InsolvencyBulletin January 2010

Two recent cases have highlighted potential pitfalls for liquidators in claims against directors for misfeasance and against guarantors for preference. The cases are a reminder that careful consideration of the provisions of the Insolvency Act is required before issuing a claim for misfeasance or to set aside a preference.

In Re Paycheck Services 3 Limited (Holland v Revenue & Customs and Another) [2009] EWCA Civ 625, the Court of Appeal considered the position of an individual director of a corporate director of the subject company. They held that the individual director was not a de jure director of the subject company and so was not liable for the misfeasance committed by the subject company.

Section 155 Companies Act 2006 requires each company to have one natural person as a director. Accordingly, a company operating as a corporate director must have an individual as its director. However, prior to the introduction of this section, there was no requirement for a company to have a natural director and it was possible for the sole director to be a corporate director.

Mr Holland and his wife were directors of Paycheck Services Limited whose function was to administer the business and taxation affairs of contractors working mainly in the IT sector. Paycheck Services Limited had two wholly owned subsidiaries, Paycheck (Directors Services) Limited and Paycheck (Secretarial Services) Limited which were the director and secretary of a number of trading companies, distinguished only be a number eg Paycheck Services 3 Limited, Paycheck Services 4 Limited etc. which provided IT services. Each company had one voting “A” share and 50 non voting shares, each non-voting share being a separate class. The “A” share in each of the trading companies was held by Paycheck Services Trustee Limited, and Mr and Mrs Holland were both directors of this company and owned 50% of the shares each. The 50 non-voting shares were each held by an IT contractor who was paid by way of dividend. Under the terms of a trust deed, Paycheck Services Trustee Limited held the “A” share for the benefit of the shareholders/employees of that company. The purpose of the structure was to minimize the corporation tax liability of Paycheck Services Limited. The trading companies paid corporation tax at the small companies rate.

Mr Holland had taken advice regarding the corporate structure of the companies in 1999 and had been advised that the trading companies were associated but could take advantage of the exemption in Extra Statutory Concession C9. The scheme to reduce the corporation tax of Paycheck Limited failed as it did not take account of the fact that the trading companies were associated with Paycheck Services Limited and this meant that corporation tax was payable at 30% and not at the small companies rate. The additional tax liability of £3.5m led to the trading companies being placed into administration and subsequently liquidation. HMRC was the largest creditor of the trading companies and issued proceedings against Mr Holland for misfeasance on the grounds that he was a de jure director of the trading companies.

HMRC asserted that whilst Paycheck (Directors Services) Limited was the only de jure director of the trading companies, Mr and Mrs Holland were de facto directors of each trading company. They asserted that Mr and Mrs Holland had caused the trading companies to pay unlawful dividends contrary to sections 263 and 270 Companies Act 1985 on the grounds that the companies had insufficient distributable profits due to the higher accruing corporation tax liability at 30% rather than at the small companies rate. The High Court dismissed the claim against Mrs Holland and ordered Mr Holland to pay £144,000 in respect of his liability under section 212 Insolvency Act 1986.

Mr Holland appealed on the grounds that he was not a de jure director or a de facto director of the trading companies and that the only director of these companies was Paycheck (Directors Services) Limited. Mr Holland asserted that he acted in his capacity as a director of Paycheck (Directors Services) Limited and as that company was the sole director of the trading companies, it was that company which had been responsible for the alleged misfeasance.

The Court of Appeal reviewed the case law and in particular the judgment of the Court of Appeal in Re Kaytech International which found that the crucial issue in relation to whether a director of a corporate director had acted as a de facto director of the trading company was whether the individual in question had assumed the status and function of a company director so as to make himself responsible under the Company Directors Disqualification Act 1986 as if he were a de jure director. The Court of Appeal held that it did not matter what the individual was called but what he had done.

In this case, the Court of Appeal found that the relevant actions were the actions carried out by the corporate director, Paycheck (Directors Services) Limited, and not by Mr Holland as a director of Paycheck (Directors Services) Limited. They could see no rational basis on which a member of the board of the corporate director, who at all times acted in relation to the trading company solely in his capacity as a director of the corporate director, should be regarded as a de facto or shadow director of the trading company.

The Court of Appeal found that Mr Holland had not acted as a director of the trading companies but only as a director of Paycheck (Directors Services) Limited in its capacity as a corporate director of the trading companies. Whilst the Court of Appeal made it clear that nothing in the Paycheck Services case was intended to suggest that there could never be circumstances in which an individual director of a corporate director can or will act so as to cause himself to be regarded as a de facto director of the subject company, they made it clear that something more than the mere performance by the individual director of his duties as a de jure director of the corporate director will be required to show that he acted as a de facto director of the subject company.

Following the introduction of the requirement for each company to have at least one individual as a director in section 155 Companies Act 2006, this removes the situation where the only directors of the company in liquidation are corporate directors. It is therefore more likely that the liquidator or creditors will take action against the individual director whenever it is alleged that there has been misfeasance or that the company has been a party to an antecedent transaction, and less likely that the individual director of the corporate director will be considered to be a de facto director of the subject company which went into liquidation.

In Re Oxford Pharmaceuticals Ltd [2009] EWHC 1753 (Ch) the High Court considered whether a preference had been granted in favour of a director who had provided a guarantee to the companies’ bank where a subsidiary had paid money to its holding company which had the effect of reducing the holding company’s overdraft.

