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Law for Business

Knowhow - guidance - precedents

06 SEP 2012

Payment of Debts on Insolvency

From February 2012 update of Jordans Company Administration and Governance: IN FOCUS

Current statistics

Insolvency is one of the few growth industries within the UK at the present time. Company liquidations are running at about 17,000 pa in England and Wales, with just over 4,000 being compulsory and more than 12,000 being creditors' voluntary arrangements. Administrations run at about 3,000 pa and company voluntary arrangements 700 pa. Receiverships are also relatively low, running at about 1,400 pa, which are registered at Companies House. With the Enterprise Act 2002 having all but abolished administrative receiverships as a mechanism for enforcing floating charges, such receiverships as there are will usually be found to be in respect of companies involved in building and property. Thus, in excess of 20,000 companies a year are descending into a formal state of insolvency. Another 15,000 or so are simply dissolved by the Registrar of Companies following an application by the directors. Against this, formal individual insolvencies are running at over 135,000 pa, the majority being bankruptcies, but including also individual voluntary arrangements and debt relief orders.

Statistically, therefore, most people involved with business are likely to encounter insolvency in one way or another, and for this reason it is worth considering some aspects of insolvency and particularly the order of payment of debts.

Basic principles

When first we study insolvency law, we learn the order of the payment of debts. This is:

1.       Costs

2.       Fixed charges

3.       Preferential creditors

4.       Floating charges

5.       Unsecured creditors

6.       Members.

In regard to this, there are a few points to be made.

Costs

Obviously costs include the fees due to the insolvency practitioner in respect of what he does in office whether as liquidator, administrator or whatever. They also include the costs necessarily incurred by him such as wages for employees whom he allows to remain in post. It is for this reason that in the rescue strategies, administrations and administrative receiverships, the office-holder is given a 14-day period on taking office before which nothing he does can be taken to have meant he was adopting contracts of employment.

Fixed charges

These are mortgages secured on specific assets, especially real property. The secured lender takes care of its own interest. If a bank has a mortgage on something such as a warehouse, it will usually take the warehouse and sell it independently of any office-holder. This will be turned to in more detail later.

Preferential creditors

Crown preference disappeared on 15 February 2003 because of the Enterprise Act 2002. As a result, preferential creditors are always relatively low in the sum total of the debts arising on an insolvency since they largely consist of no more than £800 arrears of wages together with accrued holiday pay for each employee. Sums above this owing to employees are simply unsecured debts.

Floating charges

It was under a floating charge that formerly an administrative receiver would be appointed. The appointment was by the secured lender in whose favour the charge was made, usually a bank. Once the assets under the charge had been realised and the bank repaid, the administrative receiver had to vacate office. In other words the appointment was essentially contractual. The contract would be found in the debenture and the facility agreement from the bank. This would set out how the loan was to be serviced, what interest should be paid and when capital should be repaid; it would also set out the consequences of the company's failing to comply with these obligations, namely the appointment of an administrative receiver by the bank to take over the running of the company.

His appointment being contractual, the administrative receiver was obliged to vacate office as soon as he had repaid the bank what was owed to it by the company. As such, it is difficult to imagine a more selfish type of appointment, with the administrative receiver largely owing his duties to the bank, and with very little being owed by him to the unsecured creditors or the members of the company.

It was mainly for this reason that, at least for most floating charges created on or after 15 September 2003, enforcement has now to be by the appointment of an administrator. This appointment can be made by the court, and it may be done extrajudicially by a bank having a floating charge or by the directors of the company concerned. Usually the appointment these days is done by the directors. This gives the bank the benefit of not being seen to be the person pulling the plug on the company, and with the company's directors appearing to admit to the world generally that they, the directors, have been the persons at fault. Regardless of how an administrator is appointed, he has two specific statutory duties. He must act with speed and efficiency. He must also act in the interests of the company as a whole. A breach of the duties could see the administrators being sued by the company, at least in theory.

Unsecured creditors

Prior to the abolition of Crown preference, unsecured creditors were sometimes colloquially referred to as the trade creditors. However, today unsecured creditors extend far beyond the suppliers to the company because they include all taxes owing by the company including corporation tax, outstanding VAT, and PAYE and NI deductions made from employees' wages.

Members

If at this stage anything remains in the hands of the office-holder, this will be held by him for the company and, if the company is being wound up, will be paid to the members.

