The High Court has found that two directors and one former director of a company were in breach of their duties by causing the company to implement a reorganisation and a capital reduction when they were aware there was a risk it would lose its source of income.

In addition, the statutory statement of solvency supporting the capital reduction was invalid because the director had not formed the opinion set out in it. As a result, the capital reduction and a subsequent dividend were unlawful, and the directors were liable to repay the dividend.

What happened?

In LRH Services Ltd (in liquidation) v Trew and others, LRH Services Ltd (“LRH”) was the tenant of a number of commercial properties, on which it paid rent.

LRH in turn allowed two of its subsidiaries and one of its former sister companies to occupy the properties. In exchange, those companies paid licence fees to LRH to cover the rent. There was no formal sub-lease between LRH and the occupying companies.

In 2009, LRH implemented a group reorganisation under which the following happened:

  • LRH sold the two subsidiaries to a new company in which its directors held shares.
  • LRH’s finance director (FD) resigned, leaving LRH with only one director.
  • A few minutes later, LRH reduced its share capital to £1 using the out-of-court procedure in the Companies Act 2006 (“CA 2006”). In support of the reduction, LRH’s sole remaining director made a statutory statement of solvency.
  • LRH then paid a dividend to its holding company in the region of £21 million.
  • Mid-way through the reorganisation, LRH appointed a new FD, bringing its total number of directors back to two.

Soon after the reorganisation completed, the former sister company, which was already in default, stopped paying its licence fees. Then, around 12 months after the reorganisation, one of the two (now former) subsidiaries ended its occupation of all but one property and stopped paying licence fees.

As a result, LRH became unable to pay its rent. It entered liquidation in late 2010.

The liquidators brought claims against all three individuals for breach of duty. They alleged that the directors should have known that the licence fees may not have been forthcoming, and that the solvency statement had been given without reasonable grounds.

What did the court say about breach of duty?

In short, the court said the directors had breached their duties to promote LRH’s success (under s. 172 CA 2006) and to exercise reasonable skill, care and diligence (under s. 174 CA 2006).

The directors should have realised, based on their knowledge of the three occupying companies, that there was a risk the licence fees would not be paid, or that they would not continue to cover the rent.

In particular, they knew (or should have known) that the sister company had been loss-making for some time (so much so that LRH’s parent had previously sold it for only £1). They should have been aware that this might present a risk to the sister company’s ability to pay its licence fee.

Moreover, the directors never arranged a formal licence between LRH and the former subsidiaries, and so LRH had no legal right to enforce payment of the licence fees. In addition, those subsidiaries were later given an express right to withdraw from occupation, jeopardising LRH’s source of income.

In particular, the court said the following:

  • The outgoing FD was aware of LRH’s finances and should have seen the risk that its income might fail to cover its rent. He was instrumental in planning the reorganisation and was obliged to consider the “foreseeable consequences of the actions he took”.
  • The director at the time of the reorganisation made a solvency statement that enabled LRH to be deprived of its assets. He was aware of the poor financial condition of LRH’s former sister company and should have appreciated the risk that licence fees would not be paid.
  • Although the incoming FD was appointed only mid-way through the reorganisation, he should have made enquiries to ensure the reorganisation was in LRH’s best interests. Instead, he “entirely abdicated his responsibility” and “simply signed whatever was put in front of him”.

What about the solvency statement?

The court’s comments on the solvency statement are particularly interesting.

For a company to reduce its capital without a court order, its directors must make a statement that (among other things) they have formed the opinion that the company will be able to pay its debts as they fall due for the next 12 months (a so-called “solvency statement”).

LRH’s director at the time of the reorganisation gave such a statement. However, the court found he had not in fact formed the opinion set out in the solvency statement. This meant the statement was invalid, and the capital reduction and dividend that followed were unlawful.

The directors were therefore in breach of duty and liable to repay the dividend (up to £21 million).

Notably, the court found that both the outgoing FD and the incoming FD were also responsible for the invalid solvency statement, even though neither of them was a director at the time or had signed it.

The outgoing FD knew the statement would be made in connection with the reorganisation, and he knew it was being made improperly. The incoming FD had “taken part” in the resolutions to implement the capital reduction, and he was “reckless” as to whether the opinion in the statement was proper.

Usefully, the court confirmed the position (set out in the recent case of BTI 2014 LLC v Sequana SA) that, when giving a solvency statement, directors do not need to consider the “technical test” of solvency set out in s. 123 Insolvency Act 1986. Instead, they should read the words “able to pay (or otherwise discharge) its debts” in a straightforward, non-technical sense.

Practical implications

Directors’ duties cases always revolve around specific facts. However, the judgment highlights important considerations for directors when undertaking a reorganisation or capital reduction:

  • When considering their statutory duties, directors should take future receivables into account, including the risk that they might not be paid.
  • Directors should also consider future receivables when making a statutory solvency statement to support an out-of-court capital reduction.
  • Directors can take into account any contingent assets that might be contributed voluntarily but to which the company has no present entitlement.
  • However, directors must decide how much weight to give to future receivables and contingent assets. They should ask themselves how certain it is the receivables will be paid, what the risk of non-payment is, and how dependent the company is on those receivables or assets.
  • Potential risks include not only the payer going insolvent, but also whether the company has a legal right to enforce payment, and whether payments can be ended lawfully at any point.
  • Directors will not escape responsibility for a solvency statement merely because they were not directors at the time and did not sign it.
  • The consequences of paying an unlawful distribution can be severe. Apart from breaching their duties, directors will normally be personally liable to repay the distribution.
  • Finally, directors should remember that it is a criminal offence to make and file a solvency statement without having reasonable grounds for the opinions given in it.