The Court of Appeal has recently overturned the commonly held belief that a validation order would normally be made if the disposition made by a company subject to a winding up petition was done so in good faith and in the ordinary course of business at a time when the parties were unaware of the existence of the petition.
1. The starting point
Section 127 Insolvency Act 1986 provides:
“In a winding up by the court, any disposition of the company’s property, and any transfer of shares, or alteration in the status of the company’s members, made after the commencement of the winding up is, unless the court otherwise orders, void.”
The commencement of the winding up is the date on which the petition is presented to the court. After that date, all dispositions made by the company (such as the sale of an asset or payments made to creditors) will be void if a winding up order is subsequently made on that petition. A liquidator can recover property of a company from parties who have benefited from a void disposition, while the directors of the company could be found liable for breach of duty for causing the company to enter into the void disposition.
Section 127 therefore seeks to preserve the assets of a company and to prevent one creditor from being paid in priority to another in order to protect the pari passu principle.
2. Validation order
A disposition by the company will not be void if the insolvency court makes a validation order. A validation order can be sought prior to the winding up of the company (and ideally before the company enters into the disposition) or retrospectively after the winding up order has been made. Retrospective applications are quite often made in response to a challenge by the liquidator to the disposition.
The criteria for seeking a validation order is set out within the Practice Direction: Insolvency Proceedings. However, as a general rule, the court will exercise its discretion to make a validation order if it can be shown that:
• the company is solvent and can pay its debts as the fall due; or
• the transaction is deemed to be beneficial to the company and will not prejudice the interests of all the unsecured creditors of the company.
3. The previous misconception
Since the 1980 Court of Appeal case of Re Grays Inn Construction Ltd, it had been presumed that the court would normally validate dispositions made by a company subject to a petition provided that:
• they were made in good faith in the ordinary course of business; and
• the company and the recipient were unaware of the existence of the petition.
However, this presumption was called into question last year by the Court of Appeal case of Express Electrical Engineers Ltd v Beavis  EWCA Civ 765.
4. Express Electrical Engineers Ltd v Beavis
In Express Electrical Engineers Ltd v Beavis, a company paid a creditor £30,000 one week after a winding up petition had been presented against it and at a time when neither party was aware of the petition’s existence.
After a winding up order was made, the creditor sought a validation order after the liquidator had sought repayment of the £30,000. After the County Court and High Court both refused to grant a validation order, the matter was appealed to the Court of Appeal.
In refusing to made a validation order, the Court of Appeal set out the following test to apply when considering whether to make a retrospective validation order:
• The court should not grant a validation order simply because the disposition was made in good faith and without the knowledge of the existence of the petition.
• Instead, a validation order should only be made if “special circumstances” exist.
• “Special circumstances” will require the disposition to have benefited the general body of unsecured creditors as a whole in order to override the pari passu principle. For example, “special circumstances” may be found to exist in respect of a disposition that is made in the ordinary course of business with a view to allowing the business to be sold as a going concern at a higher price, as the effect of that disposition would have the effect of benefiting creditors as a whole.
In addition, the Court of Appeal raised the issue that when a retrospective validation order is sought, the court may try and assess the disposition with the benefit of hindsight, rather than assessing whether the court would have made the validation order at the time of the disposition. The use of hindsight may make retrospective validation more difficult to achieve.
It is clear from Express Electrical Engineers Ltd v Beavis that a retrospective validation order will no longer be made simply because the parties to the disposition were ignorant of the existence of the winding up petition.
In order to persuade the court to retrospectively validate the disposition, the applicant must demonstrate, with evidence, that the disposition has or will benefit the general body of creditors. The court may well assess whether special circumstances existed using the benefit of hindsight.
It is therefore clear that the evidential burden required to persuade the court to make a validation order remains high, particularly for those sought retrospectively. Officeholders therefore should therefore bear this in mind when deciding whether or not to pursue section 127 claims.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.