JIBFL: Contracting out of expense claims in administration and liquidation

This article considers the legal efficacy of “no expense claim” clauses limiting liability in insolvency office-holders’ contracts and the associated risks for the counterparty.

Office-holders in all forms of corporate insolvency proceedings are naturally keen to limit their potential exposure to liability on their contracts. In the case of administrative receivership, there is a long-standing practice of including a term excluding personal liability on the part of the receiver. This was, and is, necessary because s 44(1) of the Insolvency Act 1986 (IA 1986) provides that, although an administrative receiver is deemed to be the company’s agent unless and until the company goes into liquidation, he is personally liable on any contract which he enters into in the course of carrying out his functions, unless the contract otherwise provides.


Although there is no equivalent statutory provision imposing personal liability on administrators and liquidators for their contracts, the receivership practice has carried across and the same exclusions of personal liability are expected.

Increasingly, these now traditional exclusions of liability are coupled with provisions to the effect that no liability or obligation under the office-holder’s contract shall constitute an expense of the administration or liquidation, as the case may be. This article discusses the extent to which it is open to administrators and liquidators to alter the natural ranking of claims arising out of their contracts by agreement with their contractual counterparties. On the one hand, there is party autonomy and freedom of contract but, on the other hand, it might be said that the statutory scheme, including the priority for expenses, is mandatory. There are also questions in respect of the effect of exemption clauses under the general law.

Exemption clauses

Exclusions of personal liability and “no expense claim” provisions are used in the context of contracts which the office-holder has entered into, under which executory obligations are being undertaken. Such a contract could be, for example, a sale agreement or it could be one of an infinite variety of agreements arising out of continued trading activity. In the case of the former, the office-holder may be concerned about the emergence of third party claims to ownership of the subject matter and about statutorily implied terms. In the case of the latter, the office-holder may be concerned about the ability of the company to fulfil its longer term obligations. These are all legitimate concerns, but clauses in a contract with an office-holder excluding personal liability and clauses providing that any liabilities shall not rank as an expense of the proceeding, despite sharing compatible objectives, do not operate in the same way. The former goes to the fundamental question as to whether there is a contract at all and, if so, with whom, whereas a clause providing that a liability will not rank as an expense of the proceeding is an exemption clause.

Liability is the product of obligation. To say that an office-holder acts without personal liability is to say that the officeholder accepts no contractual obligation. For there to be any question as to whether a liability ranks as an expense, there must first be an obligation. That in turn means there must be an obligor. In the case of an administrator or liquidator, the office-holder will usually be contracting as agent with the company as principal. For administrators. the agency is statutory, being provided for in para 69 of Sch B1 to IA 1986. For liquidators, the existence of the agency is founded in common law.

However, in circumstances where an officeholder acts as principal, most obviously where an administrative receiver contracts after the company has gone into liquidation but conceivable in other situations, then, unless the office-holder accepts some duty, however qualified, there is no obligor. It would follow that the wording of the contract which articulated the putative obligation would be meaningless and would fall away. In an extreme case, where no-one accepted any material obligations to the counterparty, there would be no contract at all. Conversely, where an administrator or liquidator contracts purely as agent without personal liability under a contract where the company is the (disclosed) principal, there is undoubtedly a contract but the office-holder is not relying on an exemption clause to protect himself from liability in respect of the company’s contractual obligations because he is not a party to the contract and so no claim under it would lie in any event.

However, where the contract also provides that any resultant liability will not rank as an expense, the office-holder (through the company) is relying on an exemption clause. In considering exemption clauses, it is necessary to distinguish between clauses which limit or deny what would otherwise be the obligation and clauses which exclude or restrict the liability which would otherwise follow from a failure to discharge the obligation. A clause excluding the implied terms of a sale of goods as to fitness for purpose and satisfactory quality, is an example of the former. A clause which provides that a liability shall not be an expense of the proceeding, is an example of the latter. The conventional approach to exemption clauses is first to ascertain the legal position in the absence of the clause and then, secondly, to consider what effect (if any) the clause has upon that position. There is some support for a more holistic approach, whereby the whole contract, including the exemption clause, should be construed as one but, for ease of exposition,the traditional approach will be followed in this article.

