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Challenges and Opportunities for Smaller Companies in Recovery Procedures

Business owners and directors of smaller companies (SMEs), which had significant owner-manager influence in the period before an insolvency practitioner (IP) is appointed, can face some unwelcome challenges. SMEs can though provide unexpected opportunities for administrators and liquidators to enhance creditor recoveries. Company Law recognises that where shareholders agree to a course of action in an informal manner that can be regarded as binding as if there had been a formal resolution of the company. This so called duomatic principle recognises the reality of the way in which most SMEs operate. The onset of insolvency or administration can however result in nasty surprises for shareholders and directors who have informally authorised certain transactions. Fertile areas for recovery professionals to examine are the company's property dealings with its owners or directors and the financial condition of the company when dividends have been paid.

There are almost irresistible tax advantages for SMEs compensating shareholders who are also directors by way of dividends. When an IP is appointed and finds unlawful dividends have been paid, the recipient may be a soft target to recovery cash from. It is often only on the onset of insolvency that the controllers of the SME learn that a company must not make a distribution (most commonly but not always dividends) except out of available profits. If a shareholder receives a dividend that he/she knows or has reasonable grounds for believing is unlawful he/she is liable to repay it to the company. The extent of reasonable grounds for believing has recently been clarified ¹. Where a company's accounts are inadequate to determine whether there were distributable profits or the information to support the distribution is sketchy a diligent IP often supported, where no other funding is available, by a no win no fee arrangement (technically a conditional fee agreement (CFA)) with a solicitor, may leverage a settlement for a claim for repayment of dividends. The impact of CFAs in this area should not be underestimated. A "success fee" of 50 per cent uplift in a CFA commonly results in solicitor hourly rates of £300-£400 per hour, even in modest cases. Uplifts of 100 per cent are more the norm. Cost estimates handed up in court with these kinds of rates, although usually met with a sharp intake of judicial breath, are allowed because the courts recognise the benefit to creditors that CFA's are increasingly performing in recovering money from shareholders.

That the Court of Appeal has recently strengthened the armoury of claimants in this area is good news for IPs and creditors and a warning to directors and shareholders. In It's a Wrap (UK) Ltd v Gula; the Court has expanded the bite of such claims. A shareholder will be liable to make a repayment if he ought reasonably to have known the facts that meant that the distribution did contravene the Companies Act. The Defendant's attempt in that case to avoid liability by claiming, with the support of some contemporaneous evidence, that the payments were in fact salary but had been classified as dividends "as an accounting method as advised and set up by our … accountant as a tax efficient way of drawing a salary." Mr Gula's claim that this was "normal practice for small businesses" was rejected. The public purpose of this legislation the Court said was designed to protect those who have a prior call on a company's funds after the appropriation of them by those who control the company. The court considered that knowledge of the unprofitability of the company, but ignorance of the technicalities of the Companies Act, should be no bar to the IP's recoupment of funds unlawfully distributed.

Widening the ambit of dividend recoupment should be embolden IP's to recoup dividend distributions where the available financial information at the time of the distribution should have been understood to indicate that the company did not have available profits.

Another area where the duomatic principal can lull directors into a failure to take into account future claims on the onset of insolvency is property transactions. The Companies Act requires shareholder approval where a director or anybody connected with the director acquires assets like property from a company or if the company acquires assets from a connected person. The failure to obtain shareholder approval to any such transaction means it can be set aside if the company applies to the court. In an SME the duomatic principal referred to above applies so that the shareholder approval can be given informally. However, avoidance provisions in the Insolvency Act can catch out directors who have engaged in dealings with assets. If an IP can successfully demonstrate that the transaction was at an undervalue/overvalue, after an IP's appointment he can seek to improve the creditor's position by applying to set the transactions aside. Even more effective, where there has been a transaction at an undervalue and the court is satisfied that the transaction was entered into in circumstances where a purpose was to put assets beyond the reach of the Claimant both IP and creditors themselves may be able to get the transactions reversed. A transaction at an "undervalue" takes place where the consideration received is significantly less than the asset's market value. Informal duomatic type shareholder approval may have been given without detailed or any valuation evidence.

Potentially, the period over which a claimant IP/creditor can focus on is lengthy. For a straightforward undervalue transaction that has taken place with directors or a person connected to them the period will be two years working backwards from the date of the administration or liquidation. Where it can be demonstrated that a purpose of the transaction was to put assets beyond the reach of the Claimant or the creditors, the period can increase to six years and sometimes longer in breach of trust cases.

While Company law accepts informal compliance in some areas, Insolvency law should make directors and shareholders of SMEs cautious. Owners and managers need to consider the history of the administration of their businesses before taking advantage of the considerable protections offered by administration and liquidation. IPs knows that the lack of ready cash within an insolvent company is no longer, of itself, a bar to pursuing asset recovery. The Insolvency CFA is increasingly supporting significant recoveries from directors and shareholders of SMEs.

^{1. It’s a Wrap (UK) Ltd ( in liquidation) v Gula and another [2006] EWCA Civ 544}

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