Void and voidable transactions on insolvency

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1 Restructuring and Insolvency briefing Spring 2012 Void and voidable transactions on insolvency Summary and implications When a company enters into a formal insolvency process, the administrator or liquidator appointed to it will investigate whether transactions took place in the period prior to the formal process which may have prejudiced any or all of the creditors of the company. Where such transactions exist, there are a number of possible actions which the administrator or liquidator (and in some cases, any victim of the transaction) can take to reverse the effects of the transaction or otherwise compensate affected creditors. We summarise below the main potential causes of action under English insolvency legislation and the criteria that would need to exist for there to be a successful challenge. Ask a question If you have any questions please contact Glen Flannery, Partner T +44 (0) g.flannery@nabarro.com The Restructuring and Insolvency team To find out more about the team, and our capabilities click here Avoidance of property dispositions (section 127 Insolvency Act This applies when a company goes into compulsory liquidation. Any of the following transactions entered into after the presentation of a winding-up petition and before a winding-up order is granted against the company, will be void, unless ratified by the court: a disposition of the company s property; a transfer of shares; or an alteration in the status of the company s members. Transactions at undervalue (section 238 Insolvency Act This applies when a company goes into administration or liquidation. If the following criteria all exist, the transaction will be vulnerable to challenge by the administrator or liquidator as a transaction at undervalue: the company has given a gift to another party, or entered into a transaction with another party for a consideration the value of which is significantly less than the value of the consideration provided by the company; 1

2 this occurred within two years prior to the date on which the administration or liquidation process is deemed to have commenced; and at the time of the transaction, the company was unable to pay its debts within the meaning of section 123 of the Insolvency Act 1986, or it became unable to do so in consequence of the transaction. Under section 123, a company will be considered unable to pay its debts if (among other things) it is either cash-flow insolvent or balance sheet insolvent. If the transaction is entered into with a connected party, inability to pay debts is presumed, albeit this presumption is rebuttable with contrary proof. However, the transaction may be protected if the statutory defence applies: namely that the company entered into the transaction in good faith for the purpose of carrying on its business and at the time of doing so, reasonably believed that the transaction would benefit the company. Transactions defrauding creditors (section 423 Insolvency Act In effect, transactions defrauding creditors are transactions at undervalue (see above) but with the additional requirement that there was a motive to put assets beyond the reach, or otherwise prejudice the interests, of a person who has made or may make a claim against the company. Particular differences to transactions at undervalue are that: the purpose of the transaction is more important than for a transaction at undervalue. According to current case law, what matters is whether the purpose (or a substantial purpose) of the transaction is to prejudice creditors; the action is not dependent upon the company being unable to pay its debts at the time of, or becoming so in consequence of, the transaction. Indeed, at the time of the transaction, the company need not even have had any creditors; there are no specified time limits in which the transaction must have occurred. Unlike a transaction at undervalue, the effluxion of two years from the date of the transaction without there being a formal insolvency process will not prohibit an action; and the company need never become subject to any formal insolvency process: an application can be made against the company by any victim of the transaction (usually a creditor) as well as by an administrator or liquidator or the supervisor of a voluntary arrangement. Preferences (section 239 Insolvency Act This applies when a company goes into administration or liquidation. If the following criteria all exist, the transaction will be vulnerable to challenge by the administrator or liquidator as a preference: the company has done anything or suffered anything to be done which has the effect of putting any of its creditors or any surety or guarantor of the company s liabilities into a better position than they would have been in the event of the company going into insolvent liquidation; 2

3 this occurred within six months (two years where the recipient of the preference is connected to the company) prior to the date on which the administration or liquidation process is deemed to have commenced; at the time of the transaction, the company was unable to pay its debts within the meaning of section 123 of the Insolvency Act 1986, or it became unable to do so in consequence of the transaction. Under section 123, a company will be considered unable to pay its debts if (among other things) it is either cash-flow insolvent or balance sheet insolvent. Unlike a transaction at undervalue, this is not presumed for a connected party; and in giving the preference, the company was influenced by a desire to put the receiving party into a better position. This is a subjective test. It is the company s mindset that is relevant, not the mindset of the receiving party. The desire is presumed if the preference is given to a party connected to the company, but this is rebuttable with proof to the contrary. Extortionate credit transactions (section 244 Insolvency Act This section applies when a company goes into administration or liquidation. If the following criteria all exist, the transaction will be vulnerable to challenge by the administrator or liquidator as an extortionate credit transaction: having regard to the credit risk accepted by the provider of credit, the terms are/were such as to require grossly exorbitant payments to be made or the terms otherwise grossly contravened ordinary principles of fair dealing; and the transaction occurred within three years prior to the date on which the company entered administration or liquidation. Avoidance of certain floating charges (section 245 Insolvency Act This section applies when a company goes into administration or liquidation. A floating charge granted by a company will be invalid and challengeable by the administrator or liquidator (except to the extent set out further below) if: it is granted within 12 months (two years where the recipient is connected to the company) prior to the date on which the administration or liquidation process is deemed to have commenced; and where the recipient is not connected to the company, at the time of granting the floating charge, the company was unable to pay its debts within the meaning of section 123 of the Insolvency Act 1986, or it became unable to do so as a consequence of granting the floating charge. Under section 123, a company will be considered unable to pay its debts if (among other things) it is either cash-flow insolvent or balance-sheet insolvent. In the case of a recipient who is connected with the company, insolvency is not a requirement for there to be a finding of an invalid floating charge. 3

4 That is, the floating charge will be invalid irrespective of solvency, if the other elements of section 245 are satisfied. However, the floating charge will not be invalid to the extent of the aggregate of: the value of the money paid, or goods and services supplied, to the company at the same time as, or after, the creation of the charge; the value of any discharge/reduction of any debt of the company, at the same time as, or after the creation of, the charge; and the amount of such interest (if any) as is payable on the amount falling within either of the above bullet points in pursuance of any agreement under which the money was so paid, the goods or services were so supplied, or the debt was so discharged/reduced. Directors Directors of financially constrained companies (and, in the case of transactions defrauding creditors, directors of all companies regardless of the company s financial position) therefore need to be aware of the provisions outlined above. Where a company has entered into a voidable transaction, its directors can be held personally liable for their role in the transaction. Entry into such a transaction would also be a relevant adverse factor in any subsequent disqualification proceedings brought against a director. Where a company has entered into a voidable transaction, its directors can be held personally liable for their role in the transaction Third parties The range of orders that the court may make where there is a successful challenge to a transaction is wide, and they do have the potential to affect third parties who have obtained an interest in property or a benefit from the transaction. Where the court makes an order in respect of a transaction at undervalue or a preference, there is some legislative protection afforded to genuine third parties who have acted in good faith and for value. However that protection is not available to the actual counter-party to the transaction. There is a presumption that a connected party who has received an interest in property or a benefit from the transaction acted otherwise than in good faith. By remaining alive to the relevant actions and criteria, and by taking advice, persons dealing with financially troubled counter-parties can assess the prospects of future challenge to any transaction in the making, and where necessary take steps to avoid or mitigate identified risk. 4

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