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between unsecured creditor claims, it avoids the need for courts to make difficult choices, as would be involved were they to adopt other possible principles: for example, distribution according to need or inability to sustain losses.7 In terms of the efficiency of the ‘creditors’ bargain’ and ‘creditor wealth maximisation’ theories, compulsory, collective proceedings are held out as reducing strategic costs and increasing the aggregate pool of assets.8 The collectivity of dealings with unsecured creditors as a class is enhanced by the pari passu principle which is efficient in so far as it avoids the costs of dealing with claims on their individual merits.9

Fairness in the procedural and substantive senses may also be said to be protected by the pari passu principle in that it prevents an intraclass race to enforce claims that is destined to be won by the strongest and swiftest and it also involves equality of treatment between unsecured creditors.10 Where, of course, the law creates exceptions to pari passu, questions arise regarding the fairness of those exceptional treatments.

Exceptions to pari passu

Liquidation expenses and post-liquidation creditors

Liquidation expenses and the claims of post-liquidation creditors will, for convenience, be dealt with here but, more strictly speaking, they can be said to fall outside the pari passu rule rather than constitute true exceptions. This is because the strong version of pari passu adverts to the

7See Milman, ‘Priority Rights’, p. 59.

8See Jackson, Logic and Limits of Bankruptcy Law, ch. 1; see also ch. 2 above.

9Mokal argues (‘Priority as Pathology’, p. 593) that it is collectivity not pari passu that avoids value-destroying races to collect; that pari passu is not necessary for efficiency. Value, however, is lost by processes that give rise to the high costs of dealing with claims individually. Pari passu reduces such costs within the class of unsecured creditors and accordingly may be justified on efficiency (as well as fairness) grounds. There is, in short, more to securing efficiency than stopping the race to collect and having creditors form an orderly queue. The claims of parties in the queue have to be dealt with efficiently. It can be conceded, however, that the claims of unsecured creditors could be dealt with collectively and at low cost without reference to pari passu, for example by paying debts according to date of loan. On the acceptability of alternatives to pari passu see ch. 15 below.

10On justice in insolvency see J. Finnis, Natural Law and Natural Rights (Clarendon Press, Oxford, 1980) p. 190; see also ch. 15 below.

pre-liquidation position of unsecured creditors and so has no application to unsecured creditors whose claims arise post-liquidation.11 Liquidation expenses are paid out of the company’s assets ahead of all other claims on the estate and are settled in full before even preferential debts.12 In order to effect the most beneficial winding up of a company the liquidator may have to sustain a period of continued trading for a given time. This may benefit all creditors. During this period, funds may be required in order to keep employees in post and to achieve continuity in the supply of materials. If creditors were asked to supply funds during this postliquidation period they would be unlikely to oblige if the debts involved were to enjoy no priority over those of pre-liquidation creditors. Such super-priority can, however, be achieved by treating the liquidator’s transactions with such creditors as expenses of the liquidation so that post-liquidation creditors do not have to prove for a dividend in competition with other creditors.13 Expenses of the liquidation (including postliquidation creditors’ claims) are thus paid first, followed by the claims of preferential creditors,14 and only the remaining pool of assets15 becomes available for distribution to the general body of unsecured creditors. While it is clear that new transactions by the liquidator constitute postliquidation claims, difficulties may arise in relation to obligations under existing contracts or leases. The relevant test is whether the liquidator

11 Se e H o , ‘ Goode’ s Swan Song’ ; Re H IH Casualty and General I nsu rance [ 2 2125 (Ch) at para. 40.

12Secured creditors will be entitled to be paid out of the proceeds of their security ahead of all other claims, but if the security is by way of a floating charge, liquidation expenses and debts that are preferential debts must be paid first. See Insolvency Act 1986 ss. 115, 107; Companies Act 2006 s. 1282 (but note s. 1282(3)); Insolvency Rules 1986 r. 4.180(1). See Insolvency Act 1986 ss. 115, 156, 175(2)(a); Insolvency Rules 1986 r. 4.218 regarding liquidators’ costs and expenses. For further discussion of liquidation expenses see Re Leyland DAF, Buchler v. Talbot [2004] 2 AC 298, Re Toshoku Finance (UK) plc [2002] 1 WLR 671, Re M. C. Bacon Ltd (No. 2) [1991] Ch 127, Re Floor Fourteen Ltd, Lewis v. IRC

[2001] 3 All ER 499, Enterprise Act 2002 s. 253 and IR r. 4.218(1)(a); and ch. 13 above.

13Rule 12.2 of the Insolvency Rules 1986 lists items to be regarded as expenses of the winding up and r. 4.218, as amended, gives the order of priority for payment of expenses of the winding up – subject, however, to the courts’ powers under the Insolvency Act 1986 s. 156. On paying corporation tax (on interest receivable after the start of a winding up) as a necessary disbursement and an expense of the winding up see Re Toshoku Finance (UK) plc [2002] 1 WLR 671, [2002] BCC 110 (HL); H. Lyons and M. Birch, ‘Insolvency Expenses’ (2005) 18 Insolvency Intelligence 150; D. Milman, ‘Post Liquidation Tax as a Winding Up Expense’ [2000] Ins. Law. 169.

14See Insolvency Act 1986 s. 175(2)(a) and (b).

15Which will have been depleted, of course, by payment to any floating charge holders.

