There is now an extensive literature chronicling the barriers that liquidators face in trying to bring avoidance proceedings under the Insolvency Act 1986. One such barrier is the treatment of the liquidator's legal costs. Broadly speaking, the liquidator is entitled to an indemnity out of the company's assets in relation to the costs incurred should the action fail. However, the value of the indemnity depends on whether the costs are treated as an expense of the liquidation ranking for payment ahead of preferential creditors and any floating charge. In Re MC Bacon (No. 2),  Millett J. held that the liquidator could not recoup the costs of an unsuccessful action against the defendant bank as a liquidation expense. The liquidator contended that his costs should be treated as an expense “properly chargeable or incurred by … the liquidator in preserving, realising or getting in any assets of the company” within rule 4.218(1)(a) of the Insolvency Rules 1986

Walters, A

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Company Lawyer2001Case CommentRe Floor Fourteen Ltd in the Court of AppealAdrian WaltersSubject: InsolvencyKeywords: Costs; Liquidators; Preferences; Voluntary winding up; Wrongful tradingCase: Lewis v Inland Revenue Commissioners Times, November 15, 2000 (CA)*Comp. Law. 215 There is now an extensive literature chronicling the barriers that liquidators face intrying to bring avoidance proceedings under the Insolvency Act 1986.1 One such barrier is thetreatment of the liquidator's legal costs. Broadly speaking, the liquidator is entitled to an indemnity outof the company's assets in relation to the costs incurred should the action fail.2 However, the value ofthe indemnity depends on whether the costs are treated as an expense of the liquidation ranking forpayment ahead of preferential creditors and any floating charge. In Re MC Bacon (No. 2), 3 Millett J.held that the liquidator could not recoup the costs of an unsuccessful action against the defendantbank as a liquidation expense. The liquidator contended that his costs should be treated as anexpense “properly chargeable or incurred by … the liquidator in preserving, realising or getting in anyassets of the company” within rule 4.218(1)(a) of the Insolvency Rules 1986. The judge ruled that therelevant cause of action was not an asset of the company as it vested in the liquidator and only aroseafter the liquidation had commenced.4 It followed that the costs were not incurred in realising orgetting in “any assets of the company” for the purposes of rule 4.218(1)(a). The apparentconsequence of MC Bacon (No. 2) is that the liquidator's costs of proceedings under sections 213,214, 238, 239 and 245 of the Insolvency Act 1986 can only be recouped from assets available fordistribution to unsecured creditors and therefore rank as an unsecured claim. The decision has beendescribed as “a formidable obstacle to those who wish to encourage liquidators to take on avoidanceactions”.5 However, as the Court of Appeal's decision in Re Floor Fourteen Ltd, Lewis v.Commissioner of Inland Revenue 6 shows, MC Bacon continues to find favour in the higher courts.In Floor Fourteen the company was in voluntary liquidation. Its liquidator applied for a declaration thathe was free to use asset realisations in his hands to fund preference and wrongful tradingproceedings against the company's former directors.7 The directors and preferential creditorscontended that the liquidator was not at liberty to use the assets to meet the costs of the proposedlitigation in the light of Re MC Bacon. The preferential creditors (meaning the various Crownagencies, including the Inland Revenue, whose claims enjoy preferred status under section 386 andSchedule 6 of the Insolvency Act 1986) had an axe to grind because their claims rank for paymentafter liquidation expenses by virtue of section 175(2)(a) of the Insolvency Act 1986. At first instance,8the deputy judge declined to follow MC Bacon, preferring instead the contrary view expressed obiterby Phillips and Morritt L.JJ. in Katz v. McNally. 9 He held that costs could be recouped as an expenseunder section 115 of the Insolvency Act 1986 as long as they were properly incurred and that this wasso whether or not they fell within rule 4.218(1). He based his conclusion on the view that section 115should be read as being logically prior to rule 4.218(1). This rule, the deputy judge said, merelydetermines the order in which certain expenses are paid. It did not bar the court from treating otheritems of expenditure as an expense within section 115 and according them priority. Contrary toreceived wisdom, the deputy judge also indicated that the recoveries of successful preference orwrongful trading proceedings would, in any event, fall within rule 4.218(1)(a). He took the view thatany monies recovered became assets of the company within the rule at the point of recovery, albeitassets held subject to the statutory trust