The question of what constitutes a breach of good faith between creditors, sufficient to establish a material irregularity in voting on a proposed individual voluntary arrangement (IVA), has recently been battled before the Court of Appeal: Moises Gertner v (1) CFL Finance Ltd (2) David Rubin [2018] EWCA Civ 1781. The judgment that has been handed down makes essential reading for debtors, creditors and insolvency practitioners alike.

Some general principles

By way of reminder, a decision approving a proposal or a modification to an IVA is made when 75% or more (by value) of the creditors voting on the decision respond in favour (rule 15.34(6)(a), IR 2016). A decision is not made if more than 50% (by value) of creditors who are not associates of the debtor vote against it (section 258, IA 1986; rule 15.34(6)(b), IR 2016).

The debtor, any creditor, a trustee in bankruptcy or the official receiver may challenge the creditors’ decision to approve an IVA on two grounds: 1) the IVA unfairly prejudices the interests of a creditor; or 2) there was a material irregularity in relation to the creditors’ decision procedure (section 262(1), IA 1986). What constitutes a “material irregularity” is a question of fact, though it is necessary to show that the irregularity was more than de minimis and it must relate to the creditors’ decision procedure. Notably, the Court of Appeal in Kapoor v National Westminster Bank plc [2011] EWCA Civ 1083 held that “the principle of good faith is included within the concept of material irregularity under section 262(1)(b) IA”.

An IVA will only bind a contingent creditor if there is, at the date of the creditors’ decision, some certainty that the contingent liability will crystallise. A debt of an unliquidated or unascertained amount is to be valued at £1 for voting purposes unless the chair decides to put a higher value on it (rule 15.31(3), IR 2016). IVA proposals must allow for the payment of preferential debts in priority to unsecured debts (section 258(5)(a), IA 1986). IVAs must not affect the rights of a secured creditor, unless the secured creditor has provided their consent (section 258(4), IA 1986).

The dispute

In this case, the debtor owed £11 million to CFL Finance Ltd (CFL) and over £547 million to an Icelandic bank (the Bank) under a personal guarantee to secure a loan to a family business. CFL presented a bankruptcy petition, which was listed to be heard on 23 November 2015. Three days before the hearing, CFL received an IVA proposal from the debtor, which provided that a sum of just under £490,000 would be paid by a third party to discharge the debtor’s tax liabilities and to pay unsecured creditors £0.07 in the pound. At the creditors’ meeting to consider and vote on the proposal, it was confirmed that the Bank, representing 90% of the creditors by value, had voted in favour of the IVA and, accordingly, the IVA was approved.

CFL rejected the proposal as it was suspicious that a settlement agreement (the Agreement) between the Bank and the debtor’s family business had been entered into before approval of the IVA and pursuant to which the Bank would receive $6 million and a share of any sums recovered from an ongoing arbitration, to which the debtor was a party.

The High Court’s findings

At first instance, CFL made an application to the High Court to revoke or suspend the approval of the debtor’s IVA pursuant to section 262 of the IA, citing both unfair prejudice and a material irregularity at or in relation to the creditors’ meeting. The judge held that the effect of the Agreement rendered the debtor’s liability to the Bank as either extinguished or contingent and therefore unliquidated and, on this basis, the Bank should either have been excluded from the vote or its claim should have been valued at the nominal sum of £1. On the second issue of material irregularity, the judge held that the Agreement breached the principle of good faith between creditors because it enabled the Bank to benefit and acted as an inducement for the Bank to support the IVA. The judge rejected CFL’s argument that the IVA proposal was also unfairly prejudicial to its interests as a creditor, on the basis that the IVA itself treated all creditors equally.

The debtor appealed against the judge’s decision on material irregularity to the Court of Appeal. CFL cross-appealed against the Judge’s rejection of its case on unfair prejudice.

The Court of Appeal’s findings

Whilst dismissing the appeal, Lord Justice Patten disagreed with the High Court’s determination and found that there was “no reason in law why a creditor could not preserve the existence of a debt owed to him whilst at the same time agreeing to take no steps himself to enforce the liability”. Accordingly, the Agreement alone did not render the debt to the Bank extinguished, unliquidated or unascertained and, for this reason, the Court of Appeal found no material irregularity in the chairman’s decision to allow the Bank to vote in respect of the entire value of the debtor’s liability.

As to whether the Agreement breached the Bank’s duty of good faith, the Court of Appeal held that the principle of good faith was not “simply a re-iteration of the rule embodied in all insolvency legislation that the general unsecured creditors should share pari passu in the available assets of the insolvent estate. The principle can be breached if a creditor receives a collateral advantage from a third party in return for entering into the arrangement.” Lord Justice Patten relied on the Court of Appeal’s decision in Kapoor v National Westminster Bank plc.

LJ Patten accepted Mr Moss’s submission that “the mere fact that some (but not all) creditors will receive preferential treatment in the form of payment by a third party does not ipso facto constitute a material irregularity”, however on the basis that the Bank was set to obtain a “significant financial advantage” over what the other creditors would receive in the IVA, it was held that “the additional consideration was intended to act and must be presumed to have acted as an inducement” to the Bank to support the IVA which would avoid the debtor’s bankruptcy. In doing so, the effect of the Agreement placed the Bank in conflict with the other creditors; and was a breach of good faith which should have disqualified the Bank from voting on the proposal.

In view of this finding, the Court of Appeal did not consider it necessary to deal with CFL’s appeal as to unfair prejudice.

Lessons to draw

Whilst it was accepted that there had been no proper disclosure of the Agreement to the IP, this case serves to reinforce the importance of caution by IPs when relying on information provided by debtors, and the need to conduct thorough and rigorous investigations into the debtor’s dealings with creditors as early as possible. In this case, CFL’s representative at the creditors’ meeting requested an adjournment of the meeting to allow for further investigations into the Agreement. Given the 14 day limit on an adjournment, the IP reasonably determined that this was not a feasible proposition. Instead, the IP reminded CFL that in the event that the debtor was found to have omitted material facts, this would form the basis of an application by the supervisor of the IVA for the debtor’s bankruptcy.

The Court of Appeal’s decision in this case turned on a breach of good faith. It is arguable that the judgment does not satisfactorily draw the line as to what level of breach constitutes a material irregularity. Indeed, on one hand, it was accepted that a preferential payment to some but not all creditors would not constitute a material irregularity, yet on the other hand and in this case, it was considered that the preferential payment was so significant that it did constitute a material irregularity. For those who prefer quantifiable and certain conclusions, this judgment does not deliver. However, what the Court of Appeal has made clear: if any creditors within an IVA are also set to benefit outside the IVA this should be disclosed, investigated and treated with the utmost caution.

If you would like to discuss the above in any more detail please feel free to contact Simeon Gilchrist and Sophia Bompas – Partner, or any member of our Restructuring & Insolvency Team.

Please note that this blog is provided for general information only. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content of this blog.

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