We consider the implications for office-holder claimants of the recent case of Kelmanson v Gallagher & De Weyer [2022] EWHC 395 (Ch).

The case raises interesting points of practice for insolvency practitioners: a director consciously trying to evade or 'game' the statute won't work to prevent office holder recovery, but a sincerely held but mistaken belief on the director's part as to what was being done doing could.

KEY POINTS:

• Layering transfers to your (perhaps connected) creditor through your corporate network to disguise the desire to prefer will generally not work to evade the preferential transaction avoidance regime: where a corporate transfers the funds to an intermediary entity, who then in turn channels those funds through the corporate group to the creditors of the original paying entity, such a pass-through arrangement would still be a ‘preference’ under s.239 of the Insolvency Act 1986 in spite of the fact that the original paying entity was technically remote, had separate legal personality, and was not directly paying the creditor(s) itself.
• There may somewhere be a very narrow window where a complex corporate group could prefer a connected creditor of that group through layering or washing payments through that group, through group members with differing directors, but ultimate common control, and perhaps through repaying mutually secured intercompany loans using treasury netting arrangements, so long as the evidence could show that the transfers were not so interlinked for it to be unrealistic to treat any one of them as being self-contained or severable from the rest. At best it might help to disguise the true intention of the arrangements, but it is always open to a judge to say it is simply a more complex sham.
• This act of 'layering' payments through a corporate structure in a way designed to prefer the creditor of the original paying entity also amounted to a breach of the directors' fiduciary duties (misfeasance in breach of the director’s duties to the Company (the creditors' interests being substituted for the Company's in the twilight zone prior to insolvency) under s.172 of the Companies Act 2006). They were liable to pay added compensation (in the amount of the directors' loans).
• A sincerely held, but mistaken belief that you were fulfilling a priority obligation to a secured creditor negates the subjective desire to prefer: a belief that a creditor had valid security at the time of payment would be enough to avoid a desire to prefer (in the sense that you could not be taken to hold two such obviously contradictory views as a director).

PREFERENTIAL TRANSACTIONS

The bar on preferential transactions under s.239 of the Insolvency Act 1986 is designed to ensure insolvency law’s rules as to how assets are distributed to creditors are not undermined in the run up to insolvency by dealings which favour particular creditors over the collective interest.

To fall foul of the preferences regime, the director must have (subjectively), at that moment, positively desired to improve creditor’s position compared to what it would have been on an immediate winding up. And, this desire must have in turn influenced their decision to then enter into the transaction itself.

The requirement is satisfied if it was one of the factors that positively operated on the minds of those who made the decision: it need not have been the only factor or even the decisive one. Many factors can influence a director, and a desire to prefer need only have been one. However, if the debtor can be shown to have at the time held a belief that flatly contradicted the idea that they also had a desire to prefer, then this goes a long way to showing that they could not have been so 'influenced' by such a desire. So, if you genuinely believed you were paying a secured creditor in this case, that genuine belief cannot be reconciled with a desire to improve the position of that creditor vis a vis other equally placed creditors; because you would necessarily have believed you had to pay them in priority by law, in accordance with their bargained for rights, not because you wanted to treat them as if they had those kinds of rights when they in fact did not.

This desire is in any event presumed satisfied in the case of a connected party here (a sister company with the same shareholders). The burden shifts in such cases (As here) to the director to show that they were not so influenced by a desire to prefer.

The test then is whether what was done or "suffered to be done" had the effect of disturbing the statutory order of payment priorities on insolvency by placing a creditor in a better position than would have been the case otherwise (i.e. relative to creditors with the same legal rights) in a liquidation. There is a requirement for debtor company being insolvent at time of payment or becoming insolvent as a result of it.

THE FACTS

Two directors of De Weyer Ltd (Company), Mr Gallagher and Ms De Weyer, had made director loans to the company of £105,250 and £210,500, respectively. Those same directors had also set up a sister entity, De Weyer Design Ltd, (Sister Co.).

