A valuable decision of the UK Supreme Court on Scottish sales at undervalue

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On 4 December 2019, the UK Supreme Court issued its decision in MacDonald and another as joint liquidators of Grampian MacLennan's Distribution Services Ltd v. Carnbroe Estates Ltd [2019] UKSC 57, a Scottish case involving insolvency and "gratuitous alienations" (sales at undervalue).

The decision is important, firstly, because it clarifies the test for "adequate consideration" under the insolvency rules. Secondly, it represents a significant departure from previous Scottish authority in recognising that the court does have the necessary flexibility to deal with a transaction (found to be a gratuitous alienation) in a way that balances the respective interests of the purchaser and the creditors of the insolvent company.

In this article, we explain the background law, examine the significance of the judgment and consider what might happen next – in this case and more generally.

What are gratuitous alienations?

The rules are complex but, at the most basic level, gratuitous alienations are disposals of property for no or inadequate consideration.

In the event of subsequent insolvency of the seller, a gratuitous alienation made within a certain period prior to the insolvency is challengeable. The challenge can be brought by a creditor or a liquidator of the seller, both at common law and (in the case of companies) under section 242 of the Insolvency Act 1986 or (in the case of individuals) section 98 of the Bankruptcy (Scotland) Act 2016.

When challenged, the onus is on the recipient to establish that the alienation was made for "adequate consideration", or that the seller's assets were greater than its liabilities at the time that it was made.

The principle is that an insolvent party should not be able to reduce the value of its estate to the detriment of its creditors.

What can the court do in the event of a successful challenge?

Under section 242, if the court concludes that there has been a gratuitous alienation, it is obliged to order decree of reduction (so as to reverse the transfer of property) or such "other redress as may be appropriate."

What does that mean in practice?

Let's take a simple example. A company had a property worth £1 million and sold it to Joe Bloggs for £500,000. If a liquidator was subsequently appointed to the company, he may well seek to challenge that transaction as a gratuitous alienation, on the basis the property was sold at undervalue.

Let's say the court agrees. The result, under section 242, would be a reduction of the sale. This would mean that the property would transfer back to the company.

What about the £500,000 – would Joe Bloggs get that back?

This is the interesting (and, some would say, very unfair) point. Joe Bloggs would not get his £500,000 back in exchange for the return of the property. Instead, he would simply have a claim against the company for that money. However, because the company is in liquidation, that claim would simply be an unsecured claim in the liquidation – and would rank alongside all of the other unsecured creditors.

Such creditors normally only get back a few pence in the pound in relation to their claims, so it can readily be seen that the result is harsh on Joe Bloggs – he has spent £500,000, but has no property. Instead, all he has to show for it is a claim worth probably only a tiny fraction of that.

The company's other creditors, by contrast, appear to have received a windfall, as the company has been able to keep the purchase price and get the property back.

In fact, Joe Bloggs would have been better off had he received the property completely gratuitously. In that event, the transfer of the property would still be reversed, but if he had not paid anything for it, he would not be any worse off.

It seems very unfair that someone who has paid at least something for the property would, therefore, be worse off than someone who has paid nothing.

But does section 242 not allow for "such redress as may be appropriate"?

Yes it does. The court is obliged to order decree of reduction or such "other redress as may be appropriate". However, the courts in Scotland have (since the case of Short's Trustee v. Chung in 1991) consistently been of the view that the reference to "other redress as may be appropriate" did not confer on the courts a general discretion as to the nature of the remedy. The court could not, for example, require a liquidator to pay a sum of money for the return of the property.

Rather, the courts have been of the view that the reference to "other redress as may be appropriate" simply gives the courts the power to grant a remedy where reduction is not available.

So what happened in Carnbroe?

In Carnbroe, the Supreme Court was considering the sale of a property for £550,000, in circumstances where it had been valued at between £800,000 and £1.2 million.

The purchaser argued that the property had been sold as part of a "fire sale" in the context of an imminent insolvency of the seller – with the result that it could not be properly exposed to the open market. On that basis, it was suggested that the price received was "adequate".

That suggestion was accepted by the Lord Ordinary at first instance, but was rejected by the Inner House of the Court of Session on appeal – which rejection has been upheld by the Supreme Court.

In so doing, the Supreme Court has given some helpful guidance on how to determine what is "adequate consideration" and stressed the fact that it is an objective test, which requires regard to the commercial justification in the particular circumstances and is assessed on the assumption that the parties to the transaction are acting in good faith and at arm's length.

