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Unlawful Distributions | Rosenblatt’s Corporate Team

18th January 2021

Summary

In this article, we consider the recent judgment of Mr Justice Zacaroli in SSF Realisations Limited (In Liquidation) v Loch Fyne Oysters Ltd.[1], which concerned the lawfulness of a distribution made by SSF Realisations Limited (In Liquidation) (“SSF”) to Loch Fyne Oysters Limited (“LFO”).

Background

LFO was incorporated in 1974 and carried on business as a supplier of fresh, frozen and live fish to shops and restaurants. In 2008, the entire issued share capital of SSF was acquired by LFO. SSF also operated in the wholesale and retail seafood business.

By 2011, both SSF and LFO were in financial difficulty and it was decided that LFO would be sold to Scottish Salmon Company Limited (“SSCL”) (“Transaction”). SSCL, however, required a clean break between SSF and LFO. As such, it was proposed that SSF should first be sold to a third party on terms that LFO would no longer owe any monies to SSF. At that time, LFO owed SSF about £900,000.

LFO commenced negotiations with James Knight of Mayfair Limited (“JKM”) for the sale of SSF and, in the meantime, the directors of SSF resolved at a board meeting on 21 November 2011 to declare a dividend of £500,000 (“Dividend”) and the assumption of a management charge of £330,000 (subsequently reduced to £244,916) (“Management Charge”) in favour of LFO. The Management Charge was stated to be in relation to services which LFO supplied to SSF but had never charged for. The Management Charge was then offset against the debt owed by LFO to SSF.

However, as a result of the Dividend and the Management Charge, the management accounts for November 2011 showed that SSF was insolvent, with net liabilities of £142,710.

The negotiations with JKM ultimately failed.

Although SSF continued to trade for a number of years, it remained insolvent. In June 2016, administrators were appointed and, in November 2016, SSF entered creditors’ voluntary liquidation.

The liquidators started proceedings in October 2017 claiming that: (i) the Management Charge was a disguised distribution to LFO; (ii) when the Management Charge was combined with the Dividend, SSF did not have sufficient distributable profits to make the distribution; and (iii) as a result, LFO and SSF’s directors were required to repay the unlawful distribution and compensate SSF.

The Management Charge

Mr Justice Zacaroli considered the cases of Progress Property Company Ltd v Moorgarth Group Ltd [2] and the comments of Hoffman J (as he then was) in Aveling Barford Ltd v Perion Ltd [3]. These cases establish that the question of whether a transaction is a distribution to shareholders depends on the substance of the transaction, and not simply its form.

It was accepted that, prior to November 2011, LFO had never imposed a management charge on SSF. The Management Change was first mentioned in November 2011 for the purpose of reducing the debt owed by LFO to SSF (by way of set-off).

Although the directors of SSF acknowledged this was the intended purpose, they argued it was nevertheless justified because it covered costs incurred by LFO. The directors of SSF produced a breakdown of such costs to support this argument. These included the benefits of seconded employees, shipments, employee accommodation and discounted products from LFO.

Mr Justice Zacaroli noted the Court of Appeal case of Heis v MF Global UK Services Limited [4] which held that, if one company in a group has provided staff to another group company, then the second company does not necessarily automatically have an obligation to reimburse the first company. An obligation to repay the cost (i.e., a recharge) would only arise if the companies entered into an express contract or the criteria for implying a contract were satisfied.

In the present case, it was held that there had been no agreement of any kind, whether express or implied, that SSF would reimburse LFO. In particular, it was noted that no provision had been made in SSF’s accounts in respect of the Management Charge. It was also noted that it was also not uncommon for a parent company to provide benefits in kind to a subsidiary and not charge for such provision; as, at least indirectly, the parent company still benefits (e.g., increasing the value of its investment in the subsidiary).

Consequently, it was held that the legal relationship under which LFO provided support to SSF was that of a shareholder, and not as a creditor. The Management Charge was, therefore, not a genuine liability. The Management Charge, instead, constituted a distribution.

The unlawful distribution

A “distribution” for the purposes of Part 23 of the Companies Act 2006 is defined as any description of a distribution of a company’s assets to its members whether in cash or otherwise (section 829).

For a distribution to be lawful, the distribution must be made out of accumulated, realised profits. The amount of those profits are to be objectively assessed against the relevant accounts, with any distribution made in excess of accumulated profits to be deemed unlawful.

In this case the relevant accounts were the October 2011 management accounts and the Dividend and the Management Charge combined exceeded the distributable profits shown in such accounts by about £316,000.

It was held that LFO was liable to repay the excess distribution as it knew, or had reasonable grounds to believe that, based on the relevant accounts, the sum distributed was in excess of that which was lawfully distributable.

Two of the directors of SSF were considered experienced businessmen and were held to have breached their duties and were personally liable to SSF for the unlawful distribution. A third director of SSF, however, was considered not have the same level of experience and ought to be excused from liability.

Comment

This case highlights and should serve as a reminder on a number of points:

  • The fundamental characteristic of a distribution is that a company is parting with something of value without receiving proper value back from its shareholder. If a company is getting nothing in return, or if the transaction is at an undervalue, some or all of the transaction will likely be a distribution;
  • When a transaction is considered, such as the Management Charge in this case, the Court will consider the substance of the transaction when determining its validity. Formally documenting arrangements between group companies will likely help to mitigate against the risk of a payment being recharacterised as a distribution, as will the keeping of accurate accounting records (e.g., provisions for intercompany receivables);
  • In considering whether a distribution should be made, it is imperative that the directors consider whether a company has sufficient distributable profits to make the distribution lawfully;
  • If a company is proposing to sell an asset to a shareholder, holding company or sister company, consideration needs to be taken as to what value is being paid? If market value, there is no distribution. If book value, there should be no distribution, provided that the company has distributable profits (even if only £1);
  • In the event of an insolvency, recent distributions are subjected to increasing levels of scrutiny.  Directors should be more mindful of their duties and of the rules relating to distributions. Where distributions are considered, detailed board minutes would be helpful; and
  • Directors can be personally liable for unlawful distributions. A court will, however, take into consideration the experience and skills of a director.

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Authors

Christopher Allen, Senior Associate (Christopher.Allen@rosenblatt-law.co.uk)

Elliott Dagul, Solicitor (Elliott.Dagul@rosenblatt-law.co.uk)

George Kestel, Trainee Solicitor (George.Kestel@rosenblatt-law.co.uk)


[1] [2020] EWHC 3521 (Ch)

[2] [2010] UKSC 55

[3] [1989] BCLC 626, 631

[4] [2016] EWCA Civ 569