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05 February 2020

Directors’ duties from beyond the corporate grave

Re System Building Services Group Limited [2020] EWHC 54 (Ch)

Summary

A recent High Court ruling has considered the character and extent of directors’ duties in the context of insolvency.

In System Building Services, Insolvency and Companies Court Judge Barber (“ICCJ Barber”) considered, amongst other things, the nature of a director’s duties to a company and whether those duties survive the company’s entry into an insolvency process.

In what is thought to be the first case to deal with this specific issue, ICCJ Barber held that the “duties owed by a director to the company and its creditors survive the company’s entry into administration and voluntary liquidation.”

Background

System Building Services Group Limited (the “Company”) was placed into administration in July 2012 and Gagen Sharma (“Ms Sharma”) was appointed as administrator. The administration was converted into a creditors’ voluntary liquidation in July 2013 and Ms Sharma was appointed as liquidator. At the time the Company entered administration and thereafter liquidation, Brian Michie (“Mr Michie”) was the Company’s sole director. The Company was dissolved in February 2016 but was restored by Stephen Hunt (“Mr Hunt”), the First Applicant in this case, in April 2017.

The background to the Company’s restoration is that, in 2014, Ms Sharma was found liable for misfeasance in office (in unrelated proceedings) and was struck off. After Ms Sharma’s misfeasance proceedings, Mr Hunt took over various of Ms Sharma’s appointments pursuant to a Block Transfer Order. Following his investigation into the affairs of the Company and the conduct of Ms Sharma, Mr Hunt made his application to restore the Company. Once the Company was restored, Mr Hunt was appointed as liquidator and brought the instant proceedings. Ms Sharma was made bankrupt in 2016 and Mr Hunt therefore had no realistic prospect of bringing misfeasance proceedings against her.

The Company owned a property known as 55 Crown Road (the “Property”). In 2014, while the Company was in liquidation, Mr Michie purchased the Property from the Company (effected by Ms Sharma as liquidator) at what Mr Hunt contended was a substantial undervalue – being £120,000. This amount was lower than: (i) the price at which the Company purchased the Property; (ii) the value attributed to the Property in the Company’s accounts, (iii) the estimated value of the Property in the Statement of Administrator’s Proposals prepared in August 2012 (£200,000); and (iv) the independent valuation of the Property obtained by Ms Sharma in September 2012 (£195,000).

In cross-examination it became apparent that in December 2012 Mr Michie reached an agreement in principle with Ms Sharma to purchase the Property for “its proper value” although no specific figure was identified. On 2 July 2014, Mr Michie and Ms Sharma agreed that the purchase price would be £120,000, and Mr Michie paid a £40,000 deposit into Ms Sharma’s client account. The balance was paid in September 2014 and completion took place in December 2014.

At no point during the liquidation was the Property ever listed on the open market, and Mr Michie admitted in cross-examination that the deposit of 33% – significantly higher than the usual deposit paid for a residential property – was paid to ensure that Ms Sharma would continue to refrain from openly marketing the Property.

A joint expert, appointed to value the Property for the purposes of the claim, reported that the value of the Property as at February 2019 was £300,000 and that in July 2014 – when the sale price of £120,000 was agreed – the value of the Property was £265,000.

In February 2017, Mr Michie listed the Property on the market for £365,000.

The Law

Directors are subject to various duties under the Companies Act 2006 (“CA06”) which regulate the manner in which they must behave as regards their companies. In particular, under section 172(1) of the CA06, a director must act in good faith for the benefit of the company. Additionally, section 172(3) of the CA06 provides that where a company is insolvent or is likely to become insolvent, the duty of a director to act in the best interests of the company includes a duty to have regard to the interests of the company’s creditors as a whole. This duty is fiduciary in nature.

Case law makes clear that where a director breaches a fiduciary duty, an automatic trust will arise, the consequence of which will be that any benefit that the director derives in breaching that duty will be held on trust for the Company.

Judgment

At paragraph 110, ICCJ Barber explained that she was satisfied that “…at all material times, Mr Michie knew that the Property was worth significantly more than the price he paid for it.”

