UK: Empty Second Charge Holder can Share in the Prescribed Part

Last Updated: 15 December 2010
Article by Martin Brown and Inga West

In the recent decision of Re PAL SC Realisations 2007 Ltd [2010] EWHC 2850 (Ch), the Court confirmed that a secured creditor of a company, which is in administration or liquidation, whose security is valueless, can release the security in its entirety and share in the "prescribed part" in respect of its (formerly secured) debt.

What is the prescribed part?

The "prescribed part" in insolvency proceedings is a share of the net proceeds realised from the sale of property covered by floating charges.  It is provided for by section 176A of the Insolvency Act 1986, which requires administrators, liquidators and receivers to set the prescribed part aside for distribution to the unsecured creditors.  The office holder is not permitted to distribute the prescribed part to the proprietor of a floating charge except insofar as it exceeds the amount required for the satisfaction of unsecured debts.

The prescribed part was created by the Enterprise Act 2002 as a quid pro quo for the abolition of Crown Preference.  In an administration, liquidation or receivership, preferential claims enjoy priority status, and are paid out of floating charge realisations ahead of any floating charge holders.  Preferential claims therefore reduce the returns to floating charge holders. 

Before 2002, certain debts due to the Crown, such as certain amounts of unpaid VAT and other tax, were preferential in insolvency proceedings.  They were referred to generically as "Crown Preference".  In 2002, Crown Preference (but not other preferential claims) was abolished.  Parliament decided that the benefit of the abolition of Crown Preference should not go to floating charge holders in the form of increased floating charge returns, but should instead be made available to the unsecured creditors.  Consequently, the prescribed part was introduced.  It was designed to prevent floating charge holders from receiving the benefit of the abolition of Crown Preference by ring-fencing a part of the floating charge realisations and requiring office holders to set the fund aside for distribution to the unsecured creditors. 

The size of the prescribed part is determined by a formula prescribed by the Secretary of State.  The formula is designed to produce an amount that is roughly equivalent to the average amount that would previously have been distributed to the Crown in respect of the former Crown preferential claims in an equivalent sized insolvency.  The formula comprises a sliding scale, which depends on the quantum of the net floating charge realisations, currently: (i) where the net property value does not exceed £10,000, 50% of that; and (ii) where the net property exceeds £10,000 in value, 50% of the first £10,000 in value and 20% of that part that exceeds £10,000 in value, subject to a maximum prescribed part of £600,000.

Previous case law

Prior to this case, there were two notable decisions concerning the prescribed part: Re Permacell Finesse Ltd (in liquidation) [2008] BCC 208 and Re Airbase Service (UK) [2008] 1 WLR 1516.  In those cases, the court held that a (fixed or floating) secured creditor whose security was not sufficient to satisfy the whole of its debt, and who continued to rely on its security for part of its debt, could not share in the prescribed part in respect of any shortfall that was not covered by the value of its security.

In respect of a floating charge holder, this was because the creditor remained a "proprietor of a floating charge", and section 176A(2)(b) of the Insolvency Act 1986 prohibits the office holder from distributing the prescribed part to the "proprietor of a floating charge". 

The reasoning in respect of a fixed charge holder differed slightly because of the drafting of the section: notwithstanding there was a shortfall in the value of the fixed charge holder's security, its debts could not be regarded as "unsecured" for the purposes of section 176A(2)(a) of the Insolvency Act 1986, which requires the prescribed part to be made available for the satisfaction of "unsecured debts".  The Judge concluded that the prescribed part provision was designed so as to exclude a secured creditor from participating in the prescribed part.  For these purposes, "secured creditor" is defined by section 248(1) of the Insolvency Act 1986, meaning a "creditor of the company who holds in respect of his debt a security over property of the company, and "unsecured creditor" is to be read accordingly."

Against the background of these two decisions in which secured creditors were not allowed to share in the prescribed part in respect of any shortfall in the value of their security, the outcome of this most recent case might appear surprising.