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had adopted the transaction and taken it over for the purposes of the winding up.16

Before the Insolvency Act 1986, this treatment of post-liquidation debts placed utility companies in a strong position relative to other trade suppliers. The large providers of gas, electricity, water and telecommunications services could use their dominant market positions to compel the payment of debts on accounts incurred before the commencement of a winding up. They would do this by threatening to cut off a supply unless arrears were paid in full or payment was personally guaranteed by the liquidator or receiver.17 Where the supply was essential to preserve the company’s assets, payment was difficult to avoid and the effect was to pay the utility debt in priority even to the statutory preferential creditors.18 Following strong criticism of this process in the Cork Report,19 section 233 (as amended) of the Insolvency Act 1986 prohibited resort to this practice. The supplier may now require the office holder to undertake personal responsibility for payment of any new supply but may not make the availability of a new supply conditional on receiving payment or security for the old supply.

Preferential debts

The Cork Committee noted that pari passu distribution of uncharged assets was in practice seldom, if ever, attained because, in the overwhelming majority of cases, the existence of preferential debts frustrated such distribution.20 Preferential debts are unsecured debts which, by force of statute, fall to be paid in a winding up in priority to all other unsecured debts (and to claims for principal and interest secured by a

16See ABC Coupler and Engineering Co. Ltd (No. 3) [1970] 1 All ER 656; Re Downer Enterprises Ltd [1974] 2 All ER 1074; Re Oak Pits Colliery Co. (1882) 21 Ch D 322; Re National Arms and Ammunition Co. (1885) 28 Ch D 474; and Re Atlantic Computer Systems plc [1992] Ch 505 (for a review of the earlier authorities). More or less automatically included now (subject to the discretion of the court) are continuing rent or hire purchase charges in respect of land or goods in the possession of the company which the liquidator continues to use for the purposes of the liquidation: see Boyle and Birds’ Company Law (6th edn, Jordans, Bristol, 2007) pp. 938–9.

17On the powerful positions of suppliers of strategic raw materials see Leyland DAF Ltd v.

Automotive Products plc [1993] BCC 389.

18The legality of this practice was upheld in Wellworth Cash & Carry (North Shields Ltd) v.

North Eastern Electricity Board [1986] 2 BCC 99, 265.

19Cork Report, ch. 33, esp. para. 1462.

20Ibid., p. 317. Preferential debts were introduced in the Preferential Payments in Bankruptcy Act 1897.

floating charge)21 but which abate rateably as amongst themselves. Preferential debts are listed in Schedule 6 of the Insolvency Act 198622 and, before the enactment of the Enterprise Act 2002, included: inland revenue debts;23 certain Customs and Excise debts;24 social security contributions for the twelve months prior to the relevant date;25 contributions to occupational pension schemes;26 certain employee bene- fits;27 and levies on coal and steel production.28 Assessed taxes such as income tax and corporation tax were not given preferential status in Schedule 6 of the Insolvency Act 1986 since the government yielded to Cork’s arguments that there was no case for priority in such instances.29

21Preferential creditors rank in priority not only above unsecured creditors, but also above debenture holders with assets covered by floating, not fixed, charges: see Insolvency Act 1986 s. 175(2)(b). See also Insolvency Act 1986 s. 251 which defines ‘floating charge’ so as to include a charge, which, though originally floating, has since become fixed. Thus, any charge which was originally a floating charge but has become a fixed charge (e.g. by crystallisation or by a notice of conversion) before the ‘relevant date’ defined by s. 387 will be subordinated to the preferential debts under s. 175(2)(b), thus depriving such decisions as Re Woodroffes Ltd [1986] Ch 366, Re Brightlife Ltd [1987] Ch 200 and Re Griffin Hotel Co. Ltd [1941] Ch 129 of force. On priority of preferential debts over charged assets see HM Commissioners for Revenue & Customs v. Royal Bank of Scotland plc [2008] BCC 135; Re Oval 1742 Ltd (in liquidation): Customs and Excise Commissioners v. Royal Bank of Scotland [2007] BCC 567 (discussing CA 1985 s. 196 (now CA 2006 s. 754) and the relationship with IA 1986 s. 40).

22See also Insolvency Act 1986 ss. 386, 387; IA 1986 s. 175 (winding up), s. 40 (receivership: see Re H & K Medway Ltd [1997] BCC 853).

23PAYE income tax deductions due from payments made in the twelve months prior to the relevant date (Sch. 6 paras. 1 and 2 – the deductions relate to s. 203 of the Income and Corporation Taxes Act 1988): see generally Keay and Walton, Insolvency Law, pp. 466–

71. The decision in Re Toshoku Finance (UK) plc [2002] BCC 110 (HL), as noted above, makes it clear that corporation tax liabilities arising after the start of a winding up are properly to be treated as expenses of the winding up and are therefore to be paid in advance of preferential debts: see Milman, ‘Post Liquidation Tax’.

24Unpaid VAT for six months prior to the relevant date and unpaid car tax; certain betting and gaming duties as well as lottery duty that became due in the twelve months prior to the relevant date (Sch. 6, paras. 4, 5 and 5B); insurance premium tax, landfill tax, beer duty and air passenger duty referable to the six months prior to the relevant date (Sch. 6, paras. 3A, 3B, 5A, 5C).

25Sch. 6, paras. 6 and 7. 26 Sch. 6, para. 8.

27Remuneration for up to four months prior to the relevant date subject to the stipulated maximum sum (Sch. 6, para. 9); accrued holiday pay (Sch. 6, para. 10); and any sum loaned and used for the specific purpose of paying employees’ remuneration (Sch. 6, para. 11).

28Sch. 6, para. 15A.

