The R3 Association of Business Recovery Professionals has published its report "Insolvency and the fight against fraud" ("the Report"). The Report paints an alarming picture of the prevalence of fraud in the UK. It also highlights the unique, and perhaps under-acknowledged, role that restructuring and insolvency professionals play in tackling fraudulent activity.
With a focus on fraud perpetrated through the vehicle of limited companies, the Report sets out a range of proposals for reform. In this article we examine three key recommendations of particular interest:
1) Proposed changes to the compulsory strike-off and company restoration processes.
2) The extension of the definition of "de facto" director.
3) Greater use of private sector expertise to prevent and investigate fraud.
Fraud and economic crime in the UK
There can be little doubt that fraudulent crimes are an increasing problem in the UK and the Report features some staggering statistics:
• Fraud accounts for up to 40% of all crime committed in the UK.
• The number of victims affected by fraud has risen by over 30% in the last two years.
• 60% of businesses in the UK have been hit by fraud, corruption or other financial crime.
The Report also quotes pre-pandemic National Crime Agency statistics confirming a cost to the UK of an eye-watering £190 billion a year. Add to that the as yet unknown impact of fraud connected to the government COVID support schemes, and the picture looks increasingly alarming. You can read about the aftermath of the COVID loan schemes in Hannah Hooper's article here.
The Report argues that recent legislative changes introduced by the Government (or in the process of being introduced in the case of the Economic Crime and Corporate Transparency Bill) do not go far enough. Proposed Companies House reforms are welcomed, but the Report expresses concern that they represent only "a partial solution" and do not assist creditors left out of pocket when companies used as vehicles for fraud are dissolved and struck off the register automatically and without the opportunity for investigation.
Reforming the Companies House 'automatic' strike-off process and company restoration.
If the registrar considers that a company is neither carrying on business nor operation, it may take action to strike a company off the register. This compulsory strike-off generally occurs where a company fails to submit timely accounts or an annual confirmation statement, the company has ceased trading, or the company has no directors appointed.
The Report estimates that around 50% of the compulsory strike-offs by Companies House are of insolvent companies. However, once the compulsory strike-off has taken place, the company must be restored to the register before an insolvency process can be instigated. Such restoration generally requires an application to court.
This can mean a significant delay to the potential recovery of assets and investigation of potential misconduct as well as additional expense for creditors. In effect this provides additional protection to potentially malfeasant directors. Indeed, the Report states that only 2% of dissolved companies are restored to the register.
The compulsory strike-off regime is ripe for abuse by errant directors looking to quietly dissolve a company without triggering any investigation into the company's financial management. Directors can apply to Companies House to dissolve a company. However, this requires a declaration that none of the circumstances set out in sections 1004 or 1005 of the Companies Act 2006 applies and for a copy of the application to be provided to creditors (including contingent or prospective creditors), and other interested parties. Not an attractive option if you have financial irregularities that you would rather keep hidden.
The Report proposes that rather than compulsory strike-off, companies should be automatically placed in a compulsory liquidation procedure overseen by the Government’s Official Receiver. Under the proposals, directors of such companies could be made personally liable for the costs of the liquidation, which would both act as a deterrent and cover the cost to the Government.
Further, it is proposed that the restoration of a company should be an administrative process, triggered by a company director or creditor once suitable requirements have been met (e.g. producing evidence of an unpaid debt or a commitment to petition for the winding-up of the restored company).
There are significant potential benefits to this proposal. It would thwart attempts to avoid insolvency, and associated investigations, via inactivity. It would allow for earlier investigation into the affairs of the company and the (potentially fraudulent) conduct of directors, as well as facilitating the earlier recovery of misappropriated company assets. In turn this should provide a stronger deterrent to fraudsters (in conjunction with a recommended 2-year disqualification for directors of companies that fail to file accounts for 12 months).
Extending the definition of "de facto" director.
