This is the third article in our series looking at how Insolvency Practitioners work and the legal framework behind financial distress. In the first, we looked at why asset valuations sit at the heart of every insolvency process. In the second, we turned to preferences in insolvency, one of the four duties directors must avoid once a company is insolvent or heading that way. This time we look at a related but distinct duty, set out in our Directors’ Duties guide as one of the “four sins” that directors must avoid in insolvency: transactions at undervalue.
What is a transaction at undervalue?
A transaction at undervalue happens when a company, while insolvent or about to become insolvent, gives something away or sells it for significantly less than it is worth. This is set out in section 238 of the Insolvency Act 1986.
There are two ways this can happen. The company might make an outright gift, receiving nothing in return. Or it might enter into a transaction where what it receives is worth significantly less than what it gives up, such as selling a company asset worth £50,000 for £15,000.
For a transaction to count, it must fall within a defined window before formal insolvency proceedings begin, known as the relevant time. For transactions at undervalue, this is always two years before the onset of insolvency, whether or not the other party is connected to the company. The company must also have been unable to pay its debts at the time, or have become unable to, as a result of the transaction. Where the other party is connected to the company, such as a director or a close family member, the law presumes this was the case unless the contrary can be shown.
The court will not make an order if the company can show it entered into the transaction in good faith, for the purpose of carrying on its business, and that there were reasonable grounds at the time for believing it would benefit the company.
Transactions at undervalue can catch directors out precisely because they rarely look like wrongdoing at the time, as Hugh Jesseman, a director and Licensed Insolvency Practitioner at our London office, explains:
“The transactions we see most often were never intended to disadvantage anyone. A director sells a company asset to a family member at a friendly price, or writes off a debt owed by a connected business, thinking it is the pragmatic thing to do at the time. The law asks a much narrower question: was there a proper commercial reason for it, and did the company get something close to what it gave up?”
Why are transactions at undervalue taken seriously?
Every asset a company has, before it becomes insolvent, exists to be shared fairly among its creditors if things go wrong and insolvency does strike. When value leaves the company for little or nothing in return, that pool of assets shrinks, and every creditor is worse off by the same amount. The law exists to restore that value, not to penalise ordinary commercial decisions made in good faith.
Does an Insolvency Practitioner have to report it?
Yes. Once appointed, an Insolvency Practitioner has a duty to look back over the period leading up to insolvency at the company’s significant transactions and decisions. These are generally known as antecedent transactions, and a transaction at undervalue is one of the specific things this review is designed to catch.
Where one is identified, the liquidator or administrator can apply to court under section 238 for an order restoring the position, which might mean the recipient returning the asset or paying its true value.
Every officeholder also has a duty under section 7A of the Company Directors Disqualification Act 1986 to report on directors’ conduct to the Insolvency Service, within three months of appointment. Evidence of a transaction at undervalue is one of the matters that can be flagged within that report, as we explained in our earlier article on directors’ conduct reports.
None of this is optional, and none of it exists to catch anyone out. It is simply part of how the system protects the wider body of creditors.
What are the consequences of a transaction at undervalue?
If the court finds that a transaction at undervalue took place, it can make whatever order it thinks fit to restore the position, which in practice might mean the recipient handing back the asset or paying its true value. A director who arranged or approved the transaction can be held personally liable. Where the conduct is serious enough, it can also contribute to a director disqualification action of up to 15 years, and in some cases a compensation order on top.
A genuine commercial decision, taken in good faith with proper regard to the company’s interests, is a very different matter from quietly moving value to a connected party ahead of insolvency. The facts of each case, and the reasoning behind the decision at the time, are what the law looks at.
How can directors avoid entering into a transaction at undervalue?
Get an independent, up to date valuation before selling or transferring any significant company asset, particularly to a connected party. Keep clear board minutes recording the commercial reasoning behind any sale, gift, or write-off made during a difficult period. Avoid informal arrangements with family members or connected businesses once financial difficulty is on the horizon. Take advice before writing off a debt owed to the company or transferring assets between group companies.
Elaine Wilkins, a director at our Bournemouth office, sees directors worry about this more than almost anything else:
“Directors often assume this only applies to obviously dishonest behaviour, and that worries them unnecessarily. In reality, most of the transactions we look at were well intentioned. The directors who come to us before a sale or transfer goes ahead, rather than after, are the ones who avoid any difficulty at all. A quick conversation with us beforehand can save a great deal of concern later on.”
Talk to Antony Batty & Company about directors’ duties at insolvency
Antony Batty & Company are Licensed Insolvency Practitioners with offices in London, Bournemouth, Brentwood, Mill Hill, Salisbury and Thames Valley. If you are concerned about a transaction you have entered into, or about the financial position of your company more generally, contact us for a free, no commitment confidential initial discussion.
Frequently asked questions about transactions at undervalue
What is the difference between a transaction at undervalue and a preference?
A preference is about treating one creditor better than others and depends on showing a desire to prefer them. A transaction at undervalue is about the company receiving significantly less than something is worth, or nothing at all, and does not depend on any particular intention behind it.
Can a transaction at undervalue be unwound years later?
The relevant time for a transaction at undervalue is always two years before the onset of insolvency, regardless of whether the other party was connected to the company. A transaction completed within that window can come under scrutiny.
Is selling an asset below market value always a transaction at undervalue?
Not necessarily. The law looks for a significant difference in value, not any shortfall, and the court will not intervene if the transaction was entered into in good faith, for a proper business purpose, with reasonable grounds to believe it would benefit the company.
What should I do if I think a transaction I made might be considered undervalue?
Speak to a licensed Insolvency Practitioner as soon as possible. Early advice gives directors the best chance of explaining the commercial reasoning behind a decision, before it is looked at in hindsight.
