Covid-19: Insolvency pitfalls to be aware of!

Alex CanhamPartner, Herrington Carmichael LLP

Apr 14, 2020

The government has introduced a number of measures in order to assist businesses during the current Covid-19 pandemic. Unfortunately, for some businesses, this may not be enough to prevent their business entering some form of insolvency.  Businesses and directors need to beware of the pitfalls that they could fall into, as they continue to trade.  Two of the most common are Preference Payments and Transfers at Undervalue, both of which are discussed below.

Preference Payments

Under s239 of the Insolvency Act 1986 (the “Act”) both Liquidators and Administrators have the power to set aside transactions which they consider to be “preferences”.

What is a preference?

A company gives a preference to either a person or another company if each of the following apply:

  • That relevant person or other company is:
    – one of the company’s creditors; or
    – a surety or guarantor for any of the company’s debts or other liabilities.
  • The company does anything or allows anything to happen which has the effect of putting that person into a position which, if the company does go into insolvent liquidation, puts that person in a better position than if nothing had been done.
  • The company was influenced in deciding to give the preference by a “desire to prefer the party”. A desire to prefer is a subjective test meaning any liquidator or administrator must show that the company did want to prefer the relevant creditor over other creditors. A desire to prefer is assumed where the creditor is a connected person (see below).
  • The preference was given during the six months before the onset of insolvency, except where the preference was given to a connected person, in which case during the two years before the onset of insolvency. A connected person is a director, shadow director, an associate of a director (e.g. a partner, family member etc.) or an associate of the company.  A connected person typically excludes employees.
  • The company was unable to pay its debts at the time of the transaction or became unable to pay its debts as a result of it.

If you decide to make payments to some creditors over others, either as a goodwill gesture or to try and ensure the continuation of the business, then there is a serious risk that such payment would be deemed to be a preference in an insolvency situation.

If a liquidator or administrator considers that a preference has taken place, then they can go to court in order to get an order dealing with the preference. The court has a range of powers and, though not an exhaustive list, has the power to order any of the following:

  • Require any property transferred to be re-vested in the company.
  • Require property bought with the proceeds of sale of property or the proceeds of sale of property to be re-vested in the company.
  • Release or discharge any security given by the company. This is relevant if security is given to one creditor in exchange for not paying this creditor.
  • Require any person (who received a benefit) to pay such sums to the liquidator as the court may direct.  This is particularly relevant if the company has been ensuring that payments are made to directors, such as paying back director loans, prior to paying other creditors.

The aim of preventing preference payments is to maximise the funds available in an insolvent company, and make these available to all the creditors of the company.  The majority of the courts powers are therefore aimed at recovering money and property which has been removed from the company shortly before insolvency.

If you are concerned that your company is in danger of entering into an insolvency situation over the next 6 months, you should be particularly wary of making any payments or entering into any transactions which are outside of your ordinary course of dealings. You should also ensure that you are not transferring assets from out of the company to any owners or directors of the company without good cause or at an undervalue.

Transfers at Undervalue

Similar to preference payments, on a corporate insolvency, a liquidator or an administrator can apply to court to set aside a transaction which has taken place at an undervalue.

The court may set aside a transaction as being a transaction at an undervalue under section 238 of the Act if all of the following conditions are satisfied:

The company:

  • made a gift or otherwise entered into a transaction on terms that provided for the company to receive no consideration; or
  • entered into a transaction for a consideration the value of which, in money or money’s worth, is significantly less than the value of the consideration provided by the company. Essentially that the transaction was for a consideration significantly less than market value. The court has full power to determine what it considers an appropriate value.
  • The transaction was entered into during the two years before the onset of insolvency (the relevant time).
  • The company was unable to pay its debts at the time of the transaction or became unable to pay its debts as a result of the transaction.

If the court orders that the transaction be set aside, it will be as if the transaction never happened, and the assets will still belong to the company.

As discussed above in relation to preference payments, the court has a wide range of powers, including ordering that the property be transferred back to the company, that the true value be paid to the company, or that security be granted to the company over the assets, preventing them being sold.

The company has the opportunity to raise a defence and the court will not make an order to set aside a transaction if it is satisfied that both of the following applied at the time the transaction was entered into:

  • The company entered into the transaction in good faith and for the purpose of carrying on its business.
  •  At the time it did so there were reasonable grounds for believing that the transaction would benefit the company.

If you are concerned that a transaction that you are about to enter into may be considered to be a transaction at an undervalue, then you should look to mitigate your risk by considering taking the following before entering into the transaction:

  • Obtaining an independent valuation of the assets.
  • Buying after an auction or other public process.
  • Where there are linked agreements which together constitute adequate consideration for the transaction ensure that the overall consideration for the transaction is stated as clearly as possible. We would recommend that you always take expert advice on the drafting of sale agreements, particularly if you have a series of linked transactions.

If you are concerned that your company is in danger of entering into an insolvency situation, or are about to enter into a transaction or make a payment which you are concerned could be deemed to be a preference or a transaction at an undervalue, then we recommend taking legal advice.

For more insights on COVID-19 and how we can assist you or your business, visit our COVID-19 hub here.

This reflects the law at the date of publication and is written as a general guide. It does not contain definitive legal advice, which should be sought as appropriate in relation to a particular matter.