Expenses

The concept of the “expenses” of an insolvency proceeding arises out of the need to provide for the payment of the necessary cost  of a procedure ahead of distributing the realised value of an estate among its unsecured creditors, according to their prescribed order of priority. Rule 12.1 of the Insolvency Rules 1986 (the 1986 Rules) provides:

“All fees, costs, charges, and other expenses incurred in the course of winding up, administration or bankruptcy proceedings are to be regarded as expenses of the winding up or the administration or, as the case may be, of the bankruptcy.”

The concept, particularly in the context of administration, is one of considerable difficulty in respect of which there remain

many unanswered questions. However, for present purposes, the starting point is fairly clear. In liquidation, expenses are the subject of r 4.218 of the 1986 Rules. Payment obligations undertaken by the liquidator and liabilities for breach of obligations will qualify either under r 4.218(3)(a)(ii) as:

“expenses which...are properly chargeable or incurred by the official receiver or the liquidator in preserving, realising or getting in any of the assets of the company or otherwise in the preparation or conduct of any legal proceedings, arbitration or other dispute resolution procedures, which he has power to bring in his own name or bring or defend in the name of the company or in the preparation or conduct of any negotiations intended to lead or leading to a settlement or compromise of any legal action or dispute to which the proceedings or procedures relate;”

or under r 4.218(3)(m) as:

“any necessary disbursements by the liquidator in the course of his administration…”

In administration, r 2.67(1)(a) provides for:

“expenses properly incurred by the administrator in performing his functions in the administration of the company;”

and r 2.67(1)(f) covers:

“any necessary disbursements by the administrator in the course of the administration…”

It might be thought that rr 4.218 and 2.67 were to like effect, since the administration rule8 was patently modelled on the pre-existing liquidation rule.

However, the position is complicated by para 99 of Sch B1 to IA 1986 which is in the following terms:

“(1) This paragraph applies where a person ceases to be the administrator of a company…

(3) The former administrator’s remuneration and expenses shall be (a) charged on and payable out of property of which he had custody or control immediately before cessation, and (b) payable in priority to [floating charges].

(4) A sum payable in respect of a debt or liability arising out of a contract entered into by the former administrator or a predecessor before cessation shall be (a) charged on and payable out of property of which the former administrator had custody or control immediately before cessation, and (b) payable in priority to any charge arising under sub-para (3)…

(5) [Adopted employee liabilities]…”

and by r 2.67(4) which states:

“For the purposes of para 99(3), the former administrator’s remuneration and expenses shall comprise all those items set out in para (1) of this rule.” Those words clearly distinguish debts and liabilities arising out of the administrator’s contracts from expenses incurred in the performance of the administrator’s functions and necessary disbursements. The better answer to this unhappy drafting relies on the opening words of r 2.67(4): “For the purposes of para 99(3)”; in other words, the special treatment of such contractual debts and liabilities under para 99(3) does not preclude the same debts and liabilities from also being expenses for the purposes of r 2.67(1).

Both rr 4.218(3) and 2.67(1) are expressed in terms of the priorities of expenses inter se and, in both cases, the expenses referred to in the quoted paragraphs rank in priority to the officeholder’s own remuneration. The ranking of all expenses in priority to distributions to creditors is derived from other provisions of the legislation, which are not directly in point for present purposes. The more pertinent point is that the rules are proscriptive, in that they preclude distributions to pre-proceeding creditors, rather than prescriptive in articulating a positive duty on the part of the officeholder to pay. In Re Toshoku Finance UK plc [2002] 1 WLR 671 (HL), Lord Hoffmann said of liquidation expenses [at 39]:

“The fact that a debt counts as an expense of the liquidation does not necessarily mean that the creditor should be allowed immediately to bring proceedings or levy execution.” In administration, the position is similar, but complicated by the overlay of the statutory charge which arises when the administrator ceases to act. It has been held that the charge must inform the administrator’s decisions as to payment during the period when he is in office and that the charge creates a payment obligation at the close of the administration, as well as the security interest.

(a) Are IA 1986 and 1986 Rules mandatory?

(b) Is it proper conduct on the part of the office-holder to reach an agreement to depart from the statutory priority?

(c) If so, what is the ranking of the contracted-out liability?

