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Issues in company law: Liquidation procedures
- Advise Maria (M) as to her possible courses of action under the common law and under statute in relation to the above events.
- If in the alternative East Bank Ltd puts Charge Ltd into liquidation in December 2004, advise the liquidator as to the company law issues and the collection and distribution of assets. Anne, Raj and Cruz will be amongst the creditors. They will each be claiming the loss of a lifetime contract as a director and for arrears of the £200,000 remuneration.
Anne (A), Raj (R) and Cruz (C) have engaged in a collection of transactions which M is disputing. Namely, the buy-back of all of their shares by Charge Ltd (Charge), the re-payment of C’s secured loan, the transfer of assets to Oxford Ltd (Oxford) and Pathway Ltd (Pathway) and M’s dismissal as director of Charge. All of these transactions will be dealt with in turn and finally we will determine if M has any possible courses of action available to her to deal with the actions taken by the other directors.
In order to enable the proper and consistent functioning of a company, the directors, who are the day-to-day management of the company, have the power to act for the company and exercise the company’s powers to their discretion. This is discretion is heavily regulated by statutory law and also by what the directors are allowed to do according to the relevant company’s Articles of Association. The directors must observe the duties that this statutory law and internal management regulation imposes on them. Furthermore, and perhaps more stringently, the directors also owe a specific fiduciary duty, which they must exercise without negligence.
The common law duty of skill and care requires a director to conduct himself (or herself) to such a standard a required by the directors’ assumption of responsibility for the property and the affairs of the company. This duty is usually of a higher standard than that required of an employee and if breached, the director will be liable to the company for damages caused under the standard tortious principles. The standard is tested subjectively clarified in Re Barings plc (no. 5)  1 BCLC 23 (CA) stating that directors need to have, and need to continually acquire, a particular knowledge and understanding of the business in order to fulfil their duties. Yet, this test remains subjective and courts may determine director's actions as adequate when others may not.
As mentioned before, directors also owe a fiduciary duty, outlined in various case law but deemed non-exhaustive. A company is owned by the shareholders and directors manage the company as a trustee to the shareholder, the effective beneficiary. In Re Smith v Fawcett  Ch 304 the duty was laid out, stating directors are bound to exercise the powers conferred on them bona fide in what they consider is in the interest of the company. This is important as it focuses on what the directors thinks is in the interests of the company, and not what the court may think. Yet, directors must act for the proper purpose thereby preventing them from collating all breaches under the protective umbrella of what they thought was in the best interests of the company. A director is answerable to the company for any misapplication of property which the director should have know was misapplication such as applying funds or property in breach of financial assistance restrictions (s. 151 Companies Act 1985 (CA)), taking or giving loans to directors in breach of s. 330 Ca, payment of dividends other than out of distributable profits or obtaining a secret profit through their office as director (Selangor United Rubber Estates Ltd v Craddock No. 3  1 WLR) (Pettet, 2001).
A, R and C may be deemed to have not acted in the best interests and therefore bona fide for the company on numerous occasions. Repaying the loan to C as well as making a transfer of the assets to Oxford and Pathway were clearly not in the best interests of the company and in essence only done to maximise the investment return received by A, R and C.
Any breach the director may have engaged in can be waived or approved and thereby forgiven by the shareholders in a general meeting by an ordinary resolution provided the directors acted bona fide in the interests of the company (Regal Hastings Ltd v Gulliver  2 AC 134). Various breaches can specifically not be ratified, such as an act (as stated above) involving a lack of bona fides, an act which is illegal under the principle of ultra vires, an act done in breach of a particular regulation in the Articles of Association of the company and therefore would qualify as an act requiring special resolution and an act involving fraud conducted on the minority.
An act is ultra vires when it falls outside the scope of power granted to a company by its Memorandum of Association, specifically the objects clause. In this scenario the object of the company is to operate passenger airlines. Usually an act which is made ultra vires can be set aside as void by a member of the company or the company itself, however, this is hardly equitable for the third party potentially involved in the transaction. S.35(1) CA deals with this situations stating that the ‘validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s memorandum’. So the company and any third party involved is preventing from escaping liability created through an action deemed ultra vires. Yet a shareholder may still have recourse provided they apply to the court to prevent the company from entering into the transaction before the transaction is entered into (s.35(2)CA). This is clearly of no use to M with regard to either the on-line shopping contract which is ultra vires as has nothing to with passenger airlines nor is it much use to any transaction A, R and C have since engaged in which deal with the transfer of the corporate assets. However, a director is not let off the hook unless all the shareholders pass a special resolution ratifying the transaction. The director must indemnify the company against any loss it suffers as a result of the ultra vires transaction (s.35(3)CA) (Pettet, 2001). A special resolution requires a 75% majority vote (s.378(2)CA) and so would require M’s support in all instances, as she is a 30% shareholder. It is unlikely that M would ratify these as they are no in her favour and so C as instigator of the on-line shopping contract and A, R and C with regard to their transferring assets extravaganza could all be liable to the company and would have to indemnify the company against any losses.
