When creditors come first

A recent Scottish appeal decision, Liquidators of Grampian Maclennan’s Distribution Services Ltd v Carnbroe Estates Ltd [2018] CSIH 7 (23 January 2018) has provided clarification and guidance on distressed sales when businesses are in financial difficulty. If a court holds that a transfer of assets by a debtor is a gratuitous alienation, the transfer can be struck down and the asset returned or other redress granted, in terms of s 242 of the Insolvency Act 1986, which provides certain defences including adequacy of consideration. 

In the appeal, Lord Drummond Young considered the fundamental principles of insolvency law in assessing the distressed sale of Grampian’s property and whether the £550,000 paid for it constituted “adequate consideration”. The court also considered whether a quick sale was required in the circumstances, given Grampian’s financial troubles and its immediate need for funds. 

What happened?

Grampian’s main asset comprised an industrial unit of 4.4 acres. Surveyors valued the property in May 2013 at £1.2 million on the open market, or £800,000 on a restricted marketing period of 180 days. 

In July 2014, Grampian was sold to a new owner who was aware of its financial issues. Grampian owed over £1 million to HMRC and to NatWest, with NatWest requiring loan payments of £4,600 per month. Shortly after the sale, invoice financing was withdrawn, leading to severe cashflow restraints and Grampian’s trucks were sold off. By the end of July 2014, the business had effectively ceased.

Meanwhile, the new owner had discussed Grampian’s financial situation with the sole shareholder and director of Carnbroe, someone with whom he had a long history of business dealings. On 24 July the property was sold on an off-market basis to Carnbroe for £550,000. Earlier, in April, Carnbroe had expressed a willingness to purchase the property for £900,000; though this was not a formal offer and Grampian did not respond. Valuations obtained by the bank financing the purchase repeated the 2013 valuations. Concerned at the possibility of a challenge on insolvency, the bank queried the difference; and the defenders’ solicitors, with the surveyor, advised that, given the lack of any willing seller/buyer or six-month window in which to dispose of the property, the valuation could even be reduced by 50% on a shorter marketing period of 90 days.

On 18 August 2014 Carnbroe made a payment of £473,604.68 to Grampian, the amount required to settle NatWest’s secured debt. Other liabilities, however, remained, and on HMRC’s petition liquidators were appointed in November 2014.

The liquidators challenged the sale as a gratuitous alienation. At proof, valuations of £820,000 and £740,000 were led, but both valuers considered a price of £550,000 not unreasonable in the circumstances. The commercial judge ([2017] CSOH 8) held that £550,000 was adequate consideration, given Grampian’s limited options and financial position, NatWest threatening to call up its standard security and no other offers being present. The judge did however hold that a close scrutiny of the transaction was justified, due to the business relationship between Grampian’s new owner and Carnbroe, and that the £473,604.68 initially paid was inadequate.

First principles

In reviewing the legislative background in relation to corporate insolvency and s 242 of the 1986 Act, Lord Drummond Young in the Inner House considered the Bankruptcy Act 1621, Bell’s Commentaries and Roman law. Three critical principles of insolvency law were highlighted:

1. Once a debtor is insolvent, their assets must be managed in such a way as to protect the interests of the creditors. 
2. If a debtor alienates property once they are insolvent, full consideration must be obtained for the property alienated. 
3. It is the person who receives the debtor’s property who must establish that full consideration was given.

The court reviewed case law in relation to the Scots law meaning of “consideration” and “adequate consideration”. It held that “If avoiding a threat to the company’s business is to amount to consideration… it is essential in our opinion that the business should be capable of continuing after payment of the debt or the granting of the security.” The court observed that any sale driven by the need for liquidity was likely to be at less than market value and likely to be prima facie at an undervalue. Where a business was about to come to an end, the need for a forced sale to maintain liquidity, and so continuation of the business, “simply disappears”. 

On the facts, Grampian was in severe financial difficulty; it could be considered insolvent on an objective assessment; the sale of its trucks made it difficult for it to continue to operate; and lastly, the sale of the premises where it was based would make its operation very difficult without a major change. Accordingly the court held that there was no realistic prospect of the business continuing; the interests of the creditors should have been put first and an attempt made to sell the property for full market value (as would have happened on a winding up). As such, the appeal was allowed and the transfer held a gratuitous alienation. 

Further comment was made in relation to the relationship between the new owner and the defender, as well as other aspects which aroused suspicion such as the precise sum paid to NatWest, but these were not considered in detail. 

The judgment provides welcome clarification on the sale of property and assets in insolvency situations, and when an insolvency process is the only proper route, as opposed to a rushed sale at an undervalue. Insolvency practitioners in particular will be relieved at the restatement of the law. Solicitors for purchasers will need to pay close attention to valuations and the basis on which they have been instructed and carried out. When considering acquisitions from businesses in trouble, failure to establish (in the sense of later being able to prove) adequate consideration could lead to the reduction of the transaction.