On the way out
Director disqualification law is failing to deter malpractice and needs reform says Don Wright
Director disqualification law is failing to deter malpractice and needs reform says Don Wright
Director disqualification has become a huge self-serving legal industry with a status and use of resources wholly disproportionate to the value of its role in countering corporate financial malpractice. I consider that the elevated status of the disqualification procedure is the result of woolly jurisprudence, bureaucratic mindset, and political expediency in the face of adverse publicity.
Insolvency is always bad news, and the limited liability company has always had the potential to provide cover, often seemingly impenetrable, for financial dishonesty. Such dishonesty, however, is invariably in contravention of law. Company law may limit the liability of shareholders from calls on their capital, but it does not exempt directors or employees from being called to account for their wrongful actions. Both company law and insolvency law provide the prosecutor with a wide range of criminal and civil actions not only to punish, but also to remedy dishonesty.
In 1985, however, it was deemed that the legislative provisions that existed to disqualify directors and hold them personally liable had not proved very effective. The revision of insolvency law in that year created a number of measures to deal with corporate malpractice, including director disqualification and the new concept of wrongful trading, introduced to supplement the law of fraudulent trading.
In the public eye
The recession of the early 1990s catapulted the new legislation into the glare of public attention. There were tens of thousands of company insolvencies, probably facilitated by the fact that corporate insolvency was now a relatively straightforward procedure with licensed specialists. Problems of corporate financial malpractice remained and, such was the volume of insolvency, that these cases were also numbered in thousands.
Legislation had again proved ineffective and again, for much the same reason ? weakness in the law itself and failure to commit adequate resources to enforcement. The Insolvency Service was blamed and instructed to concentrate on enforcing the provisions of the Company Directors Disqualification Act. As a result, disqualification prosecution now predominates, although the reported matters of unfitness regularly include a variety of misconduct prosecutable under other sections of both company and insolvency law.
Indeed, a recent High Court ruling held that a company director facing disqualification who wished to dispose of the matter quickly and without going to trial, on the basis of the summary procedure developed by the Court, can admit failings and be sentenced to a period of disqualification without the admissions being held against him in any other proceedings. It seems probable that new proposals to fast-track the disqualification procedure will follow.
In a lecture last year, Lord Hoffman, a senior Law Lord, made the point that disqualification law is fairly marginal in preventing negligent management of business, and he noted that directors were rarely sued for breach of duty. He said the courts were reluctant to accept the philosophy that directors should be disqualified, regardless of whether they were dishonest or merely genuinely incompetent.
The Courts, however, have held that gross incompetence which does not amount to dishonesty can be regarded as unfitness within the provisions of the Disqualification Act and, of course, this fits the objective of protecting the commercial world from such individuals. If incompetence is now a matter for disqualification ? and one must presume the Barings directors? disqualifications fall into this category ? the logic for an automatic disqualification without recourse to the Courts, on all directors involved with a specified number of insolvencies or a specified total loss, or a mixture of both, seems inescapable.
But, as Lord Hoffman observed, this is all very marginal in any event. It is unlikely that the possibility of disqualification deters the reckless, dishonest, or even incompetent individual. Banning them for a given period is a relatively short-term measure, possibly due to become shorter under the fast-track system, and of course there is little certainty that the ban will be observed. Already there have been a number of further disqualifications of individuals for misconduct while already disqualified. The Insolvency Service has recognised this problem and set up a telephone hotline to receive information on directors who ignore disqualification orders.
The practical protection for the commercial world remains the ability to check out a company or individual asking for credit, to assess and quantify the risk, and to ensure that credit levels are not exceeded. Undoubtedly, the Register of Disqualified Directors has a part to play in assisting such commercial prudence, and transparency in this regard, as exhorted for everybody else by regulators, should be the principal objective.
If the legislators really wish to deter the reckless or dishonest businessman, criminal prosecution or civil recovery proceedings need to be undertaken. But, as suggested above, disqualification proceedings presently appear to be using the majority of available resources. For example, the latest statistics issued, which are for the year ended 31 December 1996, show that the Insolvency Service obtained one conviction for fraud in anticipation of winding up, three convictions for transactions in fraud of creditors, one for misconduct in the course of winding up and 27 for failure to keep or maintain accounting records.
Failure to keep accounting records is a criminal offence under the Companies Act 1985. In the last analysis, a corporate legal entity only exists by its transactional footprints. If these footprints are unrecorded, deliberately concealed or destroyed, it becomes almost impossible to hold individuals to account. It is not limited liability status that provides cover to the dishonest director, it is the lack of transactional evidence.
