Lawful dividends can be challenged as undervalued transactions under section 423, says court

Section 423 of the Insolvency Act of 1986 allows the court to reverse transactions made in an attempt to put assets beyond the reach of creditors, whether or not the debtor company is in a formal insolvency process. This applies to a 'transaction at an undervalue', which is a transfer of an asset for materially less than its worth.

Arjo Wiggins Appleton Limited (AWA) paid large dividends to its parent company, Sequana, at a time when it had ceased to trade and was liable to BAT Industries under an indemnity in relation to certain environmental clean up costs in the US. A provision of €62.8 million was made against this contingent liability in AWA's interim accounts. The payment of the dividend meant that AWA had significantly fewer assets available to pay to BAT under the indemnity.

Claims were brought by AWA against the directors of AWA, who authorised the payment of the dividends, and against Sequana as a constructive trustee under s423. BAT brought a claim under s423 as a "victim" of the payment of the dividends. AWA also brought claims against its directors for breach of their duty to have regard to the interest of creditors under section 172(3) of the Companies Act 2006. AWA's claim was later assigned to BTI. At the first hearing, the court accepted that the dividend was paid in contravention of s423, but the breach of directors' duties claim failed. This decision was appealed and cross appealed. The Court of Appeal agreed with the High Court's decision.

This decision clarifies that lawful dividends, meaning those paid in accordance with the Companies Act 2006, can be challenged under s423 as transactions defrauding creditors and also clarifies the point at which a director's duty to consider creditors' interests is triggered. It is an important reminder that directors must exercise caution when considering the declaration of a dividend, or entering into other transactions, in circumstances where they have concerns about long-term contingent liabilities.

Section 423 is a wide-ranging provision which is designed to protect actual or potential creditors of a company which has tried to put assets beyond their reach. Unlike other provisions of the Insolvency Act, a challenge under s423 can be brought at any time and does not require the debtor company to be in formal insolvency proceedings. Section 423 provides that it applies to "transactions at an undervalue" which includes gifts and transactions where the company receives significantly less value than it provided.

The Court of Appeal had to decide whether a payment of a dividend is capable of being a transaction at an undervalue within the meaning of s423 even if the dividend was paid in accordance with the Companies Act. The Court of Appeal said it was. The Court of Appeal said that s423 was not just confined to gifts and there was nothing to stop the dividend payment being lawful under the relevant provisions in the Companies Act but still a transaction putting assets beyond the reach of creditors under s423.

Whether the purpose of the payment of the dividend was to put assets out of the reach of creditors was a question of fact and the court found in this case that the directors did have this purpose.

In relation to the claim that the directors acted in breach of their duty to have regard to the interests of the company's creditors, the court had to decide whether this duty had arisen and, if so, whether it applied to the payment of a dividend paid in accordance with the Companies Act, which provides that the duties imposed on directors are subject to "any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company". It does not state when that requirement arises.

The Court of Appeal said that the duty is triggered "when the directors know or ought to know that the company is or is likely to become insolvent". It said that, in this context, "likely" means probable. Once triggered, the duty did apply to the payment of lawful dividends. On the facts, the court ruled that at the time of, or as a result of, the payment of the dividend AWA was not insolvent or likely to become insolvent so the duty to creditors had not arisen.

As the Court of Appeal found that the duty to creditors had not arisen, it declined to decide whether, if the duty had arisen, the interests of creditors would be "paramount or are to be considered without being decisive". However, the court went on to say that, where the directors know or ought to know that the company is insolvent, "it is hard to see that creditors’ interests could be anything but paramount".

The Court of Appeal's decision is expected to be appealed.

James Hillman is a restructuring expert at Pinsent Masons, the law firm behind Out-Law.com