from an insolvent company.92 In short, then, a regime of mandatory setoff involves a trading of efficiency gains and fairness losses.

Subordination

It is clear from the above that the pari passu principle is not one that can be bypassed to one’s advantage by simple contractual agreements with no proprietary effect.93 It is also clear that statutory exceptions to pari passu are encountered: the Insolvency Rules make set-off mandatory and, again, there is no contracting out of set-off within current corporate insolvency law. On the matter of contractual subordination,94 however, it is possible to make an effective agreement that one’s own debt will rank behind the other unsecured debts of a company. The ground-breaking decision here was Re Maxwell Communications Corporation plc (No. 2).95

The question before the court was whether the holders of convertible subordinated bonds might effectively contract not to be repaid until after the general unsecured creditors had been satisfied in full. Vinelott J did not see why bondholders, who had entered into an investment arrangement fully aware of the subordination of their claims, should be elevated to the level of the rest of the creditors at the time of insolvency. The bondholders had freely contracted with relevant knowledge and the court saw no reason to re-open the contractual bargain. Contracting out of the pari passu principle was thus allowed on the basis that a

92See discussion in B. G. Carruthers and T. C. Halliday, Rescuing Business: The Making of Corporate Bankruptcy Law in England and the United States (Clarendon Press, Oxford, 199 8) p p. 181 – 6.

93See British Eagle [1975] 2 All ER 390; MMI v. LSE [2001] 4 All ER 223 and Neuberger J’s ten propositions, concerning ‘deprivation provisions’ and the British Eagle principle; G. Stewart, ‘The British Eagle has Landed’ (2001) Recovery (December) 7–8; ch. 15

below. On whether direct payment clauses in construction contracts offend the pari passu principle see e.g. D. Capper, ‘Direct Payment Clauses and the Pari Passu Principle’ [1998] CfiLR 54; G. McCormack, Proprietary Claims and Insolvency (Sweet & Maxwell, London, 1997) pp. 17–25.

94 On contractual subordination see generally B. Johnston, ‘Contractual Debt Subordination and Legislative Reform’ [1991] JBL 225; F. Oditah, Legal Aspects of Receivables Financing (Sweet & Maxwell, London, 1991); R. Nolan, ‘Less Equal than Others: Maxwell and Subordinated Unsecured Obligations’ [1995] JBL 484; Ferran, Company Law and Corporate Finance, pp. 549–61; Ferran, ‘Recent Developments in Unsecured Debt Subordination’ in B. Rider (ed.), The Realm of Company Law (Kluwer, London, 1998). On trust subordination and contingent-debt subordination see Ferran, Company Law and Corporate Finance, pp. 561–4; K. Thomas and C. Ryan, ‘Section 459, Public Policy and Freedom of Contract’ (2001) 22 Co. Law. 199, 200–1.

95 [1994] 1 All ER 737, [1994] 1 BCLC 1.

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creditor would be permitted to waive a debt in full (or in part) and that this might be agreed in advance of, or after, a liquidation. After all, noted Vinelott J, a creditor could waive a right to prove in liquidation and could agree to postpone his debt after winding up had commenced. Other creditors, indeed, might have given credit on the understanding that another creditor’s subordination agreement would be effective. Vinelott J also noted that contractual subordination was effective in other leading common law and civil law jurisdictions96 and he considered that, given that such agreements were recognised as effective, to strike them down would be a triumph of form over substance97

What may be difficult to deny is the value of subordinated borrowing as a form of corporate finance. Subordination may be useful in a number of circumstances,98 notably: to allow shareholders or directors to inject funds into a company where existing creditors will not allow further unsubordinated borrowings; to allow parent companies to enhance the credit of a subsidiary that is issuing securities (so that an appropriate rating for the securities will be obtained); to allow companies to appeal to investors who seek high incomes in return for higher risk bearing; and to allow a bank to issue funds for treatment as capital for capital adequacy purposes.

Why, however, allow contracting out of pari passu on subordination but not on set-off or more generally? The key consideration is fairness. On this matter the courts have consistently taken the view that an

96 For example, Australia and New Zealand: see Ferran, ‘Recent Developments’, pp. 206–9 for a discussion of provisions and case law.

97 See also SSSL Realisations (2002) Limited (in liquidation) and Save Group plc (in liquidation) [2004] EWHC Ch 1760: see G. Stewart, ‘Legal Update’ (2004) Recovery (Winter) 6. Lloyd J decided that where a parent company had covenanted not to prove in a subsidiary’s liquidation until the claims of a senior creditor had been met in full, the British Eagle principle did not prevent contractual subordination even though the parent company was in liquidation and its creditors stood to suffer from the subordination. The judge stated that the pari passu principle had to be considered separately in relation to the insolvencies of the parent and of the subsidiary and that the parent’s creditors were bound by the consequences of the parent’s agreement to subordinate its claims to those of the senior creditor in the liquidation of the subsidiary. (Other arguments relating to the subordination arrangements – e.g. that they resulted in the parent company creating a (registrable) charge (over book debts) or that the parent’s liquidator might be entitled to disclaim them as ‘onerous property’ under IA 1986 s. 178(3)(a) – were also not upheld by Lloyd J. The judge’s s. 178 ruling, inter alia, was upheld by the Court of Appeal: see Squires (Liquidators of SSSL Realisations (2002) Ltd) v. AIG Europe (UK) Ltd [2006] BCC 233.)

