Understanding s239 Preference under Insolvency Act 1986

Author: Simon Hill
In: Article Published: Thursday 30 January 2014

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Insolvency officeholder's claims to void a transaction as a preference, discussed by Mr Hill, advocate in the section 239 preferences cases of Taylor (Liquidator of The Caprice Clothing Company Limited) v Ziya [2012] BPIR 1283 and Finch Plc [2016] BCLC 394

1. The law prohibiting preferences is a small but important area of corporate insolvency law. It is designed to counter attempts to undermine or circumvent the proper application of the pari passu principle in an insolvency. The main provision, s239 of the Insolvency Act 1986 (‘the Act’) has proved an effective weapon in a liquidator or administrator’s hand; its continuing practical importance to day-to-day insolvencies in the England and Wales is evidenced by the steady stream of reported cases in this area.

THE PARI PASSU PRINCIPLE

2. It is often said that the most fundamental principle in corporate insolvency is the principle of pari passu distribution - that all creditors of a certain class within the statutory scheme should be treated equally in the distribution (see Insolvency Rules 1986 r.4.181 and s107 of the Act); for the purposes of this paper, the focus will be the principle’s application to non-preferential unsecured creditors as a class.

3. During prosperous times, a creditor’s ability to seek payment and enforcement against a company’s assets is governed by a ‘first come, first served’ or ‘race goes to the swiftest’ legal environment. During the company’s twilight, this environment is disorderly and unrestrained (at best unrestrained, at worst during the twilight period it could be described as a company asset dismemberment melee). Once a company enters insolvency, this creditor environment is replaced by one where  creditors hold general rights, standing alongside all others within their general body of creditors, to a rateable slice of the distribution of the net proceeds pari passu – see Re Gray’s Inn Construction Ltd [1980] 1 WLR 711 . The objective being that losses existing in the insolvency should be borne by the creditors equally, with each creditor receiving a certain number of pence per pound of debt.

4. The law has long recognized and made provision for the inevitable temptation that arises in some involved with a company to attempt to circumvent or undermine the application of the pari passu principle during the company’s twilight - to place a particular existing creditor (typically, it is a creditor, but sureties and guarantors can also be recipients) into a position which will prove more advantageous to that particular creditor when the anticipated insolvency comes to pass - more advantageous in comparison to what that particular creditor would otherwise have been entitled to, standing alongside the other creditors pari passu. The uplift or improvement gained will have caused a corresponding detriment to the general body of creditors – distorting the ‘equal treatment’ ethos and frustrating the proper distribution of the general pool of assets to that body.

5. Frequently encountered scenarios can involve the selective repayment of loans:

a. Received by the company from persons connected to the company, like director’s spouses or relatives;

b. Provided by certain particular creditors with whom the directors wish to maintain a continuing relationship with after the company’s insolvency; or

c. From the company’s bank, including the bank’s overdraft facility, to which directors’ guarantees are linked.

THE OFFICE-HOLDERS’ ARMOURY: THE SPECIFIC STATUTORY POWERS 

6. The preference power forms part of the liquidator and administrator’s  (‘office-holder’) ‘well-stocked armoury’ of statutory powers to challenge improper depletion/divesting of a company’s assets (e.g. s212 misfeasance, s213 fraudulent trading, s214 wrongful trading, s238 transactions at an undervalue and s423 transactions defrauding creditors). However, s239 preferences, the focus of this paper, is the main weapon for protecting the proper application of the pari passu principle.

PREFERENCES

7. The starting point for considering the ambit and scope of a statutory power is the statute itself. The provisions are detailed, particularly within s240 and 241 (the supplementing provisions) and while this survey will consider the salient parts, readers are encouraged to read the specific sections themselves, to glean the exact parameters of each section before applying it to their particular factual scenario.

