Preference or invalid set-off: which is it?

Preferences are defined in Section 239 of the Insolvency Act 1986 and arise when one creditor is placed into a better position to that of another, when an individual or a company enters into a formal insolvency procedure. The precise timescales and circumstances for a Preference are outside the scope of this post but the leading case on Preferences is Re MC Bacon Ltd [1990] BCLC 324 for more detailed consideration of the rules. This post is seeking to consider the relationship between a Preference and invalid set off for director’s loans in the context of an insolvent company. A rather common preference scenario is where a company director lends a sum of money to fund their business which at some point enters into decline. Upon the realisation that their business is in terminal decline, insolvent and likely to enter into a formal insolvency process the company director repays money (in part of in full) in consideration for the prior sums he or she has lent the company. Subject to the conditions required by the rules then a liquidator could recover such sums from the director personally in light of Section 241 of the Insolvency Act 1986 so that the recovered Preference monies can be redistributed amongst creditors as a whole. However, what about if it is the other way around? Come on now – how many of you out there are going to say surely it does not matter and that the end result is the same. Well I am afraid not and here is why not. If a company director for example withdraws sums of money from his or her company, then unless their loan account is in credit to the full amount or they have approval from the company’s shareholders / members; then in light of Section 213 of the Companies Act 2006 the transaction would be unlawful and the director would be liable to repay the sum to the company. Now you may say but liability to repay the sums withdrawn can be undertaken in various ways other than via pure monetary consideration so that for example a director’s unpaid wages could be a suitable repayment mechanism. Ah well again I am afraid not for the reasons set out below which relate to the rules on set-off. The position under Rule 4.90 of the Insolvency Rules 1986, provides for a set-off arising out of ”mutual credits, mutual debts or other mutual dealings between the company and any creditor”, was appropriately considered by Millett LJ in Manson v Smith (liquidator of Thomas Christy Ltd) [1997] 2 BCLC 161. A director liable for misappropriating funds belonging to an insolvent company sought to rely upon rule 4.90 to set off his liability against what the company owed him. Millett LJ however submitted ”a misappropriation of assets is not a dealing”. Neither is a conversion of the company’s property. Lord Uthwatt said in Winter Garden Theatre (London) Ltd v Millennium Productions Ltd [1948] A C 173, 203: ”In a court of equity, wrongful acts are no passport to favour.”. In other words you cannot adopt rule 4.90 to validate an unlawful act and as a result the money with- drawn would have to be repaid in full by the director. My suggestion would be – do not assume or presume that fairness in the eyes of the law equates to your own perception of what is reasonable and what is necessarily fair. Take independent advice particularly when engaging in transactions that may favour you whilst insolvent. Remember as a director of a company which is insolvent your obligations are first and foremost to its creditors not to the shareholders.

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