Historically, the trade-off for limited liability and separate legal personality offered by the incorporation of a private company was the transparency necessitated by Companies House filing requirements and the public availability of the information filed. The idea being that the individuals behind a company should be accountable to investors, creditors and the authorities.
The reality is that, often, increasingly complex corporate structures mean that filings provide only superficial information about some companies. This opacity, in particular via the use of layers of corporate ownership and the appointment of overseas corporates as directors, alongside the lack of an identity verification process at Companies House, makes it easier for individuals to use companies as a vehicle for criminal activity with impunity.
The Economic Crime and Corporate Transparency Bill, seeks to increase corporate transparency through additional identity verification for registered company directors and broadening the registrar's powers to ensure the reliability of information on the register. What it doesn’t do, however, is tackle the problem of registered companies controlled by opaque corporate entities, often in other jurisdictions.
In response to this, the Report recommends that natural person directors of corporate directors of UK companies should be treated as "de facto" directors, i.e. someone who has not been appointed as a director of the UK company but who is subject to the legal duties, responsibilities and potential liabilities of "de jure directors".
The result would be that those individuals with control over the corporate directors of UK companies, could be held personally liable when fraud occurs. This could be highly effective and would certainly be unpopular with those seeking to protect themselves from liability behind several layers of corporate veil.
Increasing the use of private sector capacity and expertise
The Report highlights the consistency in the number of director disqualifications made by the Insolvency Service each year, despite economic trends and fluctuations in the total number of corporate insolvencies.
Logically, one would expect that, as corporate insolvencies increase (due to the economic conditions for example), the number of director disqualifications made by the Insolvency Service would also rise, in something close to a proportionate manner. If this is not so, the inference is that the Insolvency Service does not have the resources to tackle the problem; the Service has reached capacity with regard to either investigating and identifying the behaviour on which disqualifications might be based, and/or with regard to actually taking steps to disqualify those directors whose conduct falls below the statutory standard.
In response to public sector resourcing constraints the Report proposes making greater use of private sector capabilities. IPs have extensive powers to investigate and pursue directors involved in fraudulent activity. Indeed, when acting as an office holder, an IP is required to investigate directors for evidence of misconduct and report any offences to the relevant authorities.
Opportunities to make use of this experience could be highly beneficial for the public sector. Two case studies highlighted in the Report demonstrate the impact of involving IPs in difficult cases. In both instances the cases were brought to the attention of the insolvency and restructuring profession via the Economic Crime Prevention Group ("ECPG") Insolvency Pilot. This scheme was established in 2012 as a collaboration between members of the insolvency profession and a number of public and private sector organisations. Cases referred to the pilot are generally those that would not otherwise be taken forward due to lack of resourcing.
Unlike the precise and specific proposals in relation to dissolution and de facto directors, this proposal seems light on detail. It is not clear whether it is proposed that the ECPG pilot would be expanded, or a new programme introduced. If the latter, what would that programme look like? How would cases be selected? It is also not clear whether this collaboration would take the form of a pro bono offering to the public sector? In both the case studies highlighted in the report the IPs in question provided their assistance free of charge, but might the volume of work involved in a more extensive collaborative project necessitate some form of remuneration?
The proposed changes to the compulsory strike-off process and rules on natural directors of corporate directors, are sensible responses, from the corporate governance perspective, to dramatic increases in fraudulent behaviour. Reform of this type, however, is arguably a balancing act for the Government between creating healthy transparency and accountability without upsetting big business. It remains to be seen whether the Government will be prepared to go further than its current corporate governance reforms.
The Report's recommendation for increased engagement and collaboration between the public and private sector, certainly merits further consideration. If conceived and implemented properly, this sharing of resource and expertise could, one imagines, have a significant impact on the public sector's ability to more effectively tackle fraud.
Since publication of this article it has been reported that MPs intend to table an amendment to the Economic Crime and Corporate Transparency Bill to include criminal liability for directors in circumstances where there have been failures in fraud prevention. You can read more here.