QUALIFYING PREFERENCES: TWO PRECONDITIONS

8. Not all potential preference transactions are vulnerable to a s239 application by the office-holder. S239 only permits applications to Court to be made in respect to an allegedly voidable preference that has occurred within the ‘relevant time’. ‘Relevant time’ breaks down into two mandatory preconditions - the preference must have occurred:

a. During the operative period; and

b. While the company was in a state of insolvency.

Precondition 1: During the Operative Period;

9. ‘Relevant time’ is defined, for the purposes of s239, by s240(1) as being either:

a.In the case of a preference given to a person who is ‘connected with’ the company, any time in the period of 2 years ending with the ‘onset of insolvency’; or

b.In any other case, any time in the period of 6 months ending with the ‘onset of insolvency’.

As will be immediately apparent, the terms ‘connected with’ and ‘onset of insolvency’ are important terms of art in the statute.

10. This time provision operates in a similar fashion to Limitation Act bars, providing a trailing time limit going back from the onset of insolvency. The length of the trailing time limit is Parliament’s attempt at striking the right balance between catching underminingly proximate preferences and providing a measure of commercial certainty to those interacting with companies, by guaranteeing finality of transaction after a certain point. Accordingly, an otherwise vulnerable preference may become immune from a set aside application if the company hobbles along long enough after the preference transaction is given.

‘Onset of Insolvency’

11.The ‘onset of insolvency’ is defined in s240 (3) as being one of five trigger scenarios, all relating to the company either entered into administration or going into liquidation. This may be the date of presentation of the petition for the making of an administration order, or in the case of an out of court appointment of an administrator the date on which the notice of intention to appoint is filed. In the case of a company going into liquidation following conversion of administration into winding up the onset of insolvency is the date on which the company entered administration, but in all other cases under which the company goes into liquidation the onset of insolvency is the date of the commencement of the winding-up.

‘Connected with’

12. Whether the recipient of the preference was a person ‘connected with’ the company at the time the preference occurred, has an impact on two aspects of s239’s application:

a. On the length of the trailing time limit ‘relevant time’ – as outlined above; and

b. It triggers a presumption created by in s239 (6) in respect to the ingredient ‘influenced by a desire’ – this will be considered below.

13. Persons ‘connected with’ a company is defined in a combination of s249 and s435. Section 249 reads:

‘For the purposes of any provision in [Part containing s239], a person is connected with a company if-

(a) he is a director or shadow director of the company or an associate of such a director or shadow director, or

(b) he is an associate of the company

and “associate” has the meaning given by section 435 in Part XVIII of this Act’

14. Relevant s249 terms are defined in s251 as:

 ‘”director” includes any person occupying the position of director, by whatever name called’;

‘”shadow director”, in relation to a company, means a person in accordance with whose directions or instructions the directors of the company are accustomed to act (but so that a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity)’.

15. The distinction between ‘shadow director’ and ‘de facto’ director should be kept in mind here, so as not to fall into the trap described as ‘embarrassing’ by Millett J in Re Hydrodam (Corby) Ltd [1994] 2 BCLC 180 (see also Holland v HM Revenue and Customs [2011] BCC 1).

16. The term ‘associate’ is defined in elaborate detail in s435, covering a wide and varied selection of relationships (e.g. spousal, civil partner, familial, partnership or trustee etc.) too numerous to repeat here. Reference to the section itself should be made where it is not clear whether the relationship in issue is caught by s435.

17. It is important to note that s239 (6) and s240(1) expressly exclude a person from being found to be ‘connected with’ the company if that person would qualify only by reason of being the company’s employee.

18.The rationale for why those ‘connected with’ the company are singled out, is explained by Professor Prentice in Making Commercial Law: Essay’s in Honour of Roy Goode ed. Cranston, page 454:

‘The reason for singling out connected parties (e.g. directors) for special treatment is that they will more likely than other creditors know of the company’s insolvency and will also be in a position to pressurize the company to make a preferred payment.’

