Reconciliation of the Pari Passu Principle in the UK
Jeremiah Vun traces the development of exceptions to the pari passu rule and comments upon the Malaysian judiciary's treatment of this issue.
Many believe the pari passu principle to be the most important principle in Insolvency law. In English, it means “equally” and prescribes the rule that every creditor must be treated equally in a winding-up by distributing assets equally and fairly among them.[1] This is to protect the collective interest of the general body of creditors by avoiding any unfair preference.[2]
Time and commercial sensibilities, however, have given way to many exceptions such as the prioritisation of secured creditors,[3] insolvency setoffs,[4] and the Lundy Granite principle.[5] In this article, we draw our focus to one particular exception: the validation order.
No Transfer of Assets
Section 127 of the Insolvency Act 1986 states that any transfer of property made after a winding-up has commenced is automatically void (the “No Transfer Rule”).[6] The rationale behind the rule is to maintain the insolvent company’s assets for equal distribution later on.
To some, it embodies the pari passu principle. There is nothing that illustrates equal distribution more than a rule that prohibits unequal distribution.
In practice, this means that once a company begins winding-up, all payments must cease. This includes all ongoing contracts, rent payments, utility bills and more. Most business relationships dissolve during this time, as more people become aware of the company’s financial limitations.
Although this is acceptable for companies wishing to be wound up themselves, it is very burdensome for companies who want to get back on their feet. Such companies wish to maintain their reputation, and this can only be achieved by continuing business as usual.
Exception
One way to continue business as usual is to apply for what is known as a validation order (“VO Application”). This is an order that validates the transfer of an asset or multiple assets. Such assets may include money, property or shares [7]
In an area built upon the equal distribution of assets, a VO Application forms the most direct path to the unequal distribution of assets, making it an exception to the pari passu principle.
Test
The traditional test applied in a VO Application is found in Re Gray’s Inn Construction[8] and can be summarised into three principles:
1. Transfers by a party who did not know of the winding-up are usually validated (“Transfers in Good Faith”).
2. An order can be made to allow a company to continue business as usual if the sale of the company as a functioning business is better than a non-functioning business.
3. Transfers should not be validated unless it benefits the general body of creditors (“Special Circumstance”).
Problem
Gray’s Inn was followed for many decades.[9] However, judges often found difficulty in accepting it in its entirety. Criticisms were particularly aimed at the principle of Transfers in Good Faith. Fox LJ first explained this in 1992,[10] when he said:
“But while good faith is, in my view, established, I do not think that good faith is enough by itself to justify validation.”
Fox LJ stressed that the No Transfer Rule’s original purpose was to uphold the pari passu principle. That, in his Lordship’s opinion, must be paramount when dealing with any VO Application. Good faith must not therefore be seen to override the principle that assets must be distributed equally.
Rose v AIB Group approved.[11] The High Court in Rose tried to sweep the Transfers in Good Faith principle under the rug by saying that it was not a principle at all. Instead, it was a mere statement based on the facts of Gray’s Inn.
Fundamentally, judges found it impossible to say that a Transfer in Good Faith should be allowed even if the transfer was detrimental to the general body of creditors.
Remedy
In comes our protagonist, Sir Terence Etherton. In 2016, Sir Terence finally recognised that Transfers in Good Faith should no longer be considered a principle.[12] In Express Electrical Distributors Ltd v Beavis, he said that the true test when considering whether to grant a validation order is the test of Special Circumstance.
Applicants must now show that the transfer is beneficial to the general body of creditors, thereby creating a Special Circumstance. Once the presiding judge is convinced of this, only then can the pari passu principle be disapplied to make way for a validation order.
Special circumstances include profitable transactions and transfers, which increase the business’s value in the long run.
Sir Terence referred to paragraph 9.11.7 of Practice Direction: Insolvency Proceedings [2014]:
“The court will need to be satisfied… that a particular transaction or series of transactions in respect of which the order is sought will be beneficial to or will not prejudice the interests of the unsecured creditors as a class.” [13]
Sir Terence’s emphasis on Special Circumstance offered simplicity, shifting all focus back to the original beneficiaries of the pari passu principle: the creditors.
Four months after the judgment of Express Electrical, the Singapore courts became the first to integrate the test of Special Circumstance.[14] Hong Kong’s courts followed suit, abandoning old considerations such as whether the transfer was necessary, whether an intelligent and honest man could have made it or whether it was likely to injure the company.[15]
Conclusion
Presented with a more straightforward test, the court needs only to be satisfied that a Special Circumstance exists.
