An undervalue transaction is a transaction entered into by a company who subsequently goes into bankruptcy which the court orders be set aside, usually upon the application of a liquidator for the benefit of the debtor's creditors.
Under ordinary principles of contract law, the courts will not generally look into the adequacy of the consideration provided by either side. However, if a company is in real peril of going into bankruptcy, many legal systems provide a mechanism that transactions which are seriously commercially disadvantageous to the company can be unwound, so as to prevent prejudice to the creditors of the company.
Normally, for a transaction to be set aside as an undervalue transaction, the liquidator or equivalent must demonstrate that:
- the consideration received by the company in the transaction, in money or money's worth is significantly less than the value, in money or money's worth, provided by the company;
- the transaction was entered into during the "vulnerability period"; and
- at the time of the transaction, the company was unable to pay its debts as they fell due, or became unable to pay its debts as they fell due as a result of the transaction.
The vulnerability period is the period of time immediately prior to the company going into bankruptcy. The length of the vulnerability period varies between countries, and some countries apply different vulnerability periods in different circumstances. For example, in the United Kingdom, the vulnerability period is either:
- two years, if the person with whom the company entered into the transaction with is a "connected person", or
- 6 months, in all other cases.
The period is calculated by reference to the period of time immediately preceding the company going into liquidation or administration.
The effect of a successful application to have a transaction declared as an undervalue transaction varies. Inevitably the other party to the transaction who received the benefit has to return the benefit (or account for it) it to the liquidator. In some countries the assets are treated in the normal way, and may be taken by any secured creditors who have a security interest which catches the assets (characteristically, a floating charge). However, some countries have "ring-fenced" recoveries of unfair preferences so that they are made available to the pool of assets for unsecured creditors.
Many jurisdictions which have prohibitions on undervalue transactions also provide for an exception in the case of transactions entered into in the ordinary course of business where the directors are of a view that it is for the benefit of the company, and such transactions are usually either validated or presumed to be validated.
- Some legal systems also apply undervalue transactions to insolvent individuals
- See for example, section 238 of the Insolvency Act 1986 in the United Kingdom, and section 567 of the Corporations Act 2001 in Australia
- This is the cash-flow test of insolvency. Some jurisdictions (although not many) apply the balance-sheet test of insolvency to undervalue transactions, either as an alternative to the cash-flow test, or in addition to it.
- Connected person is usually defined under the relevant legislation, e.g. in the United Kingdom, see section 249 of the Insolvency Act, and which is drafted so as to try and catch all insiders and affiliates, other than employees
- See Re Oasis Merchandising Services Ltd (1997) BCC 282, now superseded by legislation.