UK: Insolvency: The Cost Of "Assisting With Enquiries..."

Last Updated: 24 March 2009
Article by Francis Kean

Often, the first occasion on which a director will have to put his or her hand in his or her pocket to pay for legal representation is in the context of an investigation following an insolvency procedure. This article examines the reasons for this and asks how effective D&O insurance is as a protection in respect of this type of exposure.

The trigger point

The trigger point for an investigation under the Insolvency Act 1986 is the point at which the company in question is put into any form of administration or liquidation. As soon as that occurs, the officeholder (be he administrator, administrative receiver, provisional liquidator or liquidator) is immediately vested with powers of investigation under sections 235 and 236 of the Insolvency Act 1986.

Under section 235 of the Act, an officeholder is empowered to obtain information from (among others) directors as well as from employees over the last 12 months of trading as to the "...promotion, formation, business, dealings, affairs or property of the company...". The only limitation on these powers is that the information has to be "reasonably required". In practice, however, since on the day of appointment the information base on which the officeholder will be operating is likely to be low, the extent of the information he is likely to "reasonably require" will be correspondingly high. The scope for refusing to cooperate with an officeholder pursuing his enquiries under section 235 is, thus, severely limited.

The requests for information need not be limited to the provision of documentation. They can, and frequently do, extend to the requirement to attend meetings with the officeholder to answer questions. Although the procedure is supposed to be "informal", lawyers can be present and the atmosphere, nature and tone of the investigation can seem anything but informal.

It should be remembered in this context that, although the primary responsibility of an officeholder is the collection and realisation of a company's assets and the settlement of its liabilities, there is also an obligation on all officeholders to report to the Secretary of State if it appears that there has been any misfeasance on the part of the directors such as, for instance, a breach of the Company Directors Disqualification Act. In order to discharge this obligation, officeholders need to consider, for example, whether there is evidence of wrongful trading.

Section 236 investigations

Officeholders have even wider powers of investigation under section 236 of the Insolvency Act 1986. In the first place, these powers are not limited to directors, auditors and employees, but extend to any individuals who are in possession of company property or who are indebted to the company or, indeed, anyone else in the discretion of the court. Unlike section 235 investigations, section 236 investigations require a formal application to the court. If an order under section 236 is made, a director or officer may be required to make a sworn statement as to the nature of his activities in the lead up to the insolvency and may be subject to cross examination in the witness box in relation to any such statement.

A section 236 order is draconian in nature and it is in the discretion of the court as to whether an appropriate order will be made. In deciding this question, the judge is required to balance the need for information with a requirement not to be "unduly oppressive". If, for example, it is the case that the officeholder has a settled intention to pursue the director in any event, say for wrongful trading proceedings, or indeed if the director in question is likely to face criminal proceedings, these are good grounds for refusing to make an order under section 236.

In reality, and in most cases, an officeholder's preference will be to proceed under section 235 on the basis that this is a much simpler and more informal procedure than that laid out under section 236. No application to the courts is necessary. An effective tactic which is often deployed by officeholders is to request information under section 235 and to couple this request with the threat that unless the director in question cooperates, a formal application under section 236 will follow.

FSA investigations and enquiries

Although the risk of Financial Services Authority (FSA) investigations will not be relevant for every company, it is those companies in the regulated sector which have been hardest hit by the impact of the recession. Such companies may also find themselves the object of an FSA investigation or enquiry even if they successfully stave off the risk of insolvency. There are, in essence, four different types of procedure under the Financial Services and Markets Act 2000 ("FSMA"):

  • Section 165 - Powers to require information.
  • Section 166 - Skilled person report.
  • Section 167 - General investigations.
  • Section 168 - Specific investigations.

Section 165 - Powers to require information

Interestingly, although section 165 of the FSMA is often referred to as a type of investigation, it is not so regarded by the FSA itself. Instead, the FSA regards section 165 as an investigatory power, i.e. the power to require information to be given. What is more, if the FSA is seeking information from an authorised person, it may not always invoke the section 165 power. The reason for this is that, under Principle 11, an authorised person is required to disclose any information reasonably required by the FSA.

Section 166 - Skilled person report

Under section 166, the FSA may require a lawyer, accountant, industry expert or similar ("the skilled person") to produce a report. The terms of reference for this report will be set by the FSA. The report will be delivered to the FSA but must be paid for by the regulated company.

Section 167 - General investigations

Section 167 involves the formal appointment by the FSA of an investigator to examine broad issues such as systems and controls in relation to a firm.

Section 168 - Specific investigations

In this instance, the FSA has powers to investigate a specific set of circumstances, such as alleged insider dealing or market abuse. These powers tend to be reserved for the most serious cases.

Are the costs of investigations insured?

The question as to the extent of protection available under most D&O insurance products for directors who find themselves involved in a company investigation, be it insolvency- and/or FSA-related (or indeed related to other proceedings) is a real one. It is well known that many D&O policies sub-limit the amount of cover that is available for this type of exposure. It is also the case that many policies contain language to the effect that the individual concerned must be "required to attend" an investigation and/or that the investigation must be "formal or official" and/or "into the affairs of the company". Each of these preconditions to cover can be contentious and significant in its own right. For example, is a section 235 investigation "formal or official"? Is an FSA investigation under section 165 or 167 an investigation "into the affairs of the company"?

From the insurers' perspective, there are good reasons for limiting the ambit of cover for investigation costs. Carriers will wish to guard themselves against the risk of picking up the tab for every type of investigation in which a company director can find himself or herself embroiled since, after all, the main purpose of the cover is to protect directors from claims, however that term may be defined.

From the directors' perspective, the danger is that they may find themselves having to fund the cost of legal representation up front (or ask their company, if still solvent, to fund such costs) whilst having to engage in a separate coverage debate with their D&O carriers. Such a situation is far from ideal. In order to avoid or minimise the risk of this occurring, it is recommended that directors and their advisers scrutinise carefully (and, if necessary, discuss with the carriers concerned) the nature and scope of cover in this area before purchasing the insurance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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