Precondition 2: State of Insolvency

19. A time is not ‘a relevant time’ unless the company was at that moment the preference was given, unable to pay its debts within the meaning of s123 or became so in consequence of the transaction. This precondition is contained within s240 (2), which reads:

‘Where a company ... gives a preference at a time mentioned [2 years or 6 months], that time is not a relevant time for the purposes of … section 239 unless the company—

(a) is at that time unable to pay its debts within the meaning of section 123 in Chapter VI of Part IV; or

(b) becomes unable to pay its debts within the meaning of that section in consequence of the ... preference; ...’

20. Section 123(1) provides that a company is deemed unable to pay its debts in various circumstances, of which the only relevant one (a co-incidental s123 (1)(a) or (b) situation seems fairly unlikely) is:

‘(e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due.’  (‘cash-flow’ insolvent)

21. By virtue of s 123(2), a company is also deemed unable to pay its debts:

‘if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities.’ (‘balance sheet’ insolvent).

22. If the solvency of the company at the moment the alleged preference was given is in issue, then the Court will need to consider evidence of the company’s accounts at that time.  

WHAT TRANSACTIONS ARE PREFERENCES?

23. A transaction will be a voidable preference if three ‘ingredients’ are satisfied. A company gives a preference to a person if:

‘(a) that person is one of the company’s creditors or a surety or guarantor for any of the company’s debts or other liabilities (‘Ingredient 1’)

(b) the company does anything or suffers anything to be done which (in either case) has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position he would have been in if that thing had not been done.  (‘Ingredient 2’)

24. However, a Court cannot make an order setting aside a preference unless the third ingredient, contained in s239 (5), is satisfied, namely:

‘…unless the company which gave the preference was influenced in deciding to give it by a desire to produce in relation to that person the effect mentioned in [Ingredient 2]; (‘Ingredient 3’)

Ingredient 1: Recipient is an existing Creditor, Surety or Guarantor

25. This provision is relatively straightforward. Is the recipient of the transaction, either a ‘creditor’ of the company, or a ‘surety’ or a ‘guarantor’ of the company’s debts or liabilities? The existence or otherwise of this ingredient should be easily ascertainable from the recipient’s pre-existing financial relationship with the company.

Ingredient 2: The Effect is Betterment

26. This ingredient centres on the effect of the transaction (rather than motivation for the transaction), and whether the transaction that occurred was either by company commission or by the company ‘suffering’ it. This latter word, ‘suffering’, is not easy to understand at first glance; its meaning was considered in Re Parkside [2009] BPIR 549 as being ‘in the sense of allowing to happen, something it can control’ (or influence), for example, ‘…by allowing a debtor to make the relevant payment to the company’s bank or creditor on its behalf’. Some transactions can occur that involve neither commission nor such suffering – the Court in Parkside said ‘the trafficking between third parties in a debt owed by the company does not involve the company in doing or allowing anything to happen’ (see also Belmont Park Investments [2012] 1 AC 383).

27. Further, the (mere) fact that something has been done in pursuance of a Court order does not, without more, prevent the doing or suffering of that thing from constituting the giving of a preference, s 239 (7). This seems logical, otherwise the risk would exist that the Court process could be used collusively by the company and recipient as an ‘immunity cloak’. However, this issue rarely arises as by far the majority of preferences are conferred without resort to legal proceedings.

28. Whether the transaction had the identified effect (which I shall label ‘betterment’), is a question of fact. However, this issue will rarely be less than clear-cut, since it will usually be fairly apparent whether the recipient’s position has altered for the better.

29. This betterment comes in different guises. For example, it will be an improvement in the recipient’s financial position in an approaching insolvency for the recipient to:

a. be paid some (or all) of the money owing – for an example, see Taylor v Ziya  [2012] BPIR 1283; or

b. have the debt ‘upgraded’ from being unsecured to being secured, by the granting of a fixed or a floating charge over the company’s assets (or being granted further security for the debt). Secured creditors, particularly fixed charge creditors, stand in a very strong position in an insolvency - for example, see Stealth Construction v Ireland [2011] BPIR 1173 (‘Stealth’) and Re Mistral Finance Ltd [2001] BCC 27;

c. returning goods which have been delivered but not paid for - see Cork Report (1982) Command 8558;

d. have his guarantee released because the debt he stood as guarantee for has been paid off by the company – see Re Parkside [54]. A familiar scenario might be where a director stands as guarantor for the company’s overdraft; he then benefits when the bank releases him from the guarantee after the company pays off the entire overdraft.

