Insolvency litigation briefing - September 2015

30 September 2015


Our dedicated insolvency litigation team bring you their monthly update on the cases and issues affecting the insolvency and fraud investigation industry.

No breach of duties under the Companies Act 2006 where a director acts honestly, reasonably and on professional advice

The Chancery Division refused an application by a liquidator to recover a company's losses where assets had been transferred to an associated company for deferred consideration immediately prior to liquidation.

Background

In Hedger (Liquidator of Pro4sport) Ltd v Adams, Adams was the sole director and majority shareholder in Pro4sport Ltd (P) and an associated company (AC).

Adams was advised by a business advisory company (BCIA) that P's insolvency was inevitable and that his options were to either sell its assets to AC or for the liquidator to sell them either as a going concern or on the open market at auction. Valuations obtained valued P as a going concern at £37,000 plus £15,000 for good will and its assets at £24,000. Adams was also advised there were serious concerns about P's business model and profitability if sold as a going concern.

AC's major suppliers confirmed they would continue to extend credit to it and Adams' evidence was that he honestly believed AC would be able to honour any payments if it acquired P's assets. On that basis, shortly before P's liquidation, and on BCIA's advice, Adams transferred all P's assets to AC, subject to a retention of title clause, for a wholly deferred consideration of £56,400.

The liquidator adopted the contract (without either complaint or a request for a personal guarantee) and agreed a schedule of repayment with Adams. Repayments were initially maintained but AC later went into liquidation with £20,490 of the deferred consideration still outstanding.

The liquidator sought to recover this sum from Adams alleging breach of duties to P, having failed to sell the assets for the best price achievable, having sold on a risky deferred consideration basis, having failed to provide a personal guarantee and having failed to seek proper approval for substantial property transactions (ss172 and 174 Companies Act 2006 (CA)).

Decision

The High Court held that Adams had considered the creditors' interests by completing the sale quickly and avoiding the liquidator's costs of sale, which would most likely have been for a lower figure at auction. He was not obliged to seek or pay the maximum figure on the valuations. He had taken advice and considered that a sale to AC on a deferred basis was a better deal for creditors than no sale at all or a sale by the liquidator. Adams honestly believed AC would continue to trade and be able to make the payments. The liquidator had not seen fit to avoid the contract on appointment and had agreed a repayment schedule without seeking a guarantee.

Adams had sought professional advice which was an important (though not determinative) factor in deciding whether he was in breach of duty. The court found he was not, and even had he been, relief would have been granted under s1157 CA as he had acted honestly, reasonably and on advice.

Comment

The duty imposed on directors to act in the interest of the company is a subjective one - whether the particular director honestly believed that his act or omission was in the interest of the company - and not whether, when viewed objectively, the particular act or omission was in fact in the interests of the company, or whether a different director would have acted differently. The fact that Adams had received independent advice and acted in line with that advice went a long way to satisfying the court he had not acted in breach of his duties.


Insolvent company's preference of director unravelled

The High Court unravels transactions entered into by an insolvent company intended to prefer its directors over its creditors.

The background

In Re Finch UK Ltd (in Liquidation) v Finch and another, the claimant was a property development company and the defendant husband and wife were its directors and shareholders. The defendants sold various properties to the company to be held for their family trust. At the same time, 875,000 redeemable shares of £1 each were created in the claimant and allocated to Mr Finch. They were paid for by debiting £875,000 to his director's loan account which stood at over £900,000 in credit, reflecting the value of the properties he had transferred to the claimant.

On 11 January 2008, Mr Finch and the claimant agreed that those shares were not redeemable until January 2009. However, on 14 January 2008, following an EGM, a special resolution was passed to make them redeemable on demand. Mr Finch immediately sought to redeem them. The sum of £875,000 was re-credited to his loan account with the effect that the properties held in trust by the claimant were returned and reflected in his loan account.  

The claimant went into creditors' voluntary liquidation less than six months later with a deficit of over £1 million. The liquidators sought a declaration, among other things, that the defendant had received a preference from the company when it was at serious risk of insolvency.

The court's findings

The High Court found that by making the adjustments to his loan account by re-transferring the properties, the claimant had put Mr Finch in a better position than he would otherwise have been in, in the event that the claimant went into insolvent liquidation; namely the properties would form part of his assets, not the claimant's. The requirements of s239 of the Insolvency Act 1986 were satisfied and the preference had been given at a relevant time.

