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Keeping your business running in the face of a winding up petition: Validation Orders in Compulsory Liquidation

Posted: 24 Oct 2024
by
Ruby Keeler-Williams
Chartered Legal Executive
Contact Ruby Keeler-Williams
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Introduction

A validation order is a court order that approves transactions made by a company after a winding-up petition has been filed against it.

In this article, we discuss the purpose of these orders, why they are necessary, the application process, and the potential risks for businesses and directors if they fail to obtain validation orders where necessary.

This article draws upon our recent experience attending upon a client at the Rolls Building to obtain a validation order to allow the payment of a debt to the creditor following company bank accounts being frozen.

What is Compulsory Liquidation?

Compulsory liquidation is a court-ordered process that results in the winding up of a company, meaning business must cease and the company assets are distributed to its creditors. This process is governed by the Insolvency Act 1986.

Various parties, including creditors, shareholders, and even the company itself, can petition the court for a compulsory winding-up order.

Once the winding-up petition is presented to the court, the company’s assets are frozen, and either the Official Receiver (an officer of the court) or an insolvency practitioner appointed by the court as liquidator takes control of the company’s affairs.

The company effectively loses the ability to conduct business, any transactions undertaken require scrutiny and, in most cases, court approval.

The Role of Validation Orders in Compulsory Liquidation

Section 127 of the Insolvency Act 1986 sets out that:

(1) 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

This section effectively creates a freeze on the company’s ability to freely dispose of its assets or enter into certain transactions.

A transaction will not be void under section 127(1) of the Insolvency Act 1986 if the court makes an order validating the transaction. Validation orders are therefore the process by which court approval is obtained for necessary transactions that a company enters into after a winding-up petition has been filed against it.

Without a validation order, transactions conducted after the filing of a winding-up are void unless the court orders otherwise, meaning they are unenforceable and the parties involved may need to reverse the transaction.

The main reason behind the requirement to obtain court approval is to protect the interests of all creditors by preventing the dissipation or unfair distribution of company assets once a winding-up petition is on the table.

A validation order may either validate a disposition as part of a specific transaction such as the sale of a particular asset or payment of a particular debt, or alternatively permit a particular type of disposition, such as all dispositions by the company in the ordinary course of its business.

When Are Validation Orders Required?

It is vital to understand that once a winding-up petition is filed, virtually all transactions the company wishes to undertake require validation by the court – even if the transaction was initiated or agreed upon before the petition was filed but completed afterward.

In theory, it is not necessary for a liquidator to apply to court for a declaration that a transaction has been made void by the operation of section 127 of the Insolvency Act 1986. A transaction within the scope of section 127 of the Insolvency Act 1986 will be automatically void unless the court orders otherwise – making obtaining a validation order a vital step.

Some examples of circumstances that typically necessitate a validation order are:

  • Selling major assets – including property, significant stock holdings, or any asset that represents a substantial portion of the company’s value.
  • Paying debts –  as keeping the company operational may require paying wages, utility bills, rent, or other essential expenses. Any payment to a creditor, even if it was due before the petition, needs court approval to ensure equitable treatment of all creditors.
  • Continuing essential business operations – a validation order may be required to authorise limited ongoing operations that are necessary for the winding-up process or beneficial to maximize the value of the company’s assets.

The Application Process

The procedure on an application for a validation order is set out in the Practice Direction on Insolvency Proceedings at Paragraph 9.11.

First, you must gather the necessary information and evidence to support the application. This should demonstrate the need for the transaction, information as to the company’s financial position in order to assess solvency, the benefit the transaction provides to the company (and potentially creditors) and its compliance with the overall objectives of the winding-up process.

Paragraph 9.11.2 of the Practice Direction sets out that:

Save in exceptional circumstances, notice of the making of the application should be given to: (a) the petitioning creditor; (b) any person entitled to receive a copy of the petition pursuant to rule 7.9; (c) any creditor who has given notice to the petitioner of their intention to appear on the hearing of the petition pursuant to rule 7.14; and (d) any creditor who has been substituted as petitioner pursuant to rule 7.17. Failure to do so is likely to lead to an adjournment of the application or dismissal.

The Court Hearing

The application for a validation order is typically heard at the Court dealing with the winding up petition. At the hearing, the applicant (via their legal representative) must present their case and justify the need for the validation order.

The court will consider the evidence presented and may:

  • Grant the order: approving the transaction and allowing it to proceed;
  • Refuse the order: denying the transaction; or
  • Modify the order: such as approving the transaction with specific conditions.

What factors the Court considers when granting a Validation Order

When deciding whether to grant a validation order, the court considers the following factors:

  • Benefit to creditors: The court must protect creditors’ interests. The court will assess whether the proposed transaction will benefit creditors or, at the very least, not cause them prejudice.
  • Company solvency: The court considers the company’s financial position, whether it is able to pay its debts as they fall due or alternatively whether the transaction will further deteriorate its solvency.
  • Nature of the transaction: The court will look at whether the transaction is part of the company’s ordinary business operations or a special deal that may benefit certain parties over others.
  • Prejudice to creditors: The court must ensure that the transaction does not unfairly prefer one creditor over another, upholding the principle of pari passu distribution of assets.
  • Case law: The court will consider existing case law on validation orders to ensure consistency and fairness in its decision-making process.

Risks if you do not obtain a Validation Order

When a company has gone into compulsory liquidation, the liquidator may seek to recover any property that was the subject of a void disposition under section 127(1) of the Insolvency Act 1986

Conducting transactions without obtaining a necessary validation order is therefore risky and can lead to the following:

  • Transactions voided: the transaction is automatically void, requiring the unwinding of the transaction. A third party may therefore insist on a validation order to prevent the receipt of property subsequently being void.
  • Challenges by creditors: Creditors can challenge unauthorised transactions, leading to further disputes and delays in the liquidation process.
  • Personal liability for directors: Directors who authorise or participate in transactions without securing a validation order may face personal liability for breaching their fiduciary duties to the company and its creditors.

Why seek representation?

Given the complexity and potential risk associated with validation orders, seeking professional legal advice is strongly recommended.

Elysium Law can assist you with the following:

  • Preparing evidence that supports the need for the validation order and demonstrates that the transaction is in the best interests of the company and its creditors.
  • Advising on procedure and ensuring compliance with all relevant rules and regulations.
  • Representing the company in court hearings and addressing any challenges from creditors or other stakeholders.
  • Liaising with liquidators and negotiating on behalf of the company.

Conclusion

Validation orders play a critical role in the administration of companies facing compulsory liquidation as they provide a mechanism for companies to conduct necessary transactions while protecting the interests of creditors and ensuring the orderly winding up of the company’s affairs.

It is vital that companies and their directors understand the significance of validation orders and seek professional legal advice when facing a winding-up petition.

Failure to obtain necessary validation orders can lead to severe legal and financial consequences, including rendering transactions void and potential personal liability for directors.

If your business is facing a winding-up petition or you require guidance on validation orders, CONTACT our team today for a free consultation to discuss your specific circumstances and see how we may assist.

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