30. Transactions don’t always result in betterment. In Branston & Gothard Ltd [1999] BPIR 466, the company was holding money on trust for clients, the company then moved the funds from one trust bank account to another trust bank account. The Court held that this did not amount to any betterment. The beneficiaries remained in the same position.

Ingredient 3: ‘Influenced by a Desire’

31. The core element of s239 (5), namely the phrase ‘was influenced…by a desire to produce’ introduces a disapplying provision. The Court may not set aside the voidable preference unless this motivation-based ingredient is established. The motivation ingredient has two principal parts, the ‘desire’ and that the decision by the company to enter into the preference transaction being sufficiently ‘influenced’ by that ‘desire’ to satisfy s239 (5).

32. Assistance as to the nature of the ingredient can be found in M C Bacon Ltd [1990] B.C.C. 78 at 87, where Millett J stated that:

‘...desire is subjective. A man can choose the lesser of two evils without desiring either. It is not, however, sufficient to establish a desire to make the payment or grant the security which it is sought to avoid. There must have been a desire to produce the effect mentioned in the subsection, that is to say, to improve the creditor’s position in the event of an insolvent liquidation. A man is not to be taken as desiring all the necessary consequences of his actions. Some consequences may be of advantage to him and be desired by him; others may not affect him and be matters of indifference to him; while still others may be positively disadvantageous to him and not be desired by him, but be regarded by him as the unavoidable price of obtaining the desired advantages. It will still be possible to provide assistance to a company in financial difficulties provided that the company is actuated only by proper commercial considerations. Under the new regime a transaction will not be set aside as a voidable preference until the company positively wished to improve the creditor’s position in the event of its own insolvent liquidation’.

33. In Fairway Magazines [1992] B.C.C. 924 at 929, Mummery J stated that:

‘…it does not follow that, because there was a desire to grant the debenture or to make the payment, there was a desire to prefer the creditor in the event of insolvency. If the company is influenced by “proper commercial considerations” and not by a “positive wish to improve the creditor’s position in the event of its insolvent liquidation”, then the debenture is valid.’

34. Turning to how might such ‘desire’ be established as a fact, and in particular the availability of direct evidence and the scope for drawing inferences, the Court in Fairway stated:

‘...a desire to produce that effect is a subjective state of mind. As it is subjective, there may often be no direct evidence of that state of mind. The existence of the state of mind may, however, be inferred from all the circumstances...’

35. In MC Bacon, the Court considered the required degree to which the company’s desire must influence the decision to enter into the relevant transaction; for s239 (5) to be satisfied: 

‘...it requires only that the desire should have influenced the decision. That requirement is satisfied if it was one of the factors which operated on the minds of those who made the decision. It need not have been the only factor or even the decisive one….it is not necessary to prove that, if the requisite desire had not been present, the company would not have entered into the transaction…’

36. The influence required is not such that the ‘desire’ factor can be said to have ‘tipped the scales’.

37. It is important to note that the crucial date for ingredient 3 is ‘…when the decision to grant [the preference] was made’. It is not the date when:

a. the transaction putting into effect the preference was executed; or

b. the underlying contractual or other obligations were created. Where contractual obligations provide for the company to make a payment by a certain date, it is not the date the contract was formed that is relevant, nor the date for payment. Here, the relevant date is the date of the decision whether the company will honour its already existing contractual obligations, as per Wills v Corfe Joinery Ltd (In Liquidation) [1997] BCC 511. On this issue, Stealth said:

‘Most preferences involve the payment of some debts in preference to others. All debts stem from an enforceable obligation to make the payment. If the decision to incur the debt, rather than the later decision to pay it, was the relevant time at which the company’s desire was to be judged, the payment of debts would rarely constitute a preference under s 239.’

