Strictly necessary? Two aspects of strict liability in insolvency law and the law of trusts

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1 May CHANCERY COMMERCIAL NEWSLETTER Strictly necessary? Two aspects of strict liability in insolvency law and the law of trusts In this newsletter, Ian Clarke and Henry Webb consider two aspects of the civil law which involve strict liability one imposed by Parliament and the other by equity. For those who have not met Henry, we are pleased to announce that he joined Chambers in October following his successful completion of his pupillage with us. Prior to pupillage Henry obtained a law degree and the BCL degree whilst at University College, Oxford. He followed Hugh Jackson, Mark Warwick and Ian Clarke in pupillage and now practises in all areas of work undertaken by Chambers. Romie Tager Q.C. Wither the MBO? Management buy outs after Churchill v. First Independent Factors and Finance The sanctions imposed on those who, without leave, act as directors or take part in the promotion, formation or management of a phoenix company (i.e. one with a name the same as or suggesting an association with a company in insolvent liquidation) and who were directors or shadow directors of that insolvent company are both criminal 1 and civil, the latter involving joint and several liability with the phoenix company for its debts. 2 An individual can protect himself against those sanctions by obtaining the leave of the Court so to act 3 or by bringing himself within one of the excepted cases set out in rules of the Insolvency Rules Before considering those rules, it should be noted that the provisions imposed by Parliament to regulate Insolvency Act 1986, s. 216(4). Ibid., s. 217(2). Ibid., s. 216(3). MEMBERS: ROMIE TAGER QC AJMALUL HOSSAIN QC JEREMY COUSINS QC MARK WARWICK PHILIP KREMEN STEPHEN BOYD JONATHAN FERRIS HUGH JACKSON NEIL MENDOZA IAN CLARKE STUART HORNETT JULIETTE LEVY GARY BLAKER DUNCAN KYNOCH RICHARD CLEGG JUSTIN KITSON JONATHAN McNAE ZOË BARTON HENRY WEBB CLERKS: GREG PINER PAUL BUNTING

2 phoenixism apply whether the phoenixism is good or bad 4 (the latter being a phoenix situation which represents an abuse of corporate limited liability, to the detriment of creditors). Moreover, bad phoenixism remains a significant problem. 5 Two excepted cases merit consideration. The first excepted case IR applies where the successor acquires the whole, or substantially the whole of the business of the insolvent company from that company s insolvency practitioner and the provisions of the rule are complied with as to the giving of notice to creditors. IR 4.228(3) states that the notice may name a person to whom section 216 may apply as having been a director or shadow director of the insolvent company, and give particulars as to the nature and duration of that directorship with a view to his being a director of the successor company or being otherwise associated with its management. (Emphasis added.) In Churchill v. First Independent Factors and Finance Limited [2006] EWCA Civ 1623, the Court of Appeal (Ward, Jonathan Parker and Moore Bick L.JJ) was asked to construe IR and answer the question whether a successor company could give an effective notice where the directors of the liquidating company were already directors of the successor company. (The basic facts of Churchill were that the successor company was incorporated with a prohibited name on 18 January 2001 with the same directors as the liquidating company and immediately began trading. The liquidating company did not enter CVL until 3 July Notice under the Rule was given sometime within the specified 28 day period after the conclusion of the successor company s acquisition of the liqudating company s business on 18 October 2001.) The Court of Appeal (in a reserved judgment on a second appeal) held, inter alia, that the notice procedure under IR was not capable of permitting those who were, at the time, already directors of the successor company or otherwise involved in its management so to act and avoid the sanctions imposed by the Insolvency Act. Rule required that any notice must be given to [the] creditors [of the liquidating company] before the person in question starts to involve himself in the management of the successor company (per Jonathan Parker LJ at paragraph 45). The effect of this decision is such that many who thought they had the protection of notices under this rule are mistaken. Support for this construction was also derived from the provisions of IR 4.229, the second excepted case which I propose to consider. This rule allows a director or shadow director of the liquidating company to apply for the leave of the Court not 4 5 Ad Valorem Factors Limited v Ricketts [2004] 1 All ER 894 (CA) Modern Company Law for a Competitive Economy Final Report The Company Law Review Steering Group,

