Bankruptcy Discharge and Release, the Exception for Fraud and Fraudulent Breach of Trust

When a bankrupt is discharged[1] from bankruptcy, the general rule, as set out in section 281(1) of the Insolvency Act 1986[2] (the 'Insolvency Act'), is that the discharge releases the bankrupt from all unsatisfied[3] ‘bankruptcy debts’. However there are certain categories[4] of unsatisfied bankruptcy debts that the legislator has determined will not be released on discharge; consequentially any bankruptcy debts falling within into one of these categories, known as ‘exceptions’, will not be released but, after the bankrupt’s discharge, will remain due and owing to the creditor by the bankrupt, and the creditor will be able to enforce its rights and seek remedies against the bankrupt in the usual way.

2. Where, after a bankrupt’s discharge, a putative creditor seeks to assert that it continues to hold a right[5] as a creditor against the now discharged bankrupt, the Court will have to determine what the legal consequences of the discharge were. Was the bankruptcy debt now sought to be relied upon by the putative creditor released on discharge, or did it survive discharge because it fell within one of the prescribed categories. A putative creditor’s assertion may come within a ordinary civil claim seeking a judgment on the cause of action[6], or within proceedings brought by the putative creditor to enforce of a judgment debt [7a]. In either case, the discharged bankrupt may defend the putative creditor’s claim on the basis that the putative creditor’s right did not survive discharge and so the putative creditor has nothing to claim upon, and so no right to a remedy thereon. The putative creditor's assertion can, seemingly, arise also if the putative creditor brings/pursues proceedings upon the debt, against the bankrupt, prior to the bankrupt's discharge, with the putative creditor claiming the Court should not restrain the proceedings because the debt will survive any future bankrupt's discharge/release[7b].

3. This article will consider the general rule on release, and then the nature of one of the prescribed categories, contained within section 281(3) of the Insolvency Act, which can loosely be framed as ‘incurred in respect of …any fraud or fraudulent breach of trust to which he was a party’, or where forbearance was secured by ‘…any fraud or fraudulent breach of trust to which he was a party.’

Matters that Discharge Does Not Affect

4. Before considering the general rule on release and the exceptions to the general rule, it is worth noting what discharge from bankruptcy does not affect. As expressly set out in section 281(1), the discharge from bankrupt has no effect:

‘(a) on the functions (so far as they remain to be carried out) of the trustee of his estate, or

(b) on the operation, for the purposes of the carrying out of those functions, of the provisions of this Part;

and, in particular, discharge does not affect the right of any creditor of the bankrupt to prove in the bankruptcy for any debt from which the bankrupt is released.’

5. No aspect of the discharge process, affects the entitlement of a creditor to submit a proof of debt and receive a declared dividend distribution out of the bankrupt estate.

6. Further, the creditor of any secured debt against the bankrupt, retains the rights granted to him as holder of that security. This saving provision is contained in section 281(2) of the Insolvency Act. That section reads: ‘Discharge does not affect the right of any secured creditor of the bankrupt to enforce his security for the payment of a debt from which the bankrupt is released.’[8]

7. In Anglo Manx Group Ltd v Aitken [2002] B.P.I.R. 215, the Deputy High Court Judge, at paragraph 59, referred to ‘…the well established principle that a secured creditor takes outside of the bankruptcy and therefore his remedies are outside the bankruptcy.’[9]

Bankruptcy Debts

8. Bankruptcy debts are defined by section 382[10] of the Insolvency Act, and in short, encompasses most types of debts or liabilities (arising by reason of breach of obligations in tort, contract, unjust enrichment, bailment, etc.) to which the bankrupt was subject at the date of his bankruptcy (i.e. when the bankrupt order was made[11]), and debt or liability arising by reason of any such obligation incurred before that commencement date, but which may arise afterwards, and interest. In Templeton Insurance Ltd v Brunswick  [2012] EWHC 1522 (Ch) (‘Templeton Insurance’), this was summarised, at paragraph 45:

‘The definition of bankruptcy debt in relation to a bankrupt, at s.382(1) IA 1986, includes "any debt or liability to which he is subject at the commencement of the bankruptcy". It is immaterial whether the debt is present or future, whether it is certain or contingent or whether its amount is fixed or liquidated, or is capable of being ascertained by fixed rules or as a matter of opinion (s.382(3)). The meaning of liability includes a liability to pay money or money's worth, including … any liability for breach of trust, any liability in contract, tort … and any liability under an obligation to make restitution (s.382(4)).’

General Rule about Release on a Bankrupt’s Discharge from Bankruptcy

9. The structure set down by Parliament is one of general rule, with prescribed exceptions to that general rule.

10. As to the general rule, Section 281(1) of the Insolvency Act provides, so far as presently material, that:

‘Subject as follows, where a bankrupt is discharged, the discharge releases him from all bankruptcy debts...’

11. The general rule itself is designed to mitigate what would otherwise be indefinite liability upon the bankrupt[12] - in other words, without the mechanism of general release on discharge, all bankruptcy debts not already satisfied from the bankrupt estate dividend distributions, would, on discharge, be once again exercisable against the bankrupt. The creditors’ respective rights against the bankrupt would not terminate on discharge, but would continue and, coupled with the lifting of the moratorium on the Court granting remedies in furtherance of creditor rights, each of these creditors would again be able to obtain remedies from the Court against the (then discharged) bankrupt on each unsatisfied bankruptcy debt.

