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On 5 and 6 October 2010, the Supreme Court will hear an appeal in the case of Progress Property Company Limited v Moorgarth Group Limited.  This is a case concerning the legality of a sale by a company of assets at an alleged undervalue to one of its own shareholders, in circumstances where the director of the company responsible for effecting the sale was also a director of the shareholder that acquired the assets.

The case will be heard by Lords Phillips, Walker, Mance, Collins and Clarke, who will decide whether such a transaction is void as an unlawful and ultra vires distribution, even if ratified, where:

(i)               the director intends and believes the transaction to be at market value; but

(ii)             in fact the transaction is at an undervalue; and

(iii)            the director ought to have known as much and is consequently in breach of his duty of care to the company.

Background

The Appellant (“PPC”) is a property holding and development company, the majority interest in which was, until October 2003, owned by Tradegro (UK) Limited (“Tradegro”).  Shortly before the completion of the sale of PPC to its present owner, but after contracts had been exchanged, PPC disposed of a valuable property holding subsidiary (“YMS”) to a company now called Moorgarth Group Limited (“Moorgarth”).

The consideration for that disposal was discounted by approximately £4m, purportedly to take into account the release of a counter-indemnity said to have been given by PPC in respect of repairing liabilities towards the underlying property assets being disposed of.  Subsequently, however, doubts arose over whether there had been a valid counter-indemnity from which PPC could be released.  In turn this gave rise to the concern that sale of PPC’s assets to Moorgarth may have taken place at a substantial undervalue.

Moore, was also a director of Tradegro and Moorgarth, and Moorgarth was a wholly owned subsidiary of Tradegro.  It is the Appellant’s case that Mr Moore’s belief in the existence of the counter-indemnity, and in consequence his belief that the sale price of YMS represented its proper market value, was wholly unreasonable.  It accordingly contends that Mr Moore was in breach of his duty of care as a director, and that the transaction itself was ultra vires the company and should be set aside.

High Court decision

On 15 October 2008, David Donaldson QC (sitting as a Deputy High Court Judge) rejected the proposition advanced by the Appellant that “a transaction is not only illegal but ultra vires whenever the company has entered into a transaction with a shareholder which results in a transfer of value not covered by distributable profits, and regardless of the purpose of the transaction”.  In doing so, he held that this proposition was not supported, and indeed was positively belied, by the dicta of the then Mr Justice Hoffman in Aveling Barford v Perion [1989] BCLC 626.

Court of Appeal decision

On 26 June 2009, Lords Justice Mummery, Toulson and Elias rejected an appeal by the Appellant against the decision of Deputy Judge Donaldson, holding that the common law rule against the distribution of capital to shareholders did not apply in this case simply because of the link between Mr Moore and Tradegro, nor because Mr Moore ought to have appreciated the fact that the sale was at an undervalue.  In reaching this view, the Court of Appeal differentiated Aveling Barford on the basis that they considered it to be an essential part of Hoffman J’s rationale for his decision that the sale of the company’s asset was not a genuine sale and was known and intended to be at an undervalue.

Both Aveling Barford and Re Halt Garage (1964) Limited [1982] 3 All ER 1016 show that the relevant test is whether the transaction in question can be characterised as something other than a gratuitous distribution to shareholders.  In those two cases, the payment in question could not.  In this case, by contrast, the transaction was not intended by Mr Moore to be at an undervalue, and the Deputy Judge had found that there was no reason to doubt the genuineness of the sale to Moorgarth as a commercial sale of PPC’s subsidiary even though it appeared that the sale price was calculated on a basis that was misunderstood by all concerned.  Accordingly, the Court of Appeal concluded that “the payment could only properly and objectively be characterised as consideration for the sale of an asset without any element of gratuitous benefit”.

Comment

It has long been a fundamental principle of company law that a company’s integrity should be protected by the maintenance of its capital.  The common law rule affording this protection is well settled, as is the statutory requirement that distributions from a company can only be made from distributable profits (now contained in Section 830 of the Companies Act 2006, and previously Section 263 of the Companies Act 1985).

Following Aveling Barford these rules came under closer scrutiny and the 1998 Company Law Review led to the establishment of a Working Group on Capital Maintenance.  One observation recorded by the group in relation to the effect of Aveling Barford was that the common law rule on the maintenance of capital, “is now generally regarded as applying to any payment by the company, or transfer of its assets, to a shareholder or an associate of a shareholder, other than by way of lawful dividends, reductions of capital or other lawful procedures”.

This ultimately resulted in the enactment of Sections 845 and 846 of the Companies Act 2006 which permit intra-group transfers at book value where there are distributable profits.  The explanatory notes however make clear that the new provision, “does not disturb the position in the Aveling Barford case such that where a company which does not have distributable profits makes a distribution by way of a transfer of assets at an undervalue, this will be an unlawful distribution contrary to … the Act.”

The decision of the Supreme Court will be an important one in clarifying the scope of the rules as they applied prior to the Companies Act 2006, in particular as regards what if any distinction is to be drawn between the subjective and objective intent of directors effecting intra-group transactions, and the consequences of directors failing to meet the requisite threshold of care and reasonableness.