Ring-fencing a sum for the unsecured creditors

If we look at the list of the order of payment of debts, it would appear that once one level of debt has been paid, what remains in the office-holder's hands will simply cascade down to the next level. With the abolition of Crown preference, this would mean that what remained after payment of the preferential creditors would simply cascade down to the floating charge-holders, namely the banks. This was felt to be unacceptable, and so when Crown preference was abolished a supplementary provision came in so that a proportion of what remained in the office-holder's hands would be held for the benefit of the unsecured creditors. Put at its simplest, this means that 50% of the first £10,000 and 20% of any balance should be held for the unsecured creditors, with a cap on this sum standing at £600,000. The purpose of this is largely to provide a fighting fund for a liquidator to bring fraudulent or wrongful trading proceedings against directors believed to have traded in this way. It also provides liquidators and administrators with funds to tackle matters such as undervalue transactions or preferences. It might be noted that at the moment fraudulent or wrongful trading proceedings can only be commenced by a liquidator, but it appears likely that this facility will be extended to administrators in April this year.

Over-simplicity?

When first we come upon the order of payment of debts it is almost impossible to look at it other than as a list; costs first, followed by fixed charges, and after this the preferential creditors, and so on. In other words, we tend to view the list in monochrome. However, this is potentially misleading. The list should be viewed, as it were, in 3-D. In most insolvencies there will be more than one ‘estate', each of which will bear its own costs.

Take the simplest possible example. Suppose Paul goes bankrupt in circumstances where he has a mortgage on his house. Here there will be two estates: the bankruptcy estate and the mortgage estate, each of which will bear its own costs. First out of the bankruptcy estate will be the costs of the trustee in bankruptcy. Then the house on which there is a fixed charge will move to the mortgage estate. The house will be sold, and first out of the proceeds of sale will be the costs to this estate, namely the estate agent's fees for selling the house and the solicitor's costs for conveying it. This will be followed by the payment of the fixed charge, the mortgage, after which any balance will move to the bankruptcy estate. If in the bankruptcy estate there was a shortfall for the trustee's costs, the balance will be applied here. After this, any preferential creditors will be paid and then the unsecured creditors, given that individuals cannot create floating charges.

A judicial error?

It may be that looking at the order of payment of debts in monochrome caused the Court of Appeal to make an error some years ago. This arose in the case of Re Barleycorn Enterprises Ltd [1970] Ch 465. A receivership in which there were insufficient funds to pay the appointing floating charge-holder was followed by a heavily insolvent liquidation where there were insufficient funds even to pay the liquidator's costs. As a general rule any office-holder in insolvency proceedings can apply to the court for directions. The liquidator asked for guidance as to how his fees should be paid. The Court of Appeal held that in circumstances such as this where there was a shortfall in the liquidation estate, that shortfall should be made good from moneys that would otherwise be going to the floating charge-holder so far as was necessary to ensure that the liquidator's costs were paid.

With great respect, it would appear that the court had made the error of looking at the order of payment of debts in monochrome with all costs coming out of the entire insolvency estate first. Had the court instead have looked at the order of payment in 3-D, it would have noted that there were two estates, the receivership estate and the liquidation estate, each of which should bear its own costs.

Having observed this error, the decision has a certain pragmatic quality to it. Consider a major insolvency such as occurred, for example, at MG Rover. Suppose there is a shortfall in the administration and the company then descends into liquidation. If the Barleycorn decision is wrong then there would be no funds to pay a ‘private sector' liquidator, with the consequence that it would be the Official Receiver who would become the liquidator, and he does not have the resources to conduct a liquidation of that magnitude. Therefore the decision, even if wrong, provided a workable solution to this practical problem.

Barleycorn reversed

Barleycorn stood as a statement of the law for 34 years, but it was perhaps inevitable that at some stage it would be questioned in the courts. This arose in Buchler v Talbot [2004] UKHL 9. The case arose out of the Leyland Daf insolvency. There had first been a receivership in which there were insufficient funds to pay the appointing floating charge-holder. The company then descended into a liquidation where the realisations were £1½m but the liquidator's costs were £10m. Naturally the liquidator asked the receiver to add his costs to the receiver's costs. Not surprisingly, the bank holding the floating charge was unhappy about this and challenged the Barleycorn decision. The House of Lords held that Barleycorn had indeed been wrongly decided. Lord Millett was particularly scathing of Lord Denning's judgment in Barleycorn:

‘The decision in Barleycorn was clearly contrary to the understanding of the profession at the time. Lord Denning dismissed the statements to the contrary in all the standard text books ... as simply erroneous. He preferred a comment in the 1938 10th edition of ‘the little book by Mr Topham on Company Law', which was written for students. ... (and then) I think that Lord Denning misunderstood the passage in question.'

