The off-market sale by a failing Scottish haulage company of its warehouse and other property at significant undervalue was a 'gratuitous alienation' which was not in the best interests of the company's creditors, a Scottish appeal court has ruled.

The Inner House of the Court of Session ordered that the £550,000 off-market sale of the property, which had previously been valued at £1,200,000 on the open market, be cancelled following a challenge by the liquidators of the haulage company. In doing so, it overturned an earlier decision by a commercial judge, who had ruled that the £550,000 purchase price was "adequate consideration" given the circumstances of the case.

One of Scotland's most senior judges, Lord Drummond Young, gave the judgment of the court (22-page / 422KB PDF). In doing so, he "focussed and restated fundamental principles" of Scottish insolvency law, according to commercial litigation expert Craig Connal of Pinsent Masons, the law firm behind Out-Law.com.

In the words of the judge, Scottish insolvency law requires that, once a debtor is insolvent, "his assets must be managed in such a way as to protect the interests of his creditors...what in modern law is described as a fiduciary duty under which...the debtor most always act...in the interests of another person rather than his own interests". A debtor who disposes of property once insolvent must "obtain full consideration", and it is the person who received that property who must establish whether full consideration was given, the judge said.

"These passages repay careful study given their significance for a whole range of matters, the court going on to stress that the statements applied equally to corporate entities as they did to individual debtors," said Connal.

"The other main issue the court considered was where a company has to pay money as a matter of urgency to avoid a threat to the business continuing. In that circumstance, it is relatively easy to infer that the consideration was adequate. The company simply cannot afford the leisure, for instance, of a long period of marketing to get a better price. However - and this is the really critical part - if that consideration comes into play it is essential that the business be 'capable of continuing' once the debt has been paid," he said.

"As in many such cases, the consequent application of these principles to the facts is less critical. Here, there was no prospect of the company surviving, therefore the justification for selling off the assets at less than full value disappeared," he said.

Section 242 of the 1986 Insolvency Act gives the liquidator of a company the power to challenge the disposal by that company of its property up to two years before winding up begins, or five years if the recipient of that property has a close connection. One of the defences to such a challenge available to the recipient of the property is that the disposal was for 'adequate consideration'.

The liquidators of haulage company Grampian Maclennan had challenged the sale, a mere six weeks before liquidation, of its main asset, a piece of property in East Kilbride which consisted of a warehouse, vehicle workshop and yard with a gatehouse. Grampian's new owner, who had purchased the business with the intention of turning it around, had sold the property for £550,000 to a James Gaffney, with whom he had a historical business relationship. The property had been valued at £1.2m on the open market, or £800,000 if a restricted marketing period of 180 days was assumed.

The original judge in the case received two separate expert valuations, of £820,000 and £740,000 respectively. Neither expert thought that the £550,000 purchase price was unreasonable given the circumstances of the case, including the intention to obtain a quick sale. For this reason, the commercial judge held that this price was 'adequate consideration'.

Lord Drummond Young, however, noted that the need for a quick sale could only be assumed if it was likely that the company could be saved. Otherwise, the principles of insolvency law superseded this assumption, particularly the need to protect the interests of the company's creditors.

"If the debtor's business is about to come to an end, the need for a forced sale to maintain the liquidity of the business and hence its continuation simply disappears," the judge said. "In that situation the company or other entity carrying on the business should observe the general policy of the law of insolvency by giving paramount importance to the interests of creditors as a body; in other words, considerations based on insolvency should prevail over the need for payment of debts as they fall due."

The judge acknowledged that, in "exceptional cases", a quick sale to allow payment of an urgent debt may be in the best interests of the company's creditors. However, this was not such a case, he said.

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