On ceasing to trade in 2016, the Company's only material asset (a lease of its trading location) was sold, with the sale proceeds going to pay off the mortgage, with the remaining equity (£333,999) reverting to the Company's accounts. The Company was balance sheet insolvent at that point, with creditors exceeding £600,000. Mr Gallagher, then the sole remaining director, immediately following the sale, transferred the full value of the director loans to the Sister Co., which company then transferred those funds onwards to the directors of the Company. Upon the CVL in 2017 (occurring within 2 years of the payment to the connected Sister Co.), only £14,000 was left to satisfy the remaining creditor claims in the liquidation.

Neither of the directors had actually been secured creditors of the Company at any time, but it remained their case that they had nonetheless believed, albeit wrongly, that they each had the benefit of registered charges over the premises (which would have entitled them to be paid first in an insolvent liquidation of the Company) at the time that Mr Gallagher caused the relevant payments to the Sister Co. to be made. On the facts however the Court held that the directors never honestly believed they held valid security.

EVADING THE RULE: LAYERING TRANSFERS TO YOUR CREDITOR THROUGH YOUR CORPORATE NETWORK

The Court held that the payment arrangements made by the directors could be characterised both on the basis that the Company did something, and also that it suffered something to be done (two alternate possibilities for effecting a preference under s.239).

1. On the question of whether the Company itself did anything to prefer the directors, the fact that the Company as original paying entity was technically remote, had separate legal personality, and was not directly paying the creditor(s) itself was not enough to evade the regime. The Court adopted the view (from previous related case law) that commercial common sense should be applied to linked or composite transactions involving more than one stage or multiple parties in this context.

It was common ground that the payment to the Sister Co. had been made so that the Company’s cash would then be used to repay the directors loans. On that basis, the Company made a payment to the Sister Co. that was, as a matter of fact, admitted to be part of a single coordinated scheme or composite transaction, which was effected in order to discharge the debts owed by the Company to the directors. Payment to the directors was inevitable, intended, and "done" under the scheme.

2. As to the alternate question of whether the Company had "suffered something to be done" by this scheme (this is the more interesting aspect as it will not always be common ground, on a technical reading of s. 239, that the Company positively "did" something to effect a preference) – the Company suffered something to be done in allowing Sister Co. to use the Company’s funds to pay the director loans. The Court's approach relied on whether the Company could withhold consent (in the sense that its permission is needed to make it and it can be refused) or otherwise direct or control the funds flow.

Notably, common directorships or shareholdings was not determinative: "the mere fact that the insolvent company was under common control with the companies that had entered into the transaction in question did not make a difference to this conclusion".

The critical feature was instead that Sister Co. had no higher right to the funds (an equitable or security right) and that the Sister Co. never suggested as much and applied the funds at the sole direction of the Company: "[the] money received by [Sister Co.] and paid on to the [directors] in their capacity as the Company’s creditors was the Company’s money and was used to pay the Company’s debts. There was no suggestion by the [directors]…  that [Sister Co.] had set up any beneficial title of its own to the money that was used to pay the [directors], nor was there any evidence to suggest that [Sister Co.] might have had any beneficial title to that money."

The question then arises: what if the Sister Co. could have established such an equitable or secured right (a right of a higher order in the liquidation priority payments waterfall than that of an unsecured creditor)? For example, if a loan from Sister Co. to the Company was previously secured (meaning Sister Co. had the right to recover on a priority basis from the Company) could back-to-back intercompany loan repayment (loan from directors to Sister Co. – onwards secured loan from Sister Co. to Company) be used as the channel for repayment, with matters later quietly re-documented on a group accountancy basis once the charge back period (2 years for connected parties) had expired? In the case of connected parties, at least, the authors think this scheme unlikely to succeed after the High Court case of Damon v Widney plc [2002] BPIR 465. There, isolated elements in a similar pass through arrangement (though one without security overlaid) could not be singled out for special attention. That case involved asset stripping the group entity, transferring its assets to a group controlled newco., financed by the parent capitalising that new co., leaving the oldco. with only debts to its parent. The question was whether this transfer to the new co. of assets could be a caught as a preference granted to the parent.

