Financial difficulty and insolvency: Other considerations

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on  Financial difficulty and insolvency.

Other guides in this series address minimising the risks of liability; and how personal liabilities can arise.

Transactions at an undervalue

A transaction will be regarded as being at an undervalue if the company does not receive any consideration for it – or the value of what it receives is significantly less than the value of what it provides. Examples of transactions at an undervalue include:

• making a gift;
• selling an asset for a price significantly less than its value;
• guaranteeing a debt due from another group company.

A court can set aside a transaction at an undervalue and rule that a director has to help “make good” the difference in value if:

• the company is in liquidation or administration;
• the transaction was made within two years before the start of the liquidation or administration;
• the company was unable to pay its debts at the time of the transaction or became unable to pay its debts as a consequence of the transaction; and
• the liquidator or administrator has made an application to the court for an order.

If the transaction is with a “connected person”, there is no need to prove that the company was unable or became unable to pay its debts. Connected persons are broadly defined: they include directors and shadow directors and their “associates” (employers, close relatives, partners, companies controlled by them or their associates) and the associates of a company (other group companies).

A defence will be available if a court is satisfied that a company entered into a transaction in good faith and for the purpose of carrying on its business and there were reasonable grounds for believing that the transaction would benefit the company. This defence protects a wide range of bona fide business transactions that might otherwise be vulnerable.

Preferences

A “preference” occurs when a company does anything, or allows anything to be done, that puts one of its creditors, sureties or guarantors in a better position. Examples of preferences include:

• payment of one creditor in full or in part when others remain unpaid;
• granting security in respect of existing debts;
• agreeing to pay a sum for services significantly more than their value;
• making gratuitous payments to employees.

A preference can only be set aside if:

• the company is in liquidation or administration;
• the preference was made within six months before liquidation or administration – or two years in the case of transactions with “connected persons” (see above);
• the company was unable to pay its debts at the time it made the preference or became unable to do so as a result of the preference;
• the liquidator or administrator has made an application to the court for an order.

A transaction will only be deemed to be a preference (and therefore be capable of being set aside) if a company was “influenced by a desire” to put a creditor or guarantor in a better position. It is not enough for a liquidator or administrator to show that a company was aware that the transaction would put a creditor in a better position – a positive wish to achieve this end is needed. Thus, a transaction made for a proper commercial reason is unlikely to fall within this provision.

A liquidator or administrator will generally look very carefully at transactions that benefit directors or their associates, either directly (e.g. paying directors’ salaries or repaying directors’ loan accounts) or indirectly (e.g. paying off an overdraft guaranteed by a director). Any requests by banks to secure current loans would therefore need to be examined carefully.

If the transaction is with a connected person, a company is presumed to have been influenced by a desire to put the creditor in a better position.

Void floating charges

A floating charge over the company’s assets may be invalid if all of the following apply:

• the company has gone into liquidation or administration;
• the charge was created within 12 months before the start of the liquidation or administration – or two years if made in favour of a connected person;
• the company was unable to pay its debts at the time the charge was created or became unable to do so as a consequence of the charge.

If the charge is created in favour of a connected person, there is no need for a liquidator or administrator to prove that a company was or became unable to pay its debts at the time or as a result of the transaction.

A floating charge will not be regarded as invalid if fresh consideration was provided for the security. The following are regarded as fresh consideration: money paid, or goods or services supplied to a company; the discharge of any of a company’s debts; interest payable under an agreement for the payment of money, supply of goods or services or discharge of debts.

It should be noted that under the provisions for transactions at an undervalue, preferences and floating charges, a company is deemed unable to pay its debts if it is proved that the value of its assets is less than the amount of its liabilities taking into account its contingent and prospective liabilities.

Unlawful distributions

Assets may be passed to a company’s members only if there are distributable profits (i.e. accumulated realised profits less accumulated realised losses) available for this purpose. If there are insufficient distributable reserves, a transactionwith or payment to a shareholder could constitute an unlawful distribution of capital.

Directors of insolvent companies may breach their duties to creditors by making gratuitous distributions of assets. Such breaches cannot be waived by the shareholders.

These principles may also apply to distributions to persons connected with shareholders, for example, other group companies.