid liabilities as creditors have little recourse. It is not uncommon for creditors to be utterly unaware of proposed company dissolution, despite the existence of a notice period during which creditors may object to continuing the dissolution. This often results in creditors failing to raise objections promptly. As a result, creditors will have fewer options for redress, and those that existed before the Act did not adequately protect or benefit low-value creditors.
The Ratings (Coronavirus) and Directors Disqualification (Dissolved Companies) Act 2021 – What’s new?
On 15th December 2021, the Bill received Royal Assent, which amends the CDDA. The substantial majority of the Act’s provisions regarding directors’ disqualification came into effect on 15th February 2022.
The Act is intended to address concerns that the previous legislation allowed directors to:
- avoid investigation of conduct under the CDDA;
- use the company dissolution process to avoid the cost and implications of formal liquidation proceedings; and
- allow or cause a company to be dissolved, effectively shedding its liabilities, with a new company continuing its business.
The Act enhances the Insolvency Service’s powers, on behalf of the Business Secretary, to investigate and disqualify existing company directors and former directors of dissolved companies where their conduct as a director of that company makes them unfit to manage any company. This means it is no longer necessary to restore the company before bringing those disqualification proceedings. If misconduct is found, directors can face sanctions, including being disqualified as a company director for up to 15 years or prosecution, but only in the most severe cases.
Among other things, the Act will prevent directors from avoiding paying creditors by dissolving their companies without initiating a formal insolvency process. The Act enables the Insolvency Service to conduct investigations and subsequently apply directly to the Court for an order against disqualified directors, compelling them to compensate creditors who have suffered losses due to their misconducts.
The legislation’s retrospective effect
Notably, under the Act, the Insolvency Service has retrospective powers to investigate the conduct of directors of dissolved companies. The retrospective effect means Insolvency Service can now investigate the conduct of former directors’ that occurred before the Act came into force, including companies that were not dissolved before the enforcement of the Act. Prior to the Act, under section 7(2) CDDA, Insolvency Service can only make an application for a disqualification order within three years of the relevant company entering an insolvency process, unless the Court directed otherwise. The Act now applies a similar regime, with a three-year lookback period starting when the relevant company was dissolved.
Why make these changes now?
- £47 billion worth of Bounce Back Loans approved
A driving factor behind the retrospective nature of the Act is to enable greater scrutiny of companies that have taken out Government-backed loans to support them during the Covid-19 pandemic, particularly the Government’s Bounce Back Loan Scheme (“BBLS”).
BBLS is a scheme to help small and medium-sized businesses take out loans from £2,000 and up to 25% of their turnover. The maximum loan available was £50,000. The loan is 100% guaranteed by the Government with no fees or interest for the first 12 months. After 12 months, the annual interest rate is 2.5%.
Insolvency Service has a strong incentive not to let companies easily shirk its liabilities, as the UK Government provided banks with complete security in the event of non-repayment. During the pandemic, UK companies took out over £47 billion worth of BBLS. Out of the £47 billion, an estimated £17 billion is to be unpaid, while an estimated £4.9 billion have been obtained fraudulently, according to the National Audit Office. While the Government’s loss regarding BBLS is unclear at this stage, it is clear that the Government is very concerned about companies that have taken out those BBLS to benefit their directors personally. In doing so, these directors would try to dissolve the company to avoid repayment of the loans. As the Act came into effect, the Government wanted to prevent directors from exploiting the dissolution process as a method to avoid repayment of BBLS or other government-backed funding.
- Phoenixism
The Act will also help prevent directors from avoiding liabilities by applying to dissolve a company, commonly known as ‘phoenixism’. Phoenixism occurs when a company ceases trading, leaving creditors unpaid. The former directors then set up a new company that effectively takes over that business without its previous outstanding debts liabilities. The new company emerging from the ashes often trades under a similar name, offers the same services or products, and often uses the same assets.
While instances of phoenixism generally put those company directors in a better financial position, in the vast majority of cases, if the company was formally liquidated through the correct channels, the creditors of the dissolved company would be in a worse situation. This is because when an insolvency practitioner liquidates a company, all assets belonging to the company are identified before being sold for the benefit of creditors. All proceeds will only then be distributed to outstanding creditors based on a payment hierarchy set out in Insolvency Act 1986.
What will all of this mean for company directors?
The Act currently acts as a deterrent to directors considering abusing the company dissolution process to avoid resolving companies’ liabilities and serves as a basis for investigating and sanctioning directors if they are not sufficiently deterred. This was in line with the Government’s commitment to combat Covid-19 fraud in 2021.
The Act will significantly increase the number of investigations into the conduct of directors of dissolved companies and the number of disqualification orders issued. According to the legislation explanatory notes, the Act was not necessarily intended to deal with major corporate failures but rather to prevent small and medium enterprises from ‘gaming’ the system. This is because directors of these small setups, rather than publicly well-known names, often take the opportunity to dissolve their company, effectively getting rid of its liabilities, and then almost immediately set up a new company to continue the business. Nevertheless, only time will tell as to whether the investigations will be fruitful and useful. The practicalities of implementing the legislation may mean that many investigations are not be carried out. However, there is no doubt that the introduction of the legislation is a step in the right direction to ensure that creditors are paid what they are owed.
Therefore, directors of insolvent companies should exercise caution before considering dissolving the company rather than going through a formal liquidation process. With the Act coming into force, the abuse of the dissolution process can have severe consequences for directors even after their company has been struck off, according to section 1003(5) of the Companies Act 2006.
You-Xian Ng
Company Insolvency Pro Bono Scheme 