The Litigator
Edition 11
“Debt is a prolific mother of folly
and of crime”
Losing on penalties
Rescue me
Unsecured creditors,
insolvency
and litigation
www.mills-reeve.com
Contents:
Welcome to the latest edition of
The Litigator.
I am writing this just as the Bank of England has initiated
quantitative easing so it seems appropriate that this edition of
The Litigator should look at the “credit crunch” and one of its
more common effects – insolvency.
3
Litigation at Mills & Reeve
4
“Debt is a prolific mother of
folly and of crime” – Disraeli
4
Losing on penalties
6
Rescue me
8
Unsecured creditors,
insolvency and litigation
12
Litigator shorts
One issue that frequently causes confusion is the various
different types of insolvency process and what they all mean,
particularly if you are a creditor. Lino di Lorenzo who specialises
in contentious insolvency work will provide a quick guide and
highlight the main differences between the various procedures.
We also take a look at statutory demands. Under the Insolvency
Act 1986 an unsatisfied statutory demand may be taken by the
court to be evidence of insolvency sufficient to found a windingup petition. But in what format should the demand be and what
should you do if you receive one?
Sandwiched between the doom and gloom Robert Renfree asks
why you can never win on penalties and looks at so-called
penalty clauses and the difference between those and liquidated
damages clauses.
Finally, the word is that litigation is counter-cyclical and will
always increase in difficult times. We look at the interrelationship
between litigation and insolvency.
I hope that you will find something of interest in this edition of
The Litigator. As usual, any feedback is always welcome and, if
there are any topics you would like us to cover in future editions,
then please contact me or your usual Mills & Reeve contact.
Helen Prandy
Editor
01223 222344
[email protected]
2
Key contacts:
Agriculture – Helen Prandy
Arbitration – Graeme Menzies/
Helen Prandy/Rachel Higgs
Banking and finance – Jamie Wheatley
Commercial contracts – Jamie
Wheatley/Rachel Higgs/Steve Allen
Company and corporate disputes –
Jamie Wheatley/Rachel Higgs/Steve Allen/
Graeme Menzies
Construction – Ed Callaghan
Debt Recovery – Lynne Lawn
Defamation – Graeme Menzies/Rachel Higgs
Education – Gary Attle/Helen Prandy
Employment – Nicola Brown/Gillie Scoular
Environmental – Beverley Firth/
Rebecca Carriage
Family and divorce – Nick Stone
Financial Services – Rachel Higgs
Litigation at Mills & Reeve
Long known for our litigation expertise,
we have over 100 litigators operating out
of 4 offices in Cambridge, Norwich,
Birmingham and London. We have now
also further extended our national
presence by opening offices in Leeds and
Manchester. The experience and strength
in depth of the firm’s litigation practice
encompasses an extremely wide range of
skills and work in the private and public
sectors. Our clients include banks,
corporates and institutions throughout the
UK and overseas.
We are also well known for our private
client work and our litigation skills have
developed alongside that practice to
provide litigation advice, where needed,
to high-net-worth individuals, trustees
and executors.
In addition to a wide range of experience
and skills among our litigators within the
firm, we also have strong international
links through our membership of the
State Capital Group*, which gives us
access to firms in every state of the US as
well as 55 countries worldwide. We have
been involved in a number of disputes
internationally where the assistance of
these firms has been invaluable. We also
have an alliance with Trask Britt, a
specialist intellectual property firm based
in Salt Lake City, Utah. The alliance means
we have the facility to provide clients with
immediate advice on intellectual property
matters in the US as well as the UK.
Fraud – Rachel Higgs/Ian Mayers
Our litigation expertise covers a wide
range of different areas. Set out here is a
list of key contacts. If you are unable to
find the specialism you need or want to
discuss the matter further please do not
hesitate to speak to your usual Mills &
Reeve contact. Otherwise contact:
Insurance/reinsurance – Neil Davis/
Peter Driscoll
Rachel Higgs in Norwich on
01603 693233 or e-mail
[email protected],
Health and safety – Ian Mayers
Injunctions – Jamie Wheatley/
Rachel Higgs/Steve Allen
Insolvency – Jamie Wheatley
Intellectual property/IT – Graeme Menzies/
Rachel Higgs
Licensing – Harriet Wells
Mediation – Graeme Menzies/
Rachel Higgs
Partnership disputes – Rachel Higgs
Pensions disputes – Rachel Higgs
Jamie Wheatley in Cambridge on
01223 222206 or e-mail
[email protected] or
Professional negligence – Rachel Higgs/
Helen Prandy/Steve Allen
Steve Allen in Birmingham on
0121 456 8343 or e-mail
[email protected].