38. This crucial date when the motivation is judged, applies equally to whether the company should honour its pre-existing obligation to grant a security or not. As Stealth stated, there is no ‘…distinction between the payment of debts on the one hand and other obligations, such as an obligation to grant a security, on the other’. It is the decision to comply with an obligation that is the key decision date, not the date the obligation to later grant the security, was created.

39. The ingredient here is only in respect to the company’s state of mind or conduct. As stated in Stealth, ‘this is entirely an issue of the thought processes of the directors of the company…Section 239 focuses not on the conduct or state of mind of the creditor concerned, but on that of the directors or others acting for the company.’ It is company-centric. A particular state of mind or conduct from the recipient is not required for the statutory power of set aside to be available to the Court. ‘In many cases, the preferred creditor will share the desire to be preferred but this need not be so.’ The statutory power is not dependent on any finding by the Court that the recipient has acted in any way improperly.  In Stealth, the Judge found that the recipient had received a voidable Preference (which he set aside), but wanted to make clear that ‘the result in this case implies no criticism of [the recipient] at all’. She had ‘reasonably believed that she had the benefit of a charge…and that she received no more than her due’.

40. The comment can be made that a statutory power founded on mere betterment, without this motivation ingredient, would be unworkable in practice. Ailing companies would struggle to interact with their existing creditor base because individual creditors would be concerned that any betterment received due to the company’s actions or omissions under the company’s control or influence, would be vulnerable to being unwound later in insolvency. As the ailing company’s position deteriorated, refinancing would be increasingly impossible, as individual creditors would become more and more concerned about the unwinding risk.  

Presumption: ‘Influenced by a desire’ s239 (6)

41. The statute provides that upon it being proved that the recipient was ‘connected with’ the company, the Court must find as a (secondary) fact that there was the requisite ‘influenced by a desire’ ingredient, ‘unless the contrary is shown’. The presumption that this ingredient is present can be rebutted by the recipient adducing evidence showing that any such betterment was not so motivated. Rebuttal evidence may take a myriad of different form and arguments, but examples providing a contraindication of an influencing desire to prefer, might include: 

a. Intention was to secure future funding – see Fairway;

b. the lack of good will/palpable animosity between the recipient and the company – see Taylor;

c. ‘Proper commercial considerations’ generally – MC Bacon;

d. a lack of realization within the company’s board that insolvency was on the horizon.

42. On the facts of Fairway, Mummery J found that the recipient had rebutted the presumption that the relevant decision to grant the debenture was influenced by a desire to prefer the recipient. The recipient had shown that the company was solely influenced by commercial considerations in its decision, namely the need to raise money from sources other than the bank, which had placed an upper limit on any overdraft, in order to keep trading with a view to sale.

43. The question of whether the presumption has been rebutted on ‘influenced by a desire’ is a matter than should go to trial rather than be resolved at a summary judgment application, save in the clearest of cases, as per Phillips v McGregor-Paterson [2010] BPIR 239

DISAPPLICATION OF S239 TO FINANCIAL MARKET RELATED CONTRACTS

44. There exists two minor areas where s239 is disapplied; helpfully summarized in Sealy & Milman Annotated Guide to the Insolvency Legislation 2013; 13th ed, at 249 as:

a. Financial markets – a market contract to which a recognised investment exchange or clearing house is a party or which is entered into under its default rules, or a disposition of property in pursuance of such a market contract – Companies Act 1989, s165; and 

b. Payment and securities settlement systems by the Finality Regulations 1999 reg 17.

