The risks of void transactions in insolvency
Section 127 of the Insolvency Act 1986 renders void any disposition of a company’s property or transfer of its shares made once a winding up petition has been presented. A court liquidation is deemed to commence when the winding up petition is presented to the court even although the winding up order may not be made until some time later. The rationale for the provision is to seek to ensure that company assets are preserved for the benefit of all creditors and to seek to uphold the principle that unsecured creditors ought to be treated equally in the event of insolvency. The directors of a company are also subject to a legal duty to act in the best interests of the company and, where a company is insolvent, or on the verge of insolvency, that duty is owed not just to the company and its shareholders but to its creditors. For that reason, directors ought not to be entering into transactions which reduce the available assets to the detriment of creditor interests.
Liquidators may therefore rely upon Section 127 to challenge any transaction which has taken place in the period between the presentation of the liquidation petition and the winding up of a company. Liquidators may also take action against directors for breach of fiduciary duties and seek payment of a sum equivalent to the loss suffered by the company (and by implication its creditors) as a result of the transaction.
To seek to address the risk of a transaction being void under section 127, and action being brought by the liquidator for return of the property or an order for payment of the equivalent value if return of the property is not practicable, the legislation provides that an application can be made to the court for a validation order. This application can be made by the company or by any interested party which could include the recipient. Best practice is to seek the validation order in advance although it is technically possible to apply after the transaction has taken place.
There may be circumstances in which a company is subject to a pending winding up petition and, while it has been unable to settle its debts as they fall due for payment and is therefore insolvent on a cash flow basis, the company is solvent on a balance sheet basis. Despite the temporary cash flow pressures, the company may be in the course of restructuring and may be confident of reaching a resolution with the petitioning creditor. Where the pending transaction is necessary for the restructure and the long term benefit of the company, an application for a validation order can be made in advance. As well as satisfying the court on the company’s financial position, the applicant will need to show that the transaction does not pose a serious risk to creditors.
Although validation applications can also be made where the transaction has already taken place, these are less common and so the issues tend to be considered at a later stage, once the company has been wound up and in defence to a claim brought by a liquidator. The law has developed so as to indicate that a “change of position” defence is potentially available to those defending such a challenge. This defence invites the Court to validate the transaction, contrary to Section 127, on the basis that the recipient’s circumstances have changed detrimentally as a result of receiving the enrichment. For this to apply, the recipient of the property or money transferred must also have had no knowledge of winding up proceedings and acted in good faith.
This principle had recently been explored in re MKG Convenience Ltd. (in liquidation)  EWHC 1383 (Ch.), where the Court affirmed that such a defence would only be allowed in very limited circumstances.
Changtel Solutions UK Ltd. (In Liquidation), Re  EWHC 694 (Ch.)
Changtel Solutions UK Ltd. had been wound up in January 2015, following a petition presented in June 2013. After the presentation of the petition, Changtel’s accounts had been debited with five payments, totalling £47,000. These were advance payments for security services for a period of seven months up to December 2013. The liquidators of Changtel applied in 2021 to recover the payments, on the basis that they ought to be void under Section 127.
The recipient of the payments challenged the reversal of the payment under Section 127 on a number of grounds. In particular it was argued that the recipient had altered its position and continued to supply the security services in exchange for the payment. The Court held a number of key principles:
- Most notably, the Court confirmed that a “change of position” defence is available to recipients of payments challenged under Section 127, however only in ‘exceptional’ circumstances. At the very least the recipient will need to show that the transaction took place in good faith and before they were aware of the winding up petition. In addition, the court will need to be satisfied that it is appropriate in all the circumstances that the normal rules which seek to preserve the assets of a company on the verge of insolvency are overridden. Ultimately, the recipient in this case had not satisfied the Court of the existence of any such exceptional circumstances.
- A cheque issued prior to the presentation of a winding up petition, but with the payment not clearing until after the presentation of the petition, does not escape the operation of Section 127.
As a result, the Court rejected the application for validation of the transaction and ordered that the monies be repaid to the liquidators.
While the Court in Changtel affirmed existing principles, this serves as an important reminder of the strength of challenges made under Section 127, and the very limited circumstances allowing for validation of a transaction made post-winding up of a company.
Parties to all corporate transactions must be particularly aware of their counterparties’ financial situations while transacting. If there are any concerns that the counterparty to a transaction may be in financial difficulty which may lead to the presentation by a creditor of a petition for its winding up, consideration should be given by the company directors or the recipient to seeking a validation order in advance of any transaction taking place. This would be of particular relevance in the context of reorganisations or restructuring transactions intended to resolve the company’s immediate financial position.
In other cases, while many creditors may prefer a “bird in the hand” and to accept payments made, they need to be alert to the fact that there is a real danger that the transaction could later be made void in the event that the counterparty is wound up and a liquidator may seek repayment. Ring-fencing the funds received or at least factoring that risk into its own cash flow projections will provide some protection in the event that a liquidator does bring a challenge.