Chapter 10: Insolvency II – Directors’ liabilities and voidable transactions

Question 1

Fraudulent Trading

Liability of directors of an insolvent company

Answer 1

When a company faces the prospect of entering into an insolvency procedure, the directors need to be extremely careful in how they act, since they may be held to be personally liable to compensate the company and its creditors if found guilty of one of the following:

• Fraudulent trading (s 213 / 246ZA IA 1986)
• Wrongful trading (s 214 / 246ZB IA 1986)

Liquidators and administrators have the power to bring proceedings for compensation against the directors personally (for fraudulent trading and wrongful trading).

Question 2

Liability of directors for fraudulent trading

Answer 2

The provisions on fraudulent trading were enacted to prevent the abuse of limited liability by those running companies.

The concern is that directors may continue to trade and incur further debts at a time when the company is in financial difficulty, with the result that losses to creditors are increased. Therefore, the IA 1986 gives the court power to impose both criminal and civil sanctions on directors (and other persons, see below) if they are found guilty of fraudulent trading. However, claims for fraudulent trading are rare due to the evidential requirements in proving an intent to defraud creditors (see below).

Question 3

Claim for fraudulent trading

Answer 3

A claim for fraudulent trading may be made by a liquidator (s 213 IA86) or an administrator (s 246ZA IA86) by making an application to court. The provisions in s 246ZA reflect those in s 213 IA86 with the necessary changes for administration and liquidation, respectively.

Question 4

Fraudulent trading

Answer 4

• any person (s 213(2) and s 246ZA(2))
• who is knowingly party to the carrying on of any business of the company
• with intent to defraud creditors or for any fraudulent purpose (s 213(1) and s 246ZA(1)).

Although claims for fraudulent trading are usually brought against directors, ‘any person’ is a wide definition and includes banks, who may also be liable for fraudulent trading by virtue of their employees’ knowledge (Morris v State Bank of India[2005] 2 BCLC 328).

Question 5

Section 213 & Civil Liability

Answer 5

Sections 213 (in liquidation) and 246ZA (in administration) IA 1986 impose a civil liability to contribute to the funds available to the general body of unsecured creditors suffering loss caused by the carrying on of the company’s business with intent to defraud.

There is also a corresponding criminal claim for fraudulent trading under s 993 CA 2006.

Question 6

Actual Dishonesty

Answer 6

Actual dishonesty must be proven for a claim for fraudulent trading to succeed. Examples of the meaning of dishonesty and fraud are set out below.

Dishonesty is assessed on a subjective not objective basis ie what the particular person knew or believed. Knowledge includes blind-eye knowledge, which requires a suspicion of the relevant facts together with a deliberate decision to avoid confirming that they did exist.

Question 7

Actual Dishonesty

Answer 7

The meaning of fraud for the purposes of s 213 has been defined as requiring “real dishonesty involving, according to current notions of fair trading among commercial men at the present day, real moral blame.” (Re Patrick and Lyon Ltd[1933] Ch 786).

Question 8

Two-Stage Test

Answer 8

More recently, the court has formulated a two-stage test. First, the liquidator needs to demonstrate the director’s subjective state of knowledge and then second, show that the director’s conduct was dishonest applying the objective standards of ordinary decent people (Ivey v Genting Casinos [2018] AC 39).

It is not necessary to show that all of the company’s creditors have been defrauded. Provided at least one creditor has been defrauded, this will be enough to bring a claim.

Question 9

Remedies

Answer 9

A person found to be liable under s 213 / 246ZA can be ordered to make such contribution to the company’s assets as the court thinks proper. The court does not have the power to include a punitive element in the amount of any contribution to be made. The contribution should only reflect and compensate for the loss caused to the creditors.

Any sums recovered are held on trust for the unsecured creditors generally and not for the defrauded creditor.

Question 10

Disqualification Order

Answer 10

Where the court makes an order against a person under s 213 / 246ZA, and that person is also a director, the court is likely also to make a disqualification order under s 10 Company Directors Disqualification Act 1986 (CDDA 1986).

Question 11

Criminal Sanctions

Answer 11

In addition, criminal sanctions can be imposed by the court under s 993 CA 2006, to punish a person knowingly party to fraudulent trading, whether or not the company is being wound up. The penalties are imprisonment (of up to 10 years on indictment) and/or fines.