Masters International Ltd (MIL) distributed pharmaceuticals from the UK worldwide. Dr Masters and his wife were directors of MIL and owned 99% of the share capital. Oxford Pharmaceuticals Ltd (OPL) was a wholly owned subsidiary of MIL and Dr Masters was its sole director. It was incorporated with the purpose of supplying pharmaceuticals in the UK that were not otherwise available. One of OPL’s main lines involved a natural cream treatment for skin cancer. In 1996 OPL entered into a distribution agreement for the distribution of the cream with Curaderm International AVV. The cream had to undergo regulatory approvals by the Medicines Control Agency before it could be licensed in the UK and other markets which involved clinical trials. The costs of the trials were financed by money from MIL and direct from OPL’s bank. The banking facilities provided to MIL and OPL were secured by a cross guarantee and debenture entered into by each company in 1999. Dr Masters and his wife also provided unlimited guarantees to the bank for the liabilities of MIL and OPL.

By the middle of 2000, the costs of the trials had become prohibitively high and neither OPL nor MIL could sustain them. The bank pressed for a substantial reduction in both MIL and OPL’s overdrafts. OPL was already balance sheet insolvent. In June 2000 it entered into an option agreement with Loxias Technologies Pty Ltd, an Australian company, for the sale of information relating to the cream including the clinical trial results for £500,000 payable in two instalments of £250,000 each on 31 December 2000 and 31 March 2001.

Loxias exercised the option and in December 2000 paid £250,000 to OPL. OPL immediately transferred the monies to MIL. On 6 April 2001 OPL transferred £200,000 which reduced MIL’s overdraft. At about the same time, a dispute arose between OPL and Curaderm in relation to the distribution agreement. Curaderm alleged that it was entitled to damages of US$7m and issued proceedings on 10 April 2001. On 26 April 2001 Loxias paid the remaining £250,000 to OPL which immediately transferred it to MIL, thereby repaying MIL’s overdraft. In July 2001 a creditor presented a winding up petition against OPL in respect of unpaid invoices.
The liquidator sought a declaration that the payments made by OPL to MIL between December 2000 and July 2001 amounted to preferences contrary to section 239 Insolvency Act and that MIL and Dr Masters repay these sums in full.

The High Court considered the provisions of section 239 Insolvency Act in the light of the claim that Dr Masters had been preferred as a result of the payments made by OPL to MIL following receipt of the monies from Curaderm. It was common ground that the payments by OPL to MIL of £700,000 did prefer MIL within the meaning of section 239(4), were made at a relevant time and at a time when OPL had been unable to pay its debts.

The liquidator submitted that Dr Masters had also been preferred as a result of the payments to MIL as a result of his guarantee to the bank in respect of both MIL and OPL and also as a shareholder of MIL. The liquidator’s case was that there was a preference under section 239(4) as Dr Masters was a surety for the liabilities of OPL and as a result of the payments made by OPL to MIL which MIL paid on to its bank, Dr Masters was put in a better position than he would otherwise would have been in the event of the liquidation of OPL, whether or not the improvement in his position arose in his capacity as guarantor for OPL or otherwise, such as guarantor for MIL or as a shareholder of MIL. The liquidator also submitted that even if Dr Masters had not been preferred and only MIL had been, a remedy lay against Dr Masters under section 241 Insolvency Act and the power of the court to make orders against third parties.

The High Court held that there was no authority for this proposition and that the wording of section 239 did not support the liquidator’s assertion. In order to constitute a preference for the purposes of section 239(4), the payment complained of must have benefited the preferred party in his capacity as surety or guarantor for the liabilities of the company. Section 239 concerned the position where a company had caused something to be done which put one of the company’s creditors, a surety or a guarantor for any of the company’s debts or liabilities in a better position as creditor, surety or guarantor. The judge found that there was no evidence of a preference in favour of Dr Masters and that section 239 would have to have much clearer wording in order for the judge to find that a payment by OPL to MIL amounted to a preference in favour of Dr Masters as guarantor of OPL’s liability to the bank. The judge made it clear that otherwise section 239 “could operate to require a person to disgorge a benefit obtained in some other capacity from the mere accident of them being a surety or guarantor and they have not been benefited in that latter capacity”.

The High Court considered the effect of the payments in the context of the cross-guarantee and the debenture. It found that there was no sufficient benefit to Dr Masters as, in the event of a hypothetical liquidation of OPL at any time, the bank was in fact fully secured by the cross-guarantee. There had therefore been no preference as Dr Masters, in his capacity as guarantor of OPL had been in the same position as if the payments have not been made.

The liquidator sought to have a third party repayment order against Dr Masters under section 239(3) and/or section 241(1) and (2) Insolvency Act. The High Court noted that section 241(2) envisaged the making of orders against third parties who were not preferred themselves but found that the court could only exercise its discretion against the third party if the order was required as part of the process of restoring the position to what it would otherwise has been if the preferential payment had not been made, and the third party was in possession of assets applied in making the preference, or had otherwise personally benefitted in monetary terms from the payment in some direct and tangible way.
The High Court held that it was not appropriate to make an order against Dr Masters as the monies had not been paid on by MIL to him and that any benefit received by Dr Masters as a shareholder in MIL was incidental.

Liquidators need to take care in cases where they are seeing to recover funds from third parties such as directors who have given guarantees that the benefit of the alleged preference is not incidental but can be capable of being set aside on all grounds under section 239 Insolvency Act.

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