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Cracking open coconuts or standing in a coconut shy? – dangers of extracting value in difficult times

Author

Andy Wood

Andy is a practical, creative tax adviser who assists a variety of clients in achieving their personal and commercial objectives in the most tax efficient manner.

Kevin Lucas of Lucas Johnson and Andy Wood of ETC Tax explore some of the issues with seeking to extract value from companies in these tumultuous times.

The current climate is a particularly challenging one for business owners of all shapes, sizes and flavours. For many businesses, sales have fallen off of a cliff or, in some industries, have been forced to close their doors.

The Government has provided some support – with employers being reimbursed (though not until April?) for putting employees on the subs bench for a time (furloughing) with the Government also providing a guarantee under the Coronavirus Business Interruption Loan scheme.

A Self-Employed Income Support Scheme has also been created for unincorporated businesses – namely sole traders and partnerships.

However, business owners are also considering asset protection. Before the downturn fully bites, clients are looking at ways of extracting value from their companies to preserve what they consider to be their assets / retirement provision.

Cracking open the proverbial corporate coconut.

But what might potentially happen if they do this and the Company ultimately fails?

Despite the fact the Government has provided for a moratorium on wrongful trading, this does not mean there is a free for all and protection from other insolvency related matters.

As such, issues must be considered carefully.

Whilst the show is on the road

Whilst the Company is trading and in good health the Directors almost have a free ride in what they can do with the Company’s assets.

Of course, there are statutory and fiduciary duties owed to the Company (shareholders) and this will place some restrictions on the use of the company assets. These duties include:

Must act within their powers;

Must promote the success of the company;

Must exercise independent Judgement;

Must avoid conflicts of interest;

Must exercise reasonable care, skill and diligence

When the wheels fall off?

So, what happens when insolvency strikes and a liquidator or an administrator is appointed?

Of course, once appointed, the Liquidator (we’ll continue to use this term for ease rather than stating both Liquidator and Administrator) will manage the assets held by the Company.

However, he or she must also investigate whether there are claims against assets that are not held by the insolvent company where these have been transferred within the prior 6 years, paying particular attention to the final 2 years.

One such area where the liquidator can seek to do this is where a director may have been suspected of wrongful trading. As noted above, the Government has moved to ‘suspend’ such actions for the time being. As such, we will not discuss this here.

The other area, which would be highly relevant, is where the Company has entered into a transaction at undervalue.

Transactions at undervalue

A transaction at undervalue is, as the name suggests, where a company makes a transfer to another party and receives nil or a below market consideration.

The Insolvency Act allows such transactions to be set aside unless it was entered in to in good faith for the purpose of carrying on the Company’s business and at a time when it had reasonable grounds for believing that the transaction would benefit the Company whilst it remained solvent both and immediately after the transaction in question.

As such, where a company sells stock or other assets at a discount to generate cash in a time of a financial crisis then this is unlikely to be set aside unless the discount was significant and/or it was clear the purchasing party was connected in some way.

However, if cash was decanted, say, into a trust to preserve assets for the shareholder directors or group of employees then one would need to be extremely mindful of these provisions.

In the case of a transaction at undervalue, then a transaction may only be set aside if it was entered in to during the a relevant period of two years ending with the commencement of the winding up and the company is insolvent at the time of the transaction or becomes insolvent as a result of the asset disposal.

Where the transaction at undervalue has been entered into with a connected person, then insolvency is presumed unless it can be disproved, putting the defendant and directors on the back foot.

Transactions defrauding creditors

There are further provisions which allow a transaction at undervalue to be set aside.

Here, a person (usually a creditor) may apply to Court to have a transaction set aside where the transaction was made with the purpose of putting assets beyond the reach of that person.

This is far more serious than a transaction at an undervalue as the word “fraud” in the heading suggests.

This will take into far more factors than those examined for a simple transaction at an undervalue meaning complex or contrived schemes to extract value for the personal wealth preservation of director shareholders could face even more scrutiny.

Consequences

Personal liability can attach to entering into such transactions, it is not merely the recipient who is liable to account to the liquidator.

Directors responsible for causing or permitting their companies to enter into transactions at an undervalue or transactions defrauding creditors may also find themselves being disqualified from acting as directors for anywhere between 2 and 15 years. If this happens, a director may also be attacked by the government via a compensation order.

Conclusion

As such, in these rocky times, business owners should be very careful about trying to remove assets from the Company in order to protect them from a potential insolvency as a Liquidator will look at transactions which have taken place and be more suspicious than normal about whether or not they have been at an undervalue.

Recent Government announcements only apply to suspend the application of ‘wrongful trading’ to insolvency events. They do not announce a general abandonment of directors duties nor an invitation to crack open the Company like a coconut.

The danger being that one instead ends up in the coconut shy, facing a disapproving liquidator. If you have any queries please speak get in touch with one of the authors.

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