12. As will be apparent, the existence and scope of general rule granting general release to the bankrupt, is part of a wider exchange lying at the heart of the whole bankruptcy process (howsoever the bankrupt was adjudged bankrupt, voluntarily or involuntarily). In exchange for the bankrupt transferring (known as vesting) almost all his assets[13] to another, the Trustee in Bankruptcy, to form the bankrupt estate, and be liquidated and paid out to his creditors, the bankrupt gets, in essence, his slate cleaned of almost all debts and liabilities existing at the moment of the bankruptcy order (or arising from obligations existing at the moment of the bankruptcy order). In Regina (Balding) v Secretary of State for Work and Pensions [2007] 1 W.L.R. 1805, Davis J sitting in the Divisional Court said, at paragraph 48:

‘…the perceived policy underpinning section 281 of the 1986 Act…is in effect to wipe the slate clean and, broadly speaking, enable the bankrupt to make a fresh start’[14]

The Effect of Release on a Bankruptcy Debt

13. A creditor holding a bankruptcy debt (i.e. the creditor end of the legal tie/’thing in action’; the obligee end of the obligation to pay) that is caught by this statutory release will suffer a total loss of his bankruptcy debt as against the bankrupt[15] (though a fixed or floating charge, securing the bankruptcy debt, will offer the creditor an alternative right as against the property subject to the security). As indicated earlier, the same creditor may still lodge a proof of debt in the bankrupt estate (or maintain an existing proof of debt if he already lodged one), and receive from the bankrupt estate, in the normal way, whatever declared dividend distribution is due on the debt for that class of debt in the order of priority, calculated on a pari passu/pro rata basis across all debts within that class. That entitlement to any relevant declared dividend out of the bankrupt estate is not affected by the release; however, the bankruptcy debt itself, the right, will be lost[16a].

Quantum on Surviving Bankruptcy Debt

14. Where a creditor receives part satisfaction of a bankruptcy debt from a declared dividend distribution from the bankrupt estate, and that bankruptcy debt survives discharge, then the creditor must given credit in any action against the bankrupt, for the amount received in part satisfaction. Consequentially, while the bankruptcy debt might survive, the quantum of that same bankruptcy debt will be proportionately smaller as a result of the dividend distributions.

No Completely Clean Slate Granted on Exchange

15. Importantly, bankruptcy law does not offer a completely clean slate to the bankrupt, in exchange for the bankrupt estate. It bestows only a partial clean slate on the bankrupt. This partial, rather than complete slate cleaning, finds initial statutory foundation in the beginning words to section 281(1) and the phrase ‘Subject as follows’.

Exceptions to the General Rule - Fraud and Fraudulent Breach of Trust

16. The exceptions to the general rule are contained within section 281[16b] and r.10.146 of the Insolvency Rules 2016. The exception this article focuses on is that contained within section 281(3). That subsection reads:

‘Discharge does not release the bankrupt from any bankruptcy debt which he incurred in respect of, or forbearance in respect of which was secured by means of, any fraud or fraudulent breach of trust to which he was a party.’

17. Seemingly, the rationale behind this exception, is to separate out:

(1) bankruptcy debts arising from honest but potentially unfortunate behaviour or events; from

(2) bankruptcy debts arising from dishonest, fraudulent and/or rogue behaviour (the exact scope will be considered below);

with the law offering a release from (1) but not from (2).

18. In a different context, Lawton LJ in Re Stern (A Bankrupt) Ex p. Keyser Ullman [1982] 1 W.L.R. 860, said, at 866:

‘The modern law of bankruptcy has its origins in a number of Victorian statutes which were intended to relieve those in financial difficulties from the burden of debt and the possibilities of loss of liberty in a debtors' prison and to enable them to make a fresh start free from debt. The price they had to pay for these benefits was the surrender to their creditors of all their property save the tools, if any, of their trade and the wearing apparel and bedding of themselves and their families. It was recognised, however, that not all debtors were the victims of misfortune. Some were rogues, some were fools and some were willing to risk other people's money when trying to make their own fortunes.’

Fraud and Fraudulent Breach of Trust Exception

19. Turning back to section 281(3), it might first be observed that this provision is not easy to understand, or deconstruct upon first reading. It is not helped by the rather clumsy use of a sub-sentence in the middle, when perhaps separate sub-paragraphs might have aided understanding.

20. What will be apparent, is that the exception centres around:

(1) how the bankruptcy debt was incurred, involving consideration of the nature of the acts or omissions which gave rise to, or generated, the debt or liability. A question which might be posed is: what are the origins of the debt or liability itself; and

(2) the concepts of ‘fraud’ and ‘fraudulent breach of trust’,

21. The concepts of ‘fraud’ and ‘fraudulent breach of trust’ are written as alternatives, each providing an independent ingredient; satisfaction of one or the other (or both) will be sufficient, to engage the exception.

22. But, mere ‘fraud’ or ‘fraudulent breach of trust’ in a factual scenario generating a debt or liability, will not be sufficient to bring the bankruptcy debt within the section 281(3) exception, if the bankrupt was not a party to that same ‘fraud’ or fraudulent breach of trust’. Section 281(3) contains the phrase ‘to which he was a party’. Where ‘fraud’ or ‘fraudulent breach of trust’ is merely background or surrounding context, but the bankrupt was not actually implicated in it, the bankrupt's bankruptcy debt arising from some other obligation breach or misconduct, then the criteria for the section 281(3) exception will not be satisfied[17]. 

23. In addition, for section 281(3) to have application, not only must there be a ‘…fraud or fraudulent breach of trust to which he was a party’ but the bankruptcy debt must also have been “incurred in respect of” the same. Ferris J in Mander v Evans [2001] 1 WLR 2378 (‘Mander’) emphasized this, at paragraph 11:

‘[counsel for the claimant] concentrated his argument on the word “fraud” in section 281(3) but to my mind the case requires an earlier piece of analysis to be carried out. This is to determine what “bankruptcy debt” the court is concerned with, because section 281(3) has no application unless that debt was “incurred in respect of” fraud to which the defendant was a party.’

For further consideration of what 'incurred in respect of' means, see Cohen v O'Leary [2023] EWHC 1939 (Ch).