Question 12

Fraudulent Trading v Wrongful Trading

Answer 12

In practice, a very high standard of proof is required for a successful claim in fraudulent trading, which is likely to be extremely difficult for a liquidator or an administrator to establish.

It is for this reason that claims for fraudulent trading are rare and claims for wrongful trading under s 214 / 246ZB IA 1986 are more often brought against directors.

Question 13

Summary

Answer 13

• Claims for fraudulent trading may be brought by a liquidator or an administrator.
• The claim can be brought against any person who is knowingly party to the carrying on of any business of the company with intent to defraud creditors or for any fraudulent purpose, including directors and banks.
• Actual dishonesty must be proven on a subjective basis.
• A person found to be liable can be ordered to make such contribution to the company’s assets as the court thinks proper. There is no punitive element to the remedy however – the contribution should only reflect and compensate for the loss caused to the creditors.

Question 14

Summary

Answer 14

• The court is likely also to make a disqualification order under s 10 CDDA 1986 where a director has been found liable for fraudulent trading
• There is also a criminal claim for fraudulent trading under s 993 CA 2006. The remedies for this are up to 10 years’ imprisonment or fines.

Question 15

Wrongful Trading

The claim for wrongful trading

Answer 15

Liability for fraudulent trading existed long before liability for wrongful trading was introduced. However, the requirement for proof of dishonest intent to establish liability for fraudulent trading has meant that proceedings for fraudulent trading were and are rarely brought.

Following criticism of the ineffectiveness of the fraudulent trading provisions, the concept of wrongful trading was introduced in order to establish liability for directors who carry on business negligently rather than fraudulently.

Question 16

Can be brought by a liquidator or administrator

Answer 16

A civil claim for wrongful trading can be brought against a director by a liquidator under s 214 or an administrator under s 246ZB IA 1986. There are no criminal provisions for wrongful trading, in contrast to fraudulent trading which is both a civil and a criminal wrong.

Question 17

Major Risk

Answer 17

Wrongful trading is now the major risk run by the directors of a company trading on the brink of insolvency. Directors must take the risk of liability for wrongful trading seriously and it is an important part of a lawyer’s job to advise on the risk and how to mitigate it.

Question 18

Purpose of wrongful trading

Answer 18

The purpose of s 214 and 246ZB is to ensure that when directors become aware (or ought to become aware) that an insolvent liquidation (or insolvent administration, as the case may be) is inevitable, they are under a duty to take every step possible to minimise the potential losses to the company’s creditors.

Question 19

Compensation

Answer 19

If they fail to do this, the court can, under s 214 and 246ZB, order the directors to contribute to the insolvent estate by way of compensation for the losses that the general body of creditors have suffered as a result of the directors’ conduct, and thereby, increase the funds available for distribution to unsecured creditors in the insolvency.

Question 20

Personal Liability that is easier to prove

Answer 20

Wrongful trading liability therefore imposes personal liability on directors and marks a very important exception to the principle of limited liability under which those who run a company cannot be liable for its unpaid debts.

Since there is no requirement to show intent or dishonesty, it is easier for a liquidator or administrator to prove wrongful trading than it is fraudulent trading.

Wrongful trading is about the directors failing to make the right judgements about the company’s financial prospects and then failing to take steps to minimise losses to the creditors.

Question 21

Who may bring a claim? - s 214(1) / 246ZB(1)

Answer 21

A claim for wrongful trading may be brought by:

• Liquidators under s 214(1), and
• Administrators under 246ZB(1).

Administrators and liquidators can also now (under the SBEEA 2015) assign wrongful trading claims to a third party as a way of raising funds for the insolvent estate and thereby, avoid the risk of litigation.

Question 22

Against whom may a claim be brought?

Answer 22

A claim may be brought against any person who was at the relevant time a director.

This includes shadow directors as defined in s 251 CA 2006, de facto and non-executive directors as well as executive directors.

Contrast this with fraudulent trading where a claim can be brought against a wider scope of persons than just the directors; this claim can be brought against any person who was knowingly party to the carrying on of the company’s business with intent to defraud creditors.

