17 Apr 2018

In LRH Services Ltd (in Liquidation) v Raymond Arthur Trew (1) Jason Marcus Brewer (2) and Derek O'Neill (3) [2018] EWHC 600 (Ch), LRH Services Ltd (LRH), acting by its liquidators, brought claims for breach of duty against three former directors. The claims arose from a reorganisation in 2009. LRH did not trade but had two trading subsidiaries (R and E) and it was wholly owned by CSGH, which also had another subsidiary in addition to LRH, CSG. Two of the directors of LRH were substantial shareholders in CSGH. 

The reorganisation

The reorganisation involved a reduction of capital supported by a solvency statement made by one of the directors under s643 of the Companies Act 2006 (CA 2006). LRH cancelled its share premium account and capital reserve, reduced its capital to £1 and paid a dividend of approximately £21.3 million to CSGH, satisfied by, inter alia, the transfer of R and E and accrued tax losses. R and E were transferred to a new company, Aim Plus Ltd (Aim Plus), in which the same two directors had substantial shareholdings. The overall result was the separation of the group into two parts.

LRH's remaining liabilities

LRH was left with leasehold premises of which it was the tenant. Payment of the rent was largely dependent on receipts from the occupiers of the premises, which included R and E and a former subsidiary of CSGH, LCF. Aim Plus entered into an agreement under which it and its subsidiaries were permitted to occupy certain properties used by R under a licence with a fee equal to LRH's relevant rent liability, pending assignments of the relevant leases. Aim Plus subsequently was released from the obligation to seek assignments of the leases and terminated the licence in respect of all of the properties except one, which was retained and in respect of which an assignment was eventually made.

Insolvency of LRH

LRH maintained a reserve for 'onerous leases' which the liquidators argued was grossly insufficient. The liquidators also alleged that no sufficient steps were taken to secure the payments by R and LCF. LRH quickly became unable to meet its liabilities under the leases, because LCF, which was already in default, ceased to pay anything in respect of the unit it occupied. LRH was temporarily supported by CSG but the payments were without obligation and treated as loans. LRH went into liquidation in November 2010 on the petition of one of the landlords.

The liquidators' claims and the key issues before the court

The liquidators' claimed that:

  • the solvency statement was invalid because the director who made it had not formed the required opinions stated in it or could not properly have done so. The reduction of capital was therefore void and the dividend was unlawful
  • all three directors were in breach of their duties to exercise reasonable care, skill and diligence under s174 CA 2006 and to promote the success of the company under s172 CA 2006, by implementing a reorganisation which left LRH with onerous liabilities but insufficient resources to meet them. Two directors were also alleged to be in further breach by taking no proper steps to protect the company after the reorganisation.

The directors

The directors argued that they had acted reasonably and properly, on the basis of professional advice.

Mr O'Neill, the finance director of LRH, resigned at the reorganisation completion meeting before the solvency statement was made and denied responsibility. In any event, he argued that the provision made was sufficient in relation to unoccupied properties or properties occupied by unrelated entities and he had understood that the obligations on occupiers to pay the rents were legally binding.

Mr Trew, when acting as the sole director, made the solvency statement and said that he had relied on Mr O'Neill and the internal accountants. In relation to the rents, he assumed that LRH would be supported by CSG.

Mr Brewer was appointed as a director after the solvency statement was made and the reorganisation took place and denied responsibility. He said that he took no part in devising or implementing the reorganisation.

The relevant law

Solvency Statement – Section 643 CA 2006

Section 641 CA 2006 provides that a reduction of capital may be effected "in the case of a private company limited by shares, by special resolution supported by a solvency statement". Section 643 provides:

"(1)    A solvency statement is a statement that each of the directors:
            (a)    has formed the opinion, as regards the company's situation at the date of the statement, that there is no ground on which the company could then be found to be unable to pay (or otherwise discharge) its debts; and
            (b)    has also formed the opinion:

                    (ii)    …that the company will be able to pay (or otherwise discharge) its debts as they fall due during the year immediately following that date.

(2)    In forming those opinions, the directors must take into account all of the company's liabilities (including any contingent or prospective liabilities)…

(4)    If the directors make a solvency statement without having reasonable grounds for the opinions expressed in it, and the statement is delivered to the registrar, an offence is committed by every director who is in default."

Meaning of unable to pay its debts

Rose J in BAT Industries Plc v Sequana [2016], which is the subject of an appeal, held that the reference in subsection (1)(a) to a company being found to be unable to pay its debts was not the same as a finding under s123 Insolvency Act 1986 for the purposes of a winding up petition. The test in s643 is straightforward. The directors must look at the situation at the date of the statement and, taking into account contingent or prospective liabilities, form an opinion as to whether the company is able to pay its debts.

Meaning of taking into account contingent and prospective liabilities

In taking contingent and prospective liabilities into account, the directors must consider all the circumstances relevant to whether a liability will fall on the company. They are not bound to assume that it will, or that if it does, the liability will be of the maximum amount foreseeable. Rose J, in Sequana, rejected a submission that the directors must assess contingent or prospective liabilities on a worst case basis.

