Director not insulated from liability on insolvency—Re Cosy Seal Insulation Ltd (in administration); Ross v Gaffney

Oberon Kwok, barrister at St Philips Chambers, outlines that while the decision in Re Cosy Seal Insulation grants some practical knowledge to lawyers, there are legal issues, namely relating to carbon credits and the nature of ‘transaction’, that remain ambiguous.

Original news

Re Cosy Seal Insulation Ltd (in administration); Ross and others v Gaffney and another company [2016] EWHC 1255 (Ch), [2016] All ER (D) 29 (Jun)

The Chancery Division allowed the applicant administrators’ applications concerning a number of payments made by the first respondent company director and the second respondent company and arising out of the insolvency of the second respondent company. The court held that the interests of the company’s creditors had plainly been engaged, and the respondents were ordered to make repayments.

What was the background to the hearing?

Cosy Seal Insulation Ltd (CSIL) went into administration on 4 July 2014. CSIL’s sole shareholder and director was Mr Paul George James Gaffney. His wife, Mrs Gaffney, was the sole shareholder and director of Cosy Seal Insulation (UK) Ltd (CSIL(UK)).

CSIL and CSIL(UK) were both insulation contractors. Under the government’s Energy Company Obligation (ECO) scheme, energy companies were required to meet targets in helping consumers to reduce emissions. Credits of different types and quantities could be earned from qualifying actions, such as the installation of insulation. Thus CSIL, by performing insulation work, would gain credits, which could then be bought by energy companies in order to help hit their ECO targets.

CSIL, prior to entering administration, had entered into transactions and made payments that the administrators subsequently sought to impugn as preferences and/or transactions at an undervalue (TUV). Additionally, the administrators alleged misfeasance against Mr Gaffney in respect of those transactions. The transactions in question fell into three broad categories:

  • payments to Mr Gaffney, its director
  • payments to CSIL(UK), and
  • the sale of credits to CSIL(UK) for £100,000, which were shortly afterwards sold on to a third party buyer for £684,442

What were the legal issues HHJ Behrens had to decide?

In this case, there were four main legal issues that Judge Behrens had to decide upon, which I will outline separately.

Issue 1—'relevant time' in relation to both the TUV claims and preference claims

The first issue in contention was whether each transaction or payment occurred during a ‘relevant time’ as stipulated in section 240(2) of the Insolvency Act 1986 (IA 1986). That is, whether CSIL was unable to pay its debts at the time of, or became unable to pay its debts as a result of, the transaction or preference.

It was conceded that Mr Gaffney and CSIL(UK) were persons connected to CSIL under IA 1986, s 249. It was also conceded that all the impugned transactions and payments occurred within two years of the onset of insolvency.

Issue 2—the preference claims

The second disputed issue was whether, under IA 1986, s 239(5) and (6), CSIL was influenced by a desire to put Mr Gaffney or CSIL(UK) in a better position than they would have been in an insolvent liquidation. In this regard, it was conceded that Mr Gaffney and CSIL(UK) were put in a better position than they would have been in an insolvent liquidation.

Issue 3—the TUV claim

The third point in contention had to do with the valuation of the credits, namely whether the sale of the credits to CSIL (which were subsequently re-sold to a third party at a higher price) were at an undervalue.

Issue 4—the misfeasance claim

Finally, the misfeasance dispute centred on whether the matters stated above also entailed Mr Gaffney being in breach of his duty to act in creditors’ interests, as preserved in section 172(3) of the Companies Act 2006 (CA 2006).

What were the main legal arguments put forward in relation to the case's legal issues?

Taken separately, in relation to the case’s legal issues, as outlined above, the main legal arguments in this case were as follows.

Issue 1—'relevant time'

The administrators argued that CSIL was insolvent at the time of the transactions and payments, as determined by both the cash flow test and the balance sheet test under the meaning of IA 1986, s 123. They pointed to a winding up petition presented against the company amounting to £1.5m (a debt which could not be disputed), the non-payment or deferral of payments to other creditors, an email to HMRC requesting an urgent refund of VAT that was ‘desperately’ needed to pay trade creditors, and a board resolution resolving that CSIL was insolvent.

In response, counsel for Mr Gaffney argued that many of the debts were disputed. Moreover, Mr Gaffney sought to downplay the significance of the email to HMRC, saying that CSIL could still have traded through its difficulties.