Fraud – Actual as against Constructive Fraud/Equitable Fraud

24. Fraud as a concept can be subdivided into two different types:

(1) ‘Actual fraud’; and

(2) ‘Constructive fraud’ (otherwise known as ‘equitable fraud’).

25. It has been held that the word ‘fraud’ in section 281(3) refers only to ‘actual fraud’. It does not include ‘constructive fraud’. In Mander, Ferris J said, at paragraph 25:

‘In my judgment, therefore, section 281(3) must be construed in accordance with ordinary principles without assistance from authority concerning the construction of other statutes. Approaching it on that basis, I think that the natural meaning of the word “fraud” is actual fraud in the Derry v Peek 14 App Cas 337 sense.’

26. The reasoning behind construing, and limiting, the statutory meaning of ‘fraud’ to only ‘actual fraud’, was explained in Mander, at paragraph 25:

‘I find it readily comprehensible that the legislature should consider that a bankrupt who has obtained his discharge should not be relieved of liability for his actual fraud committed before the bankruptcy. I find it much less comprehensible that he should remain liable for constructive fraud, which covers a wide range of conduct regarded by equity as unconscionable but not necessarily involving actual dishonesty. If the legislature had intended to preserve liability for such conduct I think that wider language than the one word “fraud” would have been used. Somewhat wider language has indeed been used, because the full reference is to “fraud or fraudulent breach of trust”, but I think that this militates against [the claimant counsel’s] argument rather than in favour of it. “Fraudulent breach of trust” does, of course, indicate an area which is the concern of equity. The fact that it is referred to in conjunction with “fraud” indicates that “fraud” by itself is not enough to take one into such an area. It was not suggested that the acts of the defendant complained of in this case amount to fraudulent breach of trust.’

27. This conclusion, that ‘fraud’ in section 281(3) means ‘actual fraud’ and does not also include ‘constructive fraud’, has been accepted to the extent that 14 months later, counsel in Woodland-Ferrari v UCL Group Retirement Benefits Scheme [2003] Ch. 115 (‘Woodland-Ferrari’) did not seek to argue otherwise (perhaps mindful that he was before the same judge, Ferris J)[18a]. In Jones and Pyle Developments Ltd v Rymell [2021] EWHC 385 (Ch)('Jones'), HHJ Paul Matthews (sitting as a High Court Judge) said, at paragraph 23:

'It is clear that "fraud" in that subsection refers to fraud in the sense of the tort of deceit at common law, as exemplified by Derry v Peek: see Mander v Evans [2003] 1 WLR 2378, [25].'

28. Actual fraud, as noted by Ferris J in Mander paragraph 25, involves ‘actual dishonesty.’ For instance, liabilities founded upon causes of action arising from mere acts of carelessness are not fraud. Carelessness, without more, does not contain actual dishonesty.

29. Mander referred to actual fraud in the Derry v Peek 14 App Cas 337 sense. That Derry v Peek sense, one can argue, derives from the speech of Lord Herschell, from 359 onwards. Now the area of law subject to appeal in Derry v Peek was as to the exact minimum mental element required to establish the ingredient of fraud in the tort of deceit cause of action - fraud being an essential ingredient in that cause of action. Lord Herschell set down the following propositions, at 374:

‘…fraud is proved when it is shewn that a false representation has been made (1) knowingly, or (2) without belief in its truth, or (3) recklessly, careless whether it be true or false. Although I have treated the second and third as distinct cases, I think the third is but an instance of the second, for one who makes a statement under such circumstances can have no real belief in the truth of what he states. To prevent a false statement being fraudulent, there must, I think, always be an honest belief in its truth. And this probably covers the whole ground, for one who knowingly alleges that which is false, has obviously no such honest belief.... if fraud be proved, the motive of the person guilty of it is immaterial. It matters not that there was no intention to cheat or injure the person to whom the statement was made.’

30. A liability incurred by the bankrupt and founded upon a cause of action requiring actual dishonesty, will come within the section 281(3) exception, and so survive discharge; an example would be a liability founded upon the tort of deceit cause of action[18b]. But the incidents of ‘actual dishonesty’ are more prevalent that just within facts amounting to the tort of deceit. As explained in the important case of Templeton Insurance [19a], any liability founded upon a cause of action tainted by actual dishonesty will come with the section 281(3) exception, whatever the nature of the underlying obligation breached (contractual obligations, fiduciary obligations etc.) HHJ Simon Barker QC, sitting as a Judge of the High Court in Templeton Insurance said, at paragraph 55:

‘In my judgment, a 'fraudulent breach of contract' or a 'fraudulent breach of fiduciary duty' is as capable of coming within the meaning of the word 'fraud' at s.281(3) as is the tort of deceit’

‘…this is not to be understood as restricting access only to bankruptcy debts founded in the tort of deceit, but rather as a reference to debts tainted by actual dishonesty.’

31. The Judge in Templeton Insurance said that this was because it was the legislative’s intention to make section 281(3) disqualify from release, liabilities resulting from the bankrupt’s actual dishonesty, at paragraph 55:

'The purpose of s.281(3) as a qualification to s.281(1) is to prevent a person from using the process of bankruptcy or invoking his bankruptcy and discharge therefrom as a medium for becoming free from debts and liabilities resulting from his actual dishonesty. In other words, s.281(3) is an anti-avoidance and preservative provision aimed at continuing the rights of a creditor who has been defrauded by the bankrupt.’

32. Since mere equitable fraud/constructive fraud does not equate to Common Law actual dishonesty, but rather is measured by the rules of Equity’s assessment of unconscionability, the Judge in Templeton Insurance re-iterated that mere equitable fraud/constructive fraud is insufficient for the application of the section 281(3) exception. At paragraph 55, the Judge in Templeton Insurance said:

‘Thus, 'fraud' as the gateway to the application of s.281(3) and a route through the barrier imposed by s.281(1) is not satisfied by establishing 'fraud' in the equity sense ('against conscience' or 'unconscionable'). To pass through the gateway and remain on the road to recourse against the discharged bankrupt, a creditor must prove 'fraud' in the common law sense;’

33. Thus, the crucial question for section 281(3) is whether the liability generating cause of action is tainted by actual dishonesty in the common law sense. Where the cause of action is so tainted, then the liability will come within the section 283(1) exception.