The directors must also consider what assets are available to meet liabilities, including future liabilities. Provision may be by way of setting aside or holding specific assets, or it may be by way of arrangements to generate income or assets in the future. The directors must be able to form the opinion that those assets or arrangements will be sufficient to discharge the company's liabilities as they fall due, for the next 12 months.

Forming an opinion that LRH would be able to meet its liabilities under the leases, therefore required the directors to consider the security of the arrangements in place so that it could do so. They were not obliged to make a worst case assessment, but a realistic commercial one having regard to all the circumstances.

Honest opinion

Rose J concludes in Sequana that it was sufficient for the solvency statement to be valid that the directors had honestly formed the opinions stated, provided that they had applied the correct test in doing so. The liquidators accepted that Sequana was binding at first instance, but reserved the right to argue, if the case goes further, that the absence of reasonable grounds for the opinions renders the solvency statement invalid. Rose J had concluded that this was not so.

Directors' duties

The section 172 duty to promote the success of the Company.

The requirement is to promote the success of the company for the benefit of the members, not to promote the interests of the members directly.

Distributions illustrate where there may be divergence; they are of benefit to the members but may adversely affect the company's success.

Success also requires the company to meet its liabilities to creditors, otherwise it is liable to be wound up, putting an end to its success. It is in the interests of members that there should be a surplus to distribute in a winding up. Success in that context may be interpreted as producing such a surplus. Success could not lie in having previously distributed the company's assets so that it is left with a deficit.

The section 174 duty to exercise reasonable care, skill and diligence.

Section 174(2) provides that this means the care, skill and diligence that would be exercised by a reasonably diligent person with (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company, and (b) the general knowledge, skill and experience that the director has.

Application of the duties in this case

The directors when in office, were subject to these duties when considering and implementing the reorganisation and in its aftermath, at all stages, including, in Mr Trew's case, when making the solvency statement. The general duties in this context are not limited to the matters required to be addressed in the solvency statement or to the statutory period of 12 months. 

Consequence of resignation by a director

It was accepted that, save to the limited extent set out in s170(2) CA 2006, after a director resigns he or she ceases to be subject to the general duties. But this doesn't mean that the director ceases to be liable for breaches of duty prior to the resignation.

Duty to creditors

The judge considered that because the structure of the reorganisation was such that the eventual insolvency of LRH was inevitable (even if it could be made to survive for 12 months), the duty to give first consideration to the interests of creditors had arisen, although this didn't really add anything.

Breaches of duty by the directors

  • Mr O'Neill was found to be in breach of his duty under s174, as he made no enquiries beyond asking Mr Trew whether a provision should be made for the lease liabilities and there was an almost complete absence of any consideration of LRH's liabilities. Mr O'Neill was also in breach of the s172 duty which required him to seek to ensure that the company could meet its liabilities. Mr O'Neil, in the view of the judge, "was not in truth genuinely concerned to protect LRH's interest at all" but had greater regard for the interests of the other companies. Aim Plus, for example, in which he was personally interested, would benefit without profits from R and E being passed through LRH and dissipated in meeting its liabilities
  • Mr O'Neill was under these duties in relation to the reorganisation notwithstanding that he resigned shortly before they were finally implemented. He knew that the steps that he had put in place would be followed through without any meaningful further consideration by Mr Trew and so was not absolved of responsibility
  • Mr Trew was in breach of the same duties, having relied on his ability to procure support for LRH through loans from CSG, which were however (a) without any legal commitment and (b) given that they were loans, did not improve LRH's position. This may have enabled LRH to survive for the 12 months covered by the solvency statement, but did not assist its success as it would be insolvent at the end of that period. Mr Trew failed to take any steps to ensure that LRH could enforce the support of CSG. Furthermore, he was in further breach because he proceeded with the reorganisation and made the solvency statement so that LRH was deprived of its assets. His duties required him to look beyond the declaration itself and consider (but he did not) whether it was in the company's interests to be left at risk of being insolvent at the end of the 12 month period
  • Mr Brewer was also in breach of the same duties. He entirely abdicated responsibility, simply signing whatever was put in front of him. The documents he signed included a statement attributed to the "Finance Director" (which referred to himself at this point), that after the payment of the dividend, LRH would still be able to meet its liabilities. In the view of the judge, he made no enquiry whatever before signing up to that statement. Mr Brewer placed reliance on the fact that the reorganisation had been devised by lawyers and other advisers, but made no enquiry as to their role or instructions. In relation to his later appointment, the judge said duties on a director are inescapable and it is not an excuse for a director to say that he has just been appointed and not had the opportunity to familiarise himself with the company and its affairs.

Breaches of duty after the reorganisation

  • Mr Trew was also in breach of his s174 duty insofar as he caused or allowed LRH to incur further liabilities to CSG (and other companies) to meet its liabilities when he should have called in a debt due from CSGH to meet LRH's current liabilities. Further liabilities were incurred unnecessarily and Mr Trew was personally liable for the amount of the additional debt.
  • Mr Brewer was personally liable for the same amount as he also could have called in the debt from CSGH to meet current liabilities, but failed to do so. Fresh debt was therefore incurred. Although he had subsequently technically resigned, his liability continued after his resignation, as in practice all matters requiring a decision continued to be referred to and dealt with by him and so the court found that he remained a director in fact until the liquidation.