How damning can a judgment get?  A ‘little book' - the only books worth consulting are heavy tomes; written for ‘students' - the very nadir of the legal intellectual world; published in 1938 - and so the decision in 1970 was based on the Companies Act 1929 rather than that of 1948, which was, of course, the law in 1970. And as if that were not enough, Lord Denning did not understand what even Mr Topham had said. (Mr Topham was actually a county court judge and a contributor to Gore-Browne on Companies.)

Buchler v Talbot reversed

While Buchler v Talbot clearly was correct in law, it had the potential of causing major problems in practice as suggested above. For this reason it has been reversed. Section 1282 of the Companies Act 2006 inserts a new s 176ZA into the Insolvency Act 1986: ‘The expenses of winding up in England and Wales, so far as the assets of the company available for the payment of general creditors are insufficient to meet them, have priority over any claims to property comprised in or subject to any floating charge created by the company and shall be paid out of any such property accordingly.' Thus the decision in Barleycorn has effectively been reinstated. Buchler v Talbot is no longer the law.

Self-help in insolvency

There are numerous self-help remedies available to creditors when insolvency occurs, a retention of title creditor can take back goods supplied under a contract providing for such retention, a finance house can take back goods supplied on hire-purchase, a judgment creditor can levy execution and so on. These self-help remedies can destroy any hope of bringing about a voluntary arrangement and the rescue that it is intended to effect. For this reason, the Insolvency Act 1986 contained provisions that allowed the assets of an insolvent estate to be ring-fenced with the effect that creditors cannot generally avail themselves of their traditional self-help remedies. For example, a moratorium comes automatically into force on an administration. When an individual is seeking a voluntary arrangement, he can ask the court for an interim order, which has a similar effect. However, rather curiously, the Act as enacted in 1986 contained no such facility for a moratorium for a company seeking a CVA. For this reason, CVAs never became popular. If we go back a few years to before the current recession and a time when corporate and individual insolvencies were each running at about 30,000 pa, there would be approximately 5,000 IVAs as against 500 CVAs.

In an attempt to redress this, the Insolvency Act 2000 introduced the possibility of a moratorium for small companies when its directors were seeking a CVA. However, there were three main difficulties, which meant that such a moratorium was seldom encountered. First, it could only be sought by a small company; it was not available to medium and large companies. Secondly, it could only be brought about by an insolvency practitioner who had to be satisfied that the company had sufficient funds to keep it going throughout the moratorium. Thirdly, the directors, rather than the insolvency practitioner, remained in control of the company throughout the moratorium.

Proposed changes

For this reason, changes are due to be brought into effect in April. The moratorium is to be extended to all companies. The moratorium will be put in place by a High Court judge. During the moratorium, it will generally be unlawful for pre-moratorium debts to be paid.

Thus the order of payment of debts will be:

1.       Costs

2.       Fixed charges

3.       Moratorium debts

4.       Preferential debts

5.       Floating charges

6.       Pre-moratorium debts

7.       Members.

It is thought that, if this is implemented (and the draft delegated legislation to do this has been published) it will greatly increase the number of CVAs. Suppliers to the company during the moratorium can be sure that their invoices will be paid in full even in priority to preferential creditors and floating charges. Pre-moratorium debts, including trade suppliers and the Crown, will rank where they previously did, after the floating charges. Moreover, a crucial matter will be that the moratorium will be put in place by a High Court judge. As stated, before the moratorium is put in place, the judge must be satisfied that there are sufficient funds to keep the company going throughout the moratorium, just as an insolvency practitioner has to do now. However, whereas an insolvency practitioner may be sued in negligence if he makes such a statement and it proves not to be the case, a judge is immune from suit. While it is not suggested for one moment that judges will recklessly put a moratorium in place, it is to be hoped that they will be less inhibited than insolvency practitioners in doing so.

 

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