Property disputes – James Falkner
* Member firms of the State Capital Group
practise independently and not in a relationship
for the joint practice of law.
Probate Disputes – David Catchpole
Regulatory – Ian Mayers
Shareholder disputes – Graeme
Menzies/Rachel Higgs/Steve Allen
3
“Debt is a prolific mother
of folly and of crime”
– Disraeli
Helen Prandy
01223 222344
[email protected]
A formal demand for payment of a debt is the foundation of a
compulsory winding-up petition or bankruptcy. In both cases,
the failure to respond to a formal demand for payment will be
taken as evidence that the debtor is unable to pay debts as they
fall due and this in turn will be treated as evidence of insolvency.
What is meant by a formal demand for
payment?
The answer to this very much depends on whether the money
is accepted as due or not. If it is then you either need to speak
to the creditor and see if a repayment plan can be agreed or
you should take professional advice from a qualified insolvency
practitioner on what to do next.
In corporate insolvency a creditor has two means available for
demanding repayment. The creditor may use Form 4.1 prescribed
by the Insolvency Rules which is known as a statutory demand.
Alternatively, it is sufficient simply to write to the debtor
demanding repayment. The critical difference between the two
methods is time. The prescribed form 4.1 requires you to give the
debtor 21 days to repay but a written demand for payment need
only give a “reasonable time” (which may be as little as a matter
of hours) for the debt to be repaid. The courts have held that
either type of demand, if unsatisfied, is sufficient as evidence
of inability to pay.
If you do not accept that the debt is due, is disputed or the
debt is accepted but you consider that the creditor demanding
the money owes you more than you owe them then the formal
demand may be challenged.
My customer owes me £300 can I make a formal
demand and wind him up?
Similarly, with a set-off or cross-claim this must be “genuine
and serious” and for an amount equal to or exceeding the
debt owed.
In order to found a winding-up petition the debt due must be
for more than £750. Moreover, it is only appropriate to use the
demand and insolvency procedure if the debt is undisputed.
The court has expressed extreme displeasure at using the threat
of insolvency as a means of collecting disputed debts. Where
a debtor is able to show that there is a genuine dispute over
payment the winding-up petition will be dismissed as an abuse
of process and the costs will be awarded to the debtor.
4
We have received a formal demand for payment
what can we do?
However, it is not enough simply to say that the debt is disputed.
There must be a genuine dispute on substantial grounds. There
must be sufficient evidence to persuade a court that objectively
there is a genuine dispute as to the company’s liability to pay
the debt. A mere honest belief that payment is not due will
not suffice.
Also check the form of demand you have received. Many
credit controllers prepare statutory demands themselves and
not infrequently use the wrong form. If you are invited to
apply to set the demand aside then you have been served
with the wrong form.
• A statutory demand is only
appropriate where the debt
exceeds £750 and is undisputed.
• Do not ignore a statutory demand
even if it is unfounded.
• The grounds for dispute must
be substantial. A mere honest
belief that payment is not due
will not suffice.
• A creditor who persists with a
statutory demand in the face
of evidence of a dispute is likely
to be found to have abused
the process of the court.
Of course there is a genuine dispute so now
what do we do?
DO NOT DO NOTHING. If you do nothing then the
winding-up petition may be presented and the effect of
this on a company can be substantial. It will freeze its bank
accounts and could cause any transactions entered into
after presentation of the petition to be void. It will also cause
untold damage to the commercial reputation of the company.
The first step is always to write to the creditor responding to
the formal demand. If there is a genuine dispute, cross-claim
or set-off then details of this should be set out. The more detail
you can give (including referring back to meetings or
documents where these were discussed) the better.
The letter should ask for an undertaking that no petition
will be presented and should make it clear that if the creditor
does persist then an injunction will be sought to restrain
presentation of the winding-up petition.
Unlike the case of statutory demands against individuals there
is no procedure for setting aside demands against companies
so the only alternative is to seek an injunction from the court.
This is expensive but if there is a genuine dispute about the
debt then you should recover most of the costs of the
injunction from the creditor, particularly where it has been
very clear from the start that such a dispute exists.