Was the solvency statement invalid and the distribution unlawful?

The court accepted that funds required by LRH to payment and other liabilities would be provided by CSG (or CSGH) and that Mr Trew intended to provide those funds and genuinely believed he would be able to do so, sufficiently to see LRH through the 12 month period. It was, however, highly questionable whether Mr Trew was acting in the interests of CSG in making it provide support, although that was not part of the case.

The liquidators argued:

  • not that Mr Trew lacked actual belief in the opinions expressed in the solvency statement, but that he had asked himself the wrong question, i.e. not whether LRH could be found unable to pay or discharge its debts at the date of the solvency statement (or as they fell due in the following 12 months) but whether CSG or CSGH could do so. In consequence, he had not in fact held the required opinions in relation to LRH. The solvency statement was therefore ineffective and the distribution made on the basis of it void
  • that payments to which LRH was not entitled may not be taken into account in forming an opinion whether it is able to pay its debts. This had been decided in BNY Corporate Trustee Services Ltd v Eurosail [2010]
  • that Mr Trew was in breach of duty in signing the solvency statement without taking account of LRH's liabilities as required by s643.

Only assets to which the company is entitled can be taken into account

The judge agreed with the liquidators. Mr Trew had not taken into account LRH's contingent and prospective liabilities because (a) he did not in fact make any enquiry or give any consideration as to what LRH was liable for in relation to the properties and (b) insofar as he assumed that whatever was outstanding or might fall due would be covered by CSG (or CSGH), he applied the wrong test, because their resources were not assets to which LRH was entitled. LRH had no right to compel CSG to provide it with funds, even by way of loan, and was entirely dependent on

Mr Trew's continued willingness to make CSG do so. The result was that he did not properly hold the opinions he expressed in the solvency statement.

Solvency statement invalid and capital reduction unlawful

For these reasons, the solvency statement was invalid, and the dividend declared and capital reduction made on the basis of it unlawful. 

Directors in breach of duty and personally liable

The consequences were that the directors responsible were in breach of duty and liable to the company for the full amount of the assets unlawfully paid away, so potentially up to the amount of the dividend itself (approximately £21m). By concession the liquidators sought an order for repayment limited to the amount of the deficit in the liquidation.

The court was not able to establish whether the directors could have lawfully distributed a lower amount than they in fact did and hence there might have been discretionary relief to limit this liability, due to lack of evidence.

All the directors were liable

Mr Trew was plainly responsible as the only director in office throughout the entire period in which the reorganisation was planned and implemented as well as being the person who actually made the invalid declaration it depended on.

Mr O'Neill was also held to be responsible notwithstanding his prior resignation. The solvency statement and the distribution implemented the plans that he had put in place whilst a director. He knew that the basis on which Mr Trew was taking the view that LRH was and would continue to be able to pay or discharge its debts was because he was relying on support from CSG. Mr O'Neill therefore knew the basis on which the solvency statement was being improperly made.

So too was Mr Brewer. He took part in the resolutions to implement the capital reduction and dividend, and lent his name to the statement attributed to him as Finance Director. He did all this without making any enquiry at all about the propriety of these measures or what if any steps had been taken to justify them. He was, in the true sense, 'reckless' as to whether they were proper and was responsible for the consequences of the fact that they were not.

Further breach of duty

Each director was also in breach of duty in exposing LRH to the inevitable result that it wouldn't be able to repay CSG or any other company. The judge said that even if he was wrong about the validity of the solvency statement, this breach meant that the directors should not have proceeded with the reorganisation anyway, because it made the eventual insolvent winding up of LRH inevitable, even if they expected to postpone it until after the 12 month period.

Relief under section 1157?

It was argued on behalf of the directors that they should be relieved from liability under s1157 CA 2006, which gives the court discretion to relieve an officer of the company from liability for breach of duty if satisfied that the person acted honestly and reasonably. The judge said that it was for a director seeking relief to show that he acted honestly and reasonably rather than it being presumed if there is no allegation of dishonesty.

Although there was no case against the directors that the reorganisation was devised with the deliberate intention of extracting the valuable assets from the group and leaving LRH with its onerous liabilities so that it would inevitably fail, taking the evidence as a whole and looking at the events surrounding the reorganisation, there must be a very strong suspicion that it was set up with exactly that intention. The judge did not find that the directors had shown that they had acted honestly.

Furthermore, in paying so little attention to LRH's exposure and failing to provide for it properly, the directors were not acting reasonably. They had effectively subordinated LRH's interests entirely to those of the other companies, from which they hoped in the future to benefit. For these reasons, the judge declined to grant relief under s1157.

Appeals

It seems likely that, as with Sequana, this case will be appealed, so that we will have a view from the Court of Appeal as to whether the interpretation in this case of the test to apply to s643 is the correct one.