Question 23

Requirements for liability – s 214(2) / 246ZB(2)

Limb 1

Answer 23

Limb one:

The court must be satisfied that the company has gone into insolvent liquidation or administration and:

1. at some time before the commencement of the winding up or insolvent administration (for convenience, that time is referred to as the ‘point of no return’) and
2. the director knew or ought to have concluded that
3. there was no reasonable prospect that the company would avoid going into insolvent liquidation (or insolvent administration).

Question 24

Assets are insufficient to the payments of debt

Answer 24

Note that a company goes into insolvent liquidation (or as the case may be, an insolvent administration) at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of winding up or administration (s 214(6) / 246ZB(6)).

Insolvency for wrongful trading purposes is therefore judged solely on the ‘balance sheet test’ and not on the ‘cash flow test’ (see s 123 IA 1986).

Question 25

Consideration of Limb 2

Answer 25

Only if the directors know or ought reasonably to know that they cannot avoid a liquidation or administration of their company do they need to consider limb two. If directors assess on reasonable grounds that at a particular moment in time, they consider the company has reasonable prosects of avoiding an insolvency, they do not satisfy limb one and there are no further steps they need take from a wrongful trading point of view.

If, however, they have concluded or ought reasonably to have concluded that there is no reasonable prospect of avoiding an insolvency, they must go on to consider limb two.

Question 26

Continued Trading

Answer 26

It must, therefore, beproven that:

• the director in question allowed the company to continue to trade during the period in which they knew or ought to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation or administration, and
• that the continued trading made the company’s position worse.

Note however, if the company has not reached the point of no return, then wrongful trading liability cannot arise and there is no need to consider the ‘every step’ defence which we consider below.

Question 27

Every Step Defence

Answer 27

Assuming the company has reached the point of no return, a director may be able to escape liability if they can satisfy the court that, after they first knew or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvent administration or liquidation (ie from the ‘point of no return’ onwards), they took every step with a view to minimising the potential loss to the company’s creditors.

Question 28

Examples of evidence that may be supportive of establishing the every step defence include:

Answer 28

• Voicing concerns at regular board meetings;
• seeking independent financial and legal advice;
• ensuring adequate, up-to-date financial information is available;
• suggesting reductions in overheads/liabilities;
• not incurring further credit with someone who is not an existing creditor or increasing credit owed to an existing creditor; and
• Taking advice on steps such as initiating appropriate insolvency procedures or negotiating with creditors to restructure its liabilities.

Question 29

The ‘reasonably diligent person’ test – s 214(4) / 246ZB(4)

Determination

Answer 29

The court applies the ‘reasonably diligent person’ test in order to determine whether:

• a liquidator or administrator has established that a director ought to have concluded that there was no reasonable prospect of avoiding an insolvent liquidation or administration (the s 214(2) / 246ZB(2) liability which is relevant for limb one), and
• whether the director then took every step to minimise the potential loss to the company’s creditors (the s 214(3) / 246ZB(3) defence which is relevant to limb two).

Question 30

Details of the test

Answer 30

Under that test, the facts which a director ought to have known or ascertained, the conclusions which he ought to have reached and the steps which he ought to have taken, are those which would have been known or ascertained, or reached or taken, by a reasonably diligent person having both:

• the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by the director in question (an objective test); and
• the actual knowledge, skill and experience of that particular director (a subjective test). The court then applies the higher of the two standards.

Question 31

Advice to directors

Answer 31

To minimise the risk of a wrongful trading claim, directors should:

• Hold frequent board meetings to review the company’s financial position and write up minutes of each meeting so there is a written record on which the directors can later rely to justify the decisions that they took. It is common for lawyers advising a company in financial difficulties to take an active role in helping directors to prepare minutes and to ensure that board meetings consider all the relevant issues e.g. whether the directors consider on reasonable grounds that the company can avoid an insolvency in which case the minutes should set out the evidence for that view. If limb two is engaged, the board minutes should set out the steps the directors propose to take to minimise loss to creditors.

Question 32

Advice to directors

Answer 32

• Take professional advice (e.g., from lawyers, insolvency practitioners and/or accountants) as soon as possible.
• Make sure they have up to date financial information about the state of the company’s finances and that this information is considered at the board meetings and acted upon.