34a. The Judge concluded, at paragraph 56, that this ‘…analysis and conclusion is entirely consistent with the approach and analysis of Ferris J and the thrust of his decisions in Mander and Woodland-Ferrari.’

34b. In Jones, HHJ Paul Matthews (sitting as a High Court Judge) held, in enforcement proceedings, that the judgment debt survived discharge/release, as it fell within section 281(3) exception, because the trial judge had found that the '...defendant actually knew that the representations were untrue...the Derry v Peek test is satisfied in that the representations made... the defendant knowingly made the false representation and, in addition, he did so without belief in its truth.' (paragraph 25, quoting the trial judgment at paragraph 63)[19b].

Fraudulent Breach of Trust

35. The meaning of ‘fraudulent breach of trust’ was considered in Woodland-Ferrari, decided by Ferris J. At paragraph 9, he posed the question ‘What are the ingredients of “fraudulent breach of trust” for the purpose of section 281(3)?’

36. Plainly there are two elements, the breach of trust, and then separately, the requirement that such breach of trust was done fraudulently. The elements are cumulative. Simply establishing ‘breach of trust’ will be insufficient to bring a debt or liability within section 281(3)[20]. The additional component of ‘fraudulent’ must be established (for two cases illustrating a finding only of breach of trust, see In re Waldron (A Bankrupt), Ex p The Bankrupt v Official Receiver (unreported) 30.1.1985, CA[21] and In re Freeman; Ex p Freeman (1890) 7 Morr 38 [22]).  These two elements will be taken in turn.

Breach of Trust

37. The concept of a breach of trust is well known. Reference can be made to Millett LJ in Armitage v Nurse [1998] Ch 241, at 250-251:

‘Breaches of trust are of many different kinds. A breach of trust may be deliberate or inadvertent; it may consist of an actual misappropriation or misapplication of the trust property or merely of an investment or other dealing which is outside the trustees' powers; it may consist of a failure to carry out a positive obligation of the trustees or merely of a want of skill and care on their part in the management of the trust property; it may be injurious to the interests of the beneficiaries or be actually to their benefit’

Fraudulent Breach of Trust

38. On the additional element of ‘fraudulent’, Ferris J in Woodland-Ferrari held, at paragraph 50, that ‘Dishonesty …remains an essential ingredient’.

39. The concept of ‘fraudulent’ should be distinguished from ‘deliberate’. Merely because a breach of trust was done deliberately, does not mean it must therefore have been done ‘fraudulent’. To put it another way, a deliberate act is not necessarily a dishonest act. Millett LJ made this point in Armitage v Nurse [1998] Ch 241, at 250-251, where he said:

‘By consciously acting beyond their powers (as, for example, by making an investment which they know to be unauthorised) the trustees may deliberately commit a breach of trust; but if they do so in good faith and in the honest belief that they are acting in the interest of the beneficiaries their conduct is not fraudulent. So a deliberate breach of trust is not necessarily fraudulent. Hence the remark famously attributed to Selwyn LJ by Sir Nathaniel Lindley MR in the course of argument in Perrins v Bellamy [1899] 1 Ch 797, 798: 'My old master, the late Selwyn LJ, used to say, "The main duty of a trustee is to commit judicious breaches of trust."’

40. The distinction between these concepts was repeated in Templeton Insurance, where the Judge said, at paragraph 43:

‘It is important to note that there is a difference between deliberate conduct and dishonest conduct, and, therefore, between a deliberate breach and a dishonest breach…. A breach may be deliberate in the sense (1) that the defendant intended to behave as he did but did not appreciate that a breach would occur or (2) that the defendant behaved as he did appreciating that a breach would occur; neither breach, not even the latter, would necessarily be dishonest.’

41. He went on to require that the obligation breach to be wanting in honesty, or deceitful, at paragraph 43:

‘For a breach to be dishonest, there must be more. The conduct in question must be shown to be a breach, and the breach must be shown to be wanting in honesty or deceitful…

42. As to where the line is between honest and dishonest behaviour, the Judge in Templeton Insurance said, at paragraph 43:

‘…the yardstick for which is: "normally acceptable standards" of honesty.’

43. Returning to Woodland-Ferrari, when concluding that ‘Dishonesty …remains an essential ingredient’, Ferris J said that the phrase ‘fraudulent breach of trust’ in section 281(3) has the same meaning as that same expression had in section 28 of the 1914 Act. At paragraph 50 of Woodland-Ferrari, Ferris J said:

‘I see no reason for regarding "fraudulent breach of trust" in section 281(3) of the 1986 Act as meaning anything different from what the same expression meant in section 28 of the 1914 Act.’

Castle Mail Packets Case

44. This reference to the phrase having the same meaning as the same expression had in section 28 of the 1914 Act, introduces a need to consider some legal history. However, rather than set out that consideration here, and the rather long explanation for how Ex p Castle Mail Packets Co; In re Payne (1886) 18 QBD 154, a case decided on discharge orders under the now obsolete Bankruptcy Act 1883, is relevant by analogy, it shall be relegated to a footnote[23]. The case of Castle Mail Packets concerned an appeal by a creditor of the bankrupt, against a Bankruptcy Court granting the bankrupt a suspended discharge order (a now almost obsolete concept – see footnote 23). The creditor company opposed the granting of any order of discharge, on the ground that the bankrupt (as part of a partnership) had been guilty of a fraudulent breach of trust towards them.