3 later than 7 days from the date on which the company went into liquidation 6. If he does so, then from the day on which the liquidating company went into liquidation until the determination of the application or the expiry of a period of 6 weeks (whichever is the shorter) 7, he may act in any of the ways mentioned in section 216(3) without being subject to the sanctions which would otherwise be imposed. The provisions of this excepted case are clearly therefore retrospective. This may be contrasted with the prospects of obtaining retrospective leave from the Court under any application in ESS Productions Limited v Sully 8, Arden LJ expressed (at [84]) the provisional view (acknowledging that the point had not been fully argued) that it was likely and certainly possible that the Court would not give leave with retrospective effect. What are advisers to those who wish to achieve an MBO to make of this? Clearly they must advise those who wish to act in any way that would be caught by section 216(3) that they face three options (1) where appropriate, apply to the Court under IR for leave and take advantage of its retrospective effect (2) apply to the Court under section 216(2) for leave if IR is not available or (3) do nothing, and be exposed to the consequences that flow from an infringement of section Clearly, those that are already acting in breach of section 216 whether erroneously in reliance on a notice under IR or not only have options (2) or (3) open to them, unless the Court can be persuaded that there are circumstances in which it can and should extend the 7 day period prescribed under IR What criteria is the Court going to apply in determining whether to give leave? In Penrose v Secretary of State for Trade and Industry 10, Chadwick J. considered that the District Judge from whom he was hearing the appeal had erred in principle in rejecting the application for leave. The District Judge s reasons that the failure of the liquidating company had come about because of the directors inexperience and lack of capital (a feature common to the new company, as well) were rejected. Moreover, the considerations that would apply in an application for leave under the Company Directors Disqualification Act 1986 were held to be inappropriate, the provisions of section 216 being imposed for a different purpose. Chadwick J. identified them in part with reference to IR 4.228: namely, (a) to ensure that the assets of the liquidating company were not acquired at an undervalue and (b) to alert the creditors of that company to the change in corporate vehicle and thus to disclose the phoenix as such. To that Chadwick J. added the rider that the purpose of the Under Insolvency Act 1986, s.247 this is the date of the resolution for voluntary winding up or the date of the winding up order. In the former instance, the date on which the 7 day period commences is thus capable of some selection. That 6 week period may be extended see Re Bonus Breaks Limited [1991] BCC 546. [2005] BCC 435. It may be some comfort to learn that the liability imposed by section 217(2) only arises during breach of section 216 ESS Production Limited v Sully [2005] BCC 435, 75. [1996] 1 WLR

4 section was also to ensure that there were no factors present which would lead to the conclusion that the applicants were unfit to be concerned with the management of the company. 11 (In Penrose, there was no such evidence and under capitalisation itself was not thought to be a good basis to refuse leave; in Bonus Breaks, supra. Morritt J had not been required to consider whether he would have granted leave in the absence of the undertakings to maintain the company s capital.) It would thus appear that provided these factors are addressed or absent (in the case of factors which would indicate that the applicants were unfit), the Court will give leave. Thus, an applicant for leave should consider (a) adducing evidence as to the value of the business which is to be transferred and the value to be given for that business and, if the same has been marketed, some details of the period and manner of that marketing and (b) (depending on the facts of the case) adducing evidence as to the manner in which it is proposed that the second purpose (alerting creditors) is to be met. This may require undertakings to the Court. As to value, it should not be assumed that the mere say so of the insolvency practitioner concerned will necessarily be good evidence of sale other than at an undervalue. The friendly officeholder is a feature of phoenixism and should not be overlooked. 12 Clearly, many factors might indicate unfitness and the Court retains the discretion under IR to call upon the liquidator or former liquidator of the liquidating company to report to it. This discretion was exercised in both Penrose and Bonus Breaks, although in the former that may have been because, at the time of the application, there was no evidence in support. Whether the Court would seek to exercise this power in every case in the future may be questionable; a properly constituted application supported by sufficient details may give the Court the comfort it seeks. What would the Court look for in such an application? The answer must be evidence that addresses the evil to which the provisions are directed. An application by an MBO team with an explanation of the reasons for failure of the liquidating company 13 which does not indicate unfitness and supported by a coherent plan to take the business forward would, I suggest, take the applicants a substantial way towards showing the Court that it ought to grant leave. Bearing in mind that phoenixism can be both good and bad, the evidence must demonstrate the former if only by showing the absence of the latter. In matters where the information is sensitive, a practice akin to the confidentiality afforded to reports made in the administration of companies may develop. Can such an application be made prospectively, prior to but in anticipation of an infringement of section 216 (where, for example, the old company has yet to go into Penrose, at page 491D. The Cork Report, Cmnd 8858, 1813, notes this as an aggravating feature. A feature of both Penrose and Bonus Breaks. 4