for unsecured creditors. He agreed that rule 4.218(1)(a)could not extend to the costs of unsuccessful proceedings as these did not produce an “asset”.However, for good measure, he held that costs could be recouped under rule 4.218(1)(m) as a“necessary disbursement”, regardless of the outcome of the proceedings, as long as the costs wererendered necessary by the proper performance of the liquidator. For all these reasons, the deputyjudge felt able to grant the liquidator's application. The preferential creditors appealed on the groundthat, although the court had a discretion to allow the liquidator to recoup his costs as an expense,recoupment was not an automatic right. In their view, the effect of the deputy judge's decision was toPage1entitle the liquidator, in advance and as of *Comp. Law. 216 right, to treat the costs of the proposedlitigation as an expense. Their problem was that the costs of proceedings might well exhaust theavailable assets whereas, on an immediate distribution, they would be paid out of the assets ahead ofunsecured creditors.10The appeal was allowed. In delivering the court's judgment, Peter Gibson L.J. both restated andclarified the orthodox position taken in MC Bacon. The court considered itself bound by its own earlierapproval of MC Bacon in Re RS&M Engineering Co. Ltd, Mond v. Hammond Suddards. 11 First, itdisagreed with the deputy judge on the relative status of section 115 and rule 4.218. By a combinationof section 411 and Schedule 8, paragraph 17 of the Insolvency Act 1986, the Act contemplates thatthe Insolvency Rules will make provision for what fees, costs, charges and other expenses can betreated as liquidation expenses. With this in mind, Peter Gibson L.J. thought that it would produce anodd result if section 115 were to be construed as meaning that all winding-up expenses have priorityas long as they are properly incurred. In his view, section 115 deals only with the priority of expensesas against other claims, e.g. those of preferential creditors and unsecured creditors. It is rule 4.218that determines which expenses are to be treated as liquidation expenses in the first place. Rule4.218 also governs how those expenses rank for payment inter se. It follows that the liquidator cantreat any costs falling within rule 4.218(1) as liquidation expenses and recoup them as of right.However, section 115 does not confer an independent statutory right on the liquidator to recoup costsfalling outside rule 4.218(1) as an expense. It was critical therefore to determine whether the costs ofthe proposed litigation were caught by rule 4.218.On this question, the Court of Appeal was emphatic in its support for MC Bacon. Successfulavoidance or wrongful trading proceedings do not involve the “preserving, realising or getting in [of]any of the assets of the company”. Any monies recovered in such proceedings do not representproperty of the company existing at the commencement of the liquidation as the rights of action ariseonly after liquidation and can only be pursued by a liquidator.12 The costs of recovery cannot thereforefall within rule 4.218(1)(a). The court agreed with the deputy judge that the costs of unsuccessfulproceedings could not fall within rule 4.218(1)(a). However, it rejected his view that such costs were“necessary disbursements” within rule 4.218(1)(m).In line with MC Bacon and Mond, the Court of Appeal assumed that the court did have a residualdiscretion to allow the liquidator to recoup costs not falling within rule 4.218 from the company'sassets in his hands. Peter Gibson L.J. was disinclined to speculate as to the precise source andscope of the discretion. It was suggested that the court should adopt a cautious approach inexercising the discretion, especially in cases where preferential creditors who might otherwise receivea dividend object to the use of the available assets to fund speculative litigation. It was felt that therewas insufficient information before the court for it to be able to exercise the discretion in the presentcase. However, it was accepted that the liquidator was entitled to make a fresh application on fullerevidence to the Companies Court.13 It is clear from both Floor Fourteen and Mond that the sameprinciples would apply in compulsory liquidation.There are very good reasons why the courts were anxious to prevent the liquidator recovering thecosts of unsuccessful litigation as an expense in the cases of MC Bacon and Mond. In MC Bacon, theobject of the proceedings had been to avoid the defendant's floating charge. If the liquidator had beenallowed to recoup his costs as an expense, the floating charge vindicated in the proceedings wouldhave been subordinated to the costs of an unsuccessful challenge to its validity. In Mond, it was heldthat the funds in the liquidator's hands were caught by a floating charge. As in MC Bacon, it wouldhave been unfair if the court had allowed the liquidator to recoup his costs from funds