Civil recovery proceedings do not appear to be part of the Insolvency Service?s remit. Most disqualification reports are full of dubious financial transactions perpetrated by directors to preserve their finances at the expense of the company and, indirectly, the creditors. There are a variety of recovery remedies available which seek to reverse any financial benefit obtained through malpractice. The certainty, or at least possibility, of personal financial loss is a powerful deterrent when the original motive is personal financial gain.
It is left, however, to the officeholder to instigate such proceedings and this is where the jurisprudence starts to unravel. If the case is in funds, the officeholder needs the sanction of the creditors or the Court. For both, this is a value-added judgement. If the case is not in funds, the officeholder has either to seek funding from the creditors or to fund the action out of office accounts which ? even allowing for obtaining legal advice on a conditional fee basis ? involves not only risking time but also the cost of legal disbursements and possibly adverse costs insurance. This is a risk judgement with no certainty of success and, in the majority of cases and for the majority of insolvency practitioners, it is simply not economically viable.
Yet in all cases, the officeholder is obliged to make a disqualification conduct report which can involve a substantial amount of investigative work, unrewarded where the case is not in funds. The guidance notes issued by the Disqualification Unit contain over 40 paragraphs in the section on completing the report, and a conduct return checklist produced by the Joint Insolvency Monitoring Unit has over 50 questions to consider.
In certain instances, these require the provision of a working schedule. Again, if the case is followed up by the Disqualification Unit, and is not in funds, the result can be even more unrecovered time costs for the insolvency practitioner.
In my opinion, this investigative effort and cost should go into recovering assets and seeking restitution. The resources and considerable expertise of the Insolvency Service should be available to prosecute every aspect of contravention of company and insolvency law, and should be organised on a regional basis working closely with local insolvency practitioners. The present system of a disqualification unit-based in London and processing the insolvency practitioner reports from all regions, simply helps to give the proceedings, and the unit, a remoteness and importance they do not merit.
With the benefit of hindsight, director disqualification should have remained as a couple of straightforward and automatically applicable sections of the Insolvency Act 1986, with the provisions in respect of wrongful trading, and other malpractice, expanded and consolidated into a separate piece of legislation. The Insolvency Service should also have been empowered to pursue delinquent directors and to seek restitution for the creditors.
Don Wright is manager of forensic services at Baker Tilly in Manchester, and specialises in insolvency litigation. Any views expressed in this article are his own
A short history
The government produced its white paper, entitled ?A Revised Framework for Insolvency Law?, in response to the report by the committee chaired by the late Sir Kenneth Cork. The White Paper included a proposal to impose an automatic three-year disqualification on the directors of every company in compulsory liquidation. This had not been a recommendation of the Cork Committee and was withdrawn after the government was defeated in a debate on the issue in the House of Lords.
The insolvency bill was the most fundamental revision of the law dealing with both corporate and personal insolvency for more than a century, and had a very difficult passage through parliament. The resulting Insolvency Act 1985 was merged with some 200 sections of the Companies Act 1985 to create the Insolvency Act 1986. All the sections dealing with director disqualification were consolidated into a separate piece of legislation, the Company Directors Disqualification Act 1986.
The Insolvency Service became a fully accountable Executive Agency of the Department of Trade and Industry, and as such fell under the scrutiny of the National Audit Office. The role of the Agency is to deal with individual and corporate failure, and to take action in cases of insolvency related fraud and wrongdoing.
A National Audit Office study found that the Insolvency Service was not fully meeting its objective of protecting the commercial world and the public at large against directors who abuse limited liability status.
The chief executive of the Agency appeared before the House of Commons PAC and received a barrage of criticism from Labour MPs. The committee concluded that 1,712 disqualifications secured by the Agency between 1987 and 1993 was an inadequate response to the scale of unfit conduct revealed over that period. The committee was also concerned to note that a survey of company directors found 58% were not even aware of the Disqualification Act?s existence. The Agency resolved to direct more resources into disqualification proceedings and give greater publicity to the results.
The year ended 31 March 1996 showed a dramatic increase in the number of disqualification orders compared with previous years. The seven-year disqualification of boxing promoter Frank Warren received widespread coverage.
The DTI confirmed that it would seek the disqualification of ten directors of Barings, the investment bank which lost more than #800m.
The disqualification of another sporting personality, Terry Venables, again received maximum publicity. A seventh director of Barings was disqualified for four years. The DTI set up a 24-hour telephone hotline to help catch directors who disregard disqualification orders. The government proposes to introduce legislation to permit fast-track disqualification of directors.
* continuing to trade without reasonable prospect of paying creditors
* issuing cheques regardless of the prospect of the cheques being honoured
* taking excess remuneration
* retaining monies due and payable to government departments
* failing to maintain or preserve accounting records
* failing to exercise adequate financial and management control
* failing to file company accounts and returns
Disqualifications per year