Insolvency and capacity (Fehily and another v Atkinson and another)

What evidence is required to be relied upon if there is an issue of capacity during the insolvency process? Richard Drinkwater, consultant at Hewlett Swanson, comments on a ruling that expert medical evidence was required and, even then, an individual voluntary agreement (IVA) would still be binding.

Original news

Fehily and another v Atkinson and another [2016] EWHC 3069 (Ch), [2016] All ER (D) 20 (Dec)

The Chancery Division dismissed the appellant’s appeal against the making of bankruptcy orders against her. The court held that, in making the orders, the district judge had not erred in holding that she had had capacity to enter into the orders. The court held that, among other things, the correct test for capacity was that stated in the thirty-first edition of Chitty on Contracts.

What are the practical implications that those advising can take away from this appeal?

If, in the course of any insolvency process involving an individual, there is any suggestion that he or she may not have the capacity to enter into any sort of agreement, or do anything that may be asked of them, the prudent step to take (if at all possible), is to obtain independent medical evidence on which reliance can be placed. Relying on the evidence of connected persons, such as members of the individual’s family or friends, is not to be recommended.

What was the background to the appeal?

The applicants were husband and wife. They had been in partnership with another couple. That partnership had an outstanding tax liability going back as far as the 1990s. In 2011, HMRC presented bankruptcy petitions against each of the four partners. To avoid being made bankrupt, each of the four partners proposed an IVA. The terms of each IVA were basically the same and provided that each partner would settle their debts by realising sufficient of their assets to do so. The IVAs also provided that, if no monies had been paid to the supervisors (of the IVAs) within six months of the approval of the same by creditors, the partners’ properties would be sold by the supervisors and the net proceeds used to discharge their debts.

Unfortunately, the applicants did not comply with the terms of their IVAs. The supervisors successfully petitioned for the applicants to be made bankrupt based on the breach by them of the terms of the IVAs. One of the supervisors was appointed as the trustee in bankruptcy of the applicants. The applicants applied to annul the bankruptcy orders on the ground that they should never have been made. The principal contention advanced by the applicants was that the second applicant had lacked the capacity to enter in to her IVA.

The district judge dismissed the application, rejecting the argument that the second applicant had lacked capacity. Further, he decided that even if the second applicant’s IVA was ineffective, there would have been no point in annulling the bankruptcy as the applicants owed the debt to HMRC in respect of which they would inevitably be made bankrupt.

What were the issues before the deputy judge?

The applicants applied for permission to appeal against the dismissal of their application. An order was made that the application for permission would, if granted, be immediately followed by the appeal itself.

The appeal court was asked to consider two issues:

  • whether the second applicant had indeed lacked capacity to enter into, and be bound by, her IVA, and
  • whether the second applicant was liable for her share of the debts of the partnership

What were the main legal arguments put forward?

Counsel for the applicants argued that the district judge had been wrong to decide that the second applicant did have the capacity to enter in to her IVA and had applied the wrong test in deciding whether she had had capacity. The district judge had failed to deal correctly with the evidence produced in support of the contention that the second applicant had lacked capacity.

It was also argued that if the second applicant had indeed lacked capacity her IVA was void; and contrary to the other point decided by the district judge, it would not be pointless to annul the bankruptcy order because the second applicant had not been a partner in the partnership and, therefore, had no liability to HMRC.

Counsel for the applicants also unsuccessfully applied for an adjournment of the hearing in order to produce further medical evidence.

What did the deputy judge decide, and why?

The deputy judge gave the second applicant permission to appeal on the grounds that the arguments advanced on her behalf were serious arguments which had a realistic prospect of succeeding. However, he then dismissed the appeal for two reasons:

  • the district judge was entitled to conclude that the second applicant had failed to prove that she had lacked capacity to enter in to her IVA, and
  • even if she had lacked capacity, the IVA was binding on her

On the question of capacity in relation to bankruptcy proceedings the deputy judge referred to the decision of HHJ Pelling QC in Haworth v Cartmel and HMRC [2011] EWHC 36 (Ch), [2011] All ER (D) 23 (Mar). That remains the leading authority on the question of capacity. I acted for the trustee in bankruptcy in that case, Miss Cartmel, and can advise that counsel for Miss Haworth and HMRC both produced considerably more expert medical evidence on the question of capacity than was put before both the district judge and the deputy judge in the present case. Given the lack of expert medical evidence, I cannot see how the district judge or the deputy judge could have found in any other way on this point.

Turning to the second finding of the deputy judge, I would refer to para [119] of his judgment where he says as follows:

…a contract entered into for consideration by a person without the mental capacity to understand the transaction is not void. It is valid and binding unless the other contracting party was aware of her incapacity (or, possibly, ought to have been aware) in which case the contract is voidable, and the incapacitated person has the right to rescind the contract…

The deputy judge analysed a number of cases relating to the construction of IVAs, concluding with a quote from the judgment of Briggs LJ in Narandas-Girdhar v Bradstock [2016] EWCA Civ 88, [2016] All ER (D) 151 (Feb) where the judge had said:

An IVA which has been approved in that manner operated by analogy with a contract between the debtor and all his or her creditors.

The deputy judge therefore based this part of his decision on the fact that the creditors of the second applicant were not made aware that she was subject to a lack of capacity at the time of the meeting of creditors at which her proposal for an IVA was approved. The evidence filed on behalf of the supervisors was to the effect that the second applicant seemed to them to have the necessary capacity, and nothing that happened at any time during the process which resulted in her IVA being approved by creditors suggested otherwise.

To what extent is the judgment helpful in clarifying the law in this area?

The law on capacity is fairly settled now. Without wishing to be critical, what I take out of the case is the over-reliance on evidence from the family and friends of the second applicant. The first applicant, for example, clearly had an interest in the appeal of his wife succeeding given that he still stood to be made bankrupt.

Interviewed by Nicola Laver.

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

Further Reading

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What is annulment, and in what circumstances can a bankruptcy order be annulled?

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

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First published on Lexis®PSL Restructuring and Insolvency

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