UK: Two Bites At The Cherry

Last Updated: 1 February 2010
Article by Rita Lowe, Martin Brown and Inga West

The rule in Cherry v Boultbee (the "Rule") had all but disappeared from reported cases in this jurisdiction for more than half a century until 2006 when it was revived in the Court of Appeal, with potentially dramatic consequences for those within the sphere of influence of insolvent companies. Last month, two more cases bolstered the rather obscure Rule's new lease of life. The parties in both Cattles Plc v Welcome Financial Services Ltd & Ors [2009] EWHC 3027 (Ch) and Mills, Bloom & Ors (as joint administrators of Kaupthing Singer and Friedlander Ltd) v HSBC Trustee (C.I.) Ltd & Ors [2009] EWHC 3377 (Ch) accepted (for the purposes of their respective High Court hearings) the Court of Appeal's 2006 interpretation of the Rule in Re SSSL Realisations (2002) Ltd [2006] Ch. 610, but sought a ruling on whether the non-compete clauses in their respective finance documents evidenced a sufficiently clear intention to oust the Rule's effect in the calculation of dividends payable to creditors who are also debtors of the insolvent company.

The Rule in Cherry v Boultbee

The Rule is sometimes referred to as a "right of quasi-retainer", or alternatively the "fund ascertainment principle". It can be briefly summarised as the principle that no one should be admitted to share in the distribution of a fund until he has discharged his obligation to contribute to the fund.

At first sight, the principle looks similar to a right of set-off, but it is not. The Rule can only apply where there is no set-off, because where set-off (such as insolvency set-off) applies, the Rule is displaced. The Rule can also be displaced by clear contractual intention, but it has often been problematic deciding whether such a clear intention has been demonstrated, especially since the Rule's legal characteristics are hard to describe and do not fit easily within common definitions such as "asserting" or "enforcing" "rights", "security" and/or "claims".

Chadwick LJ in SSSL described the Rule as follows:

"(1) The general rule applicable in the distribution of a fund is that a person cannot take an aliquot [i.e a defined] share out of the fund unless he first brings into the fund what he owes. Effect is given to the general rule, as a matter of accounting, by treating the fund as notionally increased by the amount of the contribution; determining the amount of the share by applying the appropriate proportion to the notionally increased fund and distributing to the claimant the amount of the share (so determined) less the amount of the contribution...

(2) That general rule is applicable not only where the claimant (X) is indebted to the fund but also where the fund has a right to be indemnified by X against a liability which the fund may be required to meet in the future, as surety for a debt owed by X to a creditor (Y). It is not necessary that the liability to Y has been satisfied out of the fund: it is enough that it may have to be satisfied in the future...

(3) The general rule – as applicable to a case where the fund has a right to be indemnified by X is not displaced in a case where the claimant (X) is in bankruptcy..."

Mills & Ors v HSBC Trustee (C.I.) Ltd & Ors

KSF went into administration owing its subsidiary, Funding, GBP242,568,988. Funding also went into administration owing HSBC Trustee (the "Trustee") GBP240,330,000, which had been guaranteed by KSF.

The Trustee proved for the full amount in both KSF's and Funding's respective administrations. Funding submitted a proof for its debt in KSF's administration. The rule against double proof prevented KSF from setting off its indemnity claim against Funding (which arose from its guarantee of Funding's liability to the Trustee) in accordance with the usual insolvency set-off rules.

KSF's Administrators gave notice under r.2.68 of the Insolvency Rules 1986 that they intended to make a distribution in the administration. KSF's Administrators sought to apply the Rule to Funding's claim against KSF. In that event, KSF's fund of assets available for distribution to creditors would be notionally increased by the amount of the debt contingently due by Funding to KSF, but the dividend (calculated on the notionally increased fund) due from KSF to Funding would be reduced by the same amount (see the method described in (1) above).

Funding had no significant creditors other than the Trustee, who stood to lose the ability to recoup a significant part of its debt if Funding's dividend was reduced by the Rule. It was in the Trustee's interests to establish that the Rule had been excluded or should be applied differently. Bound by the method of application settled by the Court of Appeal in SSSL (for the purposes of the High Court hearing), the Trustee therefore sought to argue that the non-compete clause contained in the finance documents excluded the application of the Rule.

The Chancellor held that while an express reference to the Rule was not required to exclude it, a clear intention had to be demonstrated in the wording of the contract. He then went through the non-compete clause, bit by bit, taking a literal interpretative approach to the meaning of the words and the legal characteristics of the Rule, and concluded that the relevant non-compete clause did not evidence a clear intention by the parties to exclude the operation of the Rule.

Cattles Plc v Welcome Financial Services Ltd & Ors [2009] EWHC 3027 (Ch)

The Cattles case involved a group of companies that was seeking to restructure its finances. In order to do so, it became necessary to establish certain creditors' entitlements if the group companies were to go into insolvent liquidation. As with Mills, the case involved a parent and its subsidiary, various banking facilities, and some notes and bonds, some of which had been guaranteed by various group members. Also as in Mills, the parties considered themselves bound by the SSSL interpretation of the Rule, at least in the hearing before the High Court, and so they, too, sought to establish whether the various non-compete clauses contained in the several finance documents excluded the operation of the Rule. The Judge's finding on this point was obiter but he thought it appropriate to give reasons for the purposes of a subsequent appeal.

HHJ David Cooke referred to the modern approach of the courts to construction of documents contained in the principles of construction set out by Lord Hoffmann in Investors Compensation Scheme v West Bromwich Building Society [1997] UKHL 28. Cooke HHJ, differing from the Chancellor's approach in Mills (whose judgment was published after Cattles), took a more commercial view of the parties' intention as evidenced by the non-compete clauses and decided that the parties had effectively ousted the application of the Rule.

Comment

The approaches taken to contractual interpretation by the two judges in Cattles and Mills are completely different: the literal approach of the Chancellor in Mills contrasts with HHJ Cooke's commercial approach in Cattles. Obviously arguments relating to contractual interpretation depend upon the drafting of a particular clause, and so neither case can provide an exact answer to other cases unless an identical clause is being considered. However, an appeal to settle the correct approach to contractual interpretation in these circumstances is highly desirable in the interests of establishing some certainty, especially as the current economic climate is likely to produce more corporate insolvencies where the argument of whether the Rule has been excluded or not will be repeated. As in these two cases, and in SSSL before them, the effect of applying the Rule often produces big winners and losers. The issue is not likely to go away.

The other interesting aspect of any appeal will be the opportunity to review the Court of Appeal's finding in SSSL on how the Rule should be applied, particularly with respect to the amount of an indemnity liability contribution that is required to be brought into account where the guarantor is insolvent. As SSSL was a Court of Appeal decision, a "leapfrog" appeal to the Supreme Court will be necessary, and we understand that leave to apply for such an appeal has been given. We further understand that permission to appeal was also given in Cattles.

It seems that there's life left in the old Rule yet.

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 28/01/2010.

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