Print Published 18th Feb 2018, 20:23

Another reminder that company law needs strengthening

While recent business news headlines have focussed on the failure of the multinational facilities management and construction services company Carillion, and the Government has vowed to punish company directors who favour their own financial rewards over those of employee pension schemes, it is worth noting that there has been a continuing stream of examples over many years of governments turning a blind eye to defects in company legislation and ignoring breaches of company law among smaller companies.

This publication focuses exclusively on a very small segment of the UK economy, but it cannot have been alone in highlighting some of those shortcomings.  Here are just a few examples:

  • A number of companies in the marketing sector have made loans to their directors either without the necessary shareholder approval or without them being disclosed as required in their annual accounts or both.
  • A number of companies – often loss-making – have been allowed to deliver their accounts to the Registrar of Companies many months after their due date in the knowledge that the only penalty will be a modest fine.
  • At least one company has been able to defer filing its accounts for many months following a change in its year end date by no more than one day – but on several successive occasions – in one accounting period.
  • Several companies have become insolvent, but their owners have been able to buy their businesses back for a modest sum from the administrators, while creditors have suffered serious loss.
  • Founding shareholders have been able to augment the rise in value of their initial shareholdings by receiving free or discounted, albeit performance related, grants of further shares at the expense of other shareholders.

Among companies that have recently made unauthorised loans to shareholding directors are Kameleon Worldwide and Mash Strategy.

Under section 197 of the Companies Act 2006 a company may not make a loan to a director unless the transaction has first been approved by a resolution of the shareholders after circulation of a memorandum setting out the nature of the transaction, the amount of the loan and its purpose, the extent of the company’s liability under any transaction connected with the loan.

Under previous legislation, loans to directors were prohibited.   But in recent years Governments have become more lax, favouring disclosure rather than prohibition and requiring loans to be approved by shareholders.  But often private companies are controlled by the very shareholding directors who want the loans and so approval is a foregone conclusion.

Among companies that appear to have made properly authorised loans to their owner-directors is Inside Ideas Group.  It did so when its own cash resources were benefitting from a mixture of invoice discounting (a form of borrowing) and of clients’ advance payments for work done (see Last year Inside Ideas lost £247,000, had borrowed £5.6m and lent its founder £1m.  Even where such loans are lawful, creditors and others may question whether they represent the best use of the company’s cash.

Somewhere along the way governments seem to have forgotten that company law was not designed for the benefit of shareholders, but to protect those with whom their companies dealt – creditors, customers and employees.  Sometimes today’s Government seems inclined to overlook the “protection” of those parties, notwithstanding that this was an essential prerequisite to granting entrepreneurs limited personal liability if they traded through a company.

Instead the Registrar of Companies recently told Marketing Services Financial Intelligence that the Government’s objective for company law was “to provide an enabling framework that gives companies the flexibility to compete and grow effectively”.  The Registrar went on to acknowledge that entrepreneurs gained some protection from personal liability by trading through a limited company.  But what about the need for protection of the people who do business with those entrepreneurs’ limited companies?

“The price of this protection [of those dealing with a limited company] is transparency”, the Registrar argued.  But what if that transparency is clouded by delay or inadequate disclosure rules?  Transparency is useless if the relevant disclosure law itself is an ass. Self-evidently, the Government attaches less importance to addressing such shortcomings than to aiding growth and competition among companies, irrespective of how that growth and competition might be achieved.

Some governments have justified their looser stance by claiming they seek to lessen the burden on smaller companies – a justification that will inevitably find favour among those in the electorate that are owners of such companies.  But firm law and meaningful disclosures were the collective price entrepreneurs were expected to pay for the benefit of limited liability.  That is not a “burden” from which small companies and their shareholders should be relieved.

It has been all too easy for people to argue that even the current disclosure requirements – whether complied with or not – are intrusive.  Yet, if the law is intrusive, it is for good reason.  Without that intrusion many people would be more poorly served – not least those relying on the financial integrity of privately owned companies.  Such public accountability is a small price to be paid for the benefits of setting up in business with limited liability.

Forty years ago a memorandum analysing perceived defects in company law was submitted by the Consultative Committee of Accountancy Bodies to the then Department of Trade.  The analysis was derived from investigations carried out by eminent lawyers and accountants on behalf of the Department of Trade into high profile company failures – a process that no longer appears to be regarded as of sufficient importance to justify the public expense.

