Seeking to Strike Out Insolvency Claims based on use of Avoidance Schemes

Re Daystreet15 Ltd (in liquidation) (CR-2017-002096) is a recently released judgment of ICC Judge Mullen setting out handy analyses of the tests for strike out/summary judgment and fraudulent trading in the context of a company’s attempts at tax avoidance which ended in insolvency.  The case is a salutary reminder of the high bar a defendant will have to clear in order to convince the Insolvency Court to grant such relief.  Therefore any such application by a defendant should be carefully considered with solicitors and Counsel with experience of recovery actions concerning tax avoidance schemes before it is undertaken.  

The Facts

The company entered into EBT and EFRBS schemes over a number of years for the benefit of the directors, and film schemes to generate tax losses for the company.  In total almost 4.5m was paid into these schemes.  HMRC started investigating and commenced raising assessments, upon which the directors sold the business and transferred the right to receive the sale consideration to the parent company, which was in fact never paid.  The net result was that the company was left unable to pay the tax liabilities which remained with the company.  The liquidators subsequently brought claims against seven defendants for misfeasance, Part 23 unlawful distributions, unjust enrichment, fraudulent trading and transactions defrauding creditors.  The first two defendants were the directors and the remaining five were the companies who purchased parts of the Company’s business.  In their application the defendants sought to strike out or have reverse summary judgment in relation to the fraudulent trading claim and the misfeasance claims in relation to both the EBT payments from 2006 to 2010 and the film schemes entered into on 2009 and 2010.  

The Defendants’ Case

The defendants asserted that there was no reasonably credible material or facts pleaded alleging fraud or dishonesty in respect of the fraudulent trading claim.  Further they argued that even if there were it could not amount to fraudulent trading as defined in the Act.  In relation to the misfeasance claims the defendants submitted that payments into the EBT scheme after 2005 had incorrectly attributed to the 2005 scheme whereas they had been paid into the 2006 to 2010 schemes thereby overstating the value of the amounts claimed by £1.5m and that the claims in respect of the film schemes were statue barred.

With regard to the fraudulent trading claim the defendants’ case was the requirement to show actual dishonesty or real moral blame as noted in the case of Patrick and Lyon Limited [1933] Ch 786, 790.  Their Counsel submitted that the Points of Claim made no reference to evasion, but one of the claimant’s witness statements prepared in answer to the application summarised the directors’ conduct in this manner.  Counsel further submitted in effect that tax avoidance (legal) is not tax evasion (illegal) and that the company’s business was not “carried on” for the purposes of defrauding creditors – it was a legitimate employment/recruitment agency which entered into an honest, but unsuccessful tax avoidance scheme upon which it had received advice and its participation was disclosed to HMRC.

The Court’s Decision

The bulk of the judgment is given over to the Court’s consideration of its ability to strike out a case or grant summary judgment and then to apply that ability to the fraudulent trading claim.  In this regard the Judge gave a useful short summary of the Court’s ability under to strike out or grant summary judgment, and despite submissions by the claimants’ Counsel that the purpose of such applications was to reduce the burden at trial, the Judge concluded that an allegation as serious as fraud could not be “left hanging over” the defendants if it were defective or had no real prospect of success.  He then provided a useful road map to considering a fraudulent trading claim which starts with section 213 itself and the 3 elements of fraudulent trading explained by (then) Patten J in the case of Morris v Bank of India [2004] 2 BCLC 236 (paragraph 11) being:

“(1) that the business of the company in liquidation has been carried on with intent to defraud the creditors of the company or for any other fraudulent purpose; (2) that the defendant sought to be made liable … participated in the carrying on of the business of the company in that manner; and (3) that it did so knowingly: i.e. with knowledge that the transactions it was participating in were intended to defraud the creditors of the company or were in some other way fraudulent.”