Dismissal and appointment of directors can take any form so deemed to be appropriate and as stated in the Articles of Association (AA). In this situation the directors had made themselves lifetime directors with a remuneration of £200,000. This is not illegal, however, s.319 CA cannot be avoided and dictates that ‘any term of a directors’ service contact whereby his employment is to continue or may be continued for more than five years must be approved by ordinary resolution (s.319(3)CA). Assuming this was done by A, R, C and M then the clause in the AA stands. However, the dismissal of M, without a special resolution ratifying the act can be made void as an act done ultra vires under s.35A CA which applies to actions done above and beyond any limitations in the company’s constitution. While s.35(1) applies to action done outside the objects of the company, s.35A applies to any instance where the directors have acted within the objects but beyond he powers granted under the company’s constitution for example in the company’s AA. The only manner in which such an action will stand is if a third party requires it to be enforced and it was made in good faith (s.35A(1)CA). s.35A(4) states that a member (i.e. a shareholder) may bring an injunction against the company preventing it from entering into the transaction provided the action is taken before the transaction is entered into. There is no necessity to ratify contracts under s.35A and if ratification is done, the courts have commonly accepted that an ordinary resolution qualifies as adequate. There is little M can do relying on s.35A, however, s.322A CA states that transactions entered into which are ultra vires and the third party at which it is aimed is another director in the company, in this case M, then the contract can be voidable at the instance of the company (Mayson et al, 2001).
If M were to vote in favour of her removal as director from Charge, then the act of dismissing her could be ratified and A, R and C would not fall subject to a breach of duty, yet it is unlikely given the circumstances that she would ever vote in favour of such a ratification. Their breach would remain a breach.
A further M is concerned about is the buy-back or redemption of A, R and C’s shares by the company. The doctrine of maintenance of share capital prevents and limits the return of value to shareholder. Once a shareholder has invested in a company, the investment can normally not be returned beyond a distribution of profits in dividends. A return of their capital investment only occurs on winding-up and then subject to common law and statutory winding-up procedures. Redemption of shares means the company will redeem all shares, which are qualified as such under the company’s AA (s.159-162CA). In this situation, the shares are being bought back by the company from A, R and C as they are not redeemable shares but rather a collection of preference shares and ordinary shares. Preference shares are called such as they have a preference over ordinary shares to receive a cut of the profits in dividend payments, but are limited in that they hold not voting rights to them. With regard to payment, there is no significant difference between preference and ordinary shares. A purchase of own shares should only occur out of profits and then much be done by contract which requires a special resolution to be approved (s.162-169 CA). As M holds 30% of the voting share capital, the buy-back out of profits will not have been approved and so can be reversed, forcing A, R and C to reinvest their monies into the company as share capital (Mayson et al, 2001). It is unlikely that the buy-back has been done out of profits as it would have involved at least 70% of the ordinary shares of the company. A buy-back out of capital is covered under s.162-176 CA and requires a contract, which has also been approved by special resolution, a statutory declaration from the directors stating that the company can afford to do so and that to their knowledge it will not adversely affect the company. Further an auditors report is required and finally another special resolution approving the buy-back of shares from capital (s.173 CA). As two special resolutions are required and the declaration and auditors report and as it is unlikely that any of these have been provided, the buy-back will be void. The declaration and auditors report will both not have been made as the content of neither will be able to be made by A, R and C and no special resolutions approving the buy-back will have been made due to M’s 30% shareholding and the unlikelihood that she will have approved transactions she is now contesting. The buy-back will have to be reversed and the value will have to be returned to the company.
A final matter of importance is the duty of disclosure placed on directors. Under s.317 CA a director is obliged to disclose any interest he or she has in any contract whether that be a direct or indirect interest (Pettet, 2001). The transfer of assets to both Oxford and Pathway, Oxford being owned by Charge so indirectly by the remaining shareholders, A, R and C and Pathway being directly owned by A, R and C (Re British American Corporation (1903)). If the contracts are not disclosed then the directors involved can be fined under s.317(7) and would need to repay any secret profit made back to the company. Otherwise however, the contract remains valid. Yet, if A, R and C properly executed all contracts concerning the transfer of assets (provided this was done before M was dismissed) then the contract will never have been made validly, as under regulations 94 and 95 from Table A CA, if a director is interested in a contract in which he has a direct or indirect interest and the contract conflicts with the interest of the company, then that director cannot vote or count in the quorum for the board meeting at which the matter is resolved upon. This would void A, R and C and would prevent an adequate quorum from being reached and so could never be validly passed.
Ultimately, M can contest and invalidate various transactions, mainly the share buy-back and her own dismissal yet others may be more difficult to pursue. Furthermore, the breach of fiduciary duty engaged in by A, R and C would also stand in M’s favour and a court could impose an indemnity from A, R and C onto the company and therefore M as 30% shareholder.
