There’s a part of the business that is distinctly risky. How are you going to protect the rest of the company against the potential liabilities?

If you’re an FD in the film production or the utilities sector, then you’ll be comfortable with the concept of ringfencing. In theory, it’s straightforward: separate those riskier parts of the business from the rest. By keeping the company clearly separate, the risk of liability claims being made on the parent is reduced.

In the utilities sector, for example, Ofwat and Ofgem have issued guidelines and proposals for all consumer-facing utility operations to ringfence the delivery services parts of their business so that consumers are protected if the company faces insolvency. Water company AWG ringfenced Anglian Water Services in 2002; as a result Anglian Water Services is financially independent from AWG, the parent company.

Film production companies tend to face high financial risk exposure so they ringfence their operations for each film that they make by establishing special purpose vehicles (SPVs). These separate limited companies control the assets and liabilities for the individual film and ringfence it from the rest of the company’s activities. When acting as the director of a SPV (or any subsidiary company) the director is responsible for that company and must always act in that entity’s best interests – not necessarily those of the parent or holding company.

But let’s say that you aren’t in either of these two sectors. What does an FD need to bear in mind? Personnel, management and cash management systems, all records, insurance policies and day-to-day decisions for the ringfenced company should be kept completely separate from the rest of the group. It must be transparent that each entity of the group operates independently and makes decisions in accordance with the needs of each individual business.

Alicia Videon, partner in restructuring at law firm DLA Piper, says the activities of the subsidiary should be distanced from those of the group and the parent company. “To ringfence potential risks and liabilities properly, the company should be completely separate and run independently from the parent company. Proof of this will be required, which means that minutes of board meetings can be tremendously important as they prove that the company’s board made decisions based on the needs of that particular business and not at group level. They also show what transactions have been made and what business decisions governed them,” says Videon.

Julian Lewis, head of the London corporate team at law firm Halliwells, says that there are two popular ways to ringfence. The first is structural ringfencing where the company is split into different corporate entities, thereby reducing the potential for large claims being made against the parent or more than one of the corporate entities. The second is contractual ringfencing, where the company agrees with its contractors a limit on its responsibility for any liabilities caused during the contract period.

“Most firms do not worry about ringfencing their liabilities and assets unless they are taking significant borrowings,” says Lewis. “Consequently, most of those firms that do ringfence tend to be highly geared and thus highly exposed to financial risk, such as property development companies or firms involved in business ventures which traditionally have a high failure rate.”

Joint venture partnerships can also ringfence potential liabilities from the main group of companies so that commercial and legal risks can be managed outwith the core business entity. Typically, a party will consider entering into a joint venture when it needs help from a third party which will only involve the giving up of an acceptable amount of equity/profit. Joint ventures are not just for the major international companies but can often be the only way in which small and medium-sized enterprises can develop new markets or products.

Another way to ringfence risk is to set up a holding company. This involves creating a new corporate entity through a transfer of assets. Andrew Litchfield, group finance director at manufacturing business AAC Group, says that the company changed its corporate structure in 1999-2000 to protect itself from a potentially crippling legal action made by a larger rival.

“Some years ago we were the sole supplier of coat hangers to clothing retail chain Etam but as soon as we got the contract we were handed a writ for patent infringement from a larger, rival supplier which alleged that we had infringed its coat hanger design,” he explains. “It became clear that any action against us could ruin us, not just because of the possibility of losing, but mainly due to the legal costs that we were facing to fight the case.” As a result, Litchfield’s companny had to not only negotiate a settlement, but also arrange how they could protect themselves from potentially ruinous litigation from reoccurring in the future.

Litchfield says that the first step was to create a holding company. “Once we had set up the holding company, we moved all our assets out of the direct line of fire,” says Litchfield. “At the time we only had one trading company – we now have 15 – and we transferred buildings, tools, and other assets to the holding company. Shares in the trading company were also transferred to the holding company on a one-for-one basis.”

Fortunately, says Litchfield, legal action was averted, although the company was still left with a £20,000 bill for legal services and other items. These included the cost of having its manufacturing tools smashed up and selling its stock to another supplier as part of the legal settlement which took six months to agree. 

The problem with pensions

However, not all company liabilities can be so easily ringfenced. Under the 2004 Pensions Act, which came into effect last year, the parent company, or any other corporate entity within the group of companies, could be held liable for the deficits in the defined benefit pension schemes if a company in the group was unable to fill the shortfall itself. These could potentially be massive, crippling sums.

The regulator may direct that the employer and persons “connected with” or “an associate of” an employer (which could include individuals, companies and partnerships) implement financial arrangements to meet the pension liabilities of an employer if at the relevant time the employer is a service company or insufficiently resourced. An employer is defined as a service company if its turnover is principally derived from providing services to other group companies. An employer is insufficiently resourced if the value of its resources is less than 50 per cent of the statutory debt and the value of the resources of a connected or associated person plus the employer’s is 50 per cent or more of the statutory debt.

“The new Pensions Act makes it clear that pension liabilities cannot be ringfenced in the same way as other risks to the business,” says DLA’s Videon. “As a result, companies – and particularly FDs – need to be aware that even if they do structure the group of companies in such a way as to minimise the risk of potential legal and financial liabilities, ringfencing cannot provide 100 per cent protection. Companies should look at other measures to minimise risk, such as better risk management and insurance,” she adds.

Neil Hodge is a writer on business and IT issues.

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