Contracting out

The question under consideration is whether it is open to an office-holder to reach an agreement whereby a liability, which would otherwise enjoy priority under the various provisions just identified, is deprived of that priority. That broad question raises the following issues:

The starting point is not encouraging for exponents of the practice. In Powdrill v Watson, the House of Lords was concerned with the efficacy of letters written by administrators to employees stating that their contracts were not being adopted, despite the fact that they would be continuing to work for the company in administration and would be paid for services rendered. The purpose of the disclaimer was to avoid the statutory charge in respect of the wider range of liabilities under adopted contracts of employment under s 19(5) of IA 1986 (now para 99(5) of Sch B1). At first instance, it had been held that, in principle, administrators could contract out but that the letters used had been ineffective for this purpose. However Lord Browne-Wilkinson said [at 449G]:

“The mischief aimed at by the Act must mean that the concept of adoption of the contract covers at least accepting liability for payment for services rendered to the administrator under contracts which he has continued. If it were open to the administrator to exclude such liability, the Act fails to remedy the mischief. Therefore the concept of adoption of the contract is inconsistent with an ability to pick and choose between different liabilities under the contract. The contract as a whole is either adopted or not: the consequences of adoption are then spelt out by the Act.” [Emphasis added].

Following the logic of the Powdrill approach, whether or not a liability ranks as an expense is a question to be determined by reference to IA 1986 and the 1986 Rules. If it is an expense, so the argument would go, then IA 1986 and the 1986 Rules provide for its priority and it is not open to the office-holder to exclude that priority by saying that it is not an expense.

More generally, IA 1986 and the 1986 Rules have been held to create a statutory scheme for distribution in insolvencies, which cannot be displaced by agreement. Classic examples of this principle are the inability to contract out of insolvency set-off (Halesowen Presswork & Assemblies Ltd v National Westminster Bank Ltd [1972] AC 785 (HL)) or pari passu distribution (British Eagle International Airlines Ltd v Compagnie Nationale Air France [1975] 1 WLR 758 (HL); Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd [2012] 1 AC 383 (SC)). On the other hand, there is a body of authority to the effect that contractual subordination will be given effect. In the leading case, Re Maxwell Communications Corporation Plc [1993] 1 WLR 1402, Vinelott J distinguished subordination from the purported exclusion of insolvency set-off on the ground that it could adversely affect the interests of other creditors and held that the pari passu rule was directed to striking down arrangements whereby the contracting party was attempting to secure an advantage. Relevantly for present purposes, his reasoning that a pre-liquidation subordination agreement was valid was based in part on a premise that there could be no objection to subordination which was agreed during the course of the proceeding [at 1411G-1412B]:

“The question is whether [the public policy considerations in respect of insolvency set-off] should similarly invalidate an agreement between a debtor and a creditor postponing or subordinating the claim of the creditor to the claims of other unsecured creditors and preclude the waiver or subordination of the creditor’s claim after the commencement of a bankruptcy or winding up. I do not think that it does. It seems plain to me that after the commencement of a bankruptcy or winding up a creditor must be entitled to waive his debt just as he is entitled to decline to submit a proof…If a creditor can waive his right altogether I can see no reason why he should not waive his right to prove, save to the extent of any assets remaining after the debts of other unsecured creditors have been paid in full; or, if he is a preferential creditor, to agree that his debt will rank equally with unsecured non-preferential debts.”

The distinction appears to be that it is open to a creditor to forego a right, even though it is not open to the creditor to bargain for an additional right. The objection to contracting out of an expense claim, if objection there be, therefore cannot rest solely on the departure from the statutory scheme because the departure consists of a form of subordination (held by Vinelott J to be, in principle, permissible). The question is therefore whether the rules concerning the payment of expenses should be given overriding effect – as occurred in Powdrill where it was held that administrators could not exclude the consequences of adopting contracts of employment.

It may be possible to distinguish Powdrill, either on the ground that it was concerned only with purported exclusion by notice, or on the ground that it was concerned only with employee liabilities (or on both grounds). As regards the first of these grounds, although the passage previously quoted from the judgment of Lord Browne-Wilkinson is stated in general terms, it may be observed that in summarising his conclusions, Lord Browne- Wilkinson referred to it not being possible to avoid adoption by “unilaterally” informing the employees that their contracts were not being adopted [at 452G]. Thus, it may be possible to distinguish a bilateral agreement on the priority of an expense from mere assertion by the office-holder. The difficulty with this approach is the emphasis on the mischief which the 1986 Rules were introduced to overcome. The mischief being referred to was the decision in Nicoll v Cutts [1985] BCLC 322 (CA), exposing the inability of an employee who had rendered services to recover his wages for those services if unpaid.