The Judge then proceeded to review case law in relation to each of the 3 elements and concluded that whilst the relevant pleading alleging fraudulent trading was contained in just one paragraph, it had to be read in the context of the pleading as a whole, whilst also taking into account all of the directors’ actions in running the affairs of the company.  It was not just entry into the scheme alone that constituted fraudulent trading, but that the directors:

“caused the Company’s business to be carried on so that it entered into a series of tax schemes over an extended period in the knowledge that they might not be effective, and continued to do so, without making provision for the tax that might fall due, even after HMRC raised an assessment at a relatively early stage, and culminating in the restructuring of the business to in such a way that HMRC would be entirely unable to recover any tax ultimately found to be due. Those are “the transactions” that together amount to “the attempt” to defraud and the intention to defraud HMRC by so doing is expressly pleaded. Mr Foster’s witness statement glosses that as tax evasion but it is not necessary to plead that as part of the cause of action. It is not necessary that each or any debt to a creditor has been incurred as a result of illegality, fraud or dishonesty in order to sustain a claim of fraudulent trading. What is necessary is that the company carries on its business to defraud creditors, however the debts to those creditors were incurred.”

In relation to the defendants’ other main argument that its business was that of a recruitment agent not an entity to defraud HMRC. The Judge disagreed with this analysis, noting that the section was not just restricted to companies which were wholly or partially established for a fraudulent purpose.  It is enough that the business of the company should be carried on so as to defraud creditors.  In this case if the allegations of the claimants were proven, then in his view this was capable of amounting to the “carrying on” of a business with intent to defraud creditors.  Taking into account all that was required was that the claimants present a reasonable prima facia case (the applicable test as expressed by Lord Hope in Three Rivers DC v  Bank of England (No. 3) [2003] 2 AC 1)), the Judge concluded that the fraudulent trading claim was adequately pleaded and had a real prospect of success in that “it was more than merely arguable.  It is not fanciful or lacking in reality and there is sufficient material on which a claim of fraud can be based”.

In respect of the EBT scheme the Judge held that the failure to refer to all the schemes entered into by the company was not fatal.  Indeed the defendants were not prejudiced by the error as they were able to plead to the point and correct it.  Whilst the monies which were paid out should have been attributed to the subsequent 2006 to 2010 EBT schemes rather than just the 2005 scheme pleaded, the mechanics of such schemes had been laid out and all the payments sought to be recovered had been tabulated.  As such the defendants were not prejudiced by the error in the pleadings.

On the final issue, being the claims for misfeasance in respect of the film schemes and whether they were statute barred, the Judge noted that on their face the entry into the schemes had taken place more than 6 years prior to the commencement of the claimants’ claims and as there was no allegation of personal benefit to the directors, the claimants could not avail themselves of section 21(1)(b) of the Limitation Act 1980. The defendants went further to submit that there were no grounds to claim concealment or fraud so as to extend the limitation period pursuant to section 32 of the Act.  The claimants responded that if fraud or dishonesty was shown the claimants could rely on section 21(1)(a) of the Act and if not they could rely on section 32.  In respect of the section 21(1)(a) the Judge concluded that he had already determined that the claimants had a real prospect of showing that the pursuit of these schemes was part of the carrying on of the business of the company with the intent to defraud creditors.  With regards to section 32 he noted the decision of Peter Smith J in Haysport Properties Limited v Joseph Ackerman [2016] BCC 676 and held that that the question of whether there had been a breach of duty which the directors were under a duty to disclose and whether that disclosure was made was a matter for trial.  He was not satisfied that at this stage that the claim was an abuse of process by virtue of being statute barred or that it did not have a real prospect of success.

Ian Rees

Associate

Moon Beever LL

At Moon Beever LLP we have considerable experience acting for both liquidators and directors in relation to such claims along with being able to advise on all insolvency or potential insolvency and debt issues connected with the use of either corporate and personal tax avoidance schemes.  If you have any issues or concerns in relation to such matters please feel free to give us a call or send us an e-mail.