29See Cork Report, paras. 1409–50. Different considerations were said, however, to apply to taxes such as PAYE or national insurance, VAT and car tax since the Crown’s claim in such cases was for money collected by the debtor from other parties and the debtor could properly be viewed as a tax collector rather than a tax payer. Unless such debts were

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The coming into effect of section 251 of the Enterprise Act 2002, however, abolished the Crown’s status as preferential creditor.30 As a result, the preferential debts remaining are: four months of unpaid employee wages (up to a prescribed maximum limit per employee of £800) and accrued holiday entitlements;31 unpaid contributions to state and occupational pension schemes;32 and unpaid levies on coal and steel production.33 Abolition of the Crown preference created a potential

given priority the moneys collected would swell the insolvent’s estate to the benefit of private creditors rather than the state. For the case against Crown priority see A. Keay and P. Walton, ‘The Preferential Debts’ Regime in Liquidation Law: In the Public Interest?’ [1999] 3 CfiLR 84; DTI/Insolvency Service White Paper, Productivity and Enterprise: Insolvency – A Second Chance (Cm 5234, 2001) (‘White Paper, 2001’) para. 2.19.

30On the case for directing the benefits of abolishing the Crown preference towards unsecured creditors see Insolvency Service, A Review of Company Rescue and Business Reconstruction Mechanisms, Report by the Review Group (DTI, 2000) (‘IS 2000’) p. 26. Prior to the Enterprise Act 2002 reform the Crown recovered some £60–90 million of preferential debt in insolvencies each year: see Insolvency Service, A Review of Company Rescue and Business Reconstruction Mechanisms, Interim Report (DTI, September 1999) (‘IS 1999’) para. 8(b). Other countries (e.g. Germany, Austria, Canada and Australia) were ahead of the UK in either abolishing or severely restricting revenue authorities’ priority.

31Insolvency Act 1986 s. 386, Category 5, Sch. 6. Employees have defined preferential status but can also draw on the National Insurance Fund: for discussion of employee protections see pp. 608–9, 612–14 and ch. 17 below. The Crown’s right of subrogation to employees’ preferential debts paid from the National Insurance Fund remains: Employment Rights Act 1996 s. 18; Pension Schemes Act 1993 s. 127(3).

32See D. Pollard and I. Carruthers, ‘Pensions as a Preferential Debt’ (2004) 17 Insolvency Intelligence 65; and further ch. 17 below.

33In the case of insolvencies of insurance companies, the EU Insurers’ Reorganisation and Winding-Up Directive was transposed into UK law by the Insurers (Reorganisation and Winding Up) Regulations 2004 (SI 2004/353, effective 18 February 2004). Regulation 21 applies in the case of a winding up of a long-term insurer, a general insurer or a composite insurer and provides that the debts of the insurer must be paid in the following order of priority: preferential debts; insurance debts; then all other debts. (‘Insurance debt’ here means a debt to which a UK insurer is, or may become, liable, pursuant to a contract of insurance, to a policy holder or to any person who has a direct right of action against that insurer, and includes any premium paid in connection with a contract of insurance (whether or not that contract was concluded) which the insurer is liable to refund.) Preferential debts are to rank equally among themselves and must be paid in full, unless the assets are insufficient to meet them, in which case they abate in equal proportions. Insurance debts are to rank equally among themselves and must be paid in full, unless the assets available after the payment of preferential debts are insufficient to meet them, in which case they abate in equal proportions. So far as the assets of the insurer available for the payment of unsecured creditors are insufficient to meet the preferential debts, those debts (and only those debts) have priority over the claims of holders of debentures secured by, or holders of, any floating charge created by the insurer, and must be paid accordingly out of any property comprised in or subject to

windfall for the holders of floating charges and, to adjust for this, the Enterprise Act section 252 inserted a new section 176A into the 1986 Act to ring-fence, for the benefit of unsecured creditors, a prescribed part of the company’s net property that, otherwise, would be available to satisfy the claims of holders of debentures secured by floating charges. The quantum of the prescribed part is thus intended to compensate broadly for the benefit to floating charge holders of no longer being subordinated to Crown claims for unpaid taxes34 and holders of floating charges are not entitled to participate with unsecured creditors in the prescribed part fund as regards any unsecured shortfalls in their security positions except in so far as the fund exceeds the amount needed to satisfy ‘unsecured debts’.35 According to Patten J in Re Airbase (UK) Ltd,36 sense could only be made of section 176A(2)(b) if ‘unsecured debts’ excluded the unsecured balance of the secured creditor’s claim and the pari passu rule was ‘modified’ by the provision to ‘differentiate between unsecured creditors with no form of security and the unsecured claims of secured creditors’.

Can preferential debts be justified in economic efficiency terms?37 A general argument relating to unsecured creditors asserts that if parties constitute involuntary, non-adjusting creditors, their debtors will not bear the full costs of defaulting and so will not take optimal care to avoid default. The debtor will thus take excessive risks with, say, the credit offered by employees and there will be an inefficient allocation of resources in society. Employees who are paid in arrears have little option but to provide credit to their employing company for the period between wage payments.38

that charge. Section 176A of the Insolvency Act 1986 has effect with regard to an insurer so that insurance debts must be paid out of the prescribed part in priority to all other unsecured debts.

34 The relevant percentages/quantum to be paid is fixed by the Insolvency Act 1986 (Prescribed Part) Order 2003 (SI 2003/2097): see further ch. 3 above, pp. 108–10.

35IA 1986 s. 176A(2)(b). See also Re Permacell Finesse Ltd (in liquidation) [2008] BCC 208, discussed in D. Offord, ‘Case Digest’ (2008) 21 Insolvency Intelligence 30; Re Airbase (UK) Ltd, Thorniley v. Revenue and Customs Commissioner [2008] BCC 213, discussed in A. Walters, ‘Statutory Redistribution of Floating Charge Assets: Victory (Again) to Revenue and Customs’ (2008) 29 Co. Law. 129.