Note directors cannot escape liability by simply resigning. It might be an act of wrongful trading to resign. A director should only consider resigning if they are constantly out voted by the other directors and therefore unable to persuade them to change their course

Question 33

Remedies – s 214(1) / 246ZB(1)

Answer 33

If a director is found to be liable for wrongful trading, the court can order that director to make such contribution to the assets of the company as the court thinks fit. The contribution will increase the assets of the company available for distribution to the general body of unsecured creditors.

The court has a wide discretion to determine the extent of the directors’ liability. The contribution will ordinarily be based on the additional depletion of the company’s assets caused by the directors’ conduct from the date that the directors ought to have concluded that the company could not have avoided an insolvent administration or liquidation (ie from the ‘point of no return’).

Question 34

Order by court

Answer 34

An order by the court for a director to contribute to the company’s assets under s 214 / 246ZB is compensatory and not penal in nature. An order to contribute may be made against the directors on a joint and several basis. However, the court has a discretion to apportion liability between directors based on their culpability by ordering the more culpable directors to pay more than the less culpable ones.

Where the court makes a contribution order against a director under s 214 / 246ZB, the court also has a discretion to make a disqualification order against them under s 10 CDDA 1986.

Question 35

No relief under s 1157

Answer 35

Under s 1157 CA 2006, the court may ordinarily relieve a director from liability in proceedings for negligence, breach of duty or breach of trust, on such terms as it thinks fit, if satisfied that he/she acted honestly and reasonably,and having regard to all the circumstances of the case, the director ought fairly to be excused. However, that relief is not available in wrongful trading proceedings (Re Produce Marketing Consortium Ltd [1989] BCLC 513, ChD).

Question 36

Summary

Answer 36

• Claims for wrongful trading may be brought by a liquidator under s 214 IA 1986 or an administrator under s 246ZB IA 1986.
• The claim can be brought against any person who was at the relevant time a director.
• The court must be satisfied that at some time before the commencement of the winding up or insolvent administration, the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation (or insolvent administration); limb one.

Question 37

Summary

Answer 37

• A director may be able to escape liability if they can satisfy the court that, after they first knew or ought to have concluded that there was no reasonable prospect of the company avoiding an insolvent administration or liquidation, they took “every step with a view to minimising the potential loss to the company’s creditors” (s 214(3) / 246ZB(3); limb two
• The court applies the reasonably diligent person test under s 214(4) / 246ZB(4) to what the director ought to have known..
• A person found to be liable under s 214 / 246ZB can be ordered to make such contribution to the company’s assets as the court thinks proper and may also be disqualified under s 10 CDDA 1986.

Question 38

List of Voidable Transactions

Answer 38

This element considers the following voidable transactions:

Transactions at an undervalue
Transactions defrauding creditors
Preferences
Avoidance of Floating Charges.

Question 39

Aim of Voidable Transactions

Answer 39

The IA 1986 gives both a liquidator and an administrator the ability to challenge certain transactions that have taken place within specified statutory periods prior to the insolvency of a company. These are known as ‘voidable’ transactions.

The aim of a challenge is to restore the company to the same position it would have been in had the transaction not taken place and thereby, increase the funds available in the insolvent estate for the benefit of creditors.

Question 40

Clawback Provisions

Answer 40

These provisions are often described as ‘clawback’ because they can result in an order reversing transactions or more usually, providing for financial restitution to be paid, to the insolvent estate which has the effect of clawing back assets into the insolvent estate, in order to increase the assets of the insolvent company for the benefit of creditors. It is the counterparty to the transaction with the insolvent company (and sometimes its successor in title) that is the target of the claw back provisions, rather than the directors responsible for causing their company to enter into the transaction. All references below are to IA 1986 unless stated otherwise.

Question 41

Questions to ask

Answer 41

A liquidator or administrator seeking to challenge any voidable transaction (except for a transaction defrauding creditors under s 423) will need to ask the following questions in each case:

Did the transaction involve a ‘connected person’ or ‘associate’?
Did the transaction take place within the ‘relevant time’?
Was the company insolvent at the time of the transaction or did it become insolvent as a result of the transaction?
Is there a presumption available which shifts the burden of proof from the liquidator/administrator to the other party?

Question 42

Connected Persons and Associates

Answer 42

Sections 249 and 435 set out the definitions of ‘connected persons’ and ‘associates’ respectively.