In that case, it was considered "completely unrealistic", and lacking in "realism", to have treated the book entry accounting mechanics used to effect the notional payments around the group as being able to defeat the economic and legal reality. S. 239 is there taken to track the question of whether what was done / suffered to have been done by the debtor placed a creditor in a better position than would have been the case otherwise in a liquidation of that debtor. The parent in that case started the day as a creditor of the subsidiary facing the arbitral award in the sum of £2.7 million and ended the day as a creditor of the new co. (who faced no such arbitral award) for a similar amount.

Could then an even more intricate scheme be designed, within a complex corporate group, to ensure that the intercompany loans between group members (loans that could typically be said to exist on the basis that they are never really expected to be repaid in a solvent setting) are 1) secured, 2) entered into by separate legal entities, whose boards of directors are staffed by a majority of different persons, and 3) whose balances are automatically netted off at a group treasury company level – in a way that could disguise the required "desire to prefer" within that payment structure? Whether this could ever be a cost effective manner by which to run a complex corporate treasury function is one question. Could this represent a narrow window where a complex corporate group could prefer a connected creditor of that group through layering or washing payments through that group, so long as the commercial flow of payments could show that the transfers were "not so interlinked for it to be unrealistic to treat any one of them as being self-contained or severable from the rest" (Mr Justice Neuberger in Damon v Widney plc [2002] BPIR 465 at 471). At best it might help to disguise the true intention of the arrangements, but it is always open to a judge to take the view that it is simply a more complex sham lacking in genuine economic substance, as in the case of the book entry financing in Damon v Widney plc.

AVOIDING THE RULE: HONEST, BUT MISTAKEN, BELIEFS NEGATE A 'DESIRE' TO PREFER

It was held that an incorrect, but honestly held, belief that a particular creditor held registered security (such that they would be paid in priority on an insolvent liquidation) precludes the presence of any desire to prefer (a director could not be taken to hold the flatly contradictory desire to prefer).

However, on the facts, it was shown that Mr Gallagher did not in fact believe that the directors loans were validly secured at the time the repayment was made. The directors could not rebut the presumption that they had such a desire to prefer themselves (because the payment was made to connected parties, the burden shifted to those connected parties (the directors themselves) to positively prove the absence of a 'desire to prefer').

As a point of practice for insolvency office holders, the Court accepted that because the preference regime looks at a subjective state of mind before assessing the simple economic effect of the transaction: "at first blush it may seem counterintuitive to suggest that liability for a preference could be avoided where a party believed without any rational basis at all that they were secured when they were not".

However, the wording of s.239 of the IA 1986 is clear: a positive desire to improve the preferred creditor’s position on insolvency must be both present and influential on the debtor’s decision and – "[t]here is nothing in the statutory wording to require any exploration into the merits or accuracy of any inconsistent belief, although its degree of plausibility is likely to be relevant to the court’s inquiry into whether or not it was genuinely held."

The Court must be careful however to police instances of engineered ignorance by directors however.

MISFEASANCE

This act of 'layering' payments through a corporate structure in a way designed to prefer the creditor of the original paying entity also amounted to a breach of the directors' fiduciary duties (misfeasance in breach of the director’s duties to act in the best interests of to the Company (the creditors' interests being substituted for the Company's in the twilight zone prior to insolvency) under s.172 of the Companies Act 2006). The directors were liable to pay extra compensation to the creditor body in that case (in addition to restoring the funds themselves as paid away).

Applying an objective test, a reasonable director in the position of Mr Gallagher could not have reasonably thought that repaying the directors was in the interests of the Company, where less than £20,000 was left to satisfy remaining creditors.