East Bank has decided to instigate liquidation procedures on Charge, to realise their fixed and floating charges and regain some of the investment they made into the company. East Bank can do this as a creditor relying on the Insolvency Act 1986 (IA) and issue a petition for liquidation using the grounds laid out in the statute (s.122 IA). Once the procedure has been activated a liquidator is assigned to distribute the remaining assets accordingly. The first to be paid is the liquidator who will receive all his costs. The first payment to come from the assets is usually the liquidators costs in administrating liquidation but in the House of Lord’s decision in Buchler v Talbot (Re Layland Daf Limited)  UKHL 9, the assets going to the floating charge holder and the ‘free’ assets distributed to the unsecured creditors are seen as separate funds and the cost of administering each of those funds should be borne by both. In effect the liquidator is paid twice. Furthermore, the appointment of an administrative receiver will also effect the manner in which payments are made and the priority in which they are done (Goode, 1997). However, assuming no administrative receiver is in place, but merely a liquidator, the remaining assets will be divided as follows.
Firstly, the liquidator’s costs of preserving and realising the fixed charge assets. These are the fixed charges that East Bank placed over various assets back in September 2004. A charge is valid only once registered and so for East Bank from September 2004. The Bank is entitled to the first proceeds from the sale of those assets charged to them minus the deduction of costs paid to the liquidator in realising those assets. Following this the liquidator's costs for realising floating charge assets for the benefit of floating charge holders, preferential creditors and ring-fenced creditors are paid. Preferential creditors are then paid first but only up to £800 pounds and cover wages and pensions. In this instance A, R and C would receive the first £800 of their £200,000 remuneration. In order to ensure that the remaining funds are not solely taken up by the floating charge holders, a portion is ring-fenced for payment to unsecured creditors yet this is only applicable to realisations from floating charges created on or after September 2003 (Goode, 1997). Given that the earliest floating charge was created (validly registered) in October 2003 by M, all the charges are subject to ring-fencing. Now the floating charge holders, provided they hold a valid floating charge as according to Re Yorkshire Woolcombers’ Association  2 Ch 284, which in this scenario they are all presumed to be, are paid in order of registration. M first, and then A and R. It does not matter when a floating charge was created, but rather more importantly when the charge was registered. Following this the cost of realising the ‘free’ assets and the general expenses of winding-up are paid and then the unsecured creditors, which here would be On-Line Ltd to whom a payment is still outstanding. Finally, any remaining monies are returned to the shareholders.
A, R and C’s claims to loss of lifetime contracts and further to the loss of remuneration will at best only equate to £800 as preferential creditors. In reality they stand subject to pay out more than they may receive in return due to potential wrongful (s.214 IA) and fraudulent trading (s.213 IA). The liquidator may bring a claim against A, R and C as directors who prior to the winding-up, knew or ought to have know that there was a reasonable prospect of the company going into liquidation and the director failed to take very step possible to minimise the potential loss to creditors. Once found guilty by the court of wrongful trading, the director can be ordered to make a payment to the company to compensation for the director’s wrongdoing. Fraudulent trading goes one step further in that a director is guilty if their behaviour was with the intention of defrauding creditors. This requires an element of intent or dishonesty to be proven and can be more difficult that wrongful trading. An example of this being the share buy-back and C’s loan repayment. Again, the guilty director is ordered by the court to contribute to the company’s assets (Morphitis v Bernasconi  EWCA Civ 289). Additionally, criminal sanction may be imposed involving fines and/or imprisonment (s.458 CA) (Goode, 1997).
All of the transactions A, R and C engaged in to maximise the return on their investment and to ensure they lost as little as possible, as well as the on-line shopping contract, the transfer of assets and the share buy-back, all stripping the company of any working capital can be deemed wrongful and fraudulent trading. The court will most likely order all three to compensate and return assets, thereby allowing them to only walk away with what is rightfully theirs in the order of priority for winding-up. As for their claim for damages against loss of a lifetime contract, no court will look favourably on a self-imposed unrealistic regulation in the AA that they themselves have already breached with respect to M and the equitable maxim of coming to court with dirty hands will surely not do them any favours.
Buchler v Talbot (Re Layland Daf Limited)  UKHL 9
French, D. (2003). Companies Acts 1985 and 1989, Insolvency Act 1986 Blackstone’s statutes on Company Law 2003-04. Blackstones; London.
Goode, R. M. (1997) Principles of Corporate Insolvency Law, 2nd Edition. Sweet and Maxwell: London.
Mayson, S., French, D., Ryan, C. (2001). Mayson, French & Ryan on company law : 18th Edition, (2001-2002 edition) Blackstone Press: London.
Morphitis v Bernasconi  EWCA Civ 289
Pettet, B. (2001). Company Law. Longman: Harlow.
Re Barings plc (no. 5)  1 BCLC 23 (CA)
Re Smith v Fawcett  Ch 304
Re Yorkshire Woolcombers’ Association  2 Ch 284
Regal Hastings Ltd v Gulliver  2 AC 134
Selangor United Rubber Estates Ltd v Craddock No. 3  1 WLR
Tolley's company law online
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