In a Creditor/Principal Debtor/Guarantor scenario, must the Creditor specify in a bankruptcy statutory demand to be served on the Guarantor, an in rem security the Creditor holds over the Guarantor's property, the in rem security securing not the Guarantee debt but the principal debtor's debt to the Creditor?
This is the narrow question that the High Court had to resolve in the case of Promontoria (Chestnut) Limited v Bell and Bell  EWHC 1581 (Ch). The decision centres around the important question: if the in rem secured creditor released the in rem security, would this thereby augment the assets in any future bankrupt estate?
Along with resolving this narrow question however, the case drew attention to a wider and core underlying principle of bankruptcy law - that bankruptcy law ensures that creditors proving against a debtor’s bankrupt estate prove on an equal footing. A creditor holding an in rem security over assets in the bankrupt estate cannot prove in the bankrupt estate, for all of the debt, as if he did not hold the in rem security, before then exercising his in rem security rights, since that would permit that creditor to gain a preferential position over the other proving creditors.
Mr and Mrs Bell (‘the Bells’) were directors and shareholders of a company (the ‘Company’) and the Company had borrowed money from a bank. The Bells entered into a personal guarantee (with indemnity if the guarantee was unenforceable), in respect of the Company’s borrowing from the bank (‘the Guarantee’), up to a limit of £170,000 (the ‘Guarantee Limit’). In addition, a few months later, Mr Bell (only) executed a mortgage over a property owned by him, and (both) the Bells executed a mortgage over a property owned jointly by them (together, ‘the Bell Mortgages’), securing, importantly, the Company’s liability to the bank, and not Bells’ Guarantee to the bank. In other words, the Bells gave to the bank, to secure the Company’s obligation to the bank to repay monies borrowed, both: (1) a personal security, the Guarantee, and (2) a real (in rem) security, the Bell Mortgages. Subsequently, the Company borrowed money under a facility (the ‘Facility’)
By a deed of assignment, the bank’s rights under the Facility, Guarantee and the Bell Mortgages, were transferred to the Creditor Promontoria (Chestnut) Limited (the ‘Creditor’).
The Company failed to repay the Facility when demanded, and the Creditor demanded the Bells pay under the Guarantee. Following various receivers being appointed, and assets realised, the sum due from the Company to the Creditor reduced to £185,000 odd. Subsequently, the Creditor demanded payment of £170,000 under the Guarantee, and when no payment was made, the Creditor served statutory demands on the Bells pursuant to s.268 Insolvency Act 1986 (the ‘IA 1986’).
Application to Set Aside the Statutory Demands
The Bells applied to set aside the statutory demands, with the only real ground advanced at the hearing being that the Creditor held security over their property (i.e. the Bell Mortgages).
The Creditor resisted the set aside application, arguing that the Bell Mortgages were not relevant security and that the Creditor had not been obliged to specify this security in its statutory demands, because the Bell Mortgages secured the Company’s indebtedness to the Creditor, not the Bells’ indebtedness to the Creditor under the Guarantee. Moreover by reason of the terms of the Guarantee, there was no obligation on the Creditor to enforce the Bell Mortgages first as opposed to pursuing the Bells for the debt under the Guarantee.
The Deputy Insolvency and Companies Court Judge (‘Deputy Judge’) hearing the application rejected this submission and acceded to the application, setting aside the statutory demands pursuant to r.6.5(4) of the Insolvency Rules 1986 (which applied to the case, rather than the subsequent Insolvency Rules 2016, as a result of paragraph 14(1) of Schedule 2 of the Insolvency (England and Wales) Rules 1986). The Deputy Judge found that the Creditor held some security in respect of debt claimed in the statutory demands; omitting to mention this security in the Creditor’s statutory demands meant the statutory demands did not comply with r.6.1(5), that the first part to r.6.5(4)(c) was thereby engaged, and, exercising the discretion thereby arising, it was appropriate to set aside the statutory demands. The Creditor appealed.
Insolvency Rules 2016
Before considering the High Court appeal, it is worth noting here, as indicated above, that the case revolved around the correct interpretation of r.6.1(5) and r.6.5(4)(c) of the Insolvency Rules 1986. However, subject to transitions provisions, those rules have been superceded by Insolvency Rules 2016. The equivolent provisions to r.6.1(5) and r.6.5(4)(c) are found in r.10.1(9) and r.10.5(5)(c) of the Insolvency Rules 2016. They are very similarly worded, however the (key) phrase 'in respect of', from r.6.5(4)(c), is now 'in relation to' in r.10.5(5)(c).