5
Losing on penalties
A contractual term requiring a party to pay
compensation for its breach of contract
can be interpreted by a court as either a
“penalty”, or as a “liquidated damages”
clause, depending on the factual
background and the contractual wording.
Penalty provisions are unenforceable,
liquidated damages provisions are
enforceable so long as they do not in
fact amount to a penalty.
The “classic” statement of the law is that
to be enforceable as a liquidated damages
provision, the clause must be a genuine
pre-estimate of the potential damage
resulting from the breach. The courts have
also generally been more willing to uphold
clauses freely negotiated between parties
of equal bargaining strength.
6
This article examines a range of situations
where these rules have been applied
in practice.
‘Take or pay’ clauses
A manufacturer had supplied chemical
dispersant products to its customer.
The relevant contract provided:
“Article 5.3. During the term of this
Agreement the Buyer will order the
following minimum quantities of
Products…
Article 5.5. Take or pay: the Buyers
collectively will pay for the minimum
quantities of Products as indicated
in this Article at 5.3 … even if they
together have not ordered the
indicated quantities during the
relevant monthly period.”
The first question for the court was
whether the clause was even capable of
being a penalty. The judge referred to an
earlier decision that a clause could not be
a penalty if payment was triggered by an
event other than a breach of contract, a
point worth considering when drafting or
interpreting any clause of this kind. Here,
however, the judge ruled that payment
would always be triggered by a breach of
clause 5.3, and could therefore potentially
be a penalty.
However, on the facts, the judge found
that the clause had been freely negotiated
between parties of equal bargaining
power, and was a genuine attempt to
compensate the seller for the effort it was
making to ensure that minimum levels of
a scarce chemical were available to its
customer. The clause was therefore an
enforceable liquidated damages provision.
Robert Renfree
01223 222212
[email protected]
• Contractual calculations
of damages for breach
will be unenforceable
if they amount to “
a penalty”.
• Generally a clause
negotiated between
parties of equal
bargaining strength
will not be considered
a penalty.
• Keep evidence to justify
the basis of a liquidated
damages clause.
Interest provisions
Settlement agreements
In 2003 the Court of Appeal considered a
clause providing for interest to accrue on
late payments at 5 per cent per week, (an
annual interest rate of around 260 per
cent). A basic debt of around £5,000 rose
to £20,000 after interest. Despite the fact
that the parties (Barnet Football Club and
its clothing supplier) had equal bargaining
strength, the absence of evidence that the
interest rate was a genuine pre-estimate,
coupled with its punitive rate meant that
the provision was a penalty.
In 2006 the Court of Appeal interpreted a
settlement agreement, where a Mr Zhang
had accepted US$40,000 in settlement of
a potential claim against CMC group, on
condition that he agreed not to harass
CMC’s employees or make unfavourable
allegations against it. Part of the letter to
Mr Zhang detailing the settlement read:
At the other end of the scale, the High
Court has upheld a provision for interest
of 1 per cent above base rate on late
payments as a genuine pre-estimate on
the basis that it was a “modest” increase.
“For the avoidance of doubt, you hereby
agree that any breach of this settlement
agreement will render you liable to us
for the sum of US$40,000 …”
After signing the letter and accepting the
money, Mr Zhang continued to make
allegations against CMC and to contact
its employees. CMC issued a claim against
him for $40,000 under the agreement.
The court held that this sum was a penalty
as there was no evidence of it being a
genuine pre-estimate of the loss CMC was
likely to suffer as a result of the breaches.
The court observed that CMC still had a
substantial benefit from the settlement,
which prevented Mr Zhang from suing it.
Conclusions
There is no “one size fits all” approach
to determining what kind of clause might
constitute a penalty. It is necessary to both
read the clause and consider the context
within which it was negotiated. When
drafting contracts, keep evidence showing
how your clause was a genuine
pre-estimate of loss; the court will base
its decision on information available to
the parties at the time the contract was
formed. That way you keep the judge
“on side”, and hopefully do not lose
on penalties!
7
Rescue
me
The current credit squeeze has led to a huge rise in
the number of companies going into administration
or liquidation. This article gives a brief overview of the
corporate insolvency processes in England and Wales
and compares the approach in the United States.
Lino di Lorenzo
01223 222311
[email protected]
Administration
The last quarter of 2008 saw an increase of
251 per cent in administrations in England
and Wales compared with the last quarter
of 2007 and the process has claimed some
high profile names, perhaps most notably,
Woolworths. However, what is involved in
an administration is not always understood.