5 insolvent liquidation a pre requisite for liability under section 216)? The point is not without uncertainty; for my part, I would suggest that it can, provided the application is company specific and not likely to infringe the principle in Re Lightning Electrical Contractors Limited 14 that the Court will not give blanket leave and requires an informed decision about each particular company concerned. What attitude the Secretary of State for Trade s adviser takes on this remains to be seen. Churchill has re affirmed the proposition that the Court is the principal gate keeper for regulating phoenixism; company directors and their advisers must therefore refocus on that aspect. A revision to this part of the Insolvency Rules, in the light of the decision in Churchill, is expected in the near future. IAN CLARKE 15 Footnote to Churchill: Notwithstanding that the Insolvency Rules are due for wholesale revision (and are currently out to consultation), the decision of the Court of Appeal has led the DTI to formulate a stand alone amendment to clarify the position post Churchill, which will be brought into effect before that revision takes place. The final text of the SI is not yet available but the new IR will require the potentially errant director still to give notice in a prescribed form and to publish it in the Gazette and to do so prior to acting in any of the ways that would otherwise be prohibited under section 216. It thus proposes to adopt a scheme consistent with the Court of Appeal s reasoning in Churchill that the notice must be prospective. I.J.C [1996] BCC 950. Ian was Counsel for First Independent Factors and Finance Limited in Churchill. 5

6 Strict Liability For Recipients Of Trust Property X steals C s money and gives it to D. D is innocent of any wrongdoing by X and thinks it is a gift. X disappears, or is not worth suing, and D has used the money to pay his outgoings. How then may C recover his money? We know from Lipkin Gorman v Karpnale Ltd [1991] 2 AC 548 (HL) that C may bring a claim for restitution arising from unjust enrichment against D. D has been directly enriched at C s expense and in circumstances where there has been no consent from C. C therefore has a personal claim, not dependent on tracing into any specific property, for the repayment of his money by D, the recipient of his property. The liability to repay is strict, subject to defences. Suppose X holds money on trust for C and in breach of trust pays the money to D. D is innocent of any wrongdoing by X and believes himself entitled to the money. X disappears or is not worth suing, and D has used the money to pay his outgoings. Can C recover the money using the Lipkin Gorman claim? The answer to this question is no: Re Montagu s Settlement Trusts [1987] Ch 264; Bank of Credit and Commerce International (Overseas) Ltd v Akindele [2000] 4 All ER 221 (CA). C has no cause of action against D unless he can establish the equitable wrong of knowing receipt. This distinction in respect of the rights of recovery of those who own property at law and those who own property in equity has come in for considerable judicial and academic criticism, but has remained the law: (Criterion Properties Plc v Stratford U.K. Properties LLC [2004] UKHL 28; [2004] 1 W.L.R at [4] (Lord Nicholls; Lord Walker agreeing); Twinsectra Ltd v Yardley [2002] UKHL 12; [2002] 2 A.C. 164 (Lord Millett); Lord Hoffmann "The Redundancy of Knowing Assistance" in Birks (ed.), The Frontiers of Liability (1994), 27 at p.29; Birks, Unjust Enrichment (2005), pp ). Administration of Estates However the limitation to a fault based remedy against the unauthorised recipients of trust property has never applied in the analogous situation where those entitled in the estate of a deceased person seek to recover assets that have been misapplied, from those in receipt. In Ministry of Health v Simpson [1951] AC 251 (HL) it was confirmed that the next of kin of the deceased were entitled to recover by a personal remedy against each of the beneficiaries who had received distributions under the will from the personal representative in breach of his fiduciary duty (because the will had subsequently been held to be invalid). There was no requirement to show that the beneficiaries had been at fault or that their conduct was unconscionable in any way. Equally, an unsatisfied creditor of a deceased may compel a beneficiary who has been paid in priority to him to refund the money, even though the money was paid and 6