Appeal against Decision to Set Aside Statutory Demands
The High Court appeal came before Zacaroli J. The issue for Zacaroli J was whether or not the Deputy Judge had fallen into error in setting aside the statutory demands on the ground that the Deputy Judge did. Central to this, was the correct interpretation of r.6.1(5) of the Insolvency Rules 1986.
Specific Statutory Demand Rules and a Long-Standing Underlying Principle
In his judgment in Promontoria v Bell, Zacaroli J began his analysis by recalling the specific Insolvency Rules 1986 content requirements for bankruptcy statutory demands, and the Court’s powers where the statutory demands are non-compliant. Zacaroli J said, at paragraph 12 and 13:
‘Rule 6.5(4)(c) of [Insolvency Rules 1986] entitles the court to set aside a statutory demand if “it appears that the creditor holds some security in respect of the debt claimed in the demand, and either rule 6.1(5) is not complied with in respect of it, or the court is satisfied that the value of the security equals or exceeds the full amount of the debt”.
Rule 6.1(5) provides that if a creditor holds security for the debt then there shall be specified in the statutory demand the nature of the security and the value which the creditor puts upon it as at the date of the demand. The amount which may be claimed is then the full amount of the debt less the amount specified as the value of the security.’
The Court was therefore empowered by Insolvency Rules 1986, with a discretion to set aside bankruptcy statutory demands, where, for instance, they were non-compliant/defective because the creditor had failed to comply with r.6.1(5) in respect to any ‘creditor security for the debt’ - phrased in r.6.5(4)(c) as ‘some security in respect to the debt claimed in the demand’ held by the creditor.
Zacaroli J then identified similar rules about secured creditor participation in the bankruptcy petition process, as well as in proving against the bankrupt estate. As to participation in the bankruptcy petition, he noted, at paragraphs 14 to 16:
‘By s.267(2)(b) of the Insolvency Act 1986 (“IA 1986”), subject to s.269, a creditor’s petition can be presented in respect of a debt only if the debt is unsecured.
By s.269 IA 1986, a debt upon which a bankruptcy petition is presented need not be unsecured only if the petition contains a statement that the petitioner is willing, if a bankruptcy order is made, to give up the security for the benefit of the bankrupt’s estate or the petition is expressed not to be made in respect of the secured part of the debt and contains a statement by the person of the estimated value as at the date of the petition of the security for the secured part of the debt.
By s.383, a debt is secured “to the extent that the person to whom the debt is owed holds any security for the debt (whether a mortgage, charge, lien or other security) over any property of the person by whom the debt is owed.” By s.385(1), “secured” and related expressions are to be construed in accordance with s.383.’
And as to secured creditors participation in proving against the bankrupt estate, he noted, at paragraph 17:
‘A secured creditor is entitled to prove only in respect of the unsecured part (if any) of the debt. By Rule 6.98 of [Insolvency Rules 1986], the proof of debt must give particulars of any security held, and the value which the creditor puts upon it. Failure to do so will result in the security being surrendered for the general benefit of creditors (Rule 6.116) unless the court grants relief from the effect of the rule.’
A core underlying principle in bankruptcy law underpins this rules. At paragraph 18, Zacaroli J said:
‘Those Rules reflect a long-standing principle in bankruptcy that secured creditors can only participate in the bankruptcy to the extent of any unsecured part of their debt unless they are willing to give up their security for the benefit of the general body of creditors: see White v Davenham Trust Ltd  EWCA Civ 747 where, at , Lloyd LJ referred to the following authorities which explain the rationale for this principle.’
In support, Zacaroli J noted the following passages. From Re Plummer (1841) 1 Ph 56, and the speech of Lord Lyndurst, at 59:
‘For the principle of the bankrupt laws is, that all creditors are to be put on an equal footing, and, therefore, if a creditor chooses to prove under the commission, he must sell or surrender whatever property he holds belonging to the bankrupt.’
From Ex p West Riding Union Banking Co(1881) 19 Ch D 105, where Jessel MR said:
‘The principles of the bankruptcy law are plain enough. A man is not allowed to prove against a bankrupt’s estate and to retain a security which, if given up, would go to augment the estate against which he proves. That is the principle of the whole thing. The only question is whether, if the security were given up, it would augment the estate?’
And from Davenham v White, where Lloyd LJ said (after having referred to the statutory prohibitions on a secured creditor presenting a petition for bankruptcy, and the two exceptions contained in s.269 IA 1986), at paragraph 9:
“Lying behind these arrangements is the fact that bankruptcy proceedings are not intended as a means for a single creditor to enforce his debt against the debtor but rather as a method of collective realisation of the assets of a debtor who cannot pay his debts, to be distributed for the benefit of all creditors with claims on those assets. A creditor who is fully secured over assets of that debtor does not need to take bankruptcy proceedings, and should not do so, unless he is willing to give up the security, because the asset over which the security exists will not be part of the estate divisible for the benefit of the creditors generally. That is why a secured creditor cannot present a bankruptcy petition under section 267(2)(b) unless either he is willing to give up the security or his security is not adequate to cover the whole debt, in which case he ranks with the other unsecured creditors but only so far as the shortfall is concerned.”
