Thursday, August 19, 2010

Unlawful Distribution of Capital: The Question of Intent

Five judges of the United Kingdom Supreme Court are scheduled to hear an exceedingly interesting case on October 5 and 6, 2010, on what the Court of Appeal describes in the impugned judgment as a “short, but quite basic company law point”. The judgment of the Court of Appeal in the case - Progress Property v. Moorgarth Group, [2009] EWCA Civ 629 - is available here, and the point of company law that arises is the extent to which the knowledge or intent/motive of a director is relevant in judging whether the sale of an asset amounts to an unlawful distribution of capital. The prohibition on such distribution is codified under the Indian Companies Act, 1956, as well, and is of some importance today, considering the increasingly popular device of intra-group asset transfers.

As background, it is appropriate to recall that the House of Lords held in 1887 (Trevor v. Whitworth) that a corporation cannot return any part of its capital, for it is to the capital of a company that creditors look in the event of liquidation, and are entitled to assume that capital is lost only in the normal course of business. The effect of the rule was to prevent the return by a company of assets to its majority shareholder, the payment of dividend except out of distributable profit, buy-back of shares etc. It was recognised that this is necessary in some circumstances – such as an unexpected loss in assets – and statutory intervention in England through the 1980 and 1985 Companies Act specified these exceptions. The common law doctrine continued to have force outside of the statutory exceptions. The Indian Companies Act, 1956, functions on the same premise, providing in s. 205(1) that dividend may be paid only out of “profits of the company for that year”, and creating specific exceptions for buy-back of shares, reduction of capital etc.

Attempts were made to evade the rule in Trevor v. Whitworth by resorting to more ingenious methods of returning capital – payment of dividend on unrealized profit, payment without accounting unrealized losses and so on. These methods were declared illegal, either by case law or by statute, and could not be ratified by the shareholders, as it was ultra vires the company. The most prominent device to avoid the rule then came to be the sale of assets at an undervalue. This has the effect of returning capital – for example, a company that sells assets worth Rs. 1 crore at Rs. 10 lakh to its majority shareholder does no more than return capital to him. However, it is easy to disagree about valuation, and consequently harder to conclude in these circumstances that the transaction is in fact a disguised return of capital. The locus classicus on this subject is a decision of Hoffman J. in Aveling Barford v. Perion Ltd., [1989] 5 BCC 677. Faced with the sale of a valuable company asset to a company that was controlled by the majority shareholder of the vendor, Hoffman J. held that courts look at “the substance rather than the outward appearance”, and further found that “it was the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution [emphasis mine].” The words “known and intended” suggest that the company selling an asset must do so for the purpose of selling at undervalue or returning capital, and it is this question of intent that is set to be heard by the Supreme Court in Progress Property.

The facts of Progress Property are similar to Aveling Barford, with one crucial difference. In 2003, Progress Property Co. Ltd. [“PPC”] and Moorgarth Group Ltd. [“Moorgarth”] were both controlled by Tradegro (UK) Ltd. [“Tradegro”]. PPC held shares in its subsidiary, known as YMS Properties (No. 1) Ltd. [“YMS1”]. Tradegro entered into an agreement with a minority shareholder in PPC to transfer its majority shareholding in that company to him, and as part of this agreement, was required to transfer PPC’s shares in YMS1 to Moorgarth, before completion. In short, the minority shareholder acquiring PPC required Tradegro to divest PPC of its shareholding in YMS1 prior to acquisition. In pursuance of this agreement, PPC sold its stake in YMS1 to Moorgarth in October 2003, for a price of around £ 64,000. This figure was arrived at after making a deduction of £ 4 million for an indemnity which could be enforced against PPC. It later transpired that there was no such indemnity liability, but it was accepted by all parties that this mistake was a genuine one, and that the parties were under the impression that the shares had been sold at market value.

After the takeover was completed, PPC brought an action to declare the sale to Moorgarth invalid and ultra vires, and relied heavily on Aveling Barford for the proposition that a sale at less than full value is ultra vires regardless of whether the sale was effected in ignorance of the true value. The Court of Appeal was quick to reject this “optimistic submission”, pointing out that it is the sale of an asset for the purpose of paying less than full value that makes it ultra vires, and not the mere fact of sale. An important reason for this rule is that it otherwise puts directors at the peril of having every sale questioned, if it subsequently turns out the property had been wrongly valued, even if the directors acted reasonably and in the best interests of the company. PPC also argued that the director “ought” to have known of the valuation error, but the Court of Appeal held that this is of no relevance in determining whether the transaction is ultra vires – for, courts invalidate a return of capital that is “disguised” as a transfer by assigning it an unnaturally low sale price, and not a sale that coincidentally has such a price, whether through the ignorance of the vendor or otherwise.

Interestingly, the rule in Aveling Barford, based on s. 263 of the 1985 English Companies Act, was thought to greatly inconvenience intra-group transfers of assets, or restructuring assets for legitimate business reasons. S. 845 of the 2006 English Companies Act partially modifies the strict rule in Aveling Barford, and an excellent discussion of the reasons for the move is available in the Explanatory Note to the Act (¶¶1151-5). Although these statutory developments predate the events in Progress Property, it is expected that the Supreme Court will affirm the Court of Appeal’s decision, for knowledge and intention are significant factors in assessing the genuineness of a transaction for return of capital purposes.

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