There is no reason why that statutory purpose should be supposed to be satisfactorily addressed by disregarding notices, while accepting precisely the same result could be achieved by a contractual variation of the existing contract of employment (even though Lord Browne-Wilkinson appeared to accept that wholly new contracts could achieve the same limitations18). Nicoll v Cutts is equally relevant to the alternative approach of confining Powdrill to employee liabilities since the mischief clearly had nothing to do with the wider range of potential expense claims. It is suggested that Powdrill is properly regarded as being concerned only with employee liabilities in respect of contracts of employment adopted by administrators (and administrative receivers) and that it does not prevent contracting out of expense claims in respect of other liabilities in either administration or liquidation.

Even if the expense provisions do not have overriding effect, a conduct issue might still be raised in the following way. When an office-holder enters into an executory contract, he exercises a power conferred by IA 1986. The Act and the 1986 Rules have attached certain consequences to the liabilities, thereby incurred by according them priority as expenses. It could be said that it is improper for the office-holder to take advantage of his statutory powers while simultaneously seeking to disapply the consequences prescribed by the same legislation. Administrators and liquidators in a compulsory winding-up are officers of the court.19 The so-called rule in Re Condon, ex parte James (1874) LR 9 Ch App 609 (CA), requires an officer of the court to act fairly, if necessary following a higher standard than might have been required by a strict application of law. However, it is difficult to see how agreeing a “no expense claim” clause with an independent counterparty can be characterised as unfair or dishonourable conduct. Miller v Bayliss [2009] BPIR 1438 was a bankruptcy case in which a disappointed counterparty challenged the trustee’s actions in selling shares, but the same principles apply. The deputy judge said [at 101]: “…there is nothing in the authorities that suggests any different or more onerous duty falls upon a trustee who seeks to contract with a third party, and further, that to impose special duties on him with regard to third parties who seek to enter into contracts with him, would impair his obligations…to act in the best interests of the creditors.”

This appears to be obviously correct and thus conclusive as regards a conduct objection. On the footing that a clause in an officeholder’s contract, providing that a liability under that contract shall not rank as an expense of the proceeding does not offend IA 1986, the 1986 Rules or ex parte James, the remaining question as to efficacy concerns constraints under the general law. The general law distinguishes markedly between contracts entered into with consumers and contracts entered into with others. Clauses of the type under consideration are found in bespoke contracts negotiated between lawyers. For the purposes of this article, it will therefore be assumed that liability is being undertaken in the course of a business and that the counterparty is not dealing with the office-holder as a consumer.

There are relevant provisions in both the Misrepresentation Act 1967 (MA 1967) and the Unfair Contract Terms Act 1977 (UCTA 1977), but the assumption that the counterparty will not be contracting as a consumer substantially restricts their impact. A “no expense claim” clause is a term which “excludes or restricts” liability for the purposes of UCTA 1977 because it excludes a right or remedy.20 By virtue of ss 2, 6 and 7, a “no expense claim” provision will be wholly ineffective if the liability is for death or personal injury resulting from negligence (which includes negligent breach of contract) or is for breach of title obligations under s 12 of the Sale of Goods Act 1979, s 8 of the Supply of Goods (Implied Terms) Act 1973 and s 2 of the Supply of Goods and Services Act 1982. By virtue of the same sections, a “no expense claim” provision will be subject to a test of reasonableness as regards any other liability for negligence or in respect of implied terms under those Acts.22 Where the test of reasonableness applies, the requirement is: “…that the term shall have been a fair and reasonable one to be included having regard to the circumstances which were, or ought reasonably to have been, known to or in the contemplation of the parties when the contract was made.” The implied terms (where applicable) are among the more obvious examples of potential liabilities which a prudent officeholder will wish to exclude if possible.

As far as the test of reasonableness is concerned, every case will be fact specific but the office-holder can do much to lay the ground through the inclusion of fairly standard form wording to the effect that the contract is being entered into in the course of insolvency proceedings, that the office-holder’s knowledge of the business and assets of the insolvent company is necessarily limited, that the consideration reflects the circumstances, that the counterparty is aware of the risks being undertaken and that he relies on no representations (other than any that may be expressly stated or acknowledged in the contract).

