Deserving creditors: Never mind the expense?

Posted on
There has been a recent trend for an increasingly diverse range of claims to be paid, in whole or part, as "expenses" in formal insolvency procedures.

Where the creditor is able to bring itself within this principle then this will not only be at the cost of unsecured creditors generally, but normally also the insolvency practitioner (IP), acting as administrator or liquidator, who will have to accept that the creditor's claim has priority over his remuneration.

The difficulties which this poses for the "rescue culture" ,and in particular for administration, has been highlighted by R3 which is the professional association representing insolvency practitioners.

In Re MK Airlines Property Ltd (16 May 2012), the category of insolvency expenses was further extended where the judge decided that the principle applies equally where a provisional liquidator is appointed in respect of a company as it does in the more usual case where a company is in liquidation or administration. Whilst MK Airlines was another example of the most common case where the creditor was a landlord, the judge reiterated that the principle is of more general application. In essence it can assist any creditor who has a claim under a contract that was entered into before the commencement of the formal insolvency. Whilst such a creditor is normally only entitled to prove in any liquidation for its estimated future loss (ie damages for the company's failure to pay rent, or otherwise honour its side of a contract), more often than not this right to prove as an unsecured creditor is of little or no value.

Where the IP, acting as provisional liquidator, liquidator or administrator, decides that the company should continue to accept the benefit of a contract because this will be of benefit to creditors there is a long established principle that, during the period for which such benefit is conferred and accepted, the company must in turn discharge its obligations under the contact. This is sometimes called the "Lundy Granite principle"; reflecting the name of the nineteenth century case where the principle was restated in the context of liquidation.

The most usual situation where a creditor under a pre-insolvency contract can rely on the principle is when it is the landlord of an insolvent company so that sums full due for payment under the terms of a lease. However, as noted above, it is important to remember that there could be other situations where the principle will apply (eg an equipment lease or an intellectual property licence). In the case of a lease of premises, the rule is that it is only fair and equitable that if a company that is the subject of a formal insolvency uses premises then any liability that accrues from such use during the relevant period is to be treated as if it were an expense of the insolvency and paid accordingly. For these purposes it was explained in MK Airlines that the relevant period is any time when the IP's motive was to retain the premises for the convenience and benefit of the insolvency, provided that the premises were in fact being so used at this time.

Whilst it is often a fine line, the distinction that is often made is between an IP who allows a company to continue to trade from the premises during the insolvency, which is clearly "using" the premises, as compared with simply allowing equipment to remain at the premises, which is not. It would also seem that premises are being "used" where they are occupied by somebody with the IP's consent under the terms of an informal licence that has been granted without the landlord's permission, normally a buyer of the company's business who may want to negotiate a formal assignment of the lease if that's possible. The difficulty in drawing the line as to when premises are being "used" can have significant implications as the period of use also defines the period of liability and in this respect the recent cases, including MK Airlines, underline the potential for significant asymmetry.

Whilst it might be thought that in fairness an IP should only be obliged to pay for the period of actual use by the company, the judge in MK Airlines confirmed the strict rule that has emerged from the recent cases that requires any liability that falls due during the period of use to be paid as an expense. The harshness of this rule is particularly well illustrated by leases and other contracts that require payments to be made in advance. If such a payment falls due during the period of use then it is payable in full as an expense whether or not it relates to the period of use (eg even if the IP stopped using the premises the day after a quarter's rent falls due the full amount will still be payable as an expense). Unless the creditor's agreement can be obtained to some sort of pay-as-you-go arrangement (which used to be the default position for landlords with tenants in administration), this has the potential to drive uncommercial behaviours; for instance, artificially timing administrations to commence just after a rent quarter day and to vacate just before the following quarter day on the basis that since nothing falls due during the relevant period nothing is payable.

However, it is not just rent which the IP runs the risk of having to pay. Arguably any sum that accrues due under a lease during the relevant period could be an expense. Thus if the landlord had a claim for breach of covenant that crystallised during the period of use this should arguably be treated in the same way. So for example it may be that a claim for breach of lease covenant that arises during the relevant period should be treated as an expense (e.g. the cost to the landlord of making good any disrepair). Where it is possible to do so a landlord may therefore be tempted to explore the possibility of accelerating claims under the lease so that any amount that falls due can be claimed as an insolvency expense; rather than waiting until the premises are no longer being used at which point any remaining claim will be unsecured. Indeed, it may well be sensible to review existing standard form leases with just this possibility in mind.