36Re Airbase (UK) Ltd, Thorniley v. Revenue and Customs Commissioner [2008] BCC 213. Similarly the holder of a fixed charge facing a shortfall would not be able to participate in the prescribed part: see Walters, ‘Statutory Redistribution of Floating Charge Assets’.

37See generally Cantlie, ‘Preferred Priority in Bankruptcy’; V. Finch, ‘Is Pari Passu Passé?’ [2000] Ins. Law. 194, 206.

38See Cantlie, ‘Preferred Priority in Bankruptcy’, pp. 422–3.

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As for the ability to adjust credit terms, this is crucially important. If employees could adjust the terms on which they provide credit so as to take account of default risks, the economic inefficiencies noted would not arise (the risk-related component of the credit arrangement would induce the appropriate level of credit provision and care taken). Employees are ill-positioned to adjust their credit rates to take account of default risks.39 When they negotiate employment contracts with a firm there will be little discussion of insolvency risks, the employee is liable to lack the information or expertise necessary to calculate the extent of such risks and, even if employees could make the appropriate calculations, they might well be unable to negotiate wages that incorporate a risk element because they face severe competition in the market for jobs and because others in that market may be unable or disinclined to hold out for such risk elements in their wages. Arguments about the general inefficiencies of unsecured credit do not, however, explain why employees should be more sympathetically treated than other ordinary (e.g. trade) creditors. The latter, as was noted in chapter 3, may also be poorly placed to adjust their terms to cope with default risks.

All unsecured creditors now enjoy the protection offered by the prescribed part and, as argued in chapter 3, this would to some extent limit these inefficiencies in credit supply that stem from non-adjustment of rates. In deciding whether, over and above this, it is desirable in economic efficiency terms to give employees protection beyond that enjoyed by trade creditors, it is necessary to consider the possible basis for favouring some non-adjusting creditors rather than others.

A key factor here concerns the costs of risk bearing. Where given levels of risk are allocated in a manner that gives rise to inefficiency because the decision-maker relieved of risk is liable to behave with sub-optimal care, it is relevant to consider variations in the costs of bearing undue risks. It may, in turn, be desirable to give most protection to those who will incur the greatest costs in bearing the risks at issue.40

The ability to spread risks increases a party’s capacity to withstand the consequences of default.41 Trade creditors will have a certain capacity to spread risks but small suppliers may be very hard hit by defaults. The costs of default in their cases may be high, with employees losing jobs or

39See generally B. Gleig, ‘Unpaid Wages in Bankruptcy’ (1987) 21 UBC L Rev. 61–83. On employees, see C. Villiers, ‘Employees as Creditors: A Challenge for Justice in Insolvency Law’ (1999) 20 Co. Law. 222; ch. 17 below.

40See Cantlie, ‘Preferred Priority in Bankruptcy’, p. 430. 41 Ibid., pp. 433–44.

even businesses folding. Employees, as noted, are seldom able to spread default risks and so will suffer considerable hardship: for example, where lack of moneys owed prevents them from generating or gaining further employment. Not only are employees poor self-insurers against debtor default (their lack of diversification prevents effective self-insuring) but they will also be unlikely to find insurance markets in which they can contract to spread risks.42 What makes shifting risks to employees especially undesirable is that the costs of such a risk shift are liable to be higher than when insolvency risks are placed elsewhere. On this reasoning, tort creditors do not merit especially high levels of protection in insolvency because they are less likely than employees to be highly vulnerable to instances of default and, accordingly, they will not usually be extremely high-cost risk bearers. They will routinely have other sources of income, funds and products and risks will be spread by such diversification.

It has been proposed that other creditors (including secured creditors) should be deferred to tort claimants in insolvency43 but a further consideration here is the special effect that deferment to tort creditors may have on major lenders. Banks, for instance, might be deterred from advancing funds on the basis of secured loans where they face risks of giving way to potentially huge tort claims. As argued in chapter 3,44 other ways of protecting involuntary tort creditors – such as compulsory tort liability insurance for companies – might prove more consistent with efficient corporate financing.

The issue of vulnerability to risks may also militate against placing pre-paying consumer creditors in a better position than ordinary unsecured creditors. Ogus and Rowley have contended45 that there are material reasons for giving consumer pre-payers special protection – reasons based on economic efficiency. Their argument, in brief, is that few problems arise in the general provision of credit when there is voluntary choosing of investments, full information and equal bargaining power. In so far as such conditions are lacking in a trading relationship there may be a case for protecting the ill-placed party and, in so far

42Ibid., p. 437.

43For discussion see D. Leebron, ‘Limited Liability, Tort Victims and Creditors’ (1991) 91 Colum. L Rev. 1565 at 1643–50; H. Hansman and R. Krackman, ‘Towards Unlimited Shareholder Liability for Corporate Torts’ (1991) 100 Yale LJ 1879; V. Finch, ‘Security, Insolvency and Risk: Who Pays the Price?’ (1999) 62 MLR 633 at 657.

44See pp. 110–12 above.

45A. Ogus and C. Rowley, Prepayments and Insolvency (OFT Occasional Paper, 1984).

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as one group of creditors is liable to be more poorly placed than another, a relatively superior level of protection is appropriate. Consumer prepayers, Ogus and Rowley state, may be eligible for such superior protection because they tend to be ‘distanced from the company in a way that the trade creditor typically is not and may well regard the cost of negotiating over the risk of insolvency as excessive in relation to the amount at stake’.46

Consumer pre-payers may also be geographically dispersed (for example, in mail order contracting) which weakens their position, and they will rarely have easy access to such information on the trader as will allow them to assess insolvency risks. (The Office of Fair Trading has reported that it ‘does not regard it as feasible’ that consumers be expected to check on the financial standing of traders.)47 Finally, many consumer creditors may fail to see themselves as creditors of the company at all, especially where they are led by the trading company to believe that the period of prepayment is short.

