“The rule is essentially a judge-made rule, almost as old as company law itself, derived from the fundamental principles embodied in the statutes by which Parliament has permitted companies to be incorporated with limited liability.”
So said Lord Walker last week in delivering the judgment of the United Kingdom Supreme Court in Progress Property v Moorgarth. Lord Walker was, of course, referring to the common law prohibition on the unlawful distribution of capital by a company through, inter alia, the sale of its assets to shareholders at an undervalue. The Court has, as expected, affirmed the impugned judgment of the Court of Appeal, which we discussed at length in August.
The principle, sometimes called the rule on maintenance of capital, was authoritatively stated by the House of Lords in Trevor v Whitworth, and has been subsequently applied both by the courts and in statutory provisions. The objective of the rule has always been thought to be the protection of creditors, who are entitled to assume that the risk of a loss of the company’s capital is confined to ordinary commercial activity. The rule is firmly entrenched in both English and Indian law, although its scope varies considerably. Over time, various devices have been employed to circumvent the rule, of which the most prominent is perhaps the sale of corporate assets at an undervalue to (typically) the controlling shareholders. In Aveling Barford v Perion Ltd,  5 BCC 677, Hoffman J. had held that “it is the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution.”
Readers interested in a detailed analysis of the facts may refer to ¶¶5-14 of Lord Walker’s judgment, and to the previous post. It will suffice here to recall that Progress Property was a case where the director of a group company procured the sale of the shares of its wholly owned subsidiary to a third party for a sum of around £60,000. It was later shown (or assumed to be shown) that the true and reasonable value of the shares was around £4 million. The particular transaction was part of a wider commercial arrangement whereby a minority shareholder of a company agreed to buy out the majority. It was common ground that the director in question had genuinely believed that that was the fair value of the sale, and it was assumed that he may have acted in breach of his fiduciary duty in so believing. The Court of Appeal declined an invitation to distinguish or overrule Hoffman J.’s emphasis on the role of knowledge in the lawfulness of a sale, and held that an undervalued sale is not contrary to the common law or statutory rule on maintenance of capital, unless it is shown that the director knew that it was undervalued.
In an article commenting on that judgment, Eva Micheler argued that the correct question to ask is whether the transaction between the company and the shareholder was at “arm’s length”. This is a natural step to take, considering that arm’s length is used in transfer pricing disputes to address similar concerns that two parties with a unity of interest may collaborate to impart to a transaction a character it would not have had in normal market conditions. The Supreme Court, however, after noticing this suggestion, has reiterated the traditional approach to the question, which is to ascertain the real “substance” of the transaction. In addition, the Court has emphasised that Hoffman J.’s test is not as much about knowledge itself as it is about an analysis of the “substance” or “legal nature” of the transaction.
In particular, the Court explained the true scope of the rule with reference to two cases – Ridge Securities v IRC  1 WLR 479, and Re Halt Garage  3 All ER 1016. In Ridge Securities, interest payments “grotesquely out of proportion to the principal amounts secured” were made as part of a complex tax avoidance scheme. In dicta, the Court suggested that this payment was contrary to the capital maintenance rule no matter how the transaction is described. In Halt Garage, on the other hand, a small, family-run company paid a modest remuneration to its directors (promoters), which the Court partly upheld, observing that the transaction is illegal only if “the intention is to make a gift out of the capital of the company” and not if it is “genuinely director’s remuneration.” Aveling Barford was far closer to Ridge Securities than to Halt Garage, and Hoffman J. accordingly found that the transaction in that case offended the capital maintenance rule. Approving these decisions, Lord Walker also noted a very common problem in the law of tenancy is similar – whether an agreement to “licence” property in a bid to evade the application of tenancy legislation is so construed by the courts. The locus classicus on this point is, of course, Street v Mountford where Lord Jauncey noted that the question is whether the agreement is “mere dressing up in an endeavour to clothe the agreement with a legal character which it would not otherwise have possessed.”
In short, Lord Walker held, and it is submitted correctly, that the validity of such a transaction does not depend on any brightline test – be it the arm’s length or knowledge – but on an application of the usual principles of construction of documents and transactions, with the objective of ascertaining its true legal nature. In this analysis, the intention/knowledge of the parties is likely to play an extremely significant role, and may in many cases provide sufficient basis for a court to invalidate the transaction. Yet, it is wrong to conclude that knowledge is a necessary condition for invalidity, for if dividend is paid out of capital despite the best of intentions (for example because of a technical error or a misapprehension as to the state of profits), it will nevertheless be invalid. Lord Walker acknowledged that knowledge and intention are likely to be most relevant in the “paradigm example” of a distribution through the sale of an asset, and held that the result depends not on a “retrospective valuation exercise” but on a “realistic assessment of all the relevant facts.”
Lord Mance’s concurring judgment emphasises the caveat noted above – that the test is not always just about an inquiry into the motive or knowledge of the directors, but about ascertaining the “substance of the agreement…whatever the label attached to it by the parties.” Lord Mance was careful to disclaim any general proposition that knowledge is a necessary feature, or that it is essential to prove that a director acted in breach of duty to sustain a challenge to the validity of a sale.
While the Supreme Court’s approach is clearly sensitive to the particular features of individual transactions, it is interesting to contrast it with the Snook approach to “sham” transactions for tax avoidance purposes – in both cases, the courts look to the “legal substance” of a transaction (as opposed to its consequence or economic substance), and yet, it appears that the court is far more likely to attach significance to motive or knowledge and ignore interpositions of artificial devices for capital maintenance purposes.