The law on disguised distributions has recently had the benefit of a decision of the Supreme Court, in the shape of Progress Property Company Ltd v Moorgarth Group Ltd  UKSC 55 (also cited as Progress Property Co Ltd v Moore  1 WLR 1). The case was relatively straightforward, and no doubt the court reached a sensible conclusion on the facts. However, Lord Walker's comments on the test which should be applied in order to determine whether a transaction with a shareholder constitutes a disguised distribution do not appear to be entirely in line with the authorities. In particular, his suggestion that the test to be used when characterising directors' remuneration is objective in nature may be open to debate. Article continues below...
The somewhat unusual facts in this case were as follows:
a company sold shares to another company within the same corporate group
the consideration was approximately £60,000
the parties genuinely believed that the consideration represented the market value of the shares
in fact, the market value of the shares may have been as high as £4 million
the seller subsequently brought an action alleging that the sale was a transaction at an undervalue and breached the common law rule restricting a company's freedom to distribute assets to its shareholders.
the action was dismissed at first instance and that decision was upheld by the Court of Appeal.
The main judgment in the Supreme Court was delivered by Lord Walker. In his opening paragraph, he approved the observation by Hoffmann J in Aveling Barford Ltd v Perion Ltd  BCLC 626 that the characterisation of a transaction as a distribution "does not depend exclusively on what the parties choose to call it". He proceeded to review the decision in that case, as well as the decisions in Ridge Securities Ltd v Inland Revenue Commissioners  1 WLR 479 and Re Halt Garage (1964) Ltd  3 All ER 1016, before turning to the task of characterising the transaction at hand. At the heart of Lord Walker's discussion of the characterisation issue were his comments as to whether the approach should be "objective" or "subjective". An objective approach would, it seems, require the court to conclude that every transaction between a company and a shareholder in which the company did not receive adequate consideration would constitute a distribution (which would be unlawful unless the element of undervalue was covered by the company's distributable profits). By contrast, a subjective approach would require the court to assess whether the transaction was a genuine commercial transaction; if it was, it would not be struck down simply because, in the event, the company did not receive adequate consideration. In his Lordship's view: "If there were a stark choice between a subjective and an objective approach, the least unsatisfactory choice would be to opt for the latter. But in cases of this sort the court's real task is to inquire into the true purpose and substance of the impugned transaction. That calls for an investigation of all the relevant facts, which sometimes include the state of mind of the human beings who are orchestrating the corporate activity." He elaborated upon this analysis as follows:
a distribution which is described as a dividend but which is paid out of capital is unlawful, regardless of the directors' state of mind
where the transaction in question takes the form of the payment of remuneration to a director who is also a shareholder, "the test is objective (Halt Garage), but probably subject in practice to what has been called, in a recent Scottish case, a ‘margin of appreciation'"
the participants' state of mind and motives are relevant in relation to "a distribution disguised as an arm's length commercial transaction. ... If the conclusion is that it was a genuine arm's length transaction then it will stand, even if it may, with hindsight, appear to have been a bad bargain. If it was an improper attempt to extract value by the pretence of an arm's length sale, it will be held unlawful."
As far as the first point is concerned, it is plainly the case that a payment described as a dividend is intended to be a distribution to a shareholder. As such, if it is made otherwise than out of distributable profits, it will undoubtedly be unlawful, regardless of whether the directors were acting honestly or in good faith or in the mistaken belief that the company had profits available for distribution. The question of characterisation does not, in fact, arise in such an instance, for it involves no attempt to disguise the distribution. As far as the third point is concerned, too, Lord Walker's statement of the law would seem to be sound. It is true that, conceptually, one might argue that any return of capital to a shareholder otherwise than through an authorised procedure (such as a reduction of capital under the Companies Act 2006) is a breach of the implied contract with creditors that capital may only be used for the purposes of the company's business (see Re Exchange Banking Company, Flitcroft's Case (1882) 21 ChD 519). On balance, though, there is perhaps more merit in the view that as long as the capital is genuinely being used in the course of the company's business, the contract with creditors cannot be said to be breached solely on the ground that the business in question happens to be with a shareholder. If one adopts this latter approach, so that the question is whether a transaction is genuinely a commercial transaction, inevitably the motives of the parties need to be taken into account. On the facts before him, Lord Walker noted the finding that the sale of the shares was "a genuine commercial sale", and concluded that it did not constitute an unlawful distribution of capital. The difficulty with Lord Walker's comments concerns the second point, namely his reference to an objective test when the act which is being challenged is the payment of directors' remuneration.