Whether consumer creditors are placed in positions materially worse than those occupied by small trade creditors is, however, open to argument. For its part, the Cork Committee decided against special treatment for consumers, saying of consumer and trade creditors: ‘There is no essential difference. Each gives credit and if the credit is misplaced, each should bear the loss rateably.’48 What is more strongly arguable is that consumer creditors tend to be lower-cost risk bearers than employees because their risks are more widely spread (across products). This argument suggests that if preferential treatment should be given, employees, not consumer creditors, should be favoured.49

A second factor that may influence the case for protecting an unsecured creditor is his or her ability to prevent default and the taking of inefficiently low levels of care. If a party is able to intervene and forestall disaster, we may, on fairness grounds, be less inclined to protect them from default risks by giving them priority than we would in the case of someone who has no power to intervene.50 On this front, trade creditors

46 Ibid., p. 12. 47 Ibid., para. 5.11. 48 Cork Report, para. 1052.

49In the survey reported by A. Keay and P. Walton, ‘Preferential Debts: An Empirical Study’ [1999] Ins. Law. 112, 60 per cent of IP respondents said that they would not introduce a new preference category for prepayment consumer creditors.

50See Keay and Walton, ‘Preferential Debts Regime in Liquidation Law’, p. 96; Report of the Study Committee on Bankruptcy and Insolvency Legislation (Canada, 1970), para. 3.2.076–7; M. Shanker, ‘The Worthier Creditors (and a Cheer for the King)’ (1975–6) 1 Canadian Bus. LJ 341.

in a regular supply relationship with a debtor may occasionally be able to impose conditions on supply and may adjust terms or decline to supply further items. Small suppliers to a large number of customers are, however, unlikely to be in this position and, in the case of all trade creditors, market conditions and competitive pressures may rule out the institution of preventative measures. Employees may decline to supply further labour if worried about their employer’s solvency but, in a market where alternative employment is unavailable, this may be difficult. If the employee occupies a managerial position in the employing company there may, however, be opportunities to influence decision-making so as to limit default dangers, but such opportunities and influence may be very limited in many cases. Tort creditors, in contrast, will rarely, if ever, be able to take steps to influence default rates, or levels of care, and consumer creditors will occupy a similar position. The above points indicate that in terms of ability to prevent default, there is no particularly strong case for sustaining exceptions to the pari passu principle.

Do considerations of fairness suggest that certain non-adjusting creditors should be preferred to others in insolvency? Here we come to the issue that for Cork was central:

Since the existence of any preferential debts militates against the principle of pari passu distribution and operates to the detriment of ordinary unsecured creditors, we have adopted the approach that no debt should be accorded priority unless this can be justified by reference to principles of fairness and equity which would be likely to command general public acceptance.51

Thus it might be argued that if creditors cannot tailor their credit terms it is wrong to burden those creditors with risks that they are in no position to recognise, calculate, adjust terms to, or protect themselves against.52 This contention, however, found little resonance with consultees of the Insolvency Service Review Groups 1999–2000. Many unsecured creditors cannot adjust and the rationale offers no justification for giving priority to one category of unsecured creditors over another. Fairness considerations point in the direction of general protections for

51 Cork Report, para. 1398. It is arguable that the system of preferential debts causes considerable discontent in the ranks of unsecured creditors. A survey reported by Keay and Walton, ‘Preferential Debts: An Empirical Study’, revealed that 68 per cent of respondent IPs thought that there was unsecured creditor discontent.

52 Cantlie, ‘Preferred Priority in Bankruptcy’, p. 419. See IS 1999, p. 15.

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unsecured creditors – as offered by the prescribed part provisions – but not towards more particular safeguards.

Does fairness demand priority for employee creditors?53 Most employees are likely to be poorly placed to assess the financial standing of their employers, or to insist on employment terms that protect them against insolvency risks. Cork, however, rejected the case for employee creditor priority on the grounds that it would give ‘an excessive degree of indemnity to higher paid employees, including directors and senior management, at the expense of ordinary creditors who in many cases may be more deserving of sympathy’.54 Employees are protected by the Employment Protection Acts,55 said Cork, and there was no need for overlapping insolvency law protections. At present the Employment Rights Act 1996 (ERA) offers employees of an insolvent company more extensive protection than the Insolvency Act 1986. The 1986 Act gives preferential priority to unpaid wages and accrued holiday pay owed and provides for payment by the Secretary of State for up to eight weeks of pay arrears during the statutory minimum period,56 up to six weeks’ holiday pay and a basic award for unfair dismissal.57 The Secretary of State makes such payments out of the National Insurance Fund and then stands in the shoes of the employee in attempting to recover such funds from the liquidator. Less than a quarter of the money paid out of the ERA scheme can be claimed by the Crown as preferential.58

53See Cantlie, ‘Preferred Priority in Bankruptcy’; Keay and Walton, ‘Preferential Debts Regime in Liquidation Law’; Gleig, ‘Unpaid Wages in Bankruptcy’; C. Symes, ‘The Protection of Wages When Insolvency Strikes’ (1997) 5 Ins. LJ 196; D. Zalman, ‘The Unpaid Employee as Creditor’ (1980) 6 Dalhouse LJ 148; Villiers, ‘Employees as Creditors’.