• ‘Connected persons’ with the company (s.249) – are directors (including shadow directors), associates of directors and associates of the company.
• ‘Associates’ of director/company (s.435) – include spouses, business partners, employees, relatives including brother, sister, uncle, aunt, niece, nephew, etc. (widely defined in s.435(8)), certain trustees, a company which is controlled by the director and a company which is itself associated with the company in question, where both are mutually controlled by some other company or person.

Question 43

Transactions by a company at an undervalue (TUV) – s 238 IA 1986

Answer 43

The provisions under s 238 concern loss of value from a company, whether through gifts or a significant inequality in consideration, to the company’s detriment at a time when it is “insolvent”.

Insolvency means ‘inability to pay debts’ under s 123 ie the company is insolvent on either the cash flow or balance sheet basis.

Note that “insolvency” has a wider definition for voidable transaction purposes than it has for wrongful trading purposes (in the latter case, “insolvency” is restricted to balance sheet insolvency only).

A claim may be brought under s 238(1) by ‘an office-holder’ which means:

• a liquidator, or
• an administrator.

Question 44

The Onset of Insolvency

Answer 44

The ‘onset of insolvency’ is set out in ss.240(3) and 245(5) as follows:

• Administration: date of filing of application (court procedure) or notice of intention to appoint or (if none) appointment (out-of-court procedure).
• Liquidation: date of commencement of winding up (date of resolution for members’ or creditors’ voluntary winding up or date of presentation of petition for compulsory winding up (s.129)).

Question 45

TUV: What is a transaction at an undervalue?

Answer 45

A transaction at an undervalue is either:

• A gift; or
• A transaction for a consideration the value of which, in money or money’s worth, is significantly less in value than the consideration provided by the company. This involves a comparison in monetary terms between what the company gave away and what it received under the transaction. The comparison to be made is aimed at establishing if there has been an inequality of exchange adverse to the company under the transaction. A simple example would be where a company sells an asset worth £100,000 but only received £50,000 in payment.
• In some situations, the granting of security or payment of a dividend may be held to amount to a transaction at an undervalue.

Question 46

TUV: Granting security / payment of a dividend

Answer 46

It was generally thought that the granting of security by a company cannot amount to a transaction at an undervalue on the basis that the security does not itself deplete the assets of the company or diminish their value (Re MC Bacon Ltd [1990] BCLC 324).

Question 47

Hill v Spread Trustee Company Limited [2006] EWCA Civ 542

Answer 47

However, in Hill v Spread Trustee Company Limited [2006] EWCA Civ 542, it was found that the granting of security for no consideration (or for consideration significantly less than the value of the charge) can be challenged as a transaction at an undervalue. In Hill, the main purpose for the granting of security was to put assets beyond the reach of HMRC. The law is somewhat uncertain on this point because of the difference in view between the MC Bacon and Hill cases.

Question 48

Whether dividend was lawfully paid

Answer 48

Similar uncertainty existed around whether a dividend, lawfully paid, could amount to a transaction at an undervalue. The case of BTI 2014 LLC v Sequana SA & others [2019] EWCA Civ 112 now suggests that a dividend can be attacked as a transaction at an undervalue.

Question 49

TUV: When and how can the transaction be avoided?

Answer 49

The court may set aside a transaction as a transaction at an undervalue if:

The company made a gift or otherwise entered into a transaction for a consideration, the value of which in money or money’s worth is significantly less in value than the consideration provided by the company.
It took place within the ‘relevant time’ (s 238(2)) - in the two years ending with the onset of insolvency (s 240(1)(a)), which is the commencement of the relevant insolvency procedure (administration or liquidation) (s 240(3)). Note that the relevant time is two years regardless of whether the transaction took place with a connected person or not.

Question 50

TUV: When and how can the transaction be avoided?

Answer 50

It is proved by the applicant that the company was insolvent at the time of the transaction or became so as a result of it (s 240(2)). Where a transaction at an undervalue is entered into with a person connected with the company, insolvency is presumed unless the connected person proves otherwise (s 240(2)). This means that the connected person must prove the company was solvent at the relevant time.
Sections 249 and 435 set out the definitions of ‘connected persons’ and ‘associates’ respectively.

