Vol 4 (2007) - Issue 4

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When to Prefer a Transaction at an Undervalue

S Limited is insolvent. Mr S is its sole director. CIL is a separate company and is controlled by Mr A who is a friend of Mr S. Mr S borrows GBP 65,000 from CIL. CIL then pays the GBP 65,000 to S Limited on Mr S’s in-structions. Mr S, in consequence, is owed GBP 65,000 by S Limited. Shortly before going into liquidation, S Limited pays GBP 50,000 to CIL by way of satisfaction of part of Mr S’s obligation to CIL. Mr S himself pays the remaining GBP 15,000 of the debt to CIL. As a result of both these payments, Mr S satisfies his obligation as to the entire GBP 65,000 to CIL and in the process GBP 50,000 of S Limited’s GBP 65,000 obligations to Mr S is also satisfied.

S Limited, however, is in liquidation. S Limited’s liquidator seeks to reverse the payment of GBP 50,000 to CIL. The critical question is how to characterise that payment: is it a transaction at an undervalue, or a preference, or both? These are the facts and issues that engaged in the recent case of Re Sonatacus [2007] EWCA Civ 31, a decision of the Court of Appeal.

At trial, the judge, His Honour Judge Hodge QC, found that the GBP 50,000 was a transaction at an undervalue. This was on the basis that the consideration which underpinned the payment was treated as ‘precarious’. It was precarious because the payment was also capable of being challenged as a preference and it was a preference because Mr S was having his obligation effectively discharged by the payment of the GBP 50,000 made by his company, S Limited, in favour of CIL Limited. In the view of the judge, the payment’s susceptibility as a preference necessarily meant that the consideration was not sufficiently valuable.

An outspoken critical commentary appeared in an article in Issue 6 of the 2006 edition of Tolleys Insolvency Law & Practice at page 103. The article pointed out that the judge’s analysis was flawed in confusing the true nature of a transaction at an undervalue with that of a preference. It was pointed out that the GBP 50,000 transaction was ‘balance sheet neutral’ with regard to S Limited. It was claimed that there was not, and could not be, any transaction at an undervalue. S Limited, in effect, paid out GBP 50,000 in money or money’s worth in exchange for a reduction in a similar amount in terms of its balance sheet debt. It followed, so it was claimed, that if the consideration received, i.e. the discharge of GBP 50,000 of S Limited’s obligation to Mr S, was precarious, so too was the consideration given, i.e. the payment by S Limited of GBP 50,000. In practice, however, it followed, so the argument ran, that if the transaction between Mr S and S Limited was treated as a preference, there would be restitution in favour of S Limited, either from Mr S himself, or more likely, CIL Limited which would necessarily inflate the balance sheet of S Limited by GBP 50,000.

The Court of Appeal referred to the judge’s decision and found that there had been a preference. As indicated above, the Court of Appeal ordered CIL to return the GBP 50,000 as a third party recipient. The Court of Appeal, however, did not determine whether the transaction was at an undervalue. However, some comments in the judgments clearly suggest that doubts were expressed about HH Judge Hodge’s decision as to section 248, but with reservations. At paragraph 34, Smith LJ said that:

‘I think that the judge might have been wrong to hold that the payment of £50,000 by the company to CIL was a transaction at an undervalue because the consideration given by CIL (namely a partial discharge of [Mr S’s] debt) was precarious in that it was liable to set aside as a preferential payment. The argument advanced in the article was that the very fact that the consideration (discharge) was voidable meant that the payment itself was also voidable and therefore recoverable. The reduction in value to the company of the discharge (due to its precariousness) was precisely counterbalanced by the reduction in value of the payment made by the company (due [sic] its recoverability). Therefore, the transaction was financially neutral. I see the theoretical logic of that argument’.

Smith LJ however went on to state as follows:

‘However it seems to me that, in practice, the reduc-tion in value of the discharge due [sic] the chance that it would be set aside is not necessarily precisely counterbalanced by the chances of recovery of the money payment. The chances might be different. Although as a matter of law, the money would be recoverable if the preferential transaction was set aside, in practice it might not be; it might have disappeared. If CIL were of doubtful solvency, the transaction might not be financially neutral.’