54Cork Report, para. 1430.

55See now the Employment Rights Act 1996 (ERA 1996). On employees more generally see ch. 17 below.

56I.e. up to eight weeks at up to £330 per week: ERA 1996 s. 186(1)(a); Employment Rights (Increase of Limits) Order 2007 (SI 2007/3570), from 1 February 2008.

57ERA 1996 ss. 182, 186, 167. Up to six weeks’ holiday pay with a limit of £330 per week, accrued during the twelve months before insolvency. The maximum compensatory award for unfair dismissal is £63,000 (as at 1 February 2008). The NIF also guarantees payments of statutory notice pay (up to a maximum of £330 per week); unpaid contributions to an occupational or personal pension scheme; the basic award for unfair dismissal; up to eight weeks at a maximum of £330 per week of a protective award; and statutory redundancy pay.

58See Keay and Walton, ‘Preferential Debts Regime in Liquidation Law’, p. 100, who note that on 31 March 1996 £762 million was owed by insolvent employers to the Fund, of which only £177 million (23 per cent) ranked as preferential. The Crown’s right of subrogation to employees’ preferential debts paid from the National Insurance Fund remains (after the changes of the Enterprise Act 2002): Employment Rights Act 1996 s. 18; Pension Schemes Act 1993 s. 127(3).

Current law, accordingly, gives employees limited priority in relation to unpaid wages and the ERA gives further protection. The effect of limited priority in such a regime is to allow the National Insurance Fund to recover a proportion of sums paid out to employees. To abolish employees’ preferential status under the 1986 Act would consequently impose a loss not on employees but on the National Insurance Fund. It would, in doing so, make available considerable sums for other unsecured creditors. This may be no bad thing in economic efficiency terms since the Crown is likely to be a lower-cost risk bearer than the other unsecured creditors referred to, but it may be objected that it is unfair for taxpayers to foot part of the bill for an insolvency when they have enjoyed no direct involvement with the company.59 What the body of taxpayers has enjoyed, it could be riposted, is the prospect of gaining tax revenue from the potentially successful company. Having been happy to accept tax from a viable company and, in this sense, having shared in profits, such taxpayers, it could be said, are in no position to complain if they stand to bear some of the costs of failure. The Cork Committee,60 for its part, favoured the Canadian approach in which the state’s subrogated rights are not preferential. Cork noted Canadian thinking – that leaving a greater body of funds for unsecured creditors would be useful in encouraging them to play a more active part in the administration of the insolvent company’s estate – but the Committee stressed that the case for meeting employees’ debts was rooted in social policy considerations.61

In such discussions the further question arises as to the appropriateness of treating all employees who are owed wages in like terms. It is possible to distinguish some employee groups from others on the issue of fairness. Directors, for instance, might be thought to be less worthy of protection from the risks of unpaid wages than other employee creditors on the grounds that they can be taken to be better informed about risks; they are better able to monitor the activities of the company; they share ex officio some responsibility for the company’s insolvency; and they are better able to gain compensation for insolvency risks than other

59The Cork Report, para. 1433, favoured replacing insolvency law priority with statutory employment protection. As the Crown’s general preferential rights are now surrendered and the resulting fund is ring-fenced (subject to a prescribed part), then calls for abolition of employees’ preferential status may have more force: see, for example, D. Milman, ‘Insolvency Reform’ [2001] Ins. Law. 153; Mokal, ‘Priority as Pathology’, pp. 616–20.

60Cork Report, para. 1434. 61 Ibid., para. 1435.

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employees and creditors.62 This reasoning might be thought to justify excluding company directors from the group of those creditors able to benefit from the prescribed part; giving no priority to such directors’ claims to unpaid wages; and rendering directors ineligible for benefits from the National Insurance Fund in relation to unpaid wages. Directors’ claims would, on such reasoning, be subordinated/deferred to those of other creditors. Such steps might, however, be considered to be too draconian and to exaggerate the extent to which company directors are able to self-inform concerning their company’s insolvency risks, to influence financial risk-taking or to exit from excessively risky situations.63

Set-off

A well-established principle of insolvency law is that where there are mutual debts existing between a creditor and a company in liquidation, the smaller debt is to be set against the larger debt and only the balance is to be paid to the creditor out of the insolvency estate.64 Thus, if company A has supplied materials to now insolvent company B and is owed £10,000 for these but company A also owes company B £6,000 for equipment supplied by company B to company A, the principle of setoff means that £6,000 of the £10,000 debt is extinguished. There is no defence or counterclaim to an action involved here. Company B does not have to go to court to establish a counterclaim, it merely uses the debt to pay off part of the debt to company A. The effect of this, as will be returned to below, is that where company A has provided the £10,000 credit without security, it is placed in a better position than insolvent

62See generally K. Van Wezel Stone, ‘Policing Employment Contracts Within the Nexus- of-Contracts Firm’ (1993) 43 U Toronto LJ 353.

63On Cork’s approach to discouraging irresponsibility to creditors on the part of directors see Cork Report, ch. 43; and ch. 16 below. See also White Paper, A Revised Framework for Insolvency Law (Cmnd 9175, 1984) which emphasised that all directors should ensure they have full awareness of their company’s financial position; D. Milman, ‘Insolvency Act 1986’ (1987) 8 Co. Law. 61.

64See generally Cork Report, ch. 30; R. Derham, Set-off (3rd edn, Clarendon Press, Oxford, 2003); Derham, ‘Some Aspects of Mutual Credit and Mutual Dealings’ (1992) 108 LQR 99; A. McKnight, The Law of International Finance (Oxford University Press, Oxford,

in Insolvency: Part 3 – Equitable Set-off and Crown Debts’ (2000) 13 Insolvency Intelligence 9.

