A regular feature of corporate reorganisations is the transfer of assets (including shares) by one company in a group to another group company as part of a change in corporate ownership. These transfers are often part of a bigger corporate picture carried out for bona fide commercial reasons, such as tax planning.
However, at common law the Courts have devised a series of rules for the protection of a company's creditors. One of these rules provides that, except in accordance with specific statutory procedures, such as a payment of a dividend out of distributable profits, or on a winding up of the company, a distribution of a limited company's assets to a shareholder can be classified as an unlawful return of capital. In addition, the Companies Acts prohibit, subject to a limited number of exceptions, a distribution by a company to a member unless that company has profits available for distribution equal to the value of the distribution.
These rules can often amount to traps for the unwary, and there can be serious consequences if it is held that the transaction amounts to an unlawful distribution. For example, where a company makes a distribution to its members in contravention of the Companies Acts (irrespective of the position at common law), and the member knows or has reasonable grounds for believing that it was so made, that member is liable to repay what it receives to the company1. In addition, under common law rules, the recipient of an unlawful distribution from a company is deemed to hold that distribution as a constructive trustee for the company. In a number of recent decisions, the UK Courts have also held that a shareholder cannot claim that it is not liable to return a distribution which is held to be unlawful, simply because it did not know of the relevant restrictions on the making of distributions2. To complete the picture, directors who cause a company to make an unlawful distribution may in certain circumstances be held to be in breach of their fiduciary duties and accountable accordingly to their company for such unlawful payments3.
Against this background, the decision of the UK Supreme Court in Progress Property Company Limited v Moorgarth Group Limited  UKSC 55 provides some comfort for directors and shareholders who may be involved in such transactions, by providing clarification as to the tests which the Courts will apply in determining whether a corporate transaction will amount to an unlawful distribution at common law. As a Supreme Court decision, it is likely to be a very persuasive authority on these matters, should similar facts come before the Irish Courts.
The transaction in question took place against a commercial background which was described in the Supreme Court as "somewhat complicated", and indeed the Court indicated that some of the facts were still the subject of disagreement. Essentially, however, it involved an agreement by Progress Property Company Limited (PPC) to sell all of its shares in its wholly-owned subsidiary YMS Properties (No 1) Limited (YMS) to Moorgarth Group Limited (MGL) for a total sale price of approximately Stg£63,000. When the agreement was entered into, PPC was a subsidiary of a company called Tradegro (UK) Limited (TUK). MGL was also a subsidiary of TUK. TUK was in turn controlled by a Dr Cristo Wiese, a South African investor. The issue was whether there was an unlawful distribution of capital by a company, PCC, to its shareholder, TUK, when PPC sold the shares in YMS to MGL. It was accepted without discussion in the Supreme Court that this was a valid question, on the basis that the sale was to TUK's subsidiary, MGL, and there was "no distinction" in that context between TUK and MGL.
It appears that the sale price was calculated on the basis of the open market value of certain properties owned by YMS (Stg£11.83million), from which the parties subtracted liabilities to creditors of approximately Stg£8 million. According to the vendor, PPC, this appeared to leave a net value in YMS of approximately Stg£4 million. The parties then went on to subtract a further sum of Stg£4 million in the belief that PPC had given a counter-indemnity to TUK, which was to be released as part of the transaction. It was accepted by the parties that one of the directors, a Mr Moore, who was a director of TUK, PPC and MGL, genuinely believed that the agreement for the sale of the shares in YMS was an arm's length sale, and further that he genuinely believed in the existence of the counter-indemnity given by PPC to TUK. However, it turned out that in fact there was no such indemnity liability and that there was therefore nothing from which PPC could be released. There was therefore no justification for the subtraction of the Stg4 million from the sale price. PPC then subsequently alleged that, as a result, the sale of the shares by PPC to TUK had been carried out at a gross undervalue, notwithstanding Mr Moore's genuine belief that the price paid for the shares was their actual market value.
It was not alleged at any stage that there was any intention on the part of Mr Moore to prefer MGL or any of PPC's creditors, or to commit a fraud on such creditors, and it was acknowledged that he acted in the honest belief the sale was a genuine commercial transaction.
In the Supreme Court, Lord Walker reviewed the authorities in support of the common law rule on distributions of capital and held that whether a transaction infringes the common law rule is a matter of substance, not of form. In this regard he relied upon the decision of Oliver J in Re Halt Garage (1964) Ltd  3 ALL ER 1016 and also on the seminal case of Aveling Barford Ltd –v- Perion Limited  BCLC 626. Lord Walker went on to say that the essential question to be asked in a case such as this is: how the sale by the vendor of its shareholding to be properly characterised?
It had been submitted by PPC that the Court should adopt an objective approach to this issue. The consequence of this would be that there would be an unlawful distribution whenever a company enters into a transaction with a shareholder which results in a transfer of value which is not supported by distributable profits, regardless of the purpose of the transaction or the motivation of the parties entering into that transaction. However, the Supreme Court held that the Court's task is to enquire into the true purpose and substance of the impugned transaction, and in so doing to examine all the relevant facts, which can sometimes involve the state of mind of the persons involved.
On the facts, the Supreme Court, upholding the decision of the Court of Appeal, refused to hold that the share sale should be treated (or, as Lord Mance put it, re-categorised) as an unlawful distribution of capital to a shareholder. Indeed, Lord Walker indicated that there may have been a substantial overvaluation of the properties owned by YMS, and therefore of the actual market value of YMS's shares.
The Courts accordingly found that the sale of the shares in YMS to MGL should be regarded as a genuine commercial sale.