Nevertheless, there was little dispute that applicable principles could be found in BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL plc [2011] EWCA Civ 227, [2011] All ER (D) 74 (Mar), Carman (liquidator of Casa Estates (UK) Ltd) v Bucci [2014] EWCA Civ 383, [2014] All ER (D) 33 (Apr) and Re Cheyne Finance [2007] EWHC 2402 (Ch), [2007] All ER (D) 37 (Dec). These cases establish that, in relation to cash flow insolvency, the inquiry is necessarily fact-sensitive and, further, that the court’s approach should not be too blinkered and thus overlook the possibility that an inability to pay was only a result of ‘temporary liquidity’. However, there were indicators of financial problems in 2013 and 2014, which showed that the company was under ‘an endemic shortage of funds’. It was determined that this was caused partly by the non-payment of a large debt of £1.2m that was owed to the company, and partly by a large dividend paid to Mr Gaffney in 2013. As such, the company was cash flow insolvent for the whole of the period in which the transactions were impugned.

Furthermore, the judge held (obiter) that the company was also balance sheet insolvent, and he accepted that hindsight should be used to assess the company’s balance sheet. Mr Gaffney submitted that, taking into account the £1.2m debt owed to the company, CSIL was balance sheet solvent.

With the benefit of hindsight, the judge rejected the contention that the debt owed to the company should be valued in full, given a significant history of difficulty in recovering the debt. Rather, the judge imposed a discount of up to 30% to reflect the risk of non-recovery. With that discount, the company was clearly balance sheet insolvent.

Issue 2—the preference claim

The preference claim related to payments made to Mr Gaffney in repayment of loans given by Mr Gaffney to CSIL, and payments to CSIL(UK). Mr Gaffney claimed that the payments paid to him were simply part of his efforts to treat all creditors (including himself) fairly. As for the payments to CSIL(UK), these were supposedly payment for ‘consultancy’ services provided by Mrs Gaffney to CSIL.

The judge rejected both arguments. The starting point was that, pursuant to IA 1986, s 239(6), CSIL was presumed to have been influenced by a desire to prefer Mr Gaffney and CSIL(UK), being connected persons. Applying the test in Re MC Bacon Ltd [1990] BCLC 324, the judge reiterated that ‘desire’ was a subjective matter, in the sense that the company must have positively wished to improve one creditor’s position (though that desire need not have been the decisive factor in the company’s mind when it decided to make the payment). Desire could therefore be inferred where there was no direct evidence of such.

Based on the facts, there was simply no justification for the payments to Mr Gaffney or CSIL(UK). It transpired that some creditors were not paid, and others were paid late, meaning that it could not be said that all creditors were being fairly treated. Furthermore, there was no pressure on CSIL, or any evidence of a commercial reason to pay Mr Gaffney or CSIL(UK) at that time of financial difficulty for the company. Indeed, one of the payments to Mr Gaffney was made on the same day as the filing of the ‘Notice to Appoint Administrators’. As such, the presumption was not rebutted.

Issue 3—the TUV claim

The TUV claim related to the sale of credits from CSIL to CSIL(UK) in relation to 40,000 tonnes of carbon for a total price of £100,000. The sale contract was disadvantageous to CSIL—it allowed a deferral of payment of nine months, and allowed CSIL(UK) to set off previous sums owed by CSIL to CSIL(UK). A few weeks after the sale, CSIL(UK) re-sold 18,000 tonnes of that carbon to a third party buyer for £684,442. Expert evidence suggested that the £100,000 was significantly lower than the market rate, while the re-sale price was fair.

In his defence, Mr Gaffney pointed to regulatory uncertainties regarding the validity of credits, which he said led to a risk that the credits were worthless. However, the judge did not accept that argument because the third party buyer clearly treated the credits as valid and of significant worth. Notably, there was no good explanation for why the sale to the third party had to be undertaken by CSIL(UK), as opposed to CSIL. The price achieved by CSIL(UK) from the third party buyer was evidence that the initial sale from CSIL to CSIL(UK) was at an undervalue, which the judge subsequently concluded that it was.