45. It was said that the partnership had acted as shipbrokers (agents) for the ship owning and ship trading company (principal), and had from time to time received various sums of money in respect of freight for the company. The company alleged that the partnership had omitted to pay over the whole of the sums collected by the partnership brokers; that they had employed the sums which they had thus retained for their own purposes; and that they had furnished to the company misleading accounts, which purported to show that the partnership had received certain sums, but omitted to state that they had received other sums which they had actually received. And, when the company discovered the fraud and commenced an action against the partners, for the balance due to them, the partners made an entry for the first time in their books, of a larger sum which was stated to be due to them from the company for certain commissions, and brought a counterclaim thereon.

46. The ordinary civil court dismissed the partners’ counterclaim, and gave judgment to the company on its claim. This judgment debt had then founded the bankruptcy petition.

47. At first instance, the registrar hearing the application for a discharge order, held that the partners’ had been guilty of a breach of trust towards the company, but that there had not been any fraud.

48. On appeal, fraud was found, and their are some illuminating statements about fraudulent conduct (though the Court of Appeal was significantly less conclusive about whether the facts amounted to fraudulent breach of trust per se - that question was rather unhelpfully left open, on the basis that it was unnecessary to decide it).

49. Lord Esher MR ‘graphically described’ the conduct of the bankrupts that lead to the challenge to their suspended discharge, at 157-158:

‘When this application for a discharge was made the first thing shown by the opposing creditors was that the bankrupts had continued to trade after knowing themselves to be insolvent. That is no light offence. The opposing creditors also showed that the bankrupts, acting as brokers, had received money from time to time for freights largely in excess of any deduction which they were entitled to make; that they did not merely neglect to send in accounts to their principals, but that they sent in misleading accounts, and that before doing so they had misappropriated to their own private use money for which they ought to have accounted; and that, therefore, the inevitable inference was that they had knowingly misused these moneys for which they ought to have accounted; that they knew they had done wrong, and that they sent in these misleading accounts in order to conceal what they had thus done. And, still worse, when they did send in a final account, in order to get rid of that which they knew to be a valid claim against them, they knowingly, falsely, and wickedly asserted that they had a counterclaim, which they knew to be wholly unfounded.

What offences, then, have they been guilty of? Besides trading after they knew they were insolvent, they have for their own purposes, and in order to conceal a fraud, made an improper and fraudulent entry in their books. I will not say that they have been in the strict sense of the words guilty of a fraudulent breach of trust, but any more fraudulent conduct in business as between principal and agent I cannot conceive. I come, therefore, to the clear conclusion that these bankrupts have been guilty of three offences against the [1883 Act]: by trading after they knew that they were insolvent; by sending in misleading accounts and making misleading entries in their books; and by committing a wicked fraud upon their employers.

Under these circumstances the bankrupt Payne applied for his discharge, and in my opinion the only proper course is to refuse the application altogether.’

50. Lindley LJ agreed with the above, but said he was inclined to think that this was ‘fraudulent breach of trust’, at 159:

‘I am compelled to say that he has been guilty of a gross fraud. Whether technically there has been a 'fraudulent breach of trust' may be open to question. I am inclined to think that a man who, knowing that he has a balance to pay over to his employers, embezzles it, may fairly be said to be guilty of fraudulent conduct as a trustee. But, at any rate, it is clear that he comes within subsection (3)(h) of section 28 as having been guilty of fraud. In my opinion, therefore, the order of discharge ought to be refused.’

51. Another example might be the hypothetical scenario put forward by Jessel MR in Emma Silver Mining Co v Grant (No.2) (1880) 17 Ch. D. 122, at 127:

‘An agent for the purchaser of a horse, say his groom, goes to the vendor of the horse and says, “What will you take for it?” The vendor says, “I will take £100.” “No,” says the agent, “make it £120, and we will divide the £20; I will take £10 and you will take £10: make out a contract for the sale at £120.” The vendor, who is as much a rogue as the agent, agrees to this, and makes out a contract for £120. Thereupon the agent goes to the purchaser and says, “I had to give £120 for the horse: I could not get it for less: here is the receipt;” and he induces the purchaser to hand him £120, of which he pays £110 to the vendor and retains £10 for himself. Is that transaction to be characterised as a fraud on the purchaser, or is it not? In my opinion it is a clear fraud...’

Common Law Actual Dishonesty

52. For both ‘fraud’ or ‘fraudulent breach of trust’, the Court in Templeton Insurance, remarked that:

‘The touchstone in each case is that actual dishonesty on the part of the bankrupt is a necessary ingredient.’ (paragraph 49)

53. What then is ‘actual dishonesty’ in the common law sense, the essential ingredient for either alternative in section 281(3). The Judge in Templeton Insurance attempted to answer this critical question at paragraphs 31 to 43 of his judgment. He considered Royal Brunei Airlines v Tan [1995] 2 AC 378, Twinsectra Ltd v Yardley and others [2002] 2 AC 164, and Barlow Clowes International Ltd (in liquidation) v Eurotrust International Ltd [2006] 1 WLR 1476, but for present purposes, it is sufficient the quote his summary of the law as set down in Abu-Rahman v Abacha [2007] 1 Lloyd's Rep 115 and Starglade Properties Ltd v Nash [2010] EWCA Civ 1314, paragraph 39 to 42:

‘In Abu-Rahman v Abacha [2007] 1 Lloyd's Rep 115, the Court of Appeal approached the issue of dishonesty by applying Twinsectra as explained or clarified in Barlow Clowes. In so doing, Arden LJ observed that the Court of Appeal should follow Barlow Clowes. Accordingly, in her judgment, Arden LJ held that a claimant is not required to prove subjective dishonesty, in the sense of consciousness on the part of the defendant that the transaction is dishonest; that dishonesty is established if the claimant proves that the defendant knows of the elements of the transaction which make it dishonest according to normally acceptable standards of behaviour; and, that the test of dishonesty is predominantly objective: did the conduct of the defendant fall below the normally acceptable standard? Arden LJ acknowledged that there are also subjective aspects to dishonesty whereby the conduct in issue is to be assessed in the light of what the defendant actually knew at the time, as distinct from what a reasonable person would have known or appreciated; and, concluded that the law as laid down in Twinsectra as interpreted in Barlow Clowes represents the law of England and Wales.