Question 51

TUV: Defence

Answer 51

Even if all of the requirements set out above are satisfied, no order will be made to set aside the transaction if the court is satisfied that:

the company entered into the transaction in good faith and for the purpose of carrying on its business; and
at the time there were reasonable grounds for believing that the transaction would benefit the company.
This defence is often relied on in practice and can save many transactions which would otherwise be open to challenge.

Question 52

Where the defence is available

Answer 52

One example when the defence may be available is where a company grants new security to stave off a genuine threat made by an unsecured bank to terminate facilities and begin winding up proceedings if the security is not granted, in circumstances where the directors consider on reasonable grounds that the company can turn around its financial difficulties and thereby avoid entering into an insolvency procedure.

Question 53

TUV: Sanctions

Answer 53

The court has a discretion to make such order as it thinks fit to restore the position as if the company had not entered into the transaction (s 238(3)).

Section 241(1) provides a non-exhaustive list of the types of restoration order that the court might make under s 238 (and also under s 239 in relation to voidable preferences; see below). A common order would be for the counterparty to pay the amount of the undervalue the company sustained under the transaction. To continue with the earlier example, if the company sold an asset worth £100,000 for £50,000, the court may order the counterparty to pay another £50,000 to the liquidator or administrator.

Question 54

Acting in good faith or value

Answer 54

Any court order should not prejudice a subsequent purchaser from the party which transacted at an undervalue with (or received a preference from) the company, provided they were acting ‘in good faith and for value’ (s 241(2)).

However, under s 241(2A) there is a rebuttable presumption that an acquisition by a subsequent purchaser was not in good faith where the subsequent purchaser either:

had notice of the relevant surrounding circumstances (ie the transaction at an undervalue or preference) and of the relevant proceedings; or
was connected with or was an associate of either the company or the party which transacted at an undervalue with (or received a preference from) the company. In such circumstances the burden of proof shifts to the subsequent purchaser to show good faith.

Question 55

Transactions defrauding creditors (TDC) - s 423 IA 1986

Answer 55

Claims under s 423 do not necessarily relate to insolvency – these claims may also be brought by a victim of the transaction in question where the company is solvent.

The requirements for the claim are:

there has been a transaction at an undervalue; and
the intention or purpose of the transaction was to put assets beyond the reach of creditors of the company or otherwise prejudice their interests. The reference to creditors even includes future creditors who were unknown at the time of the transaction.

Question 56

Requirements of the claim are:

Answer 56

Liquidators and administrators will often prefer to bring claims under s 238 (TUV) than under s 423, assuming that the claim satisfies the criteria for challenging an undervalue transaction under the above sections (e.g., ‘relevant time’ and insolvency). This is because under s 238, there is no requirement to prove that the purpose of the transaction was to put the assets beyond the reach of creditors or otherwise prejudice them.

Question 57

TDC: Who may claim and sanctions

Answer 57

An application to the court to set aside the transaction can be made by any of the following (s 424):

a liquidator or an administrator;
a supervisor of a voluntary arrangement; or
a victim of the transaction in question.

Question 58

No Relevant Time Period

Answer 58

There is no ‘relevant time’ or period within which the transaction must have taken place. However, generally speaking, the more recent the transaction, the more likely it is that the applicant will be able to show the necessary intent.

Question 59

Role of the court

Answer 59

The court may make such order as it thinks fit to restore the position to what it would have been but for the transaction in question (s 423(2)). A non-exhaustive list of orders is set out in s 425(1).

Question 60

Advantages of TDC

Answer 60

One advantage with TDC claims compared to TUV claims is that TDC claims can be brought in respect of a transaction that took place at any time in the past whereas TUVs only concerns transactions entered into within two years of the onset of insolvency (as explained above). That said, the more recent the transaction, the more likely it is that the applicant will be able to show the necessary intent.

Question 61

Preferences by a company – s 239 IA 1986

Answer 61

The purpose of s 239 is to prevent a creditor obtaining an improper advantage over other creditors of a company at a time when that company is insolvent.

A claim may be brought under s 239(1) by:

• a liquidator, or
• an administrator.