The office-holder will also wish to exclude liability for misrepresentation as far as possible. This is particularly appropriate in cases where the officeholder is negotiating the sale of assets to former management or its connected party where the buyer may well be better informed than the seller. In this instance, the constraint is in s 3 of MA 1967, which applies the UCTA 1977 test of reasonableness to any term of the contract which would exclude or restrict a remedy for a pre-contractual representation. This will capture a “no expense claim” clause, but the comments already made as to sensible precautions to satisfy the test of reasonableness apply equally in this context.

The ranking of an excluded expense claim

It might be supposed by a counterparty that the natural effect of agreeing that a claim would not rank as an expense claim would be that it would rank pari passu with the claims of the company’s unsecured creditors (and the relevant clause may even purport to so provide). However, it is thought that this would be wrong and that the effect of contracting out is to make the claim a deferred liability.

Rule 13.12(1) of the 1986 Rules provides:

“‘Debt’, in relation to the winding up of a company means (subject to the next paragraph) any of the following –

(a) any debt or liability to which the company is subject – (i) in the case of a winding up which was  not immediately preceded by an administration, at the date on which the company went into liquidation;

(ii) in the case of a winding up which was immediately preceded by an administration, at the date on which the company entered administration.

(b) any debt or liability to which the company may become subject after that date by reason of any obligation incurred before that date;”

and r 13.12 (5) applies the same definitions to administration.

An expense claim based on a contract entered into by the office-holder cannot be a provable debt because it cannot have existed prior to the proceeding and cannot have arisen out of an obligation incurred before the proceeding. It follows that neither limb of r 13.12 (1) is satisfied. The situation is not comparable to contractual subordination as upheld in Maxwell, where the effect was simply to default to the next lower ranking, because to treat a subordinated expense claim as a provable debt would mean disregarding the language of the 1986 Rules. The position was addressed tangentially (and obiter) by Lord Neuberger in Re Nortel GmbH [2013] 3 WLR 504 (SC) where, in commenting upon the possibility that the court might have jurisdiction to direct an administrator to treat a deferred liability as a provable debt, he said [at 119 and 125]:

“Paragraph 13 of Sch 1 entitles an administrator to make any payment which is ‘necessary or incidental’ to the performance of his functions. I do not see how that can entitle him, let alone the court to direct him, to treat an unprovable debt as a provable debt (unless, conceivably, there was a resulting benefit which would redound for the benefit of the proving creditors, although even then it would be problematic). It can scarcely be said to be ‘incidental’ or ‘necessary’ to a person’s statutorily, prescribed functions to do something inconsistent with those functions…

“However, I come back to the point that, if the effect of the Insolvency Rules is that the liabilities are not provable debts, there is no basis for the court deciding that they are...”

In so far as the first part of the passages quoted leaves open the possibility that it might be possible to allow a claim to rank as a provable debt, despite its failure to conform to the definition provided in the 1986 Rules if doing so conferred a benefit, it could fairly be said that the unsecured creditors would benefit from ranking pari passu with an expense claim instead of ranking behind it. To that extent there would not be a commercial objection. However, Lord Neuberger’s observation was heavily qualified and is not compatible with the tenor of the remainder of the quoted passages. It is submitted that it is not open to the officeholder to treat an expense claim arising out of his own contract as a provable debt in direct contravention of the 1986 Rules.

There is also no basis for distinguishing liquidations from administrations in this respect. If the claim is not a provable debt, it will be a deferred liability. This means that, in legal terms, it will fall into what Lord Neuberger in Nortel identified as category (7), ranking only above returns to shareholders and that, in practical terms, the counterparty will usually have no realistic prospect of receiving any dividend, let alone payment in full.

Counterparties who agree to “no expense claim” clauses in executory contracts therefore need to appreciate that they are likely agreeing that they will have no redress for breach.

Conclusions

The conclusions which emerge from this review are that a “no expense claim” agreement does not violate any mandatory provisions of IA 1986 and the 1986 Rules, nor is the office-holder to be criticised if he chooses to negotiate such a term. On the other hand, certain limitations under the general law will preclude the clause operating at all in some circumstances and will, in other circumstances, subject it to a test of reasonableness (which a prudent office-holder should be able to satisfy in most cases). However, the effect of the clause (where operative) will be to make the claims of the contractual counterparty subordinate to the claims of unsecured creditors with provable debts – in other words, moving the claim from being at the head of the queue to almost the bottom of it.

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