In the course of reviewing the main authorities, Lord Walker considered the facts in Re Halt Garage, and quoted two passages from Oliver J's ruling: "The real question is, were these payments genuinely director's remuneration? If your intention is to make a gift out of the capital of the company, you do not alter the nature of that by giving it another label and calling it ‘remuneration'." "In the absence of any evidence of actual motive, the court must, I think, look at the matter objectively and apply the standard of reasonableness." When he turned to consider the question of characterisation, his key observation on directors' remuneration, referred to briefly above, was as follows:
"Where there is a challenge to the propriety of a director's remuneration the test is objective (Halt Garage), but probably subject in practice to what has been called, in a recent Scottish case, a ‘margin of appreciation': Clydebank Football Club Ltd v Steedman 2002 SLT 109, para 76 (discussed further below)." He did, indeed, go on to discuss Clydebank Football Club in the context of distributions disguised as arm's length commercial transactions, noting in particular the following passage from the decision in that case: "If the transaction is genuinely conceived of and effected as an exchange for value and the difference ultimately found does not reflect a payment ‘manifestly beyond any possible justifiable reward for that in respect of which allegedly it is paid', does not give rise to an exchange ‘at a gross undervalue' and is not otherwise unreasonably large, there will not to any extent be a ‘dressed up return of capital'. In assessing the adequacy of the consideration, a margin of appreciation may properly be allowed." When Lord Walker stated that the test in relation to directors' remuneration was objective, presumably he meant that if the remuneration was in excess of the value of the services provided by the director, the excess payment would constitute a distribution regardless of the parties' intentions, and as such would be unlawful unless it was covered by distributable profits. This raises the following questions.
Was it appropriate to cite Re Halt Garage in support of the proposition that the test is objective?
In Re Halt Garage, Oliver J asked himself whether remuneration which had been paid to two directors who were also shareholders was genuinely intended to be remuneration for their services to the company as directors. If it was so intended, he felt that it would not be for the court to interfere in the company's management by considering whether the amount was overly generous. This is a subjective test, since it requires the court to assess the motives of those who are paying the remuneration. There are, however, two features of the case which might seem to support Lord Walker's suggestion that the test is objective. It is submitted, though, that on a close analysis they do not, in fact, do so. First, the payments made to one of the directors in Re Halt Garage was found to involve, in part, an unlawful return of capital despite the fact that the shareholder-directors had acted honestly, in the sense that they were not alleged to have acted fraudulently. In other words, the fact that parties act honestly and in good faith will, in light of Oliver J's judgment, not necessarily prevent remuneration from constituting a distribution. Does this render the test objective in nature? It would seem not, for Oliver J drew a distinction between bona fides and genuineness, making it clear that what mattered was not whether the parties were acting honestly, but whether they genuinely considered that the payment was in respect of the directors' services. This must surely be described as a subjective test. Second, Oliver J's judgment actually refers to the need to take an objective approach on certain matters. There was, he felt, an objective element to the process of assessing the genuineness of remuneration, in the sense that a "wholly unreasonable payment ... might also be evidence that what purported to be remuneration was not remuneration at all but a dressed-up gift to a shareholder out of capital" ( 3 All ER 1016, at 1039e). It is submitted that this does not detract from the essentially subjective nature of the test, in that the court's inquiry is directed at the task of ascertaining the parties' intentions. Later in the judgment, in a passage which, as noted above, was quoted by Lord Walker, Oliver J commented as follows: "In the absence of any evidence of actual motive, the court must, I think, look at the matter objectively and apply the standard of reasonableness." ( 3 All ER 1016, at 1044f) However, this passage must be read in context. It was delivered after Oliver J had concluded that not all of the payments made to one of the directors could be regarded as genuine remuneration, and in the course of his discussion as to the approach which he should adopt to the task of determining the point at which the line had been crossed. It is submitted, therefore, that this reference to an objective test does not alter the fact that the question to be considered when seeking to determine the preliminary matter as to whether remuneration constitutes a distribution is: what were the parties'intentions?
