Court Voids Fraudulent Preferential Payments Made by Directors of Distressed Company

Background
The Company’s secured creditor, a commercial bank (the Bank) successfully made an application to place the Company under administration and the Applicant was appointed as the Company’s administrator.

Upon taking the reigns as the administrator of the Company, it came to light that there were several payments made by the directors of the Company in dubious circumstances. The Applicant filed an application at the High Court seeking to void certain resolutions by the directors of the Company to fraudulently assign fictitious debts and make preferential payments to the directors of the Company and a third party. The Applicant alleged that although the Respondents were all aware of the pending application by the Bank to place the Company under administration, the directors orchestrated several fraudulent assignments of debts and made preferential payments to themselves and a third party in breach of Section 683 of the Insolvency Act, 2015 (the Act).

The Applicant further submitted that one of the parties, a company that was a tenant at the Company’s premises, and the Company had common directors and shareholders, and that ultimately both the tenant and the Company were owned and controlled by the same individuals who were responsible for orchestrating the fraudulent preference scheme. It was also alleged that the directors and shareholders of both the tenant and the Company were related. The Company’s directors allegedly passed resolutions to assign fictitious debts purportedly owed by the Company to some of its directors to be offset from current and future rental payments due from the tenant to the Company. The Applicant alleged that these transactions amounted to fraudulent preferences to the directors of the Company who were not secured creditors of the Company.

In response, the directors contended that the debt assignments were for legitimate commercial reasons and were made in the ordinary course of business. They also contended that the transactions were undertaken while the Company was solvent.

Ruling
The High Court stated that the purpose of Section 683 (3) of the Act is to put all creditors on the same pedestal, to bring sanity to corporate governance and to correct situations where owners of companies pile debts on the company and discriminate as to which creditor is to be preferred in settlement.

The Court defined fraudulent preference as transactions, “where there is evidence of intent on the part of the company to prefer one creditor over others”. In this case, the persons to whom the assignments of debts were made were not only shareholders but were also directors of the Company and their alleged debts were not secured.

The court ruled that the said assignments and resolutions were made in bad faith and were fraudulent and therefore liable to be nullified. The court further held that the preferential payments were done to defeat the interests of other creditors of the Company and proceeded to void them.

There is a dearth of jurisprudence from the Kenyan courts on the application of the provisions of the Insolvency Act in respect of transactions carried out by directors that fraudulently prefer one creditor over another, yet this is commonplace in distressed companies. This case serves as a warning to directors of companies who use their privileged position to siphon funds from distressed companies or attempt to prefer certain creditors over others. It also offers comfort to insolvency practitioners whilst they scrutinise transactions of distressed companies, that they can hold directors and shareholders responsible for engaging in dubious transactions while the entity is insolvent and, importantly, have those transactions reversed for the benefit of all creditors.

Should you have any questions regarding the information in this legal alert, please do not hesitate to contact Sonal Tejpar or Abbas Esmail.

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Contributors
1. James Mungai – Senior Associate
2. Victor Nkonge – Principal Associate
3. Martha Mwangi – Trainee Lawyer