Share sales and insolvency claims

We all know how the story goes.

Director/shareholder wants to sell up.  A buyer is found who almost always incorporates a new company (Newco) to purchase the outgoing director’s shares.  But of course, Newco has no ability to pay for the shares, so the deal is set up in such a way that the director receives the Company’s cash and a loan is then created in that sum owing by Newco to the Company.

Off everyone goes on their merry way.

At some point down the line – weeks, months, years later – the Company fails, and the officeholder has a duty to investigate what happened.  The first thing they’re probably going to notice is all of the Company’s cash being extracted!  But is there a claim?

The recent decision of Manolete v Smith concerns a case with similar facts to the above, and there are some helpful takeaways for officeholders investigating such cases.

Insolvency

The key requirement in these cases is to establish a point of insolvency.  The Company must have either been insolvent at the time of the share sale, or become insolvent because of it.

Insolvency can be balance sheet insolvency or cashflow insolvency.  As ever, it needn’t be both.  I won’t deal with cashflow insolvency in this article, as that is very case specific.  On balance sheet insolvency however, there are a couple of big-impact adjustments that can often be made to the balance sheet:

The main line of attack is establishing the true balance sheet value of the loan due to the Company from Newco. I’ve yet to see a case where this isn’t entered at full value, but what has to be looked at is Newco’s ability to pay.  In this case, the experts agreed that Newco could only repay via (1) borrowing further monies, (2) selling its shares in the Company, or (3) the Company declaring dividends – or some combination of these three options, but in any case in an amount sufficient to discharge the loan in full.  Looking at each option in more detail:

• Can Newco sell its shares in the Company? Again, probably not for the value it has just paid for them given the decline in the balance sheet caused by the large cash extraction.
• Can the Company declare dividends sufficient to clear the loan? This one will be case specific, but in the present case the best evidence was that it would take 19.5 years to declare sufficient dividends.  The court commented that such a long period would necessitate “very significant discounting for the long time-frame necessary for repayment, and because of the inherent uncertainties over such lengthy period.”

Often the Company has borrowed money which has been used to fund the share sale, and officeholders should look closely at the terms of such borrowing.  In this case, a CBILS loan was used which was a breach of the loan terms rendering it repayable immediately, and thus creating a liability that might otherwise not be on the balance sheet.

Breach of duty

This claim hinges on demonstrating that the payments out of the Company were for the benefit of the outgoing director and/or Newco, as opposed to being in the interests of the Company’s creditors (given that insolvency has by this point been established).

This is not a difficult claim to make out in circumstances where a director has received Company monies and left creditors unpaid.  The court briefly went through the other options available to the director, noting he could have simply declared dividends or effected a share buyback, with each of those options having their own statutory rules for the protection of creditors.  But these options were not chosen.

The breach of duty claim was made out.

Transaction at undervalue

Firstly the transaction must be identified.  The court held that “the transaction was both the payment and the automatic creation of the immediate reciprocal right of the Company against [Newco].”

The second requirement is that the Company must receive less, in money or money’s worth, than the consideration it gave.  In this case, the Company paid away £748,270 and received the benefit of an irrecoverable (for the reasons set out above) loan from Newco.  That clearly is at undervalue.

A further observation by the court was the often-missed authority of Re Ciro Citterio Menswear plc [2002] EWHC 662 (which Manolete’s solicitors, MD Law, had raised in the very first letter before action), which held on the facts of that case that an interest-free loan agreement – as these cases usually concern – was at an undervalue by virtue of it being interest-free.  Again, I’ve yet to see interest be charged on these arrangements.

Finally, as ever the transaction must have taken place within two years of insolvency.

The TUV claim was therefore made out.

Defences

On defences, the judgment demonstrates that these are difficult in such claims.

As to relief under s 1157 Companies Act 2006, as ever this relief is problematic in circumstances where a director has received Company monies.  The judge did not doubt that the director in this case relied on legal advice, but (1) the director failed to produce the same, and (2) in any event the risks to the Company of using all of its cash to pay himself “should have been obvious”.

As to the defence under s 238(5) Insolvency Act 1986, this provides that an order will not be made if the Company entered into the TUV in good faith and for the purpose of carrying on its business, and there were reasonable grounds for believing the TUV would benefit the Company.  The court commented that the Court of Appeal decision in Taqa Bratani Limited v Fujairah Oil and Gas UK LLC [2025] EWCA Civ 1669 interpreted the s 238(5) defence narrowly.  On the facts of this case – and probably many others – the court noted that the Company did not receive its own advice and therefore (1) there were no reasonable grounds to believe that it would be benefitted by paying Newco’s liabilities from the share sale, and (2) the Company could not act in good faith.  Further, the transaction was clearly not directed at the carrying on of the Company’s business, but at meeting the private obligations of its shareholder.  Crucially the court noted “Even were it characterised otherwise, there could be no benefit to it in this transaction which swapped a large amount of cash, necessary for the carrying on of its business, for a promise to pay, without the addition of any interest, from a company which had no liquid assets, and whose only asset was its shares of compromised value in the Company itself.”

Neither defence succeeded.

Conclusions

In summary, whilst these transactions have always ‘smelt bad’, we now have the benefit of a useful judgment running through the formulation of claims in relation to these transactions.  Officeholders should not necessarily be deterred by the passage of time since a transaction – if the transaction caused insolvency then that is the leg work in these claims done.

Alexandra Withers - Associate Director (North East)

Alexandra@manolete-partners.com | 07413 242320