The Court of Appeal recently considered the status of contingent assets in a corporate insolvency context in the case of Evans -v- Jones  EWCA Civ 660.
The claim was brought by the Liquidators of Rococo Developments Ltd (the “Company”), which entered creditors’ voluntary liquidation on 21 April 2011. The Liquidators sought repayment of sums totalling £450,000 paid to Mr and Mrs Jones, the Company’s joint directors and shareholders, between June 2010 and March 2011. Since the payments were made within the period of 2 years prior to the onset of the Company’s insolvency, the transactions constituted preferential payments under section 239 of the Insolvency Act 1986 (the “Act”). In addition to these sums, the Liquidators had become aware that on 1 June 2010 the Company paid to Mr and Mrs Jones a dividend of £75,000.
Ordinarily a liquidator bringing such a claim has to show that the company in question was either insolvent at the time the preferential transaction was entered into or became insolvent as a consequence of that transaction. However, a company is presumed to be insolvent if the transaction is entered into with a connected person, which includes the company’s directors. The tests for insolvency in a corporate context are found in section 123 of the Act, one of which is that a company is deemed to be insolvent if its liabilities exceed its assets (commonly known as the “balance sheet test”).
In this case, Mr and Mrs Jones sought to avoid liability by arguing that the Company was in fact solvent at the time the transactions were entered into. They succeeded at first instance on the basis that the dividend paid to them in June 2010 was unlawful, as the Company did not have sufficient distributable profits at the time it was made. Mr and Mrs Jones therefore held the sum of £75,000 on trust for the Company, which consequently increased the Company’s balance sheet by this sum, thereby rendering the Company solvent and defeating the preference claim.
On appeal, the Liquidators deployed two arguments. Firstly, that at the time the preferential payments were made the potential liability of Mr and Mrs Jones to repay the unlawful dividend was unknown and had only become an issue after the Liquidators had been appointed over a year later in June 2011. Secondly, that the first instance Judge had wrongly applied hindsight when accepting the dividend as being a Company asset.
The Court of Appeal held that the definition of insolvency in section 123 of the Act is clear and whilst it refers to contingent liabilities, it does not refer to contingent assets. At the time the dividend was made, Mr and Mrs Jones did not appreciate it was unlawful and only accepted it was shortly before the first instance Trial. The unlawful dividend was therefore contingent on:
- the Company becoming insolvent;
- on being discovered; and
- being pursued by the Liquidators.
In citing “Donald Rumsfeld’s well-known distinction” the unlawful dividend was an “unknown unknown” and should not have been taken into account for the purposes of determining whether the Company was insolvent. The Court therefore allowed the Liquidators’ appeal.
The important point to take away from this case is that contingent assets are to be excluded from the balance sheet test in a corporate context. The Court also acknowledged that a “liberal… approach to the use of hindsight is permissible, what is not permissible… is to rewrite history”. Practitioners should therefore bear this ruling in mind when advising clients on either side of a reviewable transaction claim.
If you would like to discuss the above in any more detail please feel free to contact Ali Zaidi – Head of Restructuring & Insolvency, David Fendt – Associate, or any member of our Restructuring & Insolvency Team.
If you aren’t receiving our legal updates directly to your mailbox, please sign up now
Please note that this blog is provided for general information only. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content of this blog.
Edwin Coe LLP is a Limited Liability Partnership, registered in England & Wales (No.OC326366). The Firm is authorised and regulated by the Solicitors Regulation Authority. A list of members of the LLP is available for inspection at our registered office address: 2 Stone Buildings, Lincoln’s Inn, London, WC2A 3TH. “Partner” denotes a member of the LLP or an employee or consultant with the equivalent standing.