When a company enters administration,
an administrator takes over the
management from the board of directors
with the objective of either trying to
rescue the company as a going concern
or of achieving a better realisation for
creditors than would be possible in a
liquidation. An administrator can be
appointed by the directors, by the holder
of qualifying security or by creditors.
The administrator can trade all or part
of the business whilst it is restructured or
sold to meet creditors’ claims. During this
time a “moratorium” prevents creditors
from enforcing security rights or taking
any legal action against the company.
8
The media often confuse administration
with receivership or administrative
receivership. There is no requirement for
a company in receivership to be insolvent
and it is not an insolvency process.
However, it is usually a sign that the
company is in financial trouble. The
appointment of receiver is made by a
secured creditor (usually a bank) to
realise its security and will often force
the company into administration or
liquidation later on.
Creditor arrangements
A company can reach an agreement with
its creditors over payment of existing
debts as a means of avoiding formal
insolvency. A Company Voluntary
Arrangement (CVA) is effectively an
agreement with creditors to accept a
lower level of repayment, over a period
of time, with the debts being written
off in full at the end of the CVA.
A CVA approved by 75 per cent in value
of voting creditors, binds all unsecured
creditors (even those who rejected it) but
not secured creditors unless they agree.
There is no moratorium whilst a CVA is
proposed, although small companies can
apply to court for one.
An insolvency practitioner supervises a
CVA but the company can trade on and
directors remain in control.
Liquidation
Unlike administration, liquidation is always
a terminal process. When a company goes
into liquidation, it will cease trading
altogether. The liquidator will wind up the
company’s affairs, realise any assets and
distribute them to creditors according to
a fixed order of priority. The company will
then cease to exist.
There are two forms of liquidation in
England and Wales:
• Compulsory: where a company is put
into liquidation by the court, usually
following a creditor’s petition; and
• Voluntary: where 75 per cent of the
members resolve to put the company
into liquidation. If the company is
insolvent, this will be a Creditors’
Voluntary Liquidation. A Members’
Voluntary Liquidation by contrast can
only proceed if the company is solvent.
• The emphasis in the
UK is now much more
towards a rescue culture
for insolvent companies.
• Unlike liquidation
administration is not
necessarily a terminal
process.
• Chapter 11 protection
in the US remains a
more flexible process
than any of the
alternatives available
in the UK.
The United States
A “Chapter 11 Bankruptcy” in the United
States is similar to an administration.
The chief objective is also to allow the
company breathing space whilst it is
reorganised. There are, however, some
significant differences:
• unlike administration, the company’s
directors remain in control and can trade
on, subject to oversight from the court;
• companies can continue to borrow,
creating a market for unsecured “debtor
in possession” lending ranking above
other unsecured debts;
• the company can reject contracts which
are still to be performed by both parties.
An administrator is still bound by such
contracts; and
• Chapter 11 protection cannot trigger
termination of a contract (except certain
finance contracts). English contracts
frequently contain effective termination
provisions on administration.
A Chapter 7 Bankruptcy in the US is
equivalent to an English liquidation.
In the US, where the Chapter 11
procedure has been in place since 1978,
the process is more geared to rescuing the
debtor if at all possible – exemplified by
the directors remaining in control and
being able to obtain further funding
whilst being protected from creditors.
By contrast, in the UK, insolvency has
tended to be regarded more as a terminal
process involving “punishment” of all
those involved. However, the Enterprise
Act 2002 has placed an increased
emphasis on rescue in insolvency although
there is still less flexibility than under
Chapter 11.
The current testing economic conditions
will be a guide to how well the Enterprise
Act has actually created the more
entrepreneurial, “rescue” culture that it
was partially designed to encourage.
9
Unsecured creditors,
insolvency and litigation
Helen Prandy
01223 222344
[email protected]
10
In light of increasing bad news about the
economy and evidence of a significant
recession it is perhaps not surprising that
litigation is beginning to boom. While
times are good companies tend to prefer
to spend time and money on expansion
or development but when times are bad
every penny counts, every debt is chased
and every contract reviewed.
Most trade creditors are unsecured. That
means that they are just one of probably
a large number of creditors who rank
behind secured creditors in an insolvency.