More recently, in Starglade Properties Ltd v Nash [2010] EWCA Civ 1314, the Court of Appeal had to consider whether a sole director and shareholder's (N) disregard of a side letter he had signed on behalf of his company promising to hold certain monies received on trust for the claimant (S) and application of the monies in paying (and, because the company was insolvent, preferring) creditors of the company was dishonest. After referring to Royal Brunei Airlines, Barlow Clowes and Abu-Rahman, the trial judge expressed the test for dishonesty as follows: "the defendant must be guilty of conduct which transgresses normally accepted standards of conduct i.e. conduct which all normal people would regard as dishonest". The trial judge found that most people would not know whether, as a matter of law, a company director may prefer some creditors over others and that in the absence of advice or actual knowledge as to the law, the preference did not transgress generally accepted standards of commercial behaviour.

The Court of Appeal held that the test was incorrectly expressed as "conduct which all normal people would regard as dishonest"; the correct test was the ordinary and not the unanimous standard of honest behavior.

The Court of Appeal found that the trial judge had asked himself the wrong question and had approached the test of dishonesty from the wrong perspective. In particular (1) he had not addressed the question whether the relevant conduct of N (knowing that the company was insolvent but could pay a dividend to creditors and then seeking to frustrate S by paying the creditors in full) was dishonest; and, (2) the fact that N was an honest witness had no bearing on the honesty of his conduct under consideration. The deliberate removal of assets from an insolvent company so as to defeat the just claim of a creditor is not in accordance with the ordinary standards of honest behaviour, and a director could not think otherwise notwithstanding his lack of knowledge of the law.’

54. Accordingly, actual dishonesty is judged on the subjective knowledge of the bankrupt, but then judged objectively to see whether the impugned conduct, in light of that knowledge, transgresses ‘generally accepted standards of commercial behaviour’.

Awkward Fit between expanded ‘Fraud’ and its Statutory Alternative

55. It is tentatively suggested that the decision in Templeton Insurance is not above doubt however. The doubt relates to the construction of section 281(3) - that ‘fraud’ includes fraudulent breach of fiduciary obligations (since that involves ‘actual dishonesty’) and ‘fraudulent breach of trust’ means breach of trust involving actual dishonesty.  Such a construction rather begs the question as to why the legislator singled out ‘fraudulent breach of trust’ for special mention. Since fraudulent breach of trust is a type of fraudulent breach of fiduciary obligations (the obligations imposed upon a trustee, qua trustee, are almost all fiduciary obligations); so 'fraudulent breach of trust' comes within ‘fraud’ and, of course, ‘fraudulent breach of trust’. This seems an uncomfortable construction. Indeed, the Judge in Templeton Insurance touches upon this, where he states, at paragraph 76, ‘[t]hat a dishonest breach of fiduciary duty by a director may be recognised and characterised as a fraud or a fraudulent breach of trust is clear from Gwembe Valley Development Co.’[24]

Attempts to Re-characterize the Origins of the Liability or Debt

56. Given the very different outcomes to those unsecured creditors holding rights which are released upon discharge (total loss save for claim in bankrupt estate), as against those that are not, the temptation will inevitably arise in some creditors to attempt to re-frame/re-characterize how their debt arose, with a view to arguing that their bankruptcy debt fits within the section 281(3) exception Consequentially, the Court will be astute to consider whether the prism through which the creditor seeks to portray its bankruptcy debt, is indeed the correct way to view it.

57. The Court in Mander v Evans [2001] 1 WLR 2378, had to consider the legitimacy of the claimant creditor’s attempts at re-characterizing its cause of action in order explain how it came within the section 281(3) exception.

58. By way of background, the facts in Mander were that a solicitor had induced a client to lend him some £140,000. The loans were not repaid and the solicitor was adjudged bankrupt, and subsequently discharged. The client issued proceedings against the solicitor seeking repayment of the loans and/or rescission of deeds relating to the loans, and the return of the money lent in reliance thereon. The allegation raised by the client (now claimant) was that the loans were procured by undue influence, that consequentially the debts were incurred in respect of a fraud within the meaning of section 281(3)[25].

59a. On one view, what the client/claimant held was a simple breach of contract claim for failure to repay on a loan, however the client/claimant sought to re-frame the claim as one involving a claim that creditor’s consent to enter into certain deeds relating to the loans had been vitiated by undue influence, giving a rise to a right to rescission (and presumably unjust enrichment claims) though rescission hadn’t occurred, and it was unclear how any of this amounted to fraud in any event. Ferris J, at paragraphs 11 and 12, stated:

‘The difficulty which I feel in the present case is that the advantage which the defendant is said to have procured in this case is the making of loans which were, it seems, repayable on demand. Had it not been necessary to try to bring the case within section 281(3) the claimant would simply have sued for the repayment of money lent. An allegation of undue influence would have added nothing to her claim. What I find difficult to understand is how, subsequent to the bankruptcy, the making of such an allegation changes the nature of the claim. The claimant is still seeking to enforce the defendant's obligation to repay money which he borrowed. I find it difficult to see how, even assuming that the claimant was induced by undue influence to make the loans and accept in return the defendant's obligation to repay and assuming also that “fraud” includes the exercise of undue influence, this makes the repayment obligation one which was “incurred in respect of fraud”.

