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Supreme Court rules on when a sale of assets at an undervalue will be considered ultra vires

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09 February 2011

In Progress Property Co Ltd v Moorgarth Group Ltd [2010] UKSC, the Supreme Court has upheld the Court of Appeal decision in Progress Property Company Ltd v Moorgarth Group Ltd [2009] EWCA Civ 629.

The ruling was that a sale of assets made by a company to a shareholder in that company that is, objectively, at an undervalue, will not constitute an unlawful distribution of assets where those responsible for effecting the sale did not know, nor intend, the transaction to be made at an undervalue.

The Court emphasised that the subjective intentions of the parties involved were, in this case, relevant to the consideration of whether or not there had been an unlawful distribution. It was held that evidence as to the parties’ intentions ought to be taken into account particularly in those cases involving distributions disguised as arm’s length commercial transactions.

Tradegro (UK) Ltd (Tradegro) was selling its stake (approximately 75%) in Progress Property Company Ltd (PPC) to a third party. It was a term of the SPA that PPC sold its wholly-owned subsidiary, YMS Properties (No.1) Ltd (YMS1), to Moorgarth Group Ltd (Moorgarth), a subsidiary of Tradegro, prior to completion. As part of the YMS1 sale, the parties agreed a release of PPC’s liabilities under an indemnity and the sale price was reduced to approximately £60,000 (a discount of around £4 million) to reflect this. In fact, there was no such indemnity liability and, as such, there was no justification for the reduction in the YMS1 sale price.

PPC, now under new ownership, argued that the sale of shares in YMS1, which was at a gross undervalue, constituted an unlawful return of capital from PPC to Tradegro (because Tradegro indirectly got the benefit of its subsidiary, Moorgarth, acquiring YMS1 at an undervalue). Moorgarth argued that the transaction was not unlawful as PPC and Moorgarth genuinely believed that the agreed price represented market value.

The Supreme Court decision
In his judgment, Lord Walker reiterated the principle that a limited company not in liquidation cannot lawfully return capital to its shareholders except by way of a reduction of capital approved by the court. He confirmed the ruling in Aveling Barford v Perion Ltd [1989] BCLC 626 that the need to look at substance as well as form is fundamental to deciding whether an unlawful distribution exists and that the label attached to the transaction is not decisive.

The Supreme Court proceeded on the assumption, accepted at first instance and in the Court of Appeal, that those responsible for negotiating the sale of PPC’s shares in YMS1 to Moorgarth acted in the honest belief that the sale of the shares in YMS1 was a commercial transaction.

Lord Walker argued that a relentlessly objective approach to determining whether there has been an unlawful distribution would be oppressive and unworkable. It would cast doubt on any transaction between a company and a shareholder, even if negotiated at arm’s length and in perfect good faith, which later transpired to be a bad bargain. It was held that the court ought to inquire into the true purpose and substance of the impugned transaction, which meant investigating all the relevant facts, including the state of mind of those involved in the transaction.

While the states of mind of the participants involved are not always relevant, the paradigm example of when they ought to be considered includes cases involving distributions potentially disguised as arm’s length commercial transactions. Therefore, in cases such as this, the subjective intentions of the persons orchestrating the transaction ought to be examined. On this basis, if the court concludes that a deal was a genuine arm’s length transaction, then it would stand even if it appeared with hindsight to have been a bad bargain. If it was an improper attempt to extract value by the pretence of an arm’s length sale, it would be held unlawful.

In this case, the Supreme Court held that the sale of shares was lawful as the parties honestly believed that the transaction was a commercial deal for fair value. This was regardless of the fact that (as was assumed) the transaction was at an undervalue, and even if it were the case that the persons involved in the transaction ought to have appreciated this.

Comment: The Supreme Court has confirmed that the test for finding an unlawful distribution is high. This may give clients some comfort that, providing transactions are not known or intended to circumvent rules on maintenance of capital, it is less likely that they will be set aside in instances where there has in fact been a sale at an undervalue. A purely objective approach to the matter may have had this effect.

This decision may appear to be insufficiently protective of creditors. However, it is arguable that creditors are adequately protected by the anti avoidance provisions in the Insolvency Act 1986, which give the court the power to reverse transactions at an undervalue (s238) or transactions which seek to prefer one creditor over the others (s239). Moreover, this ruling does not obviate the obligations of directors to ensure that transactions into which they enter are in the best interests of the company itself (rather than the group as a whole).

Further Information
This case summary is part of the Allen & Overy Litigation Review, a montly update on interesting new cases and legislation in commercial dispute resolution. For more information please contact Sarah Garvey, or tel +44 (0)20 3088 3710.