THE DUTY TO MAINTAIN EQUALITY IN COLLECTIVE CREDITOR ACTIONS

Date01 December 2008
Published date01 December 2008

It is argued in this article that creditors who act collectively to deal with the insolvency of their common debtor, whether in formal insolvency proceedings or in a private debt restructuring exercise, owe each other a duty to refrain from receiving any additional and undisclosed benefit, from the debtor or from a third party, in consideration for taking a particular position in relation to the debtor’s insolvency. The duty is based on a line of old English authorities which, from the beginning of the last century, appeared to have lapsed into obscurity. Although more recent cases have confirmed that the duty continues to apply in contemporary insolvency regimes, new issues are likely to be encountered which may require some reformulation and refinement of the duty.

I. Introduction

1 When a creditor1 exercises his individual rights against an insolvent debtor, he is at liberty to take such steps as may be available to him to maximise the recovery of his debt. He does not owe any duty to refrain from receiving more than his proportionate entitlement of the debtor’s assets; in fact, he will probably try his level best to achieve the highest level of repayment amongst all the creditors of the same debtor. In contrast, in insolvency proceedings such as liquidation and bankruptcy, the so-called pari passu principle of insolvency law reigns supreme. In these collective proceedings against an insolvent debtor, an unsecured creditor is compelled, by a myriad of statutory provisions and judge-made law, to share in the debtor’s assets on an equal basis with his fellow creditors. The pari passu principle also strikes down contracts which seek to give a creditor an advantage, in the liquidation or bankruptcy of the debtor, over the other creditors.

2 It is suggested that, between the two extremes, there is a duty, in both common law and equity, to maintain equality amongst creditors in

a number of situations. This duty is not quite the same as the pari passu principle, and a few key differences can be highlighted. First, the duty is triggered only where two or more creditors collectively agree, share their views or vote on a plan or a course of action to deal with the insolvency of their common debtor, upon a common understanding or legitimate assumption that they would be doing so on the basis of equality. As such, while the scope of application of the duty is perhaps more limited than that of the pari passu principle, its operation cuts across formal insolvency proceedings such as liquidation or bankruptcy and into private or informal efforts by creditor groups. Secondly, it does not apply only to prevent a creditor from obtaining preferential treatment in relation to the distribution of the debtor’s assets, but goes further to prohibit the creditor’s receipt of undisclosed benefits from a third party. In particular, the use of third party funds to pay a creditor or to acquire the creditor’s debt, which results in the creditor getting a more advantageous deal than the other creditors with whom he is acting collectively. Thirdly, the duty applies not only as between a debtor and his creditors, but also between the creditors inter se. This has an impact on the nature and range of legal remedies which a breach of the duty will attract.

3 The foundation for this duty is not new and has been recognised by the courts for well over two centuries. However, much of the law is found in very early cases dealing with proposals for compositions made by individual creditors to their creditors in order to avert bankruptcy, and there is a relative dearth of case law on the subject in more recent times. The principles established in these cases have been rarely invoked in the modern commercial context where corporate debtors in financial difficulty often seek to work together with their creditors collectively towards the approval and implementation of a debt restructuring plan or a scheme of arrangement. Neither have they been often thought to be relevant to voting and decision-making by creditors under the statutory insolvency regimes in relation to the administration of the debtor’s assets and affairs.

4 In truth, the duty to maintain equality is in full accord with current notions of fair dealing, commercial morality and procedural transparency, and the principles established by the old cases remain relevant, perhaps even more so, in the present day. It has become orthodoxy in both insolvency law and practice that, in the insolvency of a debtor, the majority interests, views and decisions of the body of creditors are to be accorded critical, if not decisive, weight in determining the fate of the debtor, working out the terms of a debt restructuring or compromise plan, and fixing the level of recovery that can be enjoyed by the creditors. The courts have also declared that, as

the insolvency of a company deepens, its creditors displace its shareholders as the primary stakeholders.2 It is critical to this regime that a body of creditors has the legal assurance that, in its collective actions vis-à-vis the debtor, each creditor is duty bound to stand on an equal footing and to refrain from receiving any undisclosed benefit which has compromised the objectivity of his judgment, decision or view in relation to the collective action.

