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What is the anti-deprivation rule?
A contract term cannot operate to deprive creditors of an asset that the company had immediately before the onset of insolvency.
All unsecured creditors should receive pro-rata distributions from a common pool of assets on a company's insolvency. Any contract or arrangement designed to favour a particular creditor, or to remove assets that would otherwise be available for creditors, is contrary to public policy and can be set aside.
What is the relevant insolvency regime?
A quick reminder of some of the relevant statutory requirements:
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Voluntary winding up: On a voluntary winding up, the company's property must be applied in satisfaction of the company's liabilities with unsecured creditors ranking equally. 1
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Compulsory winding up: Where a company is wound up by court order, the liquidator must ensure that the assets of the company are got in, realised and distributed to the company's creditors with unsecured creditors ranking equally. 2
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Moratorium: Any disposal of a company's property made after the start of a winding up is void, unless the court orders otherwise. 3
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Reviewable transactions: A liquidator or administrator can apply to court to set a number of transactions aside if they have put assets beyond the reach of creditors – e.g. transactions entered into by the company at an undervalue, or giving a preference to a particular creditor. 4
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Why is the anti-deprivation rule on the radar?
There have recently been a number of high-profile cases on the scope of the anti-deprivation rule. 5
According to The Insolvency Service statistics, approximately 1 in 120 active companies went into liquidation over the last 12 months monitored. 6 In this climate, it is inevitable that the anti-deprivation rule has come under increasing scrutiny, as insolvency practitioners work to maximise the value of assets for creditors.
What is the effect?
The courts have now struck down a number of transactions as falling foul of the anti-deprivation rule – i.e. because an asset of the insolvent party was lost or became vested in a third party (rather than the unsecured creditor pool) after the company's entry into an insolvency procedure. These include:
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a contract that provided for a security interest to arise (or additional security to arise) in a company's asset on the insolvency of the company;
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a provision in a contract that automatically terminated an indemnity given by one party to another when the indemnified party entered into an insolvency process; and
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a provision in a partnership deed which stated that, in the event of the bankruptcy or insolvency of a partner, the bankrupt partner was to lose his interest in the partnership assets at a valuation which discounted certain partnership assets.
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Exceptions to the rule
The anti-deprivation rule is not offended where, for example:
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A transfer of company assets completes before the company enters into an insolvency procedure (although it will remain open to challenge if the transfer amounts to a voidable transaction under the Insolvency Act 1986).
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A third party exercises a right to acquire an interest owned by a company after the company enters into an insolvency procedure, as long as the right to acquire the asset is at or above market value (i.e. so that the company, although deprived of the asset, is not deprived of the value of the asset).
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A property owner grants a company a limited interest in that property which automatically terminates on the company's insolvency such as:
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- a provision for forfeiture of a lease on the tenant's insolvency – this simply qualifies the tenant's interest in the leased property; or
- a provision that terminates a licence (e.g. a licence of intellectual property rights) on the insolvency of the licensee.
In these instances, the anti-deprivation rule does not apply: the asset in the tenant/licensee's hands is "flawed" from the outset – i.e. the interest in the asset is always subject to termination on insolvency. Clearly, it is not unreasonable for an owner to ensure that a tenant/licensee does not enjoy the property when the tenant/licensee is insolvent, as it is almost always the case that the tenant/licensee has significant obligations – e.g. payment of rent/royalties. |
Some points to take away
Ultimately, the anti-deprivation rule is not intended to extend the scope of existing insolvency legislation – it is intended to protect it. That said, as the Court of Appeal recently acknowledged, it is "difficult to define what sort of deprivation provisions" are caught by the rule. 7 As transactions become increasingly complex (particularly in the debt financing sector) and given current market conditions, courts will probably continue to develop the law in this area – albeit on a relatively cautious, case-by-case basis.
So, in terms of some key points to take away when drafting or entering into contracts:
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Carefully consider contractual provisions providing for termination on insolvency events. A court may strike out a contractual provision if its effect is, on the insolvency of a company, to transfer an asset of the company to a third party or otherwise to deprive the company's creditors of the benefit of the asset.
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Carefully consider compulsory share transfer provisions in joint ventures. A mechanism that provides for a compulsory sale of an insolvent shareholder's shares at less than an objectively determined market value could be vulnerable to challenge.
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Bear in mind the cumulative effect of linked provisions that are triggered on a contract party's insolvency (e.g. cross-default provisions).
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If you would like to explore taking advantage of, or protecting yourself against, the anti-deprivation rule, please contact Caroline Copeland.
1 Insolvency Act 1986, s. 107.
2 Insolvency Act 1986, s. 143(1), and Insolvency Rules 1986, r. 4.181.
3 Insolvency Act 1986, s. 127.
4 Insolvency Act 1986, ss. 238 and 239.
5 The Court of Appeal's decision in Perpetual Trustee Company Ltd v BNY Corporate Trustee Services Ltd and Butters v BBC 6 Worldwide [2009] EWCA Civ 1160 and the High Court case of Mayhew v King [2010] EWHC 1121 (Ch).
6 The Insolvency Service's "Statistics Release: Insolvencies in the First Quarter 2010" dated 7 May 2010 and available at http://www.insolvency.gov.uk/otherinformation/statistics/201005/index.htm.
7 Lord Neuberger as Master of the Rolls, at para. 93 in the Perpetual Trustee Company case (as above).
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