In this case, the Inner House was of the view that it was not objectively reasonable for the vendor to accept the low price offered as there was, in reality, no fire sale. The business had already stopped trading – it was a distribution company that had sold all of its trucks and was then left with only its premises. A sale of the premises was not required to maintain liquidity to allow it to continue to trade. The Inner House therefore considered the sale to have been at undervalue and ordered the return of the property to the company.

The Supreme Court agreed that the sale was at undervalue.

So, is the purchaser just left with an unsecured claim for the £550,000?

Not necessarily. This is the really important part of the Carnbroe decision.

The Supreme Court has concluded that, contrary to previous Scottish authority, the wording of section 242 is, in fact, broad enough to allow the court to devise a remedy, in appropriate cases, to protect a good faith purchaser from a reversal of a purchase, which would otherwise give the other creditors a windfall at its expense. 

Indeed, the court observed that the general approach to the annulment of transactions requires no more from a fraudster than that he compensate the victim.

The Supreme Court held, in short, that credit could be given under section 242 for the consideration paid by a good faith purchaser – and to the extent that cases such as Short's Trustee v. Chung suggested that the court did not have this power, they were wrongly decided.

The Supreme Court has now handed the case back to the Inner House to determine exactly what remedy should be devised for the liquidators in this particular case.

What is next for the parties involved?

Unless the parties decide to settle the case, it will now be for the Inner House to consider what would be a more appropriate remedy than (unconditional) reduction of the sale. This may not be entirely straightforward. There are several possibilities.

Could reduction of the sale be ordered, but with conditions imposed by the court?

Perhaps the most likely outcome is that the Inner House reduces the sale, but on the condition that the liquidators pay Carnbroe compensation. It would be open to the court to order that the liquidators pay a lower or higher sum than the original £550,000 price.

Could Carnbroe be ordered to sell the property back to the insolvent company?

Yes, a similar potential outcome is that the Inner House could order Carnbroe to sell the property back to the insolvent company at a specified price.

However, this is not without difficulty – what should the price be? The original price of £550,000 could presumably be taken as a starting point, but what if Carnbroe has spent substantial sums improving the property since the date of its purchase? Should it be compensated for any sums that it has spent?

It is also possible that the liquidators have insufficient funds at their disposal to fund a purchase, making such an order impossible to implement.

Could the Inner House allow Carnbroe to keep the property?

Yes, the court could order that Carnbroe be allowed to keep the property, but only on the basis that it pays compensation to the insolvent company, effectively "topping up" the price which it originally paid (£550,000) to an amount which constitutes "adequate consideration".

Assessing what would have been "adequate consideration" may not be straightforward. At proof, the two valuation surveyors who gave evidence suggested a range of different valuations depending upon the precise circumstances of the sale. What circumstances must one assume for the purposes of assessing what would have amounted to "adequate consideration"?

What about Carnbroe's lender? 

Carnbroe had funded the purchase of the property with a loan of £600,000 from a bank. It granted a standard security in favour of the bank at the time of its purchase.

At the hearing before the Supreme Court, it emerged that Carnbroe had refinanced and that there was no longer any standard security over the property.

The Inner House will not, therefore, have to consider the bank's position when deciding what orders are appropriate.

What would have happened if the standard security had still been in place?

In terms of section 242(4), reduction cannot prejudice any right which a third party has acquired in good faith and for value from the purchaser.

Therefore, if the standard security had still been in place and the court ordered the return of the property to the ownership of the insolvent company, the bank would still be entitled to call up its standard security and to sell the property in satisfaction of the debt due to it.

The presence (or otherwise) of a secured lender is, therefore, another factor which the court must take into account when deciding what sort of order it ought to make when unravelling a gratuitous alienation, having regard to the various parties' interests.

What does this decision mean for the wider market?

The decision is good news for the Scottish property market, insofar as it recognises the need to balance, on the one hand, the interests of the creditors of an insolvent company and, on the other hand, the interests of a purchaser in good faith. It is also a welcome decision for lenders.

It remains to be seen how the Inner House will now proceed, based on clear directions from the Supreme Court.

What is clear is that this case has brought Scots law much closer to the law in England and Wales, where the equivalent provision (section 238 of the Insolvency Act 1986) empowers the court to make an order restoring the position to what it would have been if the insolvent company had not entered the transaction at undervalue. It had been something of an anomaly that the interests of a good faith purchaser were treated very differently across the component parts of the UK. 

Challenging gratuitous alienations may now be a less attractive proposition for liquidators, since achieving a windfall for the benefit of creditors will now be unlikely. That said, circumstances are still likely to arise – with considerable frequency – where challenges remain justified and worthwhile.

The old adage for would-be purchasers remains: if a bargain looks too good to be true, it probably is.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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