In essence therefore, the question is whether the relevant in rem security held by the creditor, if given up, would augment (increase) the assets/available value of assets already in the bankrupt estate.
Turning back to the task of properly interpreting r.6.1(5) and r.6.5(4), Zacaroli J said, at paragraph 22, that:
‘…it is necessary to have regard to the fact that their purpose is to give effect to that underlying principle.’
However, before turning to the main appeal point, Zacaroli J addressed a preliminary issue: whether 'security in respect of the debt' in r.6.5(4)(c) is to be given a different meaning to the phrase “security for the debt” in s.383 of the IA 1986.
To resolve this preliminary issue, reference was made to Re a Debtor (No. 310 of 1988)  1 WLR 452, a decision of Knox J, in which Knox J said, at 455D-G:
‘“It seems to me that one has to read the Insolvency Rules 1986 in the context of the requirements of the [IA 1986], and it does seem to me to follow that the word “security” and the conception of an “unsecured” debt all hold together, and that the requirement that value should be placed upon a security, and that the amount to be claimed shall be the amount less the amount specified as the value of the security, is closely tied to the way in which the grounds for a creditor's petition are set out in section 267(2). It seems to me, therefore, that although the turn of phrase is not exactly the same, and although the definition is in the Act and not in the rules, the two ought to be read so that they mesh together and operate hand in hand.”
Though noting that Knox J was considering a somewhat different context, Zacaroli J said, at paragraph 28:
‘…Knox J’s reasoning is in my judgment of general application. Since the service of a statutory demand is a precursor to a bankruptcy petition, and the bankruptcy petition is intended to lead to a regime where creditors can prove their debts, it is logical that the definition of secured creditors should be the same at each stage.’
On main appeal issue, Zacaroli J found, at paragraph 41, that:
‘…the deputy judge was correct to conclude that the [Bell Mortgages] provided by [the Bells] for the indebtedness of the Company to the Creditor are security in respect of the debt upon which the statutory demands were based, within the meaning of Rule 6.5(4)(c) of [Insolvency Rules 1986] interpreted in accordance with its underlying rationale and purpose (It follows, as explained above, that they are also security “for” the debt under s.383 IA 1986)’
Consequently, the appeal was dismissed. In essence, the Deputy Judge had not been wrong to find that Creditor’s statutory demands had been non-compliant, because the statutory demands had not referred to the Bell Mortgages.
In explaining his decision, Zacaroli J first dealt with the position as if the Guarantee did not contain the Guarantee Limit. That is, where the liability of the Bells as guarantors under the Guarantee, was co-extensive (in terms of amount) with the liability of the principal debtor Company.
Zacaroli J reasoned that the principle identified above applied equally to the facts in Promontoria v Bell, as they did to the 'plain case' where the in rem security secured to the serving creditor, the guarantee debt. At paragraph 43, Zacaroli J said:
‘My conclusion is based mainly upon the fact that the rationale and purpose of the Rules, including [r.]6.5(4)(c), which require a secured creditor to give up its security if it wishes to participate in the bankruptcy apply just as much in the present case as they do in the plain case where a debtor provides security over her assets to the creditor in respect of the debt owed by her to the creditor.
Zacaroli J continued, at paragraph 44:
…the rationale is that all proving creditors stand on an equal footing as regards the assets in the bankruptcy estate, and to allow the secured creditor to prove, whilst retaining its security, would place it in a preferential position. That is because it would be proving for the full amount of its debt in competition with all other creditors against the bankruptcy estate, where that estate was depleted because of the exclusion of the property over which it holds security for the debt. This explains why the sole question (per Jessel MR in West Riding Union Banking Co) is whether, if the creditor were to give up the security, it would augment the estate for the benefit of all creditors.’
He continued, at paragraph 45:
‘In this case…the receipt by the Creditor of the proceeds of realisation of the [Bell Mortgages] would result in a discharge, pro rata, of the [Guarantee] liability. Although there are two different debts – one owed by [the Bells] and one owed by the Company, both forms of security (in the broad sense) provided by [the Bells] are rooted in the same debt: [the Bells] has both guaranteed, and provided a third-party charge for, the Company’s debt.’
