Insolvency and financial difficulty: Other considerations
This article is based on UK law.
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;
- 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.