[Counsel for the claimant] argued that the claimant's case is not one in which she merely seeks to enforce the repayment obligation but one in which she complains of undue influence. But I do not find it easy to see how this makes a difference. Certainly she seeks, by way of her alternative claim, to have certain deeds rescinded, which emphasises that she has not rescinded these deeds hitherto. It is not clear to me how the rescission of the deeds will give rise to an obligation to repay which is different from the contractual obligation which already exists. Even if it did so that right will not exist until rescission takes place. I find difficulty in the concept that a contractual obligation to repay which is not “incurred in respect of fraud” can be replaced by an obligation to repay which is so incurred just because the case is presented as one of undue influence.’

59b. Similarly, in Soutzos v Asombang [2010] EWHC 842 (Ch) ('Soutzos'), the claimant failed in his attempt to frame his claim/causes of action, such as to fall within the rubric of section 281(3). In Soutzos, the claimant had made 2 loans to the first defendant, which the first defendant had not repaid. Subsequently, the first defendant had (1) been adjudged bankrupt, and (2) obtained his discharge and release. The clamant's attempted to establish causes of action of: (1) fraudulent misrepresentation (2) unlawful means conspiracy, but these failed on the facts. 

Debt/Liability Characterised as Fraud in Foreign Court’s Default Judgment, affect on English Enforcement proceedings

60. English common law[26] provides a mechanism for the enforcement in England and Wales, of judgments of foreign courts[27].  Where a foreign court judgment is entered, and then the foreign court judgment debtor is adjudged bankrupt, and is then discharged from his bankruptcy, the issue can arise as to whether the bankruptcy debt was released on the bankrupt’s discharge, under section 281(1), or whether it was not, because it fell within section 281(3). Do any findings made by the foreign court bind the English Court on the issue of whether section 281(3) is or is not engaged.

61. The Court of Appeal in Masters v Leaver [2000] BPIR 284 ('Masters') allowed an appeal against (summary) judgment entered by an English Court, on a claim for enforcement of a judgment handed down in a Texas Court. Issue estoppel can arise on findings made by a foreign court, which bind the same parties in a later English Court set of proceedings (making the issue res judicata as between the parties). In Masters, the judgment in the Texas Court was a default judgment, and so made on a statement of case – that statement of case said ‘…the nature of the relief sought was to set aside the issue of stock. In addition the claimants sought damages for fraud, oppressive conduct of the majority shareholder and in respect of the diminution in value of their shares.’ (paragraph 3).

62. The key issue then, was whether the English Court was free to decide for itself whether the debt/liability was released upon discharge, or alternatively, whether it was bound to apparent finding, underlying the foreign court’s default judgment, that there had been fraud. In other words, did the foreign court’s default judgment create as an issue estoppel on the origins of the debt/liability, making it res judicata between the parties that fraud had been involved.  

63. The Court of Appeal in Masters emphasized English law’s strong resistance to foreign court default judgment’s founding issue estoppels in English Courts, at least any more than absolutely necessary for the foreign court judgment to have been made. At paragraphs 28 to 30, the Court of Appeal in Masters, said:

‘It was established by the decision of the House of Lords in New Brunswick Railway Co. Ltd v. British and French Trust Corporation Ltd that the default judgment of a foreign court has limited effect in England. Thus Lord Maugham, Lord Chancellor, said:

“In my opinion we are at least justified in holding that an estoppel based on a default judgment must be very carefully limited. The true principle in such a case would seem to be that the defendant is estopped from setting up in a subsequent action a defence which was necessarily, and with complete precision, decided by the previous judgment; in other words, by the res judicata in the accurate sense. If that be the principle, the appellants are not in the present case estopped from raising any contention they think fit in an action on the 992 bonds.

I think it right to observe that it is in my view undesirable that judges should make declarations as to the true construction of documents on motions for judgment in default of defence. It has not, I believe, been the practice to do so in the Chancery Division for a good many years. As far as possible the Court should make such declarations only when the matter has been argued by counsel on each side, and is then the subject of adjudication by the judge.”

It was not suggested that there was an estoppel by record in that sense in this case.

In Carl Zeiss Stiftung v. Rayner & Keller Ltd [1967] 1 A.C. 853, 918, Lord Reid pointed out the need for caution in deciding what exactly the foreign judgment decided.’

64. The Court of Appeal in Masters, concluded, at paragraph 30:

‘In my view, a default judgment obtained in a foreign court on a single cause of action alleging fraud is insufficient to establish that the underlying liability was incurred in respect of the fraud of the defendant. A default judgment in an action on three causes of action, only one of which alleges fraud, is of course an a fortiori case. Such a judgment does not constitute affirmative evidence of an admission that the liability was incurred in respect of fraud, nor an estoppel precluding [the foreign court judgment debtor] in other proceedings from contending that his liability was not so incurred. Accordingly, I would allow the appeal and grant unconditional leave to defend on this issue alone.’

Where the Bankruptcy Debt Survives the Discharge

65. Where the bankruptcy debt survives the bankrupt’s discharge, because it comes within section 281(3), the creditor may enforce the bankruptcy debt in the normal way after the bankrupt’s discharge (as well as before discharge, see footnote 7b).

66. The right that the creditor had, prior to the commencement of the bankruptcy (when the bankruptcy order was made), remains the same in the creditor’s hands throughout the process of bankruptcy. At the commencement of the bankruptcy, the creditor’s entitlement to a money claim remedy (as distinct from other remedies[28a]) on the back of the right is suspended [28b](unless Court’s permission is obtained[28c] - or it is a 'will survive discharge' claim - see footnote 7b). If the creditor’s right against the bankrupt (as distinct from the creditor’s right to any dividend distribution out of the bankrupt estate) is not lost on the bankrupt’s discharge, then, it subsists in the creditors hands post discharge. On discharge, any rights that survived also have the entitlement to money claim remedies unsuspended. To put it another way[29], any debts that survive discharge, remain rights in the creditor’s hands, and crucially, the suspended remedies attached to those rights, cease to be suspended. The creditor will therefore, have, post discharge, both a right and a live entitlement to a remedy on the back of that right[30].

