Creditor’s collateral advantage breached good faith principle (Gertner v CFL Finance Ltd and another)

Stephen Atherton QC, of 20 Essex Street, examines a Court of Appeal decision that a settlement agreement between the appellant debtor and a bank had given the bank a collateral advantage not available to other creditors—such as the first respondent—which had placed it in a position of conflict with their interests. This had breached the good faith principle and should have prevented it from voting on an individual voluntary arrangement (IVA) proposal to the potential detriment of the first respondent and the remaining creditors.

Gertner v CFL Finance Ltd and another [2018] EWCA Civ 1781, [2018] All ER (D) 169 (Jul)

What are the practical implications of the judgment?

The decision is important as it cements in place the judge-made good faith principle (as between debtor and creditor and as between the creditors themselves) as part of the codified insolvency regime under the Insolvency Act 1986 (IA 1986), the Insolvency Rules 1986 (IR 1986), SI 1986/1925, and the Insolvency (England and Wales) Rules 2016 (IR 2016), SI 2016/1024.

The Court of Appeal also made clear that the good faith principle is of general application, and is not limited to the specific factual circumstances exemplified in the recent cases in which it has received recognition, nor is it inapplicable or to be disapplied in circumstances where the collateral benefit or advantage received by a creditor derives from a third party and not the debtor.

The decision may also have implications as regards the meaning of ‘material’ when determining if there has indeed been a ‘material irregularity’ at or in relation to a meeting of creditors. The Court of Appeal did not consider that the meaning of ‘material’ was as restricted as was argued for by the appellant, and rejected the suggestion that in this context it meant that any irregularity was only relevant if it had a defining effect on the outcome of the votes at the meeting. This was no doubt based on the observation made by Walker LJ in Somji v Cadbury Schweppes plc [2000] Lexis Citation 3500, at para [25], to the effect that something was ‘material’ if it would be likely to have made a material difference to the way in which the creditors would have considered and assessed the terms of the proposed IVA.

The decision is, however, disappointing with regard to the Court of Appeal being disinclined to consider the first respondent’s argument based on unfair prejudice and analyse how this ground for challenging an IVA interacts with a challenge (on the same facts) based on material irregularity.

What was the background?

The appellant owed more than £11m to the first respondent, and in excess of £547m to an insolvent Icelandic bank under a personal guarantee. The first respondent presented a bankruptcy petition in respect of the debt owed to it, but the appellant proposed an IVA, and the first respondent agreed to stay the proceedings on the petition pending the outcome of the vote on the IVA. Under the terms of the IVA, a one-off payment of approximately £487,000 would be provided by a third party. That sum would be used to discharge the appellant’s tax liability in full and make a distribution to creditors. Unsecured creditors, such as the first respondent, would receive £0.07 in the pound. The bank, which constituted more than 90% of the creditors by value, voted in favour of the IVA at the creditors’ meeting. The first respondent and one other creditor voted against, but the IVA was approved.

The first respondent discovered that the bank had entered into a settlement agreement with a number of parties, including the appellant, immediately before the creditors’ meeting. Under the terms of the agreement the bank received an immediate payment of $6m plus a share in any sums recovered from an arbitration in Israel to which the appellant was a party, and which share potentially ran into hundreds of millions of dollars. The first respondent challenged the approval of the IVA, and appealed against the decision of the chair of the meeting to admit the bank’s vote for the full value of its claim on the grounds that there had been a material irregularity in or about the creditors’ meeting (by reference to IA 1986, s 262(1)(a) and IR 1986, SI 1986/1925, r 5.22(5) (now IR 2016, SI 2016/1024, r 15.35(3)).

At first instance, the judge found that the meaning and effect of the settlement agreement was that the appellant’s liability to the bank had been extinguished, or had become contingent, and was therefore unliquidated or unascertained. The bank should therefore not have been allowed to vote or its claim should have been valued at a nominal amount, so there had been an irregularity at the creditors’ meeting. The irregularity was material given that upon discounting the bank’s claim and the claims of associated creditors, there were insufficient votes to approve the IVA. The judge also held that the entry into the settlement agreement, which was not disclosed to the other creditors or the nominee was intended to operate as an inducement to the bank to vote in favour of the IVA and, in the circumstances, this constituted a breach of the good faith principle. This was a further basis for concluding that there had been a material irregularity at or in relation to the creditors’ meeting.

The first respondent also argued that the terms of the IVA (in the context of the terms and effect of the settlement agreement) were unfairly prejudicial to it and the appellant’s other creditors (not including the bank), pursuant to IA 1986, s 262(1)(b), and IR 1986, SI 1986/1925, r 5.22(5) (now IR 2016, SI 2016/1024, r 5.35(3)). The judge rejected this argument.