CONSEQUENCES OF A TRANSACTION BEING A PREFERENCE

45. Where a transaction falls foul of s239, the transaction is voidable at the instance of the office-holder. Power is vested in the office-holder to bring proceedings to seek an order for it to be set aside. Upon a preference being established, the Court is required to ‘make such order as it thinks fit for restoring the position to what it would have been if the company had not given that preference’. Such wording has been found to extend to making no order for relief, if that is what the Court thinks fit, as per Re Paramount Airways [1993] Ch 223.

46.There are two parts to the remedy likely to be sought by the office-holder:

a. An order setting aside the transaction (or ‘avoiding’, the phrases can be used for present purposes interchangeably). From the date of the Court order onwards, the transaction is null and void (the ‘setting aside order’); and

b. An order reversing the betterment by unwinding the improvement, thereby removing the corresponding detriment to the general body of creditors (the ‘restorative order’).

47. Without contradicting the generality of the ‘as it thinks fit’ provision, s241 (1) sets out seven orders the Court may decide to make. In essence, a non-exhaustive non-binding illustrative list of possible mechanisms for achieving the restoration – a list that should be read in full. The Court will tailor the order so as to best achieve restoration in the particular circumstances of the case. The most salient parts of s 241(1) read:

‘…an order ... with respect to a ... preference entered into or given by a company may—

(a) require any property transferred as part of the transaction, or in connection with the giving of the preference, to be vested in the company [...]

(c) release or discharge ... any security given by the company

(d) require any person to pay, in respect of benefits received by him from the company, such sum to the office-holder as the court may direct ...’

48. Where an asset is to be returned to the company, and that asset has been improved during the interim, allowance can be made for the expenditure incurred by the recipient – as per Weisgard v Pilkington [1995] BCC 1108. Guarantees or sureties released or discharged following linked debt being paid off contrary to s239, can be ordered to ‘be under such new or revived obligations …as the court thinks appropriate’.

49. The ‘fruits’ of the litigation, the sum recovered pursuant to the restorative order, is vested in the office-holder. It is money arising from the power he has exercised. As stated in Re Yagerphone [1935] Ch 392:

‘The right to recover a sum of money from a creditor who has been preferred is conferred for the purpose of benefiting the general body of creditors…the sum of money…did not become part of the general assets of [the company], but was a sum of money received by the liquidator impressed in their hands with a trust for those creditors amongst whom they had to distribute the assets of the company.’

50. Such restored sums cannot therefore be subject to any floating charge granted over the company’s assets.

CONCLUSION

51. Those controlling an ailing company during its twilight may become tempted to favour certain particular non-preferential unsecured creditors over the general body of creditors of this class, by improving their positioning in the (likely) forthcoming insolvency. The availability of the Court’s power to set aside and unwind such preferences is an effective weapon in the office-holder’s fight to counter any circumventing or undermining of the fundamental pari passu principle and its ethos of sharing losses equally among the non-preferential unsecured creditors.

52. The harm to this general body is the existence of the betterment. Logically the objective of the remedy should be, and is, the restoration of the status quo ante to that betterment, with the Court given very wide power within which to achieve that stated objective.

53. However, something more is required, the ‘influenced by a desire’, motivation ingredient. Unless this is satisfied, no jurisdiction to unwind the transaction arises under s239. This ingredient ensures that only where there is an improper motive behind the betterment, namely a sufficiently influencing ‘positive wish to improve the creditor’s position in the event of its own insolvent liquidation’, will transactions be voidable. A motive consisting of proper commercial considerations, and devoid of the improper betterment desire, will not be at risk. The crucial determinant will be what the Court finds to have been the true reasons for the decision-maker deciding to commit the company to the course of action that resulted in the betterment.

SIMON HILL © 2014

BARRISTER

33 BEDFORD ROW

NOTICE: This article is provided free of charge for information purposes only; it does not constitute legal advice and should not be relied on as such. No responsibility for the accuracy and/or correctness of the information and commentary set out in the article, or for any consequences of relying on it, is assumed or accepted by any member of Chambers or by Chambers as a whole.