66The availability of set-off generally is governed by the following conditions: (1) there must be debts, credits or dealings between the company and the person seeking to assert the set-off and (2) these debts, credits or dealings must be mutual. Mutual debts are liquidated amounts owing from each of the parties to the other. Mutual credits are credits which will eventually result in money claims, e.g. where one party, who is indebted to the other, supplies the other party with property on the basis that the property is to be resold and the proceeds handed over. Mutual dealings are arrangements in which the parties extend credit to each other in respect of individual sums with the express or implied intention that at some point the individual sums will be brought into account and set off against each other: see Boyle and Birds’ Company Law, p. 931. On the arising of a right of set-off see e.g. Rother Iron Works v. Canterbury Precision Engineers Ltd [1974] QB 1 but compare Business Computers Ltd v. Anglo-African Leasing Ltd

[1977] 1 WLR 578. On the considerable scope of ‘Crown set-off’ and the operation of setoff in relation to contingent debts see Secretary of State for Trade and Industry v. Frid

[2004] 2 AC 506, [2004] BPIR 841; I. Fletcher, ‘Crown Set-off and Contingent Liabilities’ (2005) 18 Insolvency Intelligence 6.

67Insolvency Rules 1986 r. 4.90(2).

68Ibid., r. 4.90(3). See Smith (Administrator of Coslett (Contractors) Ltd) v. Bridgend CBC (Re Coslett (Contractors) Ltd (in administration)) [2001] BCC 740 (HL): conversion of a company’s property was not a mutual dealing between the Council and the company (Lord Hoffmann at p. 748); Smith v. Blake [1996] AC 243.

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their deposits f or the loans but they had guaranteed the obligati on

(answering in the affirmative) or whether this amounted to a contractual set-off and not a true security at all: see further R. Calnan, ‘Fashioning the Law to Suit the Practicalities of Life’ (1998) 114 LQR 174; R. M. Goode, ‘Charge-Backs and Legal Fictions’ (1998) 114 LQR 178; G. McCormack, ‘Charge-Backs and Commercial Certainty in the House of Lords (Re BCCI (No. 8))’ [1998] CfiLR 111; R. Mokal, ‘Resolving the MS Fashions “Paradox”’ [1999] CfiLR 106; C. Rotherham, ‘Charges Over Customers’ Deposit Accounts’ [1998] CLJ 260; M. Evans, ‘Decision of the Court of Appeal in Morris v. Agrichemicals Ltd: A Flawed Asset’ (1996) 17 Co. Law. 102; G. McCormack, ‘Security Interests in Deposit Accounts: The Anglo-American Perspective’ [2002] Ins. Law. 7.

71MS Fashions v. Bank of Credit and Commerce International SA (No. 2) [1993] BCC 70; Mokal, ‘Resolving the MS Fashions “Paradox”’.

72As the depositors owed an obligation to the bank under the guarantee and the bank owed the depositors an obligation in respect of the deposit.

with creditors. The credits and debits involved must have arisen before the company ‘goes into liquidation’: that is, before the time of the winding-up order or the passing of the resolution to wind up the company.73 Rule 4.90, as amended in 2005, makes it clear, however, that actual, contingent and future debts owed both by and to the company are to be taken into account for the purposes of set-off (formerly only contingent and future debts owed by the company were taken into account).74

When a debtor company goes into insolvency, the statutory rules set out in Rule 4.90 of the Insolvency Rules 1986 are mandatory75 and displace all other forms of set-off not exercised prior to the winding up.76 The courts have, however, had to come to grips with various attempts to exclude the mandatory application of insolvency set-off. Thus, in Rolls Razor v. Cox77 the court held that a washing-machine salesman was entitled to set-off £106 of sale proceeds against the £406 of retained commission that the now insolvent company owed him. The set-off that was involved, said the court, could not be excluded by the contractual agreement between the parties which had purported to rule it out.78

73Note that this is not the same definition of the ‘commencement of winding up’ that is used elsewhere in the Insolvency Act 1986, which refers, for other purposes, to the time the petition was presented or the resolution is passed.

74In the case of Secretary of State for Trade and Industry v. Frid [2004] 2 AC 506, [2004] BPIR 841, the House of Lords ruled that a contingent debt to the company could be included in set-off and that it was not necessary for the debt to have been due and payable before the insolvency date – it was sufficient that there should have been an obligation from contract or statute by which a monetary debt would become payable on the occurrence of some future event or events (Lord Hoffmann, at para. 9). See Fletcher, ‘Crown Set-off and Contingent Liabilities’.

75On the mandatory nature of statutory set-off see National Westminster Bank Ltd v.

Halesowen Presswork and Assemblies Ltd [1972] AC 785; Morris v. Agrichemicals.

76See Goode, Principles of Corporate Insolvency Law, pp. 214–16, where the five types of set-off are listed as: (1) independent set-off; (2) transaction set-off; (3) current account set-off; (4) contractual set-off; and (5) insolvency set-off.

77[1967] 1 QB 552.