67. As stated by Lord Sumption in the Supreme Court case In re Lehman Bros International (Europe) (in administration) (No 4) [2017] 2 W.L.R. 1497, at paragraph 197:

‘Subject to any contrary order of the court, the commencement of insolvency proceedings suspends the creditor's right to proceed against the debtor or his property for the recovery of his debt, and stays litigation already in progress. In other words, it suspends the creditor's remedies, but not his rights. The current statutory provisions are section 130 of the Insolvency Act 1986  (for a winding up by the court), section 285 (for personal bankruptcy), and Schedule B1, paragraphs 43–44  (for administration). They are no different in their general approach from those which applied before 1986. The purpose of the procedural moratorium was to allow the insolvent's assets to be realised and distributed to his creditors in proportion to their justified claims. That process was also procedural.’[31]

68. A creditor with a debt that survived bankrupt/debtor’s discharge, may exercise that right notwithstanding that the Trustee in Bankruptcy may still be administering the bankrupt estate, and that the creditor has proved in the bankrupt estate and has received part payment through a declared dividend distribution on the debt, and/or is anticipated to receive a future but as yet undeclared dividend distribution. Naturally, however, any monies received by the creditor for the debt, will reduce the size of the debt the creditor can claim for against the now discharged bankrupt. The quantum of the creditor’s right is commensurately reduced[32].

69. Should the Trustee in Bankrupt make a declared dividend distribution from the bankrupt estate, prior to the bankrupt’s discharge, amounting to 100p in the £ for the debt[33], then the debt will be satisfied. Such a debt will no longer exist to survive or indeed, be released upon discharge. In In re Lehman Bros International (Europe) (in administration) (No 4) [2017] 2 W.L.R. 1497, the majority in the Supreme Court said, at paragraph 110:

‘If a creditor who proves in a bankruptcy is paid 100p in the pound, I know of no reason why his debt should not be treated as having been satisfied in the same way as a creditor in a liquidation or administration….’

70. As an aside, it is noteworthy that prior to the discharge, the fact that the debt will survive discharge has no bearing on it as a debt. It is only at the moment of discharge that its immunity from release has importance.[34].

Limitation

71. Where a cause of action has arisen before the bankrupt was adjudged bankrupt, time will continue to run throughout the period of the bankruptcy. Depending on the nature of the cause of action, how long before the bankrupt order it arose, and the time to discharge, it may be that the cause of action will already be statute barred by the date of the bankrupt’s discharge. In Anglo Manx Group Ltd v Aitken [2002] B.P.I.R. 215, Mr John Jarvis QC, sitting as a Deputy High Court Judge, said at paragraph 74:

‘If the creditor fails to bring proceedings where the cause of action has arisen before the bankruptcy, the time in respect of that claim will run during the bankruptcy. If he fails to bring a claim during that period of time, in my judgment, if by the time of the discharge the limitation period has expired, then he will be barred from bringing the claim.’

72. The principle of the rule, was tentatively suggested by the Court of Appeal in Re Benzon [1914] 2 Ch, 68, at 76, to be that:

‘…if any man has a cause of action which is ripe so that he has an opportunity of bringing his action and does not do so, he thereby takes the risk of some unexpected event happening which takes away from him the possibility of bringing his action within the remainder of the period which he has under the statute. The rule may work hardship in particular cases, but it is so well established that no court would now decline to follow it.’[35]

73. Protective proceedings should be considered[36].

Forbearance in respect of which was secured by means of Fraud or Fraudulent Breach of Trust

74. Section 281(3) does not just contain a provision based on ‘incurred in respect of’. There is an alternative provision. To refresh, section 281(3) reads:

‘Discharge does not release the bankrupt from any bankruptcy debt which he incurred in respect of, or forbearance in respect of which was secured by means of, any fraud or fraudulent breach of trust to which he was a party.’

75. Extracting the true meaning of this alternative provision is not, on first blush, easy. On its most natural reading, a bankruptcy debt is not released where the creditor has given forbearance, but that forbearance was obtained by means of actual dishonesty by the bankrupt. From that it would seem that, a bankruptcy debt will not be released, notwithstanding that it was not tainted by actual dishonesty, if later, the creditor is persuaded to forbear on that bankruptcy debt, by reason of the bankrupt’s actual dishonesty. However, what the correct construction of this provision is, remains an open question.

Conclusion

76. Section 281 sits at the heart of the exchange that the law of bankruptcy offers individuals who are entering the process of bankruptcy (whether voluntarily or involuntarily) - the quid-pro-quo. In exchange for giving up most of his assets, the bankrupt is offered in return, release on discharge from most of his bankruptcy debts. The bargain is most; it is not all bankruptcy debts. For a variety of different, mainly public policy reasons, certain bankruptcy debts[37] are kept outside the exchange – outside of the general rule that a bankrupt on discharge gains release from his bankruptcy debts. No release is offered on the exceptions to the general rule. One such exception to the general rule is section 281(3). It is through that exception that Parliament removes from the general rule, bankruptcy debts generated, or forborn, by the bankrupt’s actual dishonest behaviour, in the Derry v Peek sense. The taint of the bankrupt's actual dishonesty (as distinct from mere constructive fraud/equitable fraud) on a bankruptcy debt, disentitles the bankrupt from release in respect to that bankruptcy debt. To be clear, the taint is on the bankruptcy debt, not on the bankrupt, in that, the criterion is applied separately to each bankruptcy debt. There is no inter-bankruptcy debt cross-contamination, or wholesale castigating or blighting of the bankrupt; even a rogue’s honestly incurred bankruptcy debts are released on discharge.