Further, in paragraph 117, ICCJ Barber said that “Mr Michie acted entirely out of self-interest and failed to have regard to the interests of the creditors as a whole” before adding in paragraph 118 that “the Court must ask itself whether an intelligent and honest man in the position of a director of the Company could, in the circumstances, have reasonably believed that the transaction was for the benefit of the creditors as a whole. The answer is plainly ‘no.’”

It was held, therefore, that Mr Michie had breached his duties to the Company in purchasing the Property from the Company at an undervalue notwithstanding the fact that: (i) the Company was in liquidation at the time of the transaction; and (ii) the transaction was effected on behalf of the Company by Ms Sharma as liquidator rather than Mr Michie as director (as his powers to act as a director ended once the Company entered administration). ICCJ Barber held that Mr Michie had breached his duties as in purchasing the Property at an undervalue he failed to have proper regard to the interests of the Company’s creditors and, instead, acted in his own interests. Therefore, the Court ruled that Mr Michie held the Property on trust for the Company with credit given for the £120,000 purchase price.

Other Claims

Separate from the matters concerning the Property, this case dealt with several other claims against Mr Michie and others. The claims against Mr Michie concerned payments which Mr Michie caused or allowed to be made to one of the Company’s creditors after the Company entered administration (the “Post-Administration Payments”), and an alleged outstanding balance on Mr Michie’s director’s loan account (the “DLA”).

As regards the Post-Administration Payments, ICCJ Barber held that Mr Michie was complicit in allowing the payments to be made post-administration and, in so doing, was in breach of his duties as director of the Company by, amongst other things, failing to give proper consideration to the interests of the Company’s other creditors and their rights to share in the Company’s assets on a pari passu basis. ICCJ Barber therefore ordered Mr Michie to contribute a sum equal to that paid out as the Post-Administration Payments.

Mr Michie argued that the DLA represented amounts due to him from the Company in respect of salary and dividends. There was significant discussion at trial about the netting off of various payments between the Company and Mr Michie and the total amount allegedly due from Mr Michie. In her judgment, ICCJ Barber held that, while Mr Michie was not dishonest in withdrawing sums from the Company in excess of his salary and dividend entitlements – Mr Michie claimed that any drawings were made on the basis of the advice of his accountant – he had drawn amounts in excess of those to which he was entitled and ordered Mr Michie to repay those sums to the Company with interest.

Comment

Had this transaction taken place at a time when the Company was solvent, this would have been a relatively ordinary case of a breach of duty by a director. The fact that the transaction occurred when the Company was in liquidation –  where the director no longer had control over the Company’s affairs – makes this a novel case. The approach taken by ICCJ Barber appears to be a significant development (and departure from established practice) in the law of directors’ duties, and will be of particular note for Insolvency Practitioners who are considering transactions with directors, in particular ‘pre-pack’ transactions, and for directors dealing with ‘friendly’ liquidators during the course of insolvency proceedings.

This case brings into question whether office holders can enter into ‘pre-pack’ transactions with directors at all. Numerous authorities have endorsed the validity and desirability of ‘pre-packs’ as the directors are often the only people who are able to act sufficiently quickly (because they understand the underlying business) to preserve continuity, save employee jobs, and thereby enhance creditor recoveries. It is not clear from this case whether directors will be able to enter into ‘pre-packs’ going forwards or whether they will be required to appoint a third-party director to conduct the negotiations so as to avoid the inherent conflict between their apparent continuing duties to the creditors and their interests as purchaser. Alternatively, it may be that the Court made its determinations because Ms Sharma was bankrupt and no recoveries could be made against her for the loss caused by her misfeasance and the Court simply manoeuvred itself in a manner to ensure that some recoveries were made for creditors.

This case also highlights the responsibility of directors to ensure that they consider the interests of the company’s creditors even after an office holder has taken over the affairs of a company.  Whilst a director may no longer have control over the company’s affairs, his or her duties remain in force and directors should be alive to the potential risks posed by a transaction between them and an office holder.

Clearly, the importance of Insolvency Practitioners and directors receiving proper advice on these matters is difficult to overstate. Further clarity from the Court in this area, particularly in how this decision impacts insolvency transactions henceforth, would be most welcome.

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