5 However, some evolution may be necessary so that the application of the relevant principles is sufficiently sophisticated and agile to deal with contemporary issues. With the increasing size and structural complexity of commercial enterprises and financial institutions, it is not surprising to find that a creditor may have different levels and types of exposure to different entities within a corporate group, just as a single debtor may find itself indebted to several creditors which are part of the same financial conglomerate, or a combination of both. The purchase of debts by parties friendly or related to the debtor, so as to be in a position to exert influence or control over the debtor’s debt restructuring proposal, is also frequently encountered. These developments may make it easier to disguise an objectionable transaction in which a creditor receives or is promised additional benefits which are not extended to his fellow creditors, in exchange for his vote or influence in respect of any proposal in relation to the debtor’s debts or assets.

II. The basic principles

6 It has been the law since the 18th century that, if a debtor makes a proposal to his creditors for a composition or arrangement of his debts, any undisclosed arrangement entered into with a particular creditor to receive more than the other creditors, for the purpose of securing that creditor’s approval of the proposal or removing that creditor’s opposition to the proposal, is void for illegality.3 The earliest English cases struck down such secret arrangements between a debtor and one of his creditors as a fraud on the other creditors. In one of the

earliest reported cases, Cockshott v Bennett,4 a debtor made a proposal to pay 11 shillings in the pound to his creditors, but one of the creditors refused to execute the deed of composition until the debtor issued a promissory note to him for the payment of the remaining nine shillings in the pound. The court held that the issue of the promissory note was a fraud on the creditors, and that it was absolutely void.

7 It was also settled early in the day that it is not essential that the illicit benefit be given by the debtor himself to the creditor concerned. A payment by a third person is just as much a fraud on the general body of creditors as a payment or an agreement to pay by the insolvent debtor itself.5 The undisclosed additional benefit can, therefore, be provided by the debtor’s brother,6 brother-in-law,7 friend8 or “family sources”.9 Further, the funds or assets that are transferred or promised to be transferred to the creditor need not come from the debtor’s assets;10 the bribery does not have to be at the expense of the debtor.11 As such, there is no necessity that the conferring of the secret benefit on a creditor be at the expense of the other creditors. A secret benefit given to a creditor may be impugned by the other creditors even though they have no legal right to insist that the secret benefit be included in the debtor’s composition for sharing amongst all the creditors. It is not necessary to show that the preference of one creditor comes from the debtor’s assets or that all the creditors will not receive an equal distribution of the debtor’s assets.12

8 It was further settled that the secret benefit need not be given to the creditor to secure the creditor’s agreement to vote in favour of the debtor’s proposal; it may be given to secure some other form of assistance from the creditor in relation to the proposal. Thus, the additional benefit may be given to the creditor to persuade him to

withdraw his opposition to the debtor’s proposal13 or even to become surety for the amounts to be paid under the debtor’s proposal.14 In fact, there need not be a successful composition at all. In Wells v Girling,15 a promissory note was signed by a debtor and the defendant and given to the plaintiff, one of the debtor’s creditors, pursuant to a secret agreement by the plaintiff that he would induce the other creditors to accept a composition of their debts on certain terms. However, the plaintiff ultimately failed to persuade the other creditors to accept the composition. The court disallowed the plaintiff’s claim against the defendant on the promissory note, which it held was a fraudulent transaction and therefore void.

9 By 1875, the legal position in England was already well established, at least in relation to debtors’ proposals for the composition or arrangement of their debts. The following leading statement of the law was given by Malins VC in McKewan v Sanderson:16

Now I take it to be thoroughly settled, both in Courts of Law and Equity, that...

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