Continuing, at paragraphs 46 and 47, Zacaroli J said:
‘It is for this reason that the rationale and purpose referred to above are equally applicable in the circumstances of this case. On the assumption that the [Guarantee] given by [the Bells] is of the whole of the Company’s debt, then it can clearly be seen, answering the question posed by Jessel MR, that if the security of the Creditor was given up it would augment the bankruptcy estate of [the Bells]. For every £1 of value of the secured property released from the security, £1 is available for distribution among unsecured creditors in the bankruptcy estate.
Conversely, adopting the language of Lloyd LJ in Davenham v White, the asset over which the security exists will not be part of the estate divisible for the benefit of the creditors generally, unless the Creditor gives up its security.
The very fact that recourse to the security over [the Bells’] property would discharge the personal debt owed by [the Bells] is a powerful indication that the third-party charges are security “for” or “in respect of” the debt.’
Conclusion contrary to Lewison J in Sofaer
Zacaroli J acknowledged that his conclusion was contrary to Lewison J's third reason given for his conclusion in Sofaer v Anglo Irish Asset Finance PLC BPIR 1736. However, Zacaroli J found that he was not bound by Lewison J's decision on this point, because:
‘(1) it was not necessary for his decision in light of his conclusions on the first two grounds for his decision, (2) no argument was addressed to him on the underlying rationale of the relevant statutory provisions and (3) no authority identifying that rationale was cited to him.’
Bankrupty Law overrides Creditor's Contractual Right to Choose which security to enforce
In addition, Zacaroli J dismissed an argument put forward by the Creditor that a finding that its statutory demands were r.6.1(5) non-compliant, would impermissible cut across the Creditor's contractual right to choose which of its range of securities it would enforce. That is, Creditor had been:
‘…entitled to choose in which order to enforce its securities and that the provisions of the [Guarantee] indicate that it is additional to other securities provided to the Creditor…’ (paragraph 50)
Zacaroli J said, at paragraph 50, that ‘…these factors do not override, in my judgment, the mandatory rule in bankruptcy embodied, among other places, in [r.] 6.5(4)(c).’
The Guarantee Limit
Having reached the above conclusions, Zacaroli J then re-introduced the Guarantee Limit back into the analysis.
‘…where, as existed in this case at the time of the statutory demands, the liability under the guarantee is less than the amount of the Company’s debt, the same analysis is appropriate, subject to one change – namely that because the Creditor is free to appropriate its security to the principal debt in such manner as it sees fit, it would be entitled to participate in the bankruptcy of [the Bells] to the extent of the shortfall between the debt owed by the Company and the value of the security over the guarantor’s property.’
Zacaroli J said that the law here was ‘…best explained by three worked examples’ (paragraph 51), which he set out at paragraphs 52 to 54:
‘First, if the Company’s debt was £200,000, the guarantee was capped at £100,000 and the property of [the Bells] over which the security was granted was worth £100,000, then the Creditor would be entitled to appropriate the entirety of its security to that part of the principal debt which was not covered by the guarantee and thus participate in the bankruptcy in respect of the full amount of the guarantee debt.
Second, if the Company’s debt was £150,000, the guarantee was capped at £100,000 and the property of [the Bells] was worth £100,000, then even if the Creditor appropriated the security first to that part of the Company’s debt which was not covered by the guarantee, that would still leave £50,000 worth of security for the remaining (guaranteed) part. Accordingly, the Creditor would be required to value the security in respect of the guarantee debt in an amount equal to half of the debt, being free to prove for the other half.
Third, if the Company’s debt was £150,000, the guarantee was capped at £100,000, but the property of [the Bells] was worth £150,000 or more, then, since however the Creditor applied its security to the principal debt the whole of it was secured, it could only participate in the bankruptcy if it gave up its security.’
An edited version of this article was published by Lexis Nexis, available here (subscription required).
SIMON HILL © 2019
33 BEDFORD ROW
NOTICE: This article is provided free of charge for information purposes only; it does not constitute legal advice and should not be relied on as such. No responsibility for the accuracy and/or correctness of the information and commentary set out in the article, or for any consequences of relying on it, is assumed or accepted by any member of Chambers or by Chambers as a whole.
The Insolvency Rules 1986 applied to the facts in the case. The equivalent rule to r.6.5 in the Insolvency Rules 1986 is r.10.5(5) in the Insolvency Rules 2016, with one very material different. Promontoria v Bellconsidered the meaning of ‘in respect of’, but those words are replaced in r.10.5(5) by the words ‘in relation to’. Promontoria v Belldoes not address the issue of whether that makes a material difference to how the law applies, though in the author’s view it is very unlikely to make a difference.