Facts

In Re PAL SC Realisations 2007 Ltd [2010] EWHC 2850 (Ch), there were three secured creditors, whose priority was governed by an intercreditor agreement.  When the company went into administration and the business was sold, the realisations fell short of the debt owed to the senior lender, leaving the private equity investors and management with empty security.  There were no creditors with preferential claims. The only return to the unsecured creditors was to be from the prescribed part. 

The security trustee, who held security on behalf of the private equity investors, released the security in its entirety (but not the underlying debt) and then mounted a claim to be allowed to share in the prescribed part.

The liquidators applied for directions. 

Decision

The Judge agreed with the security trustee.  He distinguished the facts of this case from Permacell and Airbase  because in both those cases, the secured creditor was continuing to rely on its security and seeking to share in the prescribed part in respect of a shortfall. The facts of  Re PAL SC were different because the secured creditor had surrendered its (albeit worthless) security in its entirety.

The Judge relied on the wording of Rule 4.88(2) of the Insolvency Rules 1986, which provides:

"If a secured creditor voluntarily surrenders his security for the general benefit of creditors, he may prove for his whole debt, as if it were unsecured".

He interpreted the last five words of the rule ("as if it were unsecured") to mean that in circumstances where a secured creditor voluntarily surrenders his security and proves for the whole debt, the debt becomes unsecured.

Extrapolating this reasoning to the definition of "secured creditor" in section 248(1) Insolvency Act 1986, which defines a secured creditor as "a creditor of the company who holds in respect of his debt a security over property of the company, and "unsecured creditor" is to be read accordingly", the Judge considered that as the identity of the creditor's debt had, following the surrender of its security, changed to that of an unsecured debt, so too must the creditor be regarded as an unsecured creditor.

It followed that as the creditor was, after the surrender of its security, an unsecured creditor with an unsecured debt, there was nothing in section 176A Insolvency Act 1986 that prevented it from sharing in the prescribed part.

Comment

Although this outcome might be regarded by some as surprising, we do not think that it offends the original statutory purpose of the prescribed part, which was to prevent floating charge holders from benefitting from the abolition of Crown Preference.  On these particular facts, the prescribed part has fulfilled its legislative purpose by preventing the distribution to the senior lender from being swelled by the abolition of Crown Preference. By contrast, the private equity investors were completely out of the money as secured creditors: they were never in line to receive any floating charge realisations.  To prevent such a creditor from participating in the prescribed part would seem to be going further than Parliament intended.

As the prescribed part is a relatively immature statutory creature, there are still a number of unresolved questions which have yet to receive judicial scrutiny. To consider just a few here:

Q  Would the outcome of this case be the same if the surrendering secured creditor was the senior lender with first priority instead of being a junior creditor? 

A The priority of the secured creditor ought to make no difference – the critical feature is that the secured creditor surrenders its security in its entirety and proves as an unsecured creditor in accordance with rule 4.88(2) Insolvency Rules 1986 (and equivalent rules for other procedures).

Q Is a secured creditor allowed to surrender its security and share in the prescribed part in respect of its (formerly secured) debt even where its security has some value, but the value is less than the dividend the creditor would receive by proving as an unsecured creditor and sharing in the prescribed part? 

A Any secured creditor can choose to surrender its security in its entirety and prove for its debt as if it were unsecured under Rule 4.88(2) Insolvency Rule 1986.  Applying the reasoning in Re PAL SC, suggests that such a creditor could choose to surrender and share in the prescribed part rather than rely on a low value security.  Re Permacell and Re Airbase still restrict such a creditor from doing both, however.

Q Where a junior secured creditor, whose security has no value, is required by an intercreditor obligation to turn over any distribution or dividend it receives to a senior creditor, would the junior creditor be allowed to surrender its security and share in the prescribed part even though its share would have to be turned over to the senior secured creditor?

A Applying a literal interpretation of section 176A and the reasoning in Re PAL SC, a junior creditor could surrender and share in the prescribed part notwithstanding that it was also required to turn over the dividend to senior secured creditors.  However, this would mean that the senior creditor would indirectly receive a share of the prescribed part, which is plainly contrary to the legislative purpose of the section.  It is unclear how a court would respond to these facts, but it is possible that a court may try to find a way to prevent this.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 10/12/2010.

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