The BHS Scandal – the law unwrapped

November 7th, 2016 by Julian Wilson

The collapse of BHS into administration left 11,000 employees facing an uncertain future and 20,000 current and future pensioners facing substantial cuts to their entitlements. According to the Work and Pensions Select Committee, BHS encapsulates many of its ongoing concerns about the regulatory and cultural framework in which business operates, including the ethics of business behaviour, the governance of private companies, the balance between risk and reward, mergers and acquisitions practices, the governance and regulation of workplace pension schemes, and the sustainability of defined benefit pensions.   

I want to briefly consider 3 aspects of the law as they relate to BHS: (1) Remedying the pension deficit; (2) The dividends and the deficit; (3) The Directors’ duties and the degree of regard to the position of employees and pensioners.

(1) Remedying the Pension Deficit

The Committee’s Report concluded that Sir Philip Green bore a responsibility for the BHS pension deficit. The Pensions Regulator, which initiated an anti-avoidance investigation in relation to BHS in March 2015, has now started enforcement action against Sir Philip, Taveta Investments Limited and Taveta Investments (No.2) Limited. Warning notices have been served together with statements of the Regulator’s case as to why they should be liable to support the BHS pension schemes. Those notices set out the evidence supporting the intended use of the Pension Regulators’ Contribution Notice powers under s. 38 Pensions Act 2004 and Financial Support Direction powers under s. 43.

These powers enable the Regulator to counter avoidance of pension funding obligations and reduce the exposure to claims on the Pension Protection Fund. They are referred to as “moral hazard provisions” because they are intended to counter a lack of incentive amongst directors to guard against pension fund deficit risks where the PPF offers protection from the consequences. The Regulator can look behind the corporate structures and impose liabilities on third parties connected to, or associated with, a scheme’s sponsoring employer, who are party to acts or failures to act, including knowing assistance, which were aimed at avoiding a statutory debt to the scheme. A Contribution Notice demands a specified sum of money, and a Financial Support Direction requires respondents to put ongoing support in place for a pension scheme. 

The Warning Notices give the respondents time to respond with their comments and representations, which the Regulator has to consider before the case can be passed to the Determinations Panel.  It is that Panel that decides whether the powers are to be exercised. Determination Notices of the Panel that are challenged are referable to the Upper Tribunal, which considers the case afresh. The process therefore looks very much more of a long haul than a short hop.

The contents of the Warning Notices issued are not public. There has been speculation as to whether the acts or omissions relied upon by the Regulator include a failure to notify it of the decision to proceed with the controversial sale of BHS to former bankrupt Dominic Chappell in March 2015 for £1 under the ‘notifiable events regime’ contrary to section 69 of the Pensions Act 2004. It seems clear, however, that the acts or omissions relied on are unlikely to refer to the controversial dividends paid out of BHS apparently in excess of profits because those payments were made in 2002 to 2004, well outside the 6 year qualifying period in s.38.

(2) The dividends and the deficit

According to the Committee’s Report, the total dividends paid by BHS Ltd in the 2002–04 period were £414 million, representing almost double the after-tax profits of the company of £208 million. In the same period, BHS Group, the parent, paid dividends of £423 million.

How did this happen when both the Companies Acts (s.263 CA 1985 at the time, now s.830 CA 2006) and the common law capital maintenance rule (see Progress Property in the SC) prohibit companies from making distributions other than from profits available?

The answer lies, it seems, in the small print of the definition of a company’s profits available for distribution and applicable accounting standards. A private company’s profits available for distribution are its accumulated, realised profits (so far as not previously distributed or capitalised) less its accumulated, realised losses (so far as not previously written off in a reduction or reorganisation of its share capital) (section 830(2)). Under applicable accounting standards, negative goodwill –the value arising on the purchase by a company of another entity for a price less than the value of that entity’s net assets- when recognised in the profit and loss account of the purchaser, represents a realised profit. The dividends paid by BHS included the value of amortised negative goodwill, being the difference in the value of the net assets acquired when BHS was bought and the purchase price that was paid for it. This effectively enhanced the profits available for distribution to shareholders by over £100m.

The dividends paid also included value from the sale by in 2001 of a number of BHS stores. These were sold to a Jersey company ultimately owned by Lady Green, which leased them back to BHS. The rental no doubt paid the Jersey company’s borrowing costs. This sale enhanced the BHS P&L account and made another £100m of value available for extraction by the shareholders by way of dividend.

As the Committee found, the dividends extracted by the shareholders in the short term, effectively removed value from the BHS companies in the long term, precluding its use by the companies for purposes such as investment or pension contributions.

Such forms of financial engineering, if it is right to characterise them as such, were lawful and were not uncommon. The prevailing cultural view did not favour the law’s philosophy of capital maintenance but regarded its restrictions as “dividend traps” impacting the ability of shareholders to realise value in the short term. Prominent accounting firms readily offered advice on the restructuring options that could be used to unlock the value of a company for its shareholders on what they called a “timely basis”. Sir Philip himself used such a restructuring solution to enable the subsequent Arcadia dividend. It is now a matter for the lawmakers to decide whether, ultimately, it was this culture or deficiencies in the law itself, which caused the harm to employees, pensioners and the community.

(3) The Directors’ duties and the degree of regard to the position of employees and pensioners.

On 16 September 2016, the Select Committee on Business, Innovation, and Skills launched an inquiry following the corporate governance failings highlighted by BHS. Its Terms of Reference are as follows: “Is the duty to promote the long-term success of the company clear and enforceable? How are the interests of shareholders, current and former employees best balanced?” Those TOR clearly call for an analysis of the workings of s.172 Companies Act 2006: Duty to promote the success of the company. It provides that a director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to the so-called Enlightened Shareholder Value interests of: the likely consequences of any decision in the long term, the interests of the company’s employees, the impact of the company’s operations on the community and the environment, and the desirability of the company maintaining a reputation for high standards of business conduct.

Such an analysis seems hardly necessary. The section’s shortcomings were known of before it was enacted and have been the stuff of law student essays ever since. As has been stated many times, the section pays lip service to, and offers no real protection for, the interests of employees or the wider community because: (1) it gives priority to shareholder interests (as arguably the nature of a company as an association for the purposes of profit philosophically requires); (2) it leaves the degree of enlightened regard to employees and the community as a matter for the individual director’s own subjective consideration; (3) there is no enforcement mechanism when the duty is owed only to the company; (4) it always smacked of mere tokenism. The answer to this inquiry is likely to be that the duties of directors are not the right mechanism for protecting the interests of employees, pensioners and tax payers and what is required is either a more direct form of statutory regulation, employee participation on boards or employee shareholdings.

Julian Wilson


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