to which thechargeholder had successfully established he was entitled in the litigation. However, considerations ofthis nature were not in play in Floor Fourteen. Overall, the position for liquidators remains uncertain.The Court of Appeal's acknowledgment that there is a residual discretion is of little encouragement.No one is sure how this discretion operates. At the moment, it is nothing more than a vague gloss onthe statutory provisions. The best one can say for Floor Fourteen is that it does conclusively settle thequestion as to the precise relationship between section 115 and rule 4.218. Unfortunately, it remainsdifficult for liquidators to contemplate proceedings unless unsecured creditors can be persuaded toprovide a fighting fund. There is, of course, now the option of conditional fees. However, even if theliquidator can engage his own legal team on a “no win, no fee” basis, he remains liable to pay theother side's costs if the proceedings are unsuccessful. It is possible to insure against this risk butso-called “after the event” insurance is not cheap.14 At the moment, conditional fees are the onlyrealistic option as other creative attempts to spread the liquidator's risk, for example by assigning afuture share of recoveries to a funder in return for financing and protection on costs, have beenblocked by the courts.15 If we seriously expect liquidators to make use of the armoury at theirPage2disposal, then a strong case can be made for a full review of the expenses rules at least insofar asthey apply to the costs of insolvency litigation. At the very least, they should be updated to takeaccount of the conditional fee regime. It is the writer's view that Floor Fourteen does not evenguarantee that the liquidator can recoup the premium payable for adverse costs insurance as of right.It must be arguable that recoupment should be allowed in the exercise of the residual discretion. Abetter option from the point of view of insolvency practitioners would be to amend rule 4.218 to makeit clear that the premium is a “necessary disbursement” falling within rule 4.218(1)(m) which couldtherefore be recouped as of right. Removal of the Crown's preferential creditor status would also havehelped in the present case!Adrian Walters Editorial BoardComp. Law. 2001, 22(7), 215-2171.See e.g. L. Doyle, Insolvency Litigation (Sweet & Maxwell, 1999), chapters 4 and 5 (and the works therein cited); R. Parry, “FundingLitigation in Insolvency” (1998) Company Financial and Insolvency Law Review 121; G. Bompas and H. Boedinghaus, “Funding Litigationand Assigning Claims” in Butterworths Practical Insolvency (looseleaf); and A. Walters, “Staying Proceedings on Grounds of Champerty”[2000] 1 Insolvency Lawyer 16.2.Re Wilson Lovatt & Sons Ltd [1977] 1 All E.R. 274, Ch D.3. [1991] Ch. 127; [1990] 3 W.L.R. 646; [1990] B.C.L.C. 607; [1990] B.C.C. 430, Ch D.4.See further Re Oasis Merchandising Services Ltd [1997] 2 W.L.R. 764, [1997] 1 All E.R. 1009, [1997] 1 B.C.L.C. 689, [1997] B.C.C. 282,CA.5.D. Milman and R. Parry, A Study of the Operation of Transactional Avoidance Mechanisms in Corporate Insolvency Practice (InsolvencyLawyers Association Research Report, July 1997), p. 17.6.The Times, November 15, 2000; Independent, December 18, 2000.7.On the facts, the liquidator's legal advisers had agreed to act on the basis of a conditional fee. It follows that the liquidator was, in effect,asking the court's permission to use the assets to fund payment of costs and disbursements not covered by the conditional feeagreement.8. [1999] 2 B.C.L.C. 666, [2000] B.C.C. 416. See A. Walters, “Round Up: Corporate Insolvency” (2000) 21 Company Lawyer 262.9. [1997] 2 B.C.L.C. 579, [1997] B.C.C. 784; [1998] B.P.I.R. 30, CA.10.On the facts, a dividend to preferential creditors of just under 44 pence in the pound.11. [2000] Ch. 40; [1999] 3 W.L.R. 697; [1999] 2 B.C.L.C. 485; [2000] B.C.C. 445; [1999] B.P.I.R. 975, CA. See further Walters, n. 8 above.12.The recoveries are held on statutory trust for distribution by the liquidator to unsecured creditors and are never owned by the company:see also Re Oasis Merchandising Services Ltd [1997] 2 W.L.R. 764, [1997] 1 All E.R. 1009, [1997] 1 B.C.L.C. 689, [1997] B.C.C. 282,CA.13.This sort of application was seen as analogous to an application by a minority shareholder for an indemnity in respect of the costs of aderivative action under the principle in Wallersteiner v. Moir (No. 2) [1975] Q.B. 373; [1975] Q.B. 508 (Note); [1975] 2 W.L.R. 389; [1975]1 All E.R. 849, CA.14.In the present case, the liquidator had been quoted a premium of £3,750 for limited cover of up to £25,000.15.Most notably by the Court of Appeal in Re Oasis Merchandising Services Ltd [1997] 2 W.L.R. 764, [1997] 1 All E.R. 1009, [1997] 1B.C.L.C. 689, [1997] B.C.C. 282.© 2012 Sweet & Maxwell and its ContributorsPage3Page4

Re Floor Fourteen Ltd in the Court of Appeal

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