The appellant appealed against the revocation of the IVA on the basis of the proper construction of the settlement agreement and as to the findings of there having been a material irregularity. The respondent cross-appealed on the issue of unfair prejudice.

What did the Court of Appeal decide?

Material irregularity—discharged, unliquidated or unascertained debt

The first question before the court was whether, on its proper interpretation, the settlement agreement discharged the bank’s debt or rendered it unliquidated or unascertained for the purposes of IR 1986, SI 1986/1925, r 5.21(3) (now IR 2016, SI 2016/1024, r 15.31(3)).

The settlement agreement and the IVA involved the provision of funds by a third party which would not be available to creditors in a bankruptcy of the appellant. However, the settlement agreement, which made additional provision for the bank alone, was plainly more generous than the terms of the IVA.

The terms of the settlement agreement were binding upon the parties to it such as to effect a compromise of the bank’s claim, and removed from the bank its ability to enforce its rights under the guarantee. However, the terms of the settlement agreement were such as to defer the ultimate settlement of the bank’s claim until all the consideration had been paid or provided to the bank. A creditor was free to preserve its debt, while at the same time agreeing to forego its enforcement (and no principle of law precluded such a course). Such terms did not impact upon a creditor’s ability to participate in a vote, together with the general body of creditors, as to whether an IVA should be approved, or on that creditor’s right to share in any dividend provided for under that IVA.

The settlement agreement did not render the debt to the bank unliquidated or unascertained, even if it could be said to render the debt contingent (which it did not). Simply because the debt was in one sense contingent on the performance of certain terms of the settlement agreement, it did not follow necessarily that the debt was either unliquidated or for an unascertained amount. The latter was not the necessary consequence of the former.

As a consequence, IR 1986, SI 1986/1925, r 5.21(3) (now IR 2016, SI 2016/1024, r 15.31(3)) had no application, and the bank’s entitlement to vote fell therefore to be calculated in accordance with IR 1986, SI 1986/1925, r 5.21(2)(b) (now IR 2016 SI 2016/1024, r 15.31(1)(e)). It followed that there had been no material irregularity in the chair’s decision to allow the bank to vote in respect of the full value of its claim against the appellant.

Material irregularity—good faith

The next question for the court was whether the circumstances of, and in relation to, the entry into the settlement agreement breached the duty of good faith as between the appellant and his creditors, and as between the creditors inter se.

The court held that the principle of good faith between debtors and their creditors, and the creditors as between themselves, was not simply a reiteration of the rule that unsecured creditors should share pari passu in the available assets. The principle could be breached if a creditor received a collateral advantage from a third party in return for entering into the arrangement (see McKewan v Sanderson (1875) LR 20 Eq 65, Somji and Kapoor v National Westminster Bank [2011] EWCA Civ 1083, [2012] 1 All ER 1201).

The bank had received a significant financial advantage under the settlement agreement over what the appellant had offered to his other creditors under the IVA. The Court of Appeal considered that it was obvious, when viewed objectively, that the settlement agreement was intended, and had to be presumed, to have been an inducement to the bank to vote in favour of the IVA in order to protect the appellant from bankruptcy. Although the bank was not, in terms, required to vote in favour of the IVA proposal, it had every incentive to do so, and the settlement agreement was deliberately drafted in such a way as to create such an incentive, while at the same time allowing the bank to retain its status as a creditor at the time of the creditors’ meeting. The remaining creditors, by contrast, would be limited to the dividend provided under the proposal, and any further investigation of the appellant’s affairs was effectively stifled.

The settlement agreement provided the bank with a collateral advantage not available to other creditors, which placed it in conflict with the interests of the other creditors. That was a breach of the good faith principle which disqualified the bank from voting on the proposal. The bank had been allowed to vote without disclosing a material and obvious conflict of interest as between it and the other creditors. Without the vote of the bank, the IVA would not have been approved.

Unfair prejudice caused by the terms of the IVA

The Court of Appeal concluded that it was unnecessary to deal with the first respondent’s argument founded on unfair prejudice under IA 1986, 262(1)(a).

Stephen Atherton QC appeared for the first respondent in this case.

Interviewed by Robert Matthews.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Further Reading

If you are a LexisPSL subscriber, click the link below for further information:

What is an individual voluntary arrangement and what does it seek to achieve? (subscriber access only)

How does a debtor enter into an individual voluntary arrangement (IVA)? (subscriber access only)

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