Question 62

A company gives a preference to a person if:

Answer 62

that person is a creditor of the company (or a surety or guarantor of any of the company’s debts or liabilities); and
the company does anything or allows anything to be done which has the effect of putting that person in a better position in the event of the company going into insolvent liquidation than he/she would otherwise have been in.
An example of a preference would be paying an unsecured creditor in priority to other creditors or granting security to an unsecured creditor. Please note it is usually not a preference for a company to pay a secured creditor before an unsecured one.

Question 63

When can a preference be avoided?

Answer 63

The preference is voidable if:

it was given within the ‘relevant time’ (s 239(2)) - in the 6 months ending with the ‘onset of insolvency’ (s 240(1)(b)), being the commencement of the relevant insolvency procedure (s 240(3)). The relevant time is extended to 2 years for preferences to connected persons (s 240(1)(a)). (See sections 249 and 435 for definitions of ‘connected persons’ and ‘associates’);
it is proved that the company was insolvent (on either a cash flow or balance sheet basis) at the time of the transaction or became so as a result of it (s 240(2)); and
It is proved that the company was ‘influenced … by a desire’ to prefer the creditor (s 239(5)). This is a subjective test. The company must have positively wished to put the party in a better position (see Re MC Bacon Ltd).
Note in relation to 2 above, that unlike transactions at an undervalue, there is no statutory presumption of insolvency where the preference is given to a person who is connected with the company.

Question 64

Preferences: Connected Persons

Answer 64

If the preference is given to a connected person or associate, there is a rebuttable presumption that the company was influenced by the desire to prefer the creditor (s 239(6)).

This shifts the burden of proof from the liquidator or administrator to the preferred person to rebut the statutory presumption. This means the preferred person must prove that the company was not influenced by a desire to prefer them.

Connected persons and associates are defined in s 249 and s 435 IA 1986.

Question 65

Preferences: Defence

Answer 65

The defence available is an absence of the desire to prefer required by s 239(5).

In Re MC Bacon Ltd[1990] BCLC 324, the company granted fixed and floating charges to its bank to secure an existing overdraft, as a condition of the bank not calling in the overdraft, at a time when it was insolvent. It was held that this was not a transaction at an undervalue because it had not diminished the value of the company’s assets. In relation to the claim that this was a preference, the court said it is not necessary to prove an intention to prefer (which is objective), but a desire to prefer (which is subjective).

Question 66

Security could not be challenged as preference

Answer 66

On the facts, the security could not be challenged as a preference because the directors, in granting the security, had not been influenced by a desire to prefer the bank, but only by the desire to continue trading and to avoid the calling in of the company’s overdraft (ie the security was granted as a result of genuine commercial pressure exerted by the lender and the presence of such pressure negated any desire on the debtor’s part to prefer the lender). If the company had acted out of mixed desires (to avoid calling in the overdraft and by a positive desire to prefer the bank), then the necessary desire would have been present even if the first desire had been stronger than the second.

Question 67

Preferences: Sanctions

Answer 67

The court has a discretion to make an order to restore the position as if the company had not given the preference (s 239(3)).

Section 241(1) provides a non-exhaustive list of the types of restoration order that the court may make. The range of orders the court can make are the same as with TUVs. A common court order would in the case of an unsecured creditor paid ahead of others is for the preferred creditor to pay to the liquidator or administrator the money it had received from the company.

Note that s 241(2) and s 241(2A) apply to both preferences and transactions at an undervalue.

Question 68

Avoidance of certain floating charges - s 245 IA 1986

Answer 68

The purpose of s 245 is to prevent a creditor obtaining a floating charge to secure an existing debt for no new consideration.

The section only applies in a liquidation or administration. Unlike transactions at an undervalue and preferences, s 245 avoids certain floating charges automatically and without the need for the office-holder to challenge the floating charge by bringing legal proceedings (as set out below). However, if there is a dispute between the putative floating charge holder and the office-holder about the application of s 245, legal proceedings may be necessary to determine the dispute.

Question 69

Avoidance of certain floating charges - s 245 IA 1986

Answer 69

A high-profile example of a contentious floating charge was seen in the liquidation of BHS, where its liquidators were seeking to challenge a floating charge under s 245 held by Phillip Green’s Arcadia Group. A settlement agreement was reached and the legal proceedings by the liquidator were discontinued, apparently with no judgment as to the validity of the floating charge.