For companies hoping to restart their business, it will be up to the senior management, administrators or its restructuring experts to convince the court that the transfers sought to be validated would benefit the general body of creditors. This can be achieved through cash flow projections, profit and loss statements or in-depth statistics of its financial status.[16]
This momentary departure from the pari passu principle laid the groundwork for years of constructive discussion and debate. So, although the restoration of stability to the pari passu principle in VO applications took several decades, there is little doubt that this new position will last for many more decades to come.
Author’s note (the Malaysian context)
Good/bad faith has its place in the law, but not in the test for a VO application.
We have established that if a transaction was made in good faith, but does not benefit the general body of creditors, then it should not be validated. But what happens if the transaction was made in bad faith? Should the application be automatically rejected?
Take for example a director of a company currently being wound up. He sees huge potential in the crypto market and decides to secretly borrow $100,000 from his dying business to invest. A week later, he earns 100% of his initial investment, gives back the $100,000 plus interest and keeps the rest for himself (say $95,000). If the liquidator discovers this and applies for a VO, should the court reject the application simply because it was made in bad faith or should it allow the transaction?
In my view, and by steadfastly applying the test of special circumstance, the court should allow the transaction because it improves the financial position of the general body of creditors. With regard to bad faith, a separate order can be made for the $95,000 to be returned to the company under the laws of unjust enrichment or something along those lines.
As one might observe, good/bad faith can and should operate separately and exclusively from the test of special circumstance and therefore should not exist within the same test.
Malaysia does not have a single test solution for VO applications. Mustapha Bin Mohamed v Ji Seng Hong [17] lists two broad considerations in a VO application:
1. if the transaction(s) has or will be beneficial to the general body of creditors; or
2. if it was just and fair to allow the transaction(s) with particular regard to the good and honest intention of the persons concerned.
Arab Malaysian v Orient Apparel [18] provides three guidelines:
1. The Court should encourage Companies to continue business in the ordinary way (payment of wages, etc) provided they are reasonable.
2. Dispositions made pursuant to facilities provided by the bank should be allowed if they benefit the Company directly and the creditors generally.
3. The parties must not have acted dishonestly or recklessly when arriving at such a decision.
Already we can identify three additional considerations which may cause confusion: good and honest intentions, reasonableness and dishonesty/recklessness. In reality, these considerations crumble the moment the court discovers that they jeopardise the financial position of the general body of creditors. So the question we should be asking ourselves is why should they exist at all?
It is my hope that the Malaysian judiciary’s over-complicated solution to what should be a simple problem will become apparent soon, saving unsuspecting paralegals (as I once was) from being asked to research how “good and honest intentions are treated internationally. There should have always been only one test – that of Special Circumstance.
Written by Jeremiah Vun.
