Startups, they are all the rage these days. In a report by the Startup Genome, Singapore was ranked as the world’s no. 1 location for startup talent, ahead of Silicon Valley. Startups are poised to be the future of the world economy. Monies are loaned, and credits are extended on the promise of a brighter future.
With all this optimism, it can be difficult to imagine that a startup will not succeed. But what happens if it all goes wrong, and outstanding loans and debts remain. Is the creditor left without any recourse against the startup or its directors? How should directors conduct themselves when the business is insolvent? These issues (among others) were the subject of a judgment in Living the Link Pte Ltd (in creditors’ voluntary liquidation) and others v Tan Lay Tin Tina and others [2016] SGHC 67 (“Living the Link case”).
Case Study – Living the Link Pte Ltd
Living the Link Pte Ltd (“Living”) was founded by Tina Tan in January 2007. Tina Tan sought to launch a fashion and lifestyle concept store which was to combine the retail of high-end fashion with food and beverage outlets.
Unfortunately, the global financial crisis reared its ugly head in 2008, causing Living to face cash flow difficulties throughout 2008. The business was eventually wound up and its lease was prematurely terminated on 31 July 2009. The main non-related party creditor was the landlord.
The liquidators, together with its solicitors, commenced a thorough investigation into Living’s financial affairs, and in particular into substantial intercompany transfers shortly prior to liquidation.
The investigations revealed that Tina Tan had caused Living to transfer (among other things) approximately $2.6mn worth of Living’s inventory to creditors which were associated companies of Living. Essentially, Tina Tan had stripped Living of its assets before it was wound up. The liquidators thus commenced a suit against Tina Tan and the associate companies. The liquidators sought a return of the inventory or the cash equivalent of its book value to Living. To succeed, the liquidators had to establish that the inventory transfers were undue preference transactions under section 329 of the Companies Act (Cap. 50).
The law on unfair preference transactions
Section 329 of the Companies Act provides that “any transfer, mortgage, delivery of goods, payment, execution or other act relating to property made or done by or against a company which, had it been made or done by or against an individual, would in his bankruptcy be void or voidable under section 98, 99 or 103 of the Bankruptcy Act (Cap. 20) (read with sections 100, 101 and 102 thereof) shall in the event of the company being wound up be void or voidable in like manner”.
Hence, transactions may be void or voidable if they fall foul of sections 98, 99 or 103 of the Bankruptcy Act (read with sections 100, 101 and 102 thereof). In the case of Living the Link, the liquidators sought to void (among others) the inventory transfers as unfair preference transactions under section 99 of the Bankruptcy Act.
Sections 99(3) and 99(4) of the Bankruptcy Act provide that an individual gives an unfair preference to a person if:
- that person (i.e. the one receiving the asset) is one of the individual’s creditors or a surety or guarantor for any of his debts or other liabilities;
- the individual does anything or suffers anything to be done which (in either case) has the effect of putting that person into a position which, in the event of the individual’s bankruptcy, will be better than the position he would have been in if that thing had not been done; and
- the individual who gave the preference was influenced in deciding to give it by a desire to produce in relation to that person the effect mentioned in (b).
However, the said preference must have been given at the relevant time. Section 100(2) of the Bankruptcy Act provides that the unfair preference transaction (which must have occurred during insolvency or caused insolvency) may be set aside if:-
- in a transaction with an “associate”, the unfair preference transaction falls within two years of making of the application or commencement of winding up; or
- in any other case, within six months of the same date.
As can be seen, whether a person receiving the preference is an “associate” has significance -it extends the relevant period by one and a half years.
Under Regulation 5 of the Companies (Application Of Bankruptcy Act Provisions) Regulations, a company is regarded as an associate of another company if:-
- the same person has control of both companies, or a person has control of one company and persons who are his associates, or he and persons who are his associates, have control of the other company; or
- a group of 2 or more persons has control of each company, and such groups either consist of the same persons or could be regarded as consisting of the same persons by treating (in one or more cases) a member of either group as replaced by a person of whom he is an associate.
The judgment in Living the Link
The High Court first considered whether Living was insolvent at the time of the impugned transactions. It applied both the cash flow test and the balance sheet test under section 100(4) of the Bankruptcy Act and held that Living was both cash flow and balance sheet insolvent at the time the inventory transfers took place. It was not disputed that the creditors who received the inventory were associated companies for the purposes of section 100(2) of the Bankruptcy Act. The inventory transfers thus fell within the relevant time period.
The next issue to be determined was whether Living’s directors were motivated by a subjective desire to improve the associated company’s positions in the event of Living’s liquidation. If Living’s directors were instead solely motivated by proper commercial considerations, the inventory transfers to the associated companies could not be voided. Living’s directors and the associate companies sought to persuade the High Court that the transfers were not intended to prefer the associate companies and should accordingly not be voided. Two explanations were offered. First, they said that Tina Tan genuinely believed that the landlord would not be a creditor following the premature termination of the lease. It was thus claimed that the transfers were not motivated by a desire to prefer the associate companies since it was believed that there would be no other substantial creditor. Second, they relied on continued payments made by the associate companies to Living after the transfers of the inventory and shares as evidence that there was no desire to prefer the associate companies in the first place. The High Court rejected both explanations as they were inconsistent with the evidence and held that it was “implausible that a desire to better the position of the associate companies did not operate on Tina Tan’s mind at all when she procured these transfers to the family-owned associate companies to the exclusion of Living’s other creditors”.
Given the circumstances, the High Court held that the transfers of inventory did fall foul of section 329 of the Companies Act and ordered the related companies to pay Living the sum of approximately $2.6mn. Tina Tan was also made personally liable for the sum as the Court held that these unlawful transfers amounted to a breach of her fiduciary duty to ensure that Living’s assets were not misapplied to prejudice creditors’ interests (including the landlord’s).
Takeaways
Loaning money to a startup company poses risks to the lender. However, such risks can be properly managed with a well-drafted loan agreement. For example, personal guarantees or security over the company’s assets can be sought. These are preventive measures which can ensure a better chance of recovery should the company be wound up.
For directors, they have to be aware that when the company is solvent, their duty is to act in the best interest of a company. However, when insolvency looms, directors should be alive to the duty they owe creditors and should be cautious when dealing with the company’s assets.
When a company is unable to keep up with payments, a creditor should assess if an extension of credit terms is commercially sensible. If the answer is a resounding no and the debt owing is above $10,000, the creditor should consider issuing a statutory demand to the company. If the company is unable to pay within 21 clear days (excluding the day of service), it raises a rebuttable presumption of the company’s inability to pay its debts. This gives the court jurisdiction to make a winding up order should the creditor choose to make a winding up application against the company.
When a company has been wound up, liquidators will be appointed to carry out the liquidation process. A sudden depletion of assets prior to winding up should set alarm bells ringing as it suggests that the company has been stripped of its assets to defeat the interests of its creditors. As was the case in Living the Link, liquidators may, for the benefit of all of the company’s creditors, seek recourse against the errant directors or preferred creditors under section 329 of the Companies Act.
Conclusion
As can be seen, transactions entered into by companies which are in financial difficulties raise complex legal and factual issues. It is advised to sought legal advice whenever in doubt.
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This article is written by Bryan Tan from Nair & Co.
This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to a practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.