One of the relatively common threads running through those reports was the danger posed by a “dominant director” – an individual whose shareholding and board position had led to conduct that failed to distinguish between self-interest and the wider interests and responsibilities of a corporate entity.

After the accountancy bodies made that submission, company law was amended to address some of the worst excesses of boardroom behaviour, almost invariably by seeking increased disclosure.  But memories are short-lived.  Some of those disclosure requirements have been eased.  Others are being ignored.  And no-one in Government seems to care.

The timely filing of accounts is just one essential element of protection for those dealing with limited companies.  Delayed filing needs much tougher sanctions as soon as the delay extends beyond, say, one month unless the Registrar of Companies grants dispensation for valid and substantive reasons.

Why should the law allow a company like Freud 3.0 to defer filing its accounts by many months simply because it has changed the end of its accounting year by one day on two successive occasions (see Freud group loses £6m on sale of yacht bought from Matthew Freud)?  When the revised deadline was approaching, the company changed its accounting year-end by a further day and thereby extended the filing deadline by almost another three months.  There is a clear flaw in current law that allows the filing deadline to be delayed in this way.  Why should this be?

No sensible person would question the need to accommodate changes, such as those of an accounting date.  But there needs to be a bona fide reason for doing so and a tighter filing regime in such circumstances.

There are other examples of companies that slip under the company law radar.  What about those companies that rise again from the ashes of insolvency under virtually the same ownership and management as the failed ones?  A deal of this type is commonly described as a “phoenix”.  Two examples from the marketing industry come to mind – the company formerly known as Leagas Delaney London in 2003 and Media Square in 2011.

At Leagas Delaney the creditors lost about £3.4 million, but at Media Square it appears that only the banks lost money.  However, even if Media Square’s ordinary creditors were paid out in full and only the shareholders suffered loss, is it reasonable for a bank and the administrators to have done a deal with the former management behind the scenes without first seeking the approval of either creditors or shareholders of the failed business?  Surely, as this publication has suggested, it would be better to make it unlawful for a former director of an insolvent company to become a director of or shareholder in any company that acquires a business from that insolvent company or any of its subsidiaries within five years of the insolvency.   At least everyone would then know where they stood.

Another aspect of company conduct that has aroused critical comment is the scale of rewards sometimes permitted in the form of share incentive schemes where participants may exercise options to buy shares at less than their current market price in response to achieving specified performance targets.  It is a widespread practice in the United States, a situation that arguably puts pressure on big UK companies to compete.  The best known example in the marketing sector is that of shares allocated to WPP’s highly successful chief executive Sir Martin Sorrell.

Last year it was reported that Sir Martin’s latest £41.5 million share award had brought the value of his stake in WPP to £385 million (see Latest £41.5m share award brings Sorrell’s WPP stake to £385m). That value may have fallen a little since then as the company’s share price has been in decline. However, the question raised at the time remains equally valid today: why would a founding shareholder need any more shares?

The value of Sir Martin’s existing substantial shareholding grows in response to any further improvement in the profits earned by WPP.  Is that not reward enough?  Why dish out even more shares which dilute the interests of other shareholders and perhaps could be more usefully reserved to motivate emerging executives who might, for example, secure the longer term continuity of management?

Some might argue that options should not be exercisable at less than the shares’ market price at that time.   Last year Marketing Services Financial Intelligence made a more lenient suggestion (see Is it time to toughen the rules for share schemes?):

  • Options and similar performance based share awards should not be granted to an employee who already holds shares and options that together account for more than a specified statutory percentage of share capital issued or under option – say 15%. (That would not prevent an executive from buying more shares on the open market for cash.)
  • Options and similar performance based share awards granted to an employee in any one financial year should not exceed the higher of a specified percentage of the aggregate shares and options held by that employee at the start of that period and an absolute percentage of the company’s issued share capital – say 5%.

To police such a regime, companies would need to disclose any award that resulted in the prescribed limits having been breached, with particulars of the nature and extent of the breach.

Such is the current Government’s apparent indifference to the quality and effectiveness of company law that none of the above examples appear to have received serious attention.  Of course, health and education are more politically sensitive.  It is only when high profile corporate failures hit the headlines – like Carillion and British Home Stores, for example – that for a brief moment our politicians divert their attention to the state of company law and its enforcement.   That is not good enough.

Will Carillion make any difference to the trend of political indifference?   On past evidence there will be a lot of tub-thumping in the short term and some modest changes in the law to give some semblance of greater security for pension funds.  And then the matter will be forgotten…until the next Carillion shakes the State momentarily from its slumbers.