UK: Disclaimers In Insolvency and Debt Subordination: Trust, Contract Or Charge?

In the recent case of Re SSSL Realisations (2002) Ltd; Squires v AIG Europe (UK) Ltd (2006), a parent company ("Group") retailed petrol through stations owned by its subsidiary ("SSSL"), in relation to which AIG provided excise bonds to HM Revenue and Customs in respect of Group’s liability for excise duty. Group and SSSL indemnified AIG in this regard and the deed of indemnity subordinated sums owed by the indemnitors to AIG (including sums owed by SSSL to Group) to sums owed by SSSL to AIG until AIG was paid in full. Both Group and SSSL went into insolvent liquidation with SSSL owing substantial sums to its parent, Group.

The initial question to be determined was whether the deed of indemnity itself was an "unprofitable contract" within the meaning of the Insolvency Act 1986, s178(3)(a) such that it could be disclaimed by the liquidators of Group, thereby allowing Group to prove in the liquidation of SSSL. The consequence of such a disclaimer would of course be detrimental to AIG since the loss to AIG flowing from the disclaimer would only give AIG the right to prove for such loss in Group’s insolvent liquidation. After reviewing the, principally Australian, authorities on this point, the Court concluded that an unprofitable contract in this context is one which imposes future obligations, the performance of which may be detrimental to creditors of the company in liquidation. A contract is not unprofitable in this context just because it is disadvantageous. The critical feature is that performance of the future obligations in the contract will prejudice the liquidator’s ability to realise company property and pay a dividend to creditors in a reasonable time.

It was argued by the liquidators of Group that certain of the obligations (e.g. to provide cash cover on demand) did not necessarily crystallise upon the liquidation of Group and therefore remained to be performed in future. In this case, however, the Court of Appeal concluded that the deed of indemnity could not be disclaimed since its effect was not to impose future performance obligations or prospective liabilities but merely prevented Group from proving in SSSL’s liquidation. There could not arise a circumstance in which AIG would have been paid in full such that the restrictions in the deed would have fallen away (interestingly, had this possibility been present, the Court suggested the conclusion may have been different).

The result reached by the Court of Appeal in relation to disclaimer and the enforceability of the contractual subordination provisions meant that it was not necessary for the Court to consider in detail the question of whether the subordination provisions were void as creating a registrable charge (which was of course unregistered). This question has vexed commentators for some time and although the Court of Appeal only briefly expressed its view, it is submitted that this represents the correct approach, namely that typical "subordination trust" language extends only to amounts necessary to ensure the senior creditor is paid in full and that while the senior creditor will have a proprietary interest in the fund to an extent necessary to pay what is owed to it, this is as the beneficiary of a trust for such payment. A charge could only be established if it applied to all receipts by the junior creditor irrespective of the amount necessary to pay out the senior creditor. Interestingly (and perhaps controversially), Lloyd J at first instance had also indicated that he considered even if a charge was created in this manner, it was not registrable since the fund held by the junior creditor could not be considered to be a "book debt".

It was argued that AIG could elect to waive the restriction in the deed of indemnity so as to allow Group to prove in the liquidation of SSSL. The language of the indemnity was of a form typically used whereby no indemnitor was permitted to claim against any other indemnitor or to receive any payment from any indemnitor until AIG had been paid in full. This of course was intended to protect AIG against competing claims in respect of intercompany indebtedness owed between Group and SSSL. A further consequence however (which, as Chadwick LJ noted, may not have been considered by the parties when entering into the deed of indemnity) was that this provision also operated to protect creditors other than AIG from such competing claims. Having reached this conclusion, the Court held that it was not possible for AIG unilaterally to waive this restriction since it also operated for the benefit of each group company (as a creditor of the other) and for any other creditors.

It is submitted that this conclusion is correct. Like Chadwick LJ, the author suspects, however, that this consequence of what is a commonly used form of wording in multilateral guarantees and indemnities is frequently overlooked. Indeed, in this case it prevented AIG from acting in a manner it considered most beneficial to it, even though it would have considered the clause was intended to protect its rights!

Having reached these conclusions, it was not strictly necessary for the Court to consider the rule in Cherry v Boultbee. The Court did, however, do so in some detail. The rule arose out of cases concerning insolvent estates; however, it is now clear that it applies equally to cases involving double corporate insolvencies and the Court of Appeal reiterated that.

In essence, the rule prevents a person taking a share out of a fund (e.g. receiving a dividend as creditor in an insolvency) unless he first brings into the fund the amount that he owes to that fund. This applies distinctly from setoff (which would not apply where, for example, mutuality was not present due to the rule against double proof preventing a surety from proving in an insolvency of the principal debtor until the creditor has been paid in full, or where the requirements for equitable setoff were not present). Even if Group were permitted to prove in the insolvency of SSSL (contrary to the above conclusions), Group would therefore first be required to bring into account the full amount of its liability to SSSL (even although there was no set off applicable between these sums). That amount, in this case, exceeded the resulting dividend that would notionally be payable to Group and therefore a proof by Group would in any event be fruitless.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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