98 See Ferran, ‘Recent Developments’, p. 201.

agreement that purports to improve the position of a creditor who would normally be subject to the pari passu rule will not, for reasons of public policy, be effective when the debtor company is in liquidation.99 Subordination, as mentioned above, however, has been seen, notably by Vinelott J in the Maxwell Communications case, as worsening only the position of the contracting party and, accordingly, as a manoeuvre involving no unfairness to other creditors.100 This would be the case if such contracts could not be terminated or adjusted in the periods leading up to insolvency.

It is possible, however, to think of circumstances in which, under current conditions, unfairness could be occasioned by use of a subordination agreement. If bank A agrees to advance funds to company B in difficult times and agrees to subordinate its debt to those of creditors C, D and E, creditors C, D and E may be inclined to increase their lending to company B in the knowledge that A’s advance is subordinated to their own claims.101 If, at a later date, A renegotiates the terms of its loan to B and ends the subordination, lenders C, D and E may have been led to make loans available in unfair conditions. If, in the alternative, the debtor company seeks to make payments to the allegedly subordinated creditor, the unsubordinated unsecured creditors are poorly positioned to protect their own interests as they are not parties to the subordination agreement and the doctrine of privity of contract will rule out enforcement against the company.102 Nor do arguments that contractual subordinations constitute waivers of statutory rights give the unsubordinated creditors any rights of enforcement or allow them to prevent variations in the terms of the subordination agreement.103 The potential to subordinate at

99See British Eagle [1975] 2 All ER 390.

100For Commonwealth judgments consistent with the line of Vinelott J in Maxwell Communications see Horne v. Chester & Fein Property Development Pty Ltd and Others (1986–7) 11 ACSR 485; Ex parte de Villiers, Re Carbon Developments (Pty) Ltd (in liquidation) [1993] 1 SA 493.

101On reliance on subordination by third-party creditors see Nolan, ‘Less Equal than Others’, p. 495, who argues that there is little that third-party creditors can do to protect themselves against variations in subordination terms. The advent of liquidation should, however, prevent variations after the start of the winding up: see Ferran, ‘Recent Developments’, p. 214.

102See Nolan, ‘Less Equal than Others’, p. 495; Dunlop Pneumatic Tyre Co. Ltd v. Selfridge & Co. Ltd [1915] AC 847 at 853.

103See Nolan, ‘Less Equal than Others’, pp. 496–7, who also reviews arguments that unsubordinated creditors might be able to secure damages from a liquidator who distributes in breach of valid contracts of subordination and arguments that restitution could be sought from subordinated creditors who have received funds contrary to the terms of the subordination agreement: see Ministry of Health v. Simpson [1951] AC 251.

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will creates uncertainties in the lending regime, it makes the task of liquidation more complex and this, in itself, will increase costs. Where lenders C, D and E gain the relevant information on subordination (or non-subordination) by A, they are likely to increase their interest rates to reflect any uncertainties in the system. Moving beyond a simple subordination agreement – in which a creditor agrees to rank behind all other creditors of a particular debtor – that creditor may wish to agree to rank behind some, but not all, of the other creditors.104 A group of creditors, indeed, may seek to agree a ranking order amongst themselves, so that, for example, A, B and C agree to rank behind all other general creditors but to rank between themselves, A first, B second and C last. The central issue here is whether the British Eagle ruling is offended by such arrangements and parties are seeking to opt out of pari passu to their own advantage. Where a creditor agrees to subordinate to some, but not all, other creditors, it is arguable that the pari passu principle is not breached because the subordinator gains no advantage over parties who are not involved in the subordination agreement. Where, as in the example of A, B and C above, a ranking order is agreed, third-party creditor interests are not prejudiced but A will gain a priority advantage over B and C. This is a consensual agreement, however, that has been treated in Commonwealth case law as not infringing the public policy of the pari passu rule.105

Deferred claims

Claims may be deferred by statute, that is placed in priority below the claims of other creditors.106 Thus section 215(4) of the Insolvency Act 1986 provides that ‘where a court makes a declaration under [sections

104See Ferran, Company Law and Corporate Finance, pp. 554–6.

105See Horne v. Chester & Fein Property Development Pty Ltd and Others (1986–7) 11 ACSR 485, discussed in Ferran, Company Law and Corporate Finance, p. 555. See also US Trust Corporation v. Australia and New Zealand Banking Group (1995) 17 ACSR 697.

106See Finch, ‘Is Pari Passu Passé?’, p. 199. See generally Goode, Principles of Corporate Insolvency Law, pp. 198–200. Goode notes the development in the USA of the doctrine of equitable subordination but suggests that in England the terms of the Insolvency Act 1986 give the courts the powers they need. On the doctrine of equitable subordination and inter-company loans see ch. 13 above. See also Justice, Insolvency Law: An Agenda for Reform (Justice, London, 1994) p. 25. For a discussion of an adjustable priority rule involving the deferral of secured claims to the unsecured claims of non-adjusting parties see ch. 15.