Question 70

When can floating charges be avoided?

Answer 70

For the floating charge to be invalid:

The floating charge must have been created within the ‘relevant time’. The relevant time is 12 months preceding the onset of insolvency, ie the commencement of administration or liquidation (s 245(2) and 245(3)(b)).
The relevant time is extended to 2 years in the case of a floating charge granted to a connected person (s 245(3)(a)). (See s 249 and 435 for definitions of ‘connected persons’ and ‘associates’).

Question 71

Proving that company was insolvent

Answer 71

Unless the floating charge was granted to a ‘connected person’ (in which case there is no insolvency requirement), it must be proved that the company was insolvent (on either a cash-flow or balance sheet basis) at the time of the floating charge’s creation or became insolvent in consequence of the transaction under which the charge was created (s 245(4)).

Question 72

When are new floating charges valid?

Answer 72

Even if the above requirements are met, a floating charge will be valid to the extent that ‘new money’ or other fresh consideration (which can include goods or services) is provided to the company (or existing debts of the company are extinguished) in return for the grant of the floating charge on or after its creation (s 245(2)).

Question 73

Effect of 245(2)

Answer 73

The effect of s 245(2) is that if a floating charge is granted to secure the repayment of a new loan made on or after the creation of the charge, then it will be valid.

An example of when a floating charge would be void is where an existing unsecured creditor is granted a floating charge by a company which is insolvent (as defined above) and the charge purports to secure the repayment of existing monies owed to that creditor. If s 245 did not apply, such an unsecured creditor would thereby improve its position in the order of priority if the company later went into an insolvency procedure, which would be unfair on the company’s other unsecured creditors.

However, if (and to the extent that) an existing unsecured creditor provides further credit to the company (or to the extent that any other new credit is given by a new creditor) then that creditor is entitled to have the protection of a valid floating charge.

Question 74

Overdrafts

Re Yeovil Glove Co. Ltd [1965] CH 148,

Answer 74

the company granted a floating charge to its bank to secure an existing unsecured overdraft, as a condition of the bank not calling in the overdraft, at a time when it was insolvent. The company owed £67,000 under the overdraft at the time the floating charge was created. The company went into liquidation a few months later.

The liquidator argued the floating charge was invalid as it secured debt incurred by the company before the date the floating charge was created. The court held that the floating charge was valid because (1) each time the company used its overdraft facility after the creation of the floating charge, this was deemed to be ‘new money’ advanced by the bank (2)

Question 75

Devaynes v Noble [1816] 1 Mer. 572

Answer 75

Provides that payments into a bank account by the company is first applied in discharging the oldest advances made by the bank. As the company had paid more than £67,000 into the account since the grant of the floating charge, it could be said that the pre-charge debt of £67,000 had been paid off and that the existing overdraft balance at the time of appointment of the liquidator was ‘new’ debt.

Question 76

Avoidance of floating charges

Answer 76

Where a floating charge is void under s 245, only the security (and its advantage to a floating charge creditor in the order of priority) is void and not the debt itself.

Remember that a floating charge is also void against a liquidator, administrator and other creditors if it is not duly registered with Companies House under s 859H CA 2006.

Note that a floating charge granted to a creditor may also be voidable as a transaction at an undervalue or a preference under s 238 and 239.

Question 77

Summary (all references to IA 1986 Transactions at an undervalue s 238:

Answer 77

• Transaction for an undervalue
• Within 2 years prior to onset of insolvency
• Company insolvent at time / as a result (this is presumed with connected persons)

Avoidance of floating charges s 245:

• Floating charge created for no new consideration
• within 12 months prior to onset of insolvency
• Within 2 years if connected person
• Company insolvent at time / as a result (unless granted to a connected person in which case insolvency is presumed).

Question 78

Summary (all references to IA 1986

Transactions at an undervalue s 238:

Answer 78

Transactions defrauding creditors s 423:

• Transaction for an undervalue
• Intention to defraud creditors
• No need for company to be insolvent
• No time limit before insolvency to consider

Preferences s 239:

• Company puts creditor in better position and influenced by desire to prefer
• Within 2 years prior to onset of insolvency
• 6 months if connected person and presumption of preference
• Company insolvent at time / as a result