78 For criticism of this decision see Goode, Principles of Corporate Insolvency Law, pp. 235–7. See also National Westminster Bank Ltd v. Halesowen Presswork and Assemblies Ltd [1972] AC 785 where the House of Lords held that a person for whom a right exists cannot waive that right so as to exclude the statutory rules of set-off: see discussion at pp. 619–21 below. In British Eagle International Airlines Ltd v. Compagnie Nationale Air France [1975] 1 WLR 758, [1975] 2 All ER 390 (‘British Eagle’) debts were cleared through a clearing house with seventy-six IATA member airlines. The court held that the liquidator of British Eagle had a legitimate claim for the net sum owed by Air France to British Eagle (after sums owed by the latter to the former had been set-off

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Why should insolvency set-off be mandatory? Should contracting out of insolvency set-off be resisted on efficiency or fairness grounds? As one commentator has asked: ‘What is so special about insolvency set-off which makes contracting out of it totally impossible whereas contracting out of the pari passu rule is to be possible provided the contracting out operates to the detriment rather than the benefit of the creditor which is a contracting party?’79

The Cork Committee noted the efficiency benefits of allowing contracting out of set-off.80 When the law allowed contracting out,81 a company in financial difficulties, attempting to reorganise its affairs, found it useful to open a new account with the bankers to whom it was indebted. This account would be maintained in credit and the bank would agree that in a subsequent liquidation it would not set-off any credit balance on the account against existing indebtedness. This meant that the funds in the new account would be handed over intact to the liquidator and the bank would not become preferred to other creditors through the funds in the new account. For its part, the company would be able to run the business on a cash basis for the general benefit of all creditors. After contracting out was legally prevented, such a company might open a new account with a new bank but not, if properly advised, its former bank.82 Cork deemed this need for new banking arrangements to be an ‘unnecessary and undesirable complication’.83 The Committee

under the statutory rules). To allow pre-insolvency clearing arrangements to continue post-liquidation would offend the pari passu principle as sums due from Air France to British Eagle would, on clearing, be used to satisfy the debts of clearing house member creditors to the ‘determent’ of non-members. See further M. Bridge, ‘Clearing Houses and Insolvency’ (2008) 2 Law and Financial Markets Review 418; Oditah, ‘Assets’, p. 466; Mokal, ‘Priority as Pathology’, pp. 598–601. On the ‘football creditor rule’ and a decision indicating that the British Eagle approach is not offended when the claims of certain (but not all) unsecured creditors are paid off, not out of club assets, but by a purchaser of the club, see Commissioners of the Inland Revenue v. Wimbledon Football Club [2004] BCC 638.

79See E. Ferran, ‘Subordinated Debt Agreements’ (1993) CCH Company Law Newsletter (28 June 1993) 8, 9; Ferran, Company Law and Corporate Finance, pp. 552–4; Capper, ‘Contracting Out of Insolvency Set-off’. On contracting out of pari passu to the detriment of the contracting creditor see Re Maxwell Communications Corp. (No. 2) [1994] 1 BCLC 1, [1993] BCC 369, [1994] 1 All ER 737 (‘Maxwell Communications’) and discussion below.

80See Cork Report, paras. 1341–62.

81That is, until the decision in National Westminster Bank Ltd v. Halesowen Pressworks and Assemblies Ltd [1972] AC 785.

82See V. Selvam, ‘Revisiting the Justifications for Insolvency Set-off’ (2004) 25 Co. Law. 343.

83Cork Report, para. 1341.

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company to refinance its operations by arranging additional credit facilities. This will happen where existing creditors will not agree to the refinancing deal if it involves a new creditor being given preference through set-off.87 Implementation of the Cork recommendation to allow contracting out of set-off would give greater financing flexibility in such scenarios.

Is mandatory set-off fair? In Forster v. Wilson88 the aim of insolvency set-off was said to be to do ‘substantial justice’ between the parties.89 This implies that if creditor A owes troubled company B £1,500, yet A is owed £2,000 by B, it is just that the £1,500 debt is allowed to be set-off. The effect, however, is to repay to A £1,500 of his debt as a matter of preference over other creditors of B (who, when deciding to lend, may have seen the debt in the company (B’s) account as an asset). Allowing set-off worsens the position of other creditors who are not engaged in a mutual debt relationship with the company and who may have difficulty in discovering the existence of ‘an unpublished security’.90 The effect of set-off is to remove from the insolvency estate the asset that is the debt due from the creditor to the company.91 An alternative would be for A to pay the £1,500 debt to B and then prove for the £2,000 in Company B’s insolvency, taking a percentage dividend on the sum owed alongside other unsecured creditors. To an independent observer this alternative arrangement might seem fairer than set-off because set-off ‘rewards’, with priority, those solvent creditors who happen also to have borrowed

87Ibid., p. 343. Mandatory set-off is likely, of course, to make creditors more willing to lend to the troubled company if they also owe debts to the company that are sufficiently large to allow them to set-off their own debts against debts owed to them by the company (see Lord Hoffmann in Smith v. Blake [1996] AC 243). When they reach the point at which their loans exceed their debts to the company this incentive disappears since any set-off will apply only to a sum equal to their debt to the company and, beyond that point, they will recover only pro rata as an unsecured creditor.

88(1843) 12 M&W 191 at 203–4. See Oditah, ‘Assets’, p. 467.

89The ‘substantial justice’ purpose attributed to Parke B in Forster v. Wilson has been quoted with approval several times: see, for example, Stein v. Blake [1996] 1 AC 243 at 251E; Gye v. McIntyre [1991] 171 CLRT 609 at 618. In National Westminster Bank Ltd v.

Halesowen Pressworks and Assemblies Ltd [1972] AC 785 Viscount Dilhorne stated that set-off prevented the ‘unfairness’ of the creditor having to pay off a debt to the company and then prove for a dividend.

90Selvam, ‘Revisiting the Justifications for Insolvency Set-off’, p. 343.

91Of course, the principal limiting requirement is that of mutuality. Insolvency set-off is usually said to guard against injustice to the solvent party, i.e. against the solvent party’s having to pay in full knowing it will in turn merely get a few pence in the pound.