The court did not accept Mr Finch's explanation for the redemption, being to eliminate a debt balance in his loan account to avoid taxation on himself and the claimant. It also concluded that Mr Finch was aware that the company was at serious risk of insolvency at the date of redemption. His intention had been to extricate the properties from the claimant in order to preserve them for the benefit of his family. On the evidence, the court was satisfied that the liquidators had discharged the burden of showing that the company was in financial difficulties in 2007 and insolvent at the time of the redemption.

Further, the court found that, in any event, redeemable shares could only be redeemed out of profits available for distribution to the company (s160 Companies Act 1985) and the company had insufficient profit to redeem them all at the relevant time. The redemption was therefore unlawful and a breach of the directors' duties which could not be validated by the defendants' unanimous agreement.

The share redemption would be cancelled and the company would retain the beneficial interests in the various properties debited to the director's loan account in January 2008.

Comment

The court also held that unlike in the Adams case above, no relief should be granted to the defendants under s727 Companies Act 1985 or s1157 Companies Act 2006. They had failed to rebut the presumption of intention to prefer themselves. They had failed to seek legal advice as to their duties as directors and had not acted honestly or reasonably nor ought fairly to be excused. Mrs Finch's abrogation of the discharge of her duties as director, leaving everything to her husband, was of itself held to be unreasonable.

The fact that the defendants didn’t take advice in this case, different to the Adams case above, may have proved fatal here as, had they done so, they would more than likely have been advised not to proceed with the redemption given the solvency of the company.


Defence to wrongful trading claim - where does the burden of proof lie?

The High Court has clarified where the burden of proof lies in establishing a defence under s 214 of the Insolvency Act 1986.

The background

In Brooks and Willetts (Joint Liquidators of Robin Hood Centre PLC) v Armstrong and Walker, the defendants were directors of a company which went into liquidation in February 2009. The liquidators sought contributions from the directors to the company's assets pursuant to s214 of the Insolvency Act 1986 (IA) on the basis the directors were guilty of wrongful trading.

The liquidator argued that the year-end accounts for 2005 - 2007, a large VAT liability and an impending rent rise all indicated that there was no reasonable prospect of the company avoiding insolvent liquidation. Despite this evidence, the directors had continued to trade, thereby increasing the losses of the company.

The decision

The High Court held that once it had been established that the director knew or ought to have concluded that there were no reasonable prospects of avoiding insolvent liquidation, the onus in establishing a defence under s 214 (3) IA (that he had taken every step within his power to minimise the potential loss to the company's creditors) was on the director. It was not for the liquidator to prove that the director did not take all necessary steps. If the director could establish the defence, no compensation order would be made.

The liquidators had to prove the directors' knowledge of insolvency only at some time before the winding-up rather than as at a particular date. There was no duty not to trade while insolvent if the directors anticipated profits in the foreseeable future for the benefit of existing creditors.

On the evidence, and applying the reasonably diligent director test, balancing the adverse consequences of liquidation against the potential benefits of trading, the directors were not wrong to continue to trade initially.

However, once they knew, or ought to have known, that the company had no reasonable prospects of avoiding insolvent liquidation, it was for the directors to establish that they had done everything in their power to minimise the potential loss. The court found that this date was by May 2007. Whether the directors had taken every step, or not, had to be judged by reference to all the creditors as a whole.    

Although the directors had continued to pay trade creditors, they had not paid other creditors. As a result, the losses to the creditors as a class continued to increase. The requirement to take every step was aimed at minimising losses for all creditors and so the defence was not made out. Compensation orders would be made.

Comment

It should be noted that the guidance on the burden of proof given by the court in this case is contrary to the guidance as set out in Sealy & Milman: Annotated Guide to the Insolvency Legislation (2015) 18th edition in which it is stated:

"On principle and, it is submitted, on the language of the section, the onus of proof to show that a director has failed to take every step that he ought to have taken should be on the liquidator".

The court disagreed with that construction as it considered it was not the natural construction of the words used and it did not make sense to require the liquidator to prove the director took every step. It considered that if Parliament had intended the burden to be on the liquidator it would have expressly provided that a declaration would not be made unless the applicant satisfied the court that 'every step' had been taken. It was right and appropriate for the directors, who were continuing to trade knowing there was no reasonable prospect of avoiding insolvent liquidation, to justify continuing to trade in those circumstances.

Dishonesty is not required in wrongful trading cases. As the burden of proof is therefore lower than in fraudulent trading claims, readers will themselves be aware that wrongful trading claims tend to be easier for liquidators to pursue.


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