Whether or not Re Halt Garage was good authority for Lord Walker's proposition that the test is objective, was the proposition in any case conceptually sound?
It is difficult to see why a transaction with a shareholder which happens to take the form of the payment of remuneration in exchange for services provided as a director should be treated differently from any other transaction with a shareholder. If one accepts the premise that genuine arm's length commercial transactions with shareholders do not involve a distribution even if there is an element of undervalue on the facts, why should that rule apply, say, to an arm's length agreement to purchase a business from a shareholder, but not to an arm's length agreement to remunerate that shareholder for his services as a director? One might perhaps argue that since the latter is an on-going arrangement, it provides an on-going opportunity to take money out of the company at the expense of creditors, but as long as the arrangement is found to be genuine, it is not clear why it should be treated as a special case.
Two cases decided at the end of 2012 are worthy of note in connection with Lord Walker's comments on the test applicable in relation to directors' remuneration. In Iliffe News and Media Ltd v Commissioners for HMRC  UKFTT 696 (TC), subsidiaries paid their parent licence fees which were in excess of the market value of the licences. Applying the approach adopted in Progress Property, the First-Tier Tribunal Tax Chamber asked itself whether the licence fee arrangements were a genuine transaction, and in the course of so doing considered whether the fees were "unreasonably large or manifestly beyond what was possibly justifiable" ( UKFTT 696 (TC), para 220). Having concluded that, on the facts, the subsidiaries were not seeking to disguise a distribution as an arm's length transaction, and that they had taken professional advice as to the value of the licences, the Tribunal concluded that the fees did not constitute a distribution. For the purposes of this article, however, the most interesting feature of the decision was the Tribunal's remark that the case did not fall within the class of cases in relation to which Lord Walker had held that the parties' state of mind is irrelevant, one such case being, in the Tribunal's words, that of "excessive director's remuneration" ( UKFTT 696 (TC), para 211). Clearwell International Ltd v MSL Group Holdings Ltd  EWCA Civ 1440, by contrast, was a case concerning directors' remuneration. Although the basis of its decision that the payments in question were not disguised distributions appears to have been that, in fact, they did not involve any element of overpayment, the Court of Appeal seemed to take the view that this was a type of transaction in relation to which the parties' intentions were relevant. Thus, even if there had been an overpayment, that in itself would not, it seems, necessarily have led to a finding that the payments were distributions; rather, the key question was whether the transaction was "a bona fide transaction for consideration" ( EWCA Civ 1440, para 51). The court referred to the decision in Progress Property, but made no mention of Lord Walker's observation on the nature of the test to be applied in cases of directors' remuneration.
Lord Walker's observation was, it must be said, a very brief one, and it may be that courts will take the view which seems to have been taken in Clearwell, and assume that the test to be applied when characterising directors' remuneration is the same as that which applies in other types of dealings with shareholders. On the other hand, the Tribunal's reference to an objective test in Iliffe suggests that there may be instances in which Lord Walker's approach is followed faithfully. As discussed above, it is not clear that an objective test for directors' remuneration can be justified either conceptually or on the basis of the authority which Lord Walker cited. Be that as it may, this very narrow - but important - question would benefit from further consideration by the courts, whether to expand upon the reasons for adopting an objective test or to bring directors' remuneration within the category of cases in which the parties' intentions are considered to be relevant.