Issue 4—misfeasance

It was held as common ground that Mr Gaffney had a duty to consider and act in the best interests of the creditors when the company was of doubtful solvency. He had a duty to not do anything that would put creditors’ prospects of being paid at real risk. The director was required to act bona fide (in a subjective sense) in their interests. In this case, Judge Behrens based his judgment mainly upon the principles summarised in the decision of John Randall QC, sitting as a deputy judge of the High Court, in Re HLC Environment Projects [2013] EWHC 2876 (Ch), [2013] All ER (D) 240 (Sep). He therefore accepted that:

  • the subjective test could only work where there is evidence that creditors’ interests were actually considered—in the absence of such, the test became objective, namely what an intelligent and honest man in Mr Gaffney’s situation would have reasonably believed was in the company’s best interests
  • the objective test must equally be applied where a very material interest, such as a large creditor, is unreasonably overlooked in light of the facts that were known (or ought to have been known) to the director at the time without the use of hindsight

The judge therefore applied an objective approach, presumably because Mr Gaffney did not appear to have actually considered the interests of creditors. On that basis, none of the impugned payments of the company were in the interests of creditors and, as such, Mr Gaffney was in breach of duty. Given that Mr Gaffney had gained financially as a result of his breach, it was deemed that this was not an appropriate case for relief from liability being granted under CA 2006, s 1157.

What practical lessons can those advising take away from this case?

This case demonstrates that a company’s prejudicial communications may be just as potent or damning as the company’s financials when demonstrating insolvency at a particular point in time. The judge here relied on the company accountant’s email to HMRC, which claimed that the company ‘desperately’ needed the refund, and the board’s own conclusion that the company was insolvent.

Moreover, lawyers should keep in mind that the court is likely to look with disfavour at directors’ later attempts to distance themselves from such communications. In this case, for example, Mr Gaffney was caught in a bind. If the email to HMRC was true, then that served as evidence of insolvency. If it was untrue, then the email would have constituted an attempt to mislead HMRC. This case reiterates the need for company directors to be especially attentive to the content of written communications when the company’s solvency is in doubt.

To what extent is the judgment helpful in clarifying the law in this area?

To a large extent, the judgment involved the application of clear and well-established principles in clawback claims and breach of duty. However, there are two points to note. First, that there is a duty to consider the company’s creditors. In this case, the judge accepted, without question, the notion in HLC that where the interests of a large creditor were unreasonably overlooked, the objective test must be applied. At the time that the decision in HLC was handed down, this was a relatively novel proposition. As Newey J held in GHLM Trading Ltd v Maroo [2012] EWHC 61 (Ch), [2012] All ER (D) 172 (Jan), at para [168]:

Where creditors’ interests are relevant, it will similarly, in my view, be a director’s duty to have regard to the interests of the creditors as a class. If a director acts to advance the interests of a particular creditor, without believing the action to be in the interests of creditors as a class, it seems to me that he will commit a breach of duty.

The better view, it is therefore suggested, is that the interests of creditors as a class may begin to intersect with the interests of a large creditor by virtue of the relative size of his debt within that class. If a large creditor’s interests are overlooked then, depending on the circumstances and the debts of other creditors, this could serve as evidence that creditors’ interests as a class have been overlooked and the objective test may be applied. It would probably be incorrect to put it any higher than that.

Second, this case touched on the issue of carbon credits and ‘transaction’, but it did not ultimately provide clarification. The juridical nature of carbon credits as property has been a source of much debate but little judicial attention to date. Waste management licences and milk quotas have been previously held to fall under the definition of ‘property’ under IA 1986, s 436 (Re Celtic Extraction Ltd (in liq) [2001] Ch. 475, [1999] All ER (D) 783, and Swift v Dairywise Farms Ltd [2000] 1 All ER 320). Indeed, in Armstrong DLW GmbH v Winnington Networks Ltd [2012] EWHC 10 (Ch), [2012] All ER (D) 64 (Jan) it was determined that EU emissions trading system (EU ETS) carbon credits were held to constitute ‘property’ under the common law definition. However, in Armstrong the issue was obiter as it had been conceded by the parties and, in any event, it was a first instance case that did not concern the IA 1986. Currently, the matter is not yet settled.

This issue is of potential importance in the context of IA 1986, s 238 because it was held in Re MC Bacon by Millett J (in the context of the creation of a charge over company assets) that there can be no TUV if there is no depletion or diminution of the company assets in the first place. If a carbon credit does not constitute ‘property’, it cannot form part of the company’s assets. A fortiori there is no diminution in the company’s assets when carbon credits are transferred away, and therefore no TUV can have taken place.

The point was not raised in argument and, as such, the judgment did not deal with this point. While the possibility of such an argument succeeding is remote, it might have resulted in a useful contribution to this notoriously difficult area of the law.

Interviewed by Giverny Tattersfield.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Further Reading

If you are a LexisPSL subscriber, click the links below for further information:

A summary procedure under section 212 of the Insolvency Act 1986 and the process for bringing a misfeasance claim

Can a liquidator or an administrator challenge or unwind transactions entered into by the company before it was wound up or entered into administration?

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First published on LexisPSL Restructuring and Insolvency

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