Practical implications for Irish companies
The UK Supreme Court made a number of very useful observations on the way to finding that the impugned share sale transaction was in fact a genuine sale. These can be summarised as follows:-
- As already mentioned, the Court rejected the suggestion that an objective approach was the correct approach to take in determining whether a transaction amounts to an unlawful return of capital. In coming to this conclusion, Lord Walker cited with approval an extract from the Judgment of Lord Hamilton in Clydebank Football Club Limited – v- Steedman (2002) SLT109 where he said:-
"a mere arithmetical difference between the consideration given for the asset........ and the figure or figures at which it or they are in subsequent proceedings valued retrospectively will not of itself mean that there has been a distribution".
- The Courts must look at the substance rather than the form of the transaction, and the label which the parties put on the transfer in question will not prevail over the facts as found by the Courts.
- While the state of mind of the people involved in the transaction will sometimes be irrelevant (for example where a distribution is described as a dividend but is actually paid out of capital) the participant's intentions are sometimes very relevant.
- In particular, if a company sells assets to a shareholder at a low value when those assets are difficult to value precisely, but are potentially very valuable, then if the conclusion is that it was a genuine arm's length transaction, it will stand, even if it may, with hindsight, appear to have been a bad bargain. This is particularly helpful in the context of intra-group reorganisations where in some circumstances the assets (e.g. property) will not be easy to value with total accuracy.
- Lord Walker cited with approval another part of the judgment of Lord Hamilton in the Clydebank case where he said that directors are liable only if it is established that, in effecting the unlawful distribution, they were in breach of their fiduciary duty, and that this involves consideration not only of whether they knew at the time that what they were doing was unlawful, but also of their state of knowledge at the time of the material facts. Lord Walker expressly approved that part of Lord Hamilton's judgment where he cited from another case in which the judge there stated that, in effect, directors should not be held liable:-
"unless the payments were made with actual knowledge that the funds of the company were being misappropriated, or with knowledge of the facts that established their misappropriation".
- Equally helpfully, Lord Mance stated that "the Courts will not second-guess companies with regard to the appropriateness or wisdom of the terms of any transaction" though he did say that there may come a point at which an agreement cannot be regarded as involving anything other than a return, or distribution, of capital.
Other lessons to be learned?
In addition, there is perhaps a lesson to be learned for those involved in corporate reorganisations. It would seem that, based on one valuation, the value of the YMS shares at the time of the share sale was around Stg£4million. Despite this, MGL only paid PPC some Stg£63,000 for the shares. TUK had given an indemnity to YMS in respect of certain costs of YMS, and Mr. Moore, a director of TUK, MGL and PPC, believed that PPC had given a corresponding counter-indemnity to TUK as security. Both the indemnity and the counter-indemnity were valued at Stg£4 million. The parties could have left the (alleged) counter-indemnity in place, in which case the price for the YMS shares would have had to have been around Stg£4 million. Instead, they structured the deal so that TUK released PPC from its counter-indemnity, and only Stg£63,000 was paid for the shares. However, as both the High Court and the Supreme Court noted, regardless of the actual value of the YMS shares, this was illogical, in that the parties treated the credit for the release of the counter-indemnity as a reduction in the actual value of the shares in YMS, whereas in fact this was a matter as between the vendor, PPC, and its parent, TUK.
The lesson for management (and perhaps advisers) who are involved in such transactions is to clearly establish the actual legal position in relation to alleged liabilities, and also to ensure that those liabilities are apportioned correctly and logically.
This case will be of interest to Irish companies given the relative scarcity of UK authorities on the subject, and indeed the absence of any reported decision of the higher courts here dealing with these issues. In particular, the decision indicates that transactions should not be re-categorised as illegitimate distributions of capital at common law, in circumstances where the parties genuinely belief them to be bona fide sales of assets at market value. However, there is also a warning in the judgment that each case will turn on its own facts, and that an improper attempt by a shareholder to extract value from a company by the pretence of an arm's length sale will in all likelihood be held to be unlawful – with potentially serious consequences for all concerned. In addition, it should be remembered that a separate statutory test, under the provisions of the Companies (Amendment) Act 1983, will always have to be met where "distributions" (as defined) of a company's assets to members are involved.
It's unlikely that this case will affect the vast majority of intra-group transactions. It only applies to clarify that, where the parties genuinely belief that they are applying an arms-length consideration to a transaction, the Courts will not second guess this. Therefore, where the consideration for YMS had two elements, a cash payment of £63,000 and the release of a counter-indemnity (thought to have been given by PCC to the buyer, TUK) valued at £4,000,000, it was clear that PCC thought it was getting full value for YMS. The fact that this was based on a mistaken belief that the counter-indemnity had been given was not relevant once that belief was genuine.
What the decision does establish is that where it is established that a transaction is a genuine arms-length transaction, it will stand even if it may, with hindsight, appear to have been a bad bargain. It was already well established that a sale for full consideration is not a distribution. This case helpfully clarifies that the court will not apply an objective test (based on its assessment of value of the asset sold) to determine whether an intra-group transaction is a sale for full consideration. It is enough that the parties genuinely believe that it is a sale for full consideration.
What the decision does not establish is that parties are free to transfer at any price. Nor does it necessarily mean that knowledge of the undervalue and an intention to transfer at an undervalue are necessary. The Court left open the question of whether a transfer at a price that one party believes is genuine might still be a distribution. For example, if the buyer believes that the price is genuine but the seller knows it to be an undervalue, it is possible that, notwithstanding the buyer's lack of intention and knowledge, the transfer would be a distribution to the extent of the undervalue.