Transactions at an undervalue – a cautionary tale

A recent case involving a successful challenge under provisions in the Insolvency Act 1986 dealing with transactions at undervalue sets out a number of issues to considered by sellers and their advisers acting on an employee ownership trust (“EOT”) transition.

The High Court case of Manolete Partners PLC v David Smith [2026] EWHC 1046 is a cautionary tale for sellers contemplating a sale to an EOT or any buyer where the consideration is being funded by the target company. The case involved the sale of A & D Joinery Limited (“the Company”). The Company had a successful 30-year trading history when it was sold to a “trade buyer” before running out of cash and becoming insolvent within four months of the sale. Manolete, a litigation funder which had taken an assignment of the Company’s claims from its Administrators, was successful in arguing that the sale was a transaction at an undervalue under section 238 Insolvency Act 1986 leading to declarations and orders being made against David Smith, as the seller of the Company and also as its director.

Background information

The Company had been run successfully by Mr Smith for over 30 years. The shares were purchased at the end of July 2021 for £748,270 by a company specifically formed for the purpose of the purchase with the strategy of a “buy and build” plan and a future sale of a larger group of companies. The purchase price was funded by cash within the target company, including a CBILS loan of £250,000.

The purpose of the CBILS loan was to support the Company’s business and fund its expansion and growth after Covid. Breach of this term would result in immediate repayment of the CBILS loan. Mr Smith claimed that the individuals behind the buyer persuaded him to take out the loan to provide cash for the purchase price. The buyer was effectively a shell company with no cash of its own.

Completion required cash being notionally circulated around the parties using a letter of direction (which is quite common in transactions to avoid the need for bank transfers). After completion, the Company had a cash balance of £258,721. However, a number of payments to creditors fell due shortly after completion. The Company was also required to repay the CBILS loan, the terms of which had been breached due to the use of the money to pay Mr Smith for his shares.

Why was it a “transaction at an undervalue”?

A transaction at an undervalue under section 238 Insolvency Act 1986 occurs if a company enters into a transaction which either provides for the company to receive no consideration, or consideration which is significantly less in value than the consideration provided by the company.

Application of the legislation requires the transaction to be considered from the point of view of the company A transaction will fall foul of section 238 unless the company receives a benefit from it. There have been a number of cases in the Court of Appeal and the House of Lords (now the Supreme Court) that have considered the point and developed the following principles:

• An insolvent company should not deplete the assets available to creditors by preferring the interests of its shareholders
• Identifying the consideration is a question of fact
• The value of the consideration must be considered from the company’s point of view
• The future prospects of the company should be based on facts rather than speculation
• It is for the party relying on the consideration to establish its value, i.e. that there was no undervalue

In Smith, the court held that the Company could not have been sold after completion for the price paid by the purchaser, because that price was based upon the Company retaining the cash reserves which were in fact used to pay Mr Smith. The court also held that the Company was balance sheet insolvent at the time of completion.

Director’s duties

The court also considered the duties that Mr Smith owed to the Company as a director under the Companies Act 2006. The court found that Mr Smith had breached those duties in making the payments to himself via the purchaser, because those payments were for his benefit, not in the best interests of the Company, and adverse to the interests of the creditors of the Company.

Mr Smith’s advisers stated that the Company had sufficient cash to last for eight weeks. In practice, the cash ran out in two weeks. There was also no evidence for a full order book as claimed by Mr Smith.

The court was critical of the lack of critical thinking on the part of Mr Smith regarding the financial future of the Company having taken £735,687 in cash from it. In particular,

• The consideration would have taken 19 years to be paid if the Company had paid normal dividends
• No cash flow forecast was prepared to support the assertions that the Company could continue to trade successfully
• The lack of cash resources or assets of the buyer was not questioned
• The Company did not receive separate professional advice on its position

Outcome of the case

The court found in favour of Manolete both in relation to the undervalue claim and the breach of duty claim. As a result, Mr Smith will most likely be required to repay all or a substantial proportion of the purchase price he received.

Application to EOT and other M&A transactions

The case is particularly relevant to EOT transactions which are funded by contributions from the target company to the EOT buyer. It is also relevant to other M&A transactions where funding for the consideration is provided by the target company. If the company fails within two years of the transaction, then the transaction can potentially be set aside as a transaction at undervalue. If in allowing the company to enter into the sale the seller has breached his duties as a director, then there is potential liability no matter how long ago the sale completed.

EOT trustees have a legal obligation to ensure that the EOT is not paying more than market value for the shares in the company. It is common for EOT trustees to obtain an independent valuation of the company and not rely on a valuation produced for the seller. We also recommend that the valuer produces a cash flow forecast to support the affordability of the payment of the consideration at completion and any future deferred consideration. Smith is a timely reminder that sellers need to look very closely at the valuation and the affordability of the payments. The change in HMRC interpretation concerning payments to the EOT – that the payments are treated as distributions to be made out of distributable reserves – will also be an important factor.

The case is also relevant to EOT transitions involving a dispute over valuations where the deferred consideration is now unaffordable. Trustees and the management team will point out the case to sellers as an indication of a likely position to be taken by a liquidator as the sellers could be faced with having to pay back a large proportion of the sale consideration. This is even without HMRC challenging the tax position under the transaction in securities legislation. Some EOT sellers could be very nervous about their position.

Advisers on current EOT transitions will want to ensure that:

• Robust valuations are prepared
• Cash flow forecasts back up the affordability of the transaction
• Board minutes of the target company deal with director’s duties and any question of a transaction at an undervalue, including the benefit to the company of carrying out the transaction
• Their engagement terms set out the identity of their client and the scope of their engagement

Conclusion

The days of an EOT transaction being pretty simple are long gone. Advisers will need to ensure that the transaction “adds up” from a financial point of view and the completion paperwork supports the directors’ duties for the target company. Without covering off the issues, advisers could be an easy target for disgruntled clients given that professional advisers generally have professional indemnity cover for when things go wrong.

At Geldards we have specific expertise in advising the various parties where an EOT-owned company has become insolvent. Please contact Andrew Evans or Ruth Thurland should you have any concerns regarding EOT insolvency or valuation issues.