[1] Rizwaan Jameel Mokal, 'Priority as Pathology: The Pari Passu Myth' (2001) 60 Cambridge LJ 581 [2] Roy Goode, Principles of Corporate Insolvency Law (5th ed, Student ed, Sweet & Maxwell 2019), para 8-03 [3] Peter Walton, 'Execution Creditors - (Almost) the Last Rights in Insolvency' (2003) 32 Comm L World Rev 179 [4] Roy Goode, Principles of Corporate Insolvency Law (5th ed, Student ed, Sweet & Maxwell 2019), para 8-19 [5] Lightman G, Moss GS, Lightman and Moss on the Law of Administrators and Receivers of Companies (6th ed, Sweet & Maxwell 2017), para 4-007 [6] Insolvency Act 1986 (c. 45) [7] Fletcher I, The Law of Insolvency (5th ed, Sweet & Maxwell 2017), para 26-006 [8] Re Gray's Inn Construction Co Ltd [1980] 1 W.L.R. 711 [9] Coutts & Co v Stock [2000] 2 All ER 56 para [10] [10] Denney v John Hudson & Co Ltd [1992] BCLC 901 [11] Rose v AIB Group (UK) plc and another [2003] 1 WLR 2791 para [26] [12] Express Electrical Distributors Ltd v Beavis and others [2016] 1 WLR 4783 para [56] & [20] [13]Paragraph 11.8 of Practice Direction: Insolvency Proceedings [2014] BCC 502,; this is now replaced by Paragraph 9.11.7 of Practice Direction: Insolvency Proceedings [2020] B.C.C. 698 which essentially states the same [14] Centaurea International Pte Ltd (in liquidation) v Citus Trading Pte Ltd [2016] SGHC 264, para [34] [15] Van Dessel v Connolly & anor [2020] IEHC 663; Chan Mei Chun v K & A International Company Ltd & anor [2013] HKCU 2873; Winbless Inc v Central Billion Inc & ors [2013] HKCU 2877; ONC Lawyers, ‘English Court of Appeal Clarifies the Approach in Granting Validation Orders’ (Insolvency & Restructuring Newsletter, 2016) http://www.onc.hk/en_US/english-court-appeal-clarifies-approach-granting-validation-orders/; ; Ng L, ‘Legal Updates on Case Law’ (ONC Lawyers, 2017) http://www.onc.hk/wp-content/uploads/2017/04/HKICPA_Insolvency-Legal-updates-on-case-law-development-by-Ludwig-Ng_v....pdf [16] Foster A and others, ‘Post Petition Dispositions’ (Clyde & Co, 2012) https://www.mondaq.com/uk/insolvencybankruptcy/166266/post-petition-dispositions [17] Mustapha Bin Mohamed (As the Receiver and Manager if Sykt Ji Seng Hong Plastic Manufacturing Sdn Bhd) v Ji Seng Hong Plastic Manufacturing Sdn Bhd (Ng Bak Soon & ors, Petitioners) [2014] 11 MLJ 793 (HC) [18] Arab Malaysian Merchant Bank Bhd v Orient Apparel Bhd & ors [2002] 1 MLJ 89 (HC)
Bibliography
Books
1. Roy Goode, Principles of Corporate Insolvency Law (5th ed, Student ed, Sweet & Maxwell 2019)
2. Lightman G, Moss GS, Lightman and Moss on the Law of Administrators and Receivers of Companies (6th ed, Sweet & Maxwell 2017)
3. Fletcher I, The Law of Insolvency (5th ed, Sweet & Maxwell 2017)
Journal Articles
1. Rizwaan Jameel Mokal, ‘Priority as Pathology: The Pari Passu Myth’ (2001) 60 Cambridge LJ 581
2. Peter Walton, ‘Execution Creditors - (Almost) the Last Rights in Insolvency’ (2003) 32 Comm L World Rev 179
Legislation
1. Insolvency Act 1986 (c. 45)
2. Practice Direction: Insolvency Proceedings [2020] B.C.C. 698
3. Practice Direction: Insolvency Proceedings [2014] BCC 502
Cases
1. Re Gray's Inn Construction Co Ltd [1980] 1 W.L.R. 711
2. Coutts & Co v Stock [2000] 2 All ER 56
3. Denney v John Hudson & Co Ltd [1992] BCLC 901
4. Rose v AIB Group (UK) plc and another [2003] 1 WLR 2791
5. Express Electrical Distributors Ltd v Beavis and others [2016] 1 WLR 4783
6. Centaurea International Pte Ltd (in liquidation) v Citus Trading Pte Ltd [2016] SGHC 264
7. Van Dessel v Connolly & anor [2020] IEHC 663
8. Chan Mei Chun v K & A International Company Ltd & anor [2013] HKCU 2873
9. Winbless Inc v Central Billion Inc & ors [2013] HKCU 2877
10. Mustapha Bin Mohamed (As the Receiver and Manager if Sykt Ji Seng Hong Plastic Manufacturing Sdn Bhd) v Ji Seng Hong Plastic Manufacturing Sdn Bhd (Ng Bak Soon & ors, Petitioners) [2014] 11 MLJ 793
11. Arab Malaysian Merchant Bank Bhd v Orient Apparel Bhd & ors [2002] 1 MLJ 89
Websites
1. ONC Lawyers, ‘English Court of Appeal Clarifies the Approach in Granting Validation Orders’ (Insolvency & Restructuring Newsletter, 2016) http://www.onc.hk/en_US/english-court-appeal-clarifies-approach-granting-validation-orders/
2. Ng L, ‘Legal Updates on Case Law’ (ONC Lawyers, 2017) http://www.onc.hk/wp-content/uploads/2017/04/HKICPA_Insolvency-Legal-updates-on-case-law-development-by-Ludwig-Ng_v....pdf
3. Foster A and others, ‘Post Petition Dispositions’ (Clyde & Co, 2012) https://www.mondaq.com/uk/insolvencybankruptcy/166266/post-petition-dispositions