The recent case of Progress Property Company Ltd v Moorgrath Group Ltd has shed further light on what a Court will consider to be an unlawful distribution of capital.
The general rule in relation to a distribution of a company’s assets to its members is that this must be made out of its profits available for distribution (distributable reserves). This rule extends not just to distributions which take place by way of a cash dividend, but also applies in relation to distributions of non-cash assets.
One of the leading authorities for some time in this area has been Aveling Barford v Perion Ltd . In this case, the defendant indirectly owned and controlled Aveling Barford and procured its sale to Perion, which was also controlled by him. The property in question, which consisted of a country house and 18 acres of land in Grantham, was sold for £350,000 rather than the £1,150,000 it had been valued at for prospective mortgagees. The court focused on the need to look at substance over form and concluded that it was an unlawful distribution as it was known and intended to be a sale at an undervalue.
The consequences of an unlawful distribution are severe, as it cannot be ratified by the shareholders. The recipient of the unlawful distribution is liable to repay it, or, where the distribution is of a non-cash asset, to repay a sum equal to the value of the distribution. The directors of the company at the relevant time may also find themselves in breach of their duties. For many years the Aveling Barford case caused confusion for companies contemplating a transfer of assets to shareholders, since it was unclear whether the company in question would need sufficient distributable reserves to cover the difference between the transfer price of the asset and its market value (where greater than the book value of the asset), or whether the book value of the asset was the relevant figure.
Following the introduction of the Companies Act 2006, the position on this point has at least been clarified. In broad terms, where a company has distributable reserves, any transfer of an asset for at least its book value will not amount to an unlawful distribution. Where the transfer takes place at less than book value, the difference needs to be covered by distributable reserves. And, where the company does not have distributable reserves, any transfer at less than market value would not be permitted.
Despite this, there are still potential traps for the unwary, as the Progress Property case shows. In this case, the appellant (“P”) argued that there had been an unlawful distribution when the share capital of its subsidiary was sold to the respondent (“M”). All three companies were members of the same group. P asserted that the sale was at a “gross undervalue” because the purchase price paid by M had been reduced by £4m, amongst other reductions, to reflect an indemnity liability which P believed it was subject to. This liability turned out not to exist. The claimant argued that an objective approach to the situation should be taken whereby an unlawful distribution would occur any time a company enters into a transaction with a shareholder which results in a transfer of value not covered by its distributable profits. The Supreme Court took the opposite stance by concluding that all the facts surrounding the distribution should be given consideration. The Court emphasised this point by stating that the validity of a distribution should be determined by looking at the “true purpose and substance of the impugned transaction” rather than the form. In other words, the label given to the transaction should not be seen as decisive.
In Progress Property the director who entered into the transaction on behalf of P believed that the agreed purchase price was also the market value of the shares. The Court stated that this could be a relevant consideration, and stressed that in this case one determining factor was the lack of knowledge or intention to sell at an undervalue. The transaction could be characterised as one which involved a genuine arm’s length deal, albeit one which with hindsight was not a great deal for the selling company given that, at the time, the directors had misunderstood the nature of the indemnity liability which the company faced.
In reaching this conclusion, the Court showed an admirably commercial approach. It recognised that had the objective test proposed by the claimant been adopted, this would have potentially been both oppressive and unworkable, since any transaction between a company and a shareholder could have been called into question if the company was subsequently shown not to have got the best of the deal. This would have been the case even where the deal had been negotiated in good faith and at arm’s length.
All in all, this case is welcome clarification of a tricky area of law. However, any company considering disposing of assets to its shareholders should take legal advice at an early stage given the very real consequences of getting it wrong.