7 received in good faith and without notice of the creditor s claim and the estate has been fully administered (March v Russell (1837) 3 M & Cr 31). The most likely basis for these claims is that in each case the property is paid away without the consent of the next of kin/creditor who is entitled to it in priority. Even if the recipient is not at fault, and even if he no longer retains the very property received, the recipient remains enriched by its value. The enrichment is at the expense of the next of kin/creditor because the beneficiary has intercepted a benefit which should otherwise have accrued to the claimant. This enrichment of the beneficiary remains extant unless and until the recipient can show a change of position or he refunds the property. Developments in Australia Such reasoning has recently been unequivocally accepted in Australia outside the realms of the administration of estates. In Say Dee Pty Ltd v Farah Constructions Pty Ltd [2005] NSWCA 309, unreported, the Claimant and Defendant entered into a joint venture to purchase and develop some land. The application for planning permission was made by the Director and controller of the Defendant, X, and was refused on the grounds that the development was too small. X was, however, told that permission would be granted if surrounding land were included within the development. X informed the Claimant that the permission had been refused but did not inform it of the potential for a development including the surrounding land. Subsequently X arranged for the surrounding land to be purchased by another company he controlled as well as by his wife and daughters. This was held to have been a breach of fiduciary duty by X. In relation to the liability of the wife and daughters, the New South Wales Court of Appeal held that, whether or not they had the necessary knowledge to establish the equitable wrong of participation in a breach of fiduciary duty, the wife and daughters each held half of their interests in the properties on constructive trust for the Claimant on the basis of a strict liability in unjust enrichment for the receipt of trust property: But in the absence of any High Court authority to the contrary, I see no reason why the proverbial bullet should not be bitten by this Court in favour of the Birks/Hansen approach. In my opinion there is support for the adoption of the restitutionary approach in Lipkin in the House of Lords and in the exposition on the subject by Hansen J in Koorootang On the foregoing basis, Mrs Elias and the two children are liable to account for any profit or benefit they derived from the acquisition of their respective interests in No. 15 as a result of Mr Elias' and Farah's breach of their fiduciary duties. They hold those interests on constructive trust for the joint venture. (Tobias JA at [234] [235]). 7

8 Money improperly paid from a company A recent case decided by Lawrence Collins J, Primlake Ltd v Matthews Associates [2006] EWHC 1227 (Ch), [2006] All ER (D) 395 (May), indicates that developments in this country may not be far behind and that momentum is building towards strict recipient liability in equity. The facts of the case may be simplified for these purposes as these: the Claimant company, which was in liquidation, brought proceedings against M, for whom the entire share capital of the Claimant was held as nominee, but who was not appointed an officer of the company. The director of the company, R, acting on instructions from M, paid sums to M or M s pension fund over a number of years, apparently for no consideration. Lawrence Collins J reviewed all the potential bases for the payments advanced by M and concluded that there was no legal justification for them. He held (at para. [334]) that M was liable for breach of his fiduciary duty as a de facto director of the company. Importantly, however, if he was wrong on this he held that M was liable as a constructive trustee on the basis of knowing assistance and dishonest receipt. He then held (at [335]): The prevailing view is that there is no separate cause of action for unjust enrichment as such, and that it is necessary for the case to be brought within one of the recognised restitutionary heads, such as money had and received, constructive trust, and resulting trust. In my judgment the authorities would justify the conclusion that Mr Matthews is liable for money had and received (and also, probably, as a trustee on resulting trust) on the basis of an absence of consideration in the sense of no legal basis for the payments: Woolwich Equitable Building Society v Commissioners of Inland Revenue [1993] AC 70, 197; Westdeutsche Landesbank Girozentrale v Islington LBC [1996] AC 669, 683 and 710; Guinness Mahon & Co Ltd v Kensington and Chelsea RLBC [1999] QB 215; Goff & Jones, Restitution, 6 th ed. Para This is significant for two reasons. Firstly, the analysis for the recovery of the money on a strict liability basis in restitution (unjust enrichment) follows immediately on from the analysis that M was liable in respect of the very same property in equity for knowing receipt. This reinforces the view that the equitable wrong of knowing receipt has in fact be covering much of the ground that can be dealt with by an alternative cause of action for strict liability (subject to defences) for the receipt of trust property. Secondly, if the reasoning is correct, it cannot be separated from the analogous situation in which the strict liability remedy has always been denied, that is unauthorised payments from an inter vivos trust. The reasoning is this: the recipient has been enriched by property which belonged in equity to the Claimant and is 8

9 therefore enriched at the Claimant s expense. Unless the recipient can establish a legal basis for the payment then, absence the change of position defence, it must be returned. Hence it may not be long before a case arises for decision which cannot be resolved on the established bases for liability for the receipt of trust property and which raises the question of strict liability on the Lipkin Gorman lines in stark contrast. It seems likely that in such a situation the courts in England may well also bite the proverbial bullet. HENRY WEBB 9

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