Secured creditors tend to be banks or
other lenders who have taken security
over the company’s property and other
assets. If, as is often the case, there are
insufficient assets to pay the secured
creditors in full then the unsecured
creditors will receive nothing from
the insolvency.
This article looks at whether the courts
can ever assist once a company has
gone bust.
Minimise the risk
Although obvious it is worth saying that
the best course of action is to try to avoid
a situation where you might end up in
court. This might seem easier said than
done but simple things like checking the
credit rating of a supplier, tightening and
enforcing credit terms, reviewing retention
of title clauses (ensuring they are properly
incorporated into contractual documents
and enforceable) can make a big difference
in ensuring that you are not caught out
by an insolvency in the supply chain.
The position of unsecured
creditors in existing litigation
With the exception of voluntary
liquidations, once a company goes into
liquidation or administration, any creditor
who has already begun proceedings will
find that those proceedings are stayed.
Whilst the stay can be lifted by the court
a cost/benefit analysis is essential as any
recovery made will only go into the
general pot available to all creditors in
the insolvency. Pursuing litigation gives
you no priority as a creditor and most
litigants are not that altruistic.
Unfortunately, if you are defending
proceedings then an insolvent claimant
does not necessarily mean the end of the
action. The liquidator or administrator of
an insolvent company is free to continue
proceedings already begun in the
company’s name or to start proceedings
to enforce the company’s rights. However,
if you do find yourself facing an insolvent
company in court you should almost
certainly apply for what is known as
security for costs, an order that a sum of
money is paid into court by the insolvent
company which will be available to pay
the defendant’s costs should the insolvent
company lose.
Potential claims by liquidators
or administrators
The recovery of money paid to creditors
by insolvent companies just before they
go into liquidation or administration is
another area where creditors might be
caught out. It is not uncommon for the
directors of an insolvent company to
want to resurrect their business in another
company and sometimes, to do that,
they may need to remain on good terms
with certain key suppliers. This may
mean paying that supplier’s debts or
giving security in preference to the
claims of other creditors.
A liquidator or an administrator has the
power to review the insolvent company’s
transactions prior to insolvency and may
apply to the court to set aside those
where it can be shown that the intention
of the transaction was to prefer one
group of creditors over another. This can
be difficult to demonstrate but a claim
is more likely to succeed where the
former directors have set up “phoenix
companies” and have carried on the
same business relying on the same
key suppliers.
Claims against directors
A frequently asked question when a
company goes bust is whether there is
any claim that might be brought by the
creditor against the directors personally.
In the absence of fraud the answer is
generally no. The company’s right of
action against the directors, for example,
for wrongful trading, can be brought by
the liquidator or administrator but not by
a creditor. In addition the liquidator or
administrator must prepare a report on
the directors’ conduct which can lead to
proceedings under the Company Directors
Disqualification Act.
• Certain simple steps can
help to minimise the
chances of finding
yourself the creditor
of an insolvent company.
• Retention of title clauses
in particular could elevate
you from an unsecured
to a secured creditor but
require careful drafting.
• Claims against insolvent
companies are generally
stayed but claims by
insolvent companies
may still be brought
or continued.
• A liquidator or
administrator has certain
claims which might arise
from the insolvency
including preference claims
or for transactions at an
undervalue against
creditors and wrongful
trading claims against
directors.
Creditors’ committees
Once a company is insolvent creditors
generally cease to take much interest
in it. However, creditors do have rights
to ask to sit on creditors’ committees
overseeing the actions of the liquidator
and approving them. Whilst this will not
improve the position as a creditor it may
give greater influence over the steps taken
to maximise assets and therefore increase
the potential recovery.
11
Litigator shorts
• The excitingly named Rome II Regulation came into
force from 11 January 2009. Until January 2009 the
courts of each member state of the EU used their own
conflict of law rules to determine which law to apply
in non-contractual disputes. However, Rome II, which
applies throughout the whole of the EU, except
Denmark, has now introduced standardised rules
dealing with this. Generally speaking the law to be
applied to non-contract claims will be the law of the
country where the damage occurred.
• From 6 April 2009 new cost-capping rules will apply.
Costs caps may apply to the litigation as a whole or to
particular parts of it but will only be considered by the
court if it is in the interests of justice to do so and there
is a substantial risk that, without such an order, costs
will be disproportionately incurred and the court is not
satisfied that the risk can be adequately controlled by
case management and detailed assessment of costs.
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May 2009