Fri 17 Feb 2017

Insolvency Update: Adequate Consideration

Under section 242(4) of the Insolvency Act 1986 the court must reduce any transaction, restore any property to a company or grant other redress if it holds that a transaction is a gratuitous alienation. However, there are statutory defences to such an action. First, if the company can establish that its assets were greater than its liabilities at the time the transaction was undertaken. Secondly, if the alienation was made for adequate consideration. The second of these defences was at issue in the recent case of Liquidators of Grampian MacLennan's Distribution Services Limited v Carnbroe Estates Limited [2017] CSOH 8 in which Lord Woolman issued his decision on 18 January 2017.

The facts of the case can be briefly stated. In July 2014, just a few months before it went into liquidation, Grampian sold property to Carnbroe for £550,000. The owners of Grampian and Carnbroe had a close relationship. On the date of settlement, Grampian did not receive any payment. Instead, Carnbroe paid £473,604.88 to the bank in order to discharge its security. That was the precise amount of the debt under the Grampian's loan facility with the bank. The balance of the purchase price was not paid to Grampian until well after it had gone into liquidation and, from the manner in which it is described in the decision, it was only paid following legal advice to Carnbroe to the effect that they had to pay it in order to avoid the decision going against them. On 12 September 2017 Grampian went into liquidation on the petition of HMRC which was owed unpaid taxes of £550,000, the precise amount of the purchase price agreed between Grampian and Carnbroe.

On being appointed, the liquidator sought to challenge the property sale as an alienation and the action was defended on the basis that adequate consideration had been paid for it. Lord Woolman considered a number of existing authorities and said this about the test: "The test is an objective one. The defender need not establish that the consideration was the best that could have been obtained. It must, however, be not less than would reasonably be expected in the circumstances if the parties were acting in good faith and at arm's length. Put short, the court enquires whether the transaction was a commercial one. If the answer is yes, then the consideration is presume to be adequate".

With that test in mind Lord Woolman heard from two experienced surveyors who gave evidence to the effect that the subjects were valued at £820,000 and £740,000 respectively. However, despite these valuations, the surveyors also gave evidence to the effect that they would not "have raised an eyebrow" at a price of £550,000 in the circumstances and having regard to the marketing costs and an estate agency fee. The "circumstances" which the surveyors referred to seemed to include, in particular, a shortened marketing period and that the transaction was not at arm's length on the open market due to the fact that the bank was threatening to call up its security and use other diligence against the company in terms of the bond and floating charge.

On the basis of that evidence, Lord Woolman concluded that while £473,604.88 would have been inadequate consideration (and that, therefore, the liquidator was justified in raising the action), £550,000 was adequate in terms of the 1986 Act.

It is difficult to see how the approach taken by the court in Grampian can be correct. It is important to bear in mind the purpose of the provisions of section 242 of the 1986 Act. The purpose of insisting on "adequate" consideration is to ensure that the company gets "full value, in money or money's worth…by way of consideration for the obligation undertaken by the insolvent company" (Lord Drummond Young, Jackson v RBS plc 2002 SLT 1123). "Adequacy" must be tested at the time of the transaction in question. In the present case, at the time of the transaction the consideration given was clearly not adequate (as the court accepts). Lord Woolman permits the defender to make up the balance as he is entitled to do under section 242.

Of more concern, however, is the way in which the court applied the test. As all the existing case law demonstrates, the standpoint from which the adequacy of the consideration is to be addressed is assuming a "sale at arm's length and on the open market in all the circumstances". In Grampian it seemed clear from the evidence given and from an earlier DM Hall valuation that such a sale would have resulted in a price that was far higher than the £550,000 agreed between the parties. That price was not negotiated at arm's length but rather in a private closed sale between the parties justified by them on the basis of time pressure and the threatened insolvency of Grampian. Lord Woolman seemed influenced by the surveyor's evidence to the effect that in a distress sale of this kind the price was "not unusual or inappropriate if the property had been marketed on a closed basis for a period of six months". However, that is not the test and the surveyor's evidence in that regard should have been disregarded. The court should have confined its assessment to what the position would have been on an open market sale between unconnected parties.

The test is, of course, qualified by the phrase "in all the circumstances". It may be that Lord Woolman considered that these circumstances must include the "perilous financial position" of the company and the options that Grampian had in order to sell the property quickly and avoid liquidation. With respect, that phrase cannot be read in that way because doing so puts the interests of the company ahead of its ordinary creditors. The deal which Grampian and Carnbroe did clearly prejudiced Grampian's ordinary creditors because it ensured that the only money changing hands was applied to pay off the bank. Had it not been for the court's intervention Grampian would have received nothing for the sale of the property. Moreover, every alleged gratuitous alienation is challenged because the company was in a perilous financial position at the time of the alienation. If a company's financial position was to become one of the "circumstances" which the court was entitled to consider then it would almost always be open to a company to claim that it had no choice but to sell the property at lower than full value in order to avoid liquidation, which would be very unsatisfactory. The need or desire of the company to avoid insolvency should not be a consideration for the court.

In Grampian the defender's counsel concluded his submissions by saying that adequate consideration should have regard to the "real world". That is right. However, the real world to which regard should be had by the court is an objective one where the company is not in financial distress and is selling a property at arm's length on the open market, not a world in which the company is fighting for its life and will do anything to achieve a quick sale and avoid liquidation. If these were the "circumstances" that required to be considered then the defence of adequate consideration in section 242 would lose any practical meaning.

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