Unlawful dividend payments are not assets for the purposes of assessing inability to pay debts under the Section 123 of the Insolvency Act 1986

In the recent case of Evans v Jones and anor [2016] EWCA Civ 660 (CA) the court of appeal was asked to consider whether the payment of unlawful dividends by Rococo Developments (the “Company”), a claim which had been conceded by its former shareholders Mr and Mrs Jones before trial, was an asset of the Company which has the effect of restoring the Company’s solvency.

The point was of relevance because Mr and Mrs Jones had been repaid loans by the Company prior to its entering liquidation. It was accepted that each of the payments was factually a preference, but Mr and Mrs Jones disputed the allegation that the Company was unable to pay its debts within the meaning of Section 123 of the Insolvency Act 1986 (“the Act”) (or became so as a result of the payment) in order for the preferences to be given at a “relevant time” for the purposes of Section 240(2) of the Act1986.

Section 123 of the Act provides: –

“(1)          A company is deemed unable to pay its debts: –

                (a)           if, a creditor (by assignment or otherwise) to whom the company is indebted in a sum                                        exceeding £750 then due has served on the company, by leaving it at the company’s                                            registered office, a written demand (in the prescribed form) requiring the company to pay the                               sum so due and the company has for 3 weeks thereafter neglected to pay the sum or to secure                               or compound for it to the reasonable satisfaction of the creditor, or

                (b)           if, in England and Wales, execution or other process issued on a judgment, decree or order of                       any court in favour of a creditor of the company is returned unsatisfied in whole or in part, or…

                (e)           if it is proved to the satisfaction of the court that the company is unable to pay its debts as they                        fall due.

 (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….”

If the court held that the unlawful dividends were to be treated as assets the preference claim against Mr and Mrs Jones may have failed on the basis that the Company was solvent at the time the loan repayments were made in accordance with the so-called “Balance Sheet” test of insolvency set out at Section 123(2) of the Act.

The court held that contingent assets could not be taken into account for the purposes of assessing inability to pay debts within Section 123 of the Act and that the unlawful dividends were contingent on being discovered and being pursued. In effect, the dividends could not be taken into account and the Company was unable to pay its debts within the meaning of Section 123 of the Act when the repayments were made.

This case is of interest for a number of reasons; the question of inability to pay debts for the purposes of Section 123 of the Act appears to have been considered as a single question, and does not distinguish clearly between the “Cash Flow” (Section 123(1) of the Act) and the “Balance Sheet” (Section 123(2) of the Act) which is in contrast to the decision in Eurosail, where the Supreme Court did make a distinction between cash flow insolvency, which included debts falling due from time to time in the reasonably near future, and the balance sheet test, which may still be breached even if cash flow solvency is established.

As to whether the unlawful dividend was a contingent asset (contingent on discovery and pursuit) or a present asset (held on constructive trust for the Company) of note is paragraph 24 of the judgement where Lewison LJ commented: “One of the lessons that emerges clearly from Eurosail is that the statutory test in section 123 must not be mechanistically applied, but must be applied in a way that has regard to commercial reality”.  There does not, however, seem to have been much consideration of the concept of a contingent asset but rather whether it would be appropriate to allow Mr and Mrs Jones to benefit from the concession that unlawful dividends had been taken.

This case serves as a reminder to practitioners that the insolvency tests used to determine whether a Company is unable to pay its debts gives the court flexibility to exercise discretion which is perhaps unhelpful given that it only serves to create more, not less, certainty around this important test for companies.

For further information about this case or for any insolvency queries please contact Lauren Hartigan-Pritchard on 01905 677045 or lhartiganpritchard@thursfields.co.uk

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