Keywords: pari passu
principle, collectivity, transaction
avoidance, fairness, orderliness, non-distribution
principle, liquidation regime, corporate
liquidation
This chapter analyses the pari
passu principle of insolvency law, and asks how it relates to other
principles available for the treatment of claims in corporate liquidation. The
discussion in section 2, below, reveals that the principle has rather
limited effect in governing distributions of the insolvent’s estate. Not only
do various types of secured claim fall beyond its ambit, even unsecured claims
are often exempt from its application. Nevertheless, the principle thrives both
in judicial rhetoric and in academic arguments. For example, many a challenge
to the different priorities accorded to different types of claim in a company’s
insolvency begins with an incantation of the pari passu principle.
Finch states (on the second page of her encyclopaedic study on secured credit):
The normal rule in a corporate insolvency is that
all creditors are treated on an equal footing—pari passu—and share in
insolvency assets pro rate according to their pre-insolvency entitlements or
the sums they are owed. Security avoids the effects of pari passu distribution
by creating rights that have priority over the claims of unsecured creditors.1
Bridge sees an
inherent tension between the ‘two fundamental principles of credit and
insolvency law’, that of the freedom of contract which allows one to (p.93) bargain
for priority, and the mandatory pari passuprinciple.2 And Cranston, after considering and
discounting lesser objections to the existence of secured credit, concludes
that ‘there are other social policies antipathetical to extensive security,
like the pari passuprinciple[,] which are less easily refuted.’3
The pari passu principle
is said to be ‘the foremost principle in the law of insolvency around the
world’.4Commentators claim to have found this principle
entrenched in jurisdictions far removed from ours in geography and time.5 At English law, statute itself seems to confirm Finch’s ‘normal rule’,
that all creditors of an insolvent company are to be treated ‘equally’ by
having their pre-insolvency claims abated rate and rate alike.6 The principle is thought to be ‘all-pervasive’, and its effect is to
‘strike down all agreements which have as their object or result the unfair
preference of a particular creditor by removal from the estate on winding up of
an asset that would otherwise have been available for the general body of
creditors.’7 The Cork Committee, despite noting
significant exceptions to the principle, reiterated its fundamental importance.8 The principle is said to be supported both by the need for an orderly
liquidation of insolvents’ estates, and by requirements of fairness. So it is not surprising that its
invocation as the starting point for, say, the debate on the priority of
secured or preferential claims, weights the argument in a particular way Since
the pari passu principle has been recognized so widely and for
so long as vital, and since it serves such desirable aims as orderliness in
liquidation and fairness to all creditors, any deviation from it must be a
cause for concern. It seems to follow therefore that:
Before a
creditor is entitled to claim a preferred position it must be demonstrated that
deviation from the inveterate and equitable pari passu principle
is warranted.9
On this view, the
priority (say) of secured or preferential claims is an abnormality, a pathology
to be diagnosed and controlled, perhaps even ‘cured’. Since ‘equality’ is the norm, the onus must be on
those supporting differing priorities to justify their claim.10 To the extent that their efforts are
unpersuasive, the case for (p.94) priority
must be considered not established, and the ‘default principle’ of ‘equality’
must prevail.11
This chapter seeks to overturn this
order of things. It is argued here that the pari passu principle
is rather less important than it is sometimes made out to be, and does not
fulfil any of the functions often attributed to it. It does not constitute an
accurate description of how the assets of insolvent companies are in fact
distributed. It has no role to play in ensuring an orderly winding up of such
companies. Nor does it underlie, explain, or justify distinctive features of
the formal insolvency regime, notably, its collectivity. The case-law said to
support the pari passu principle serves actually to undermine
its importance. And the principle has nothing to do with fairness in
liquidation. An important part of the argument here seeks to explain the actual
role of the principle. If the arguments made here succeed, then the initial
onus of justifying their position shifts from those arguing in favour of the
priority of secured and preferential creditors, etc., to those who support a
more ‘equal’ distribution of the insolvent’s estate. The chapter concludes by
analysing the likely effect of the recent abolition of the preferential
treatment previously accorded to certain tax claims.
Since there is confusion in the
literature about the correct identification of the pari passu principle,
it would be useful to begin with a word on terminology. The pari passu principle,
as it appears in (corporate) insolvency law, has a fairly specific purpose. The
standard statement of the principle seeks to be informative, to answer the
broad question how insolvency law
decides on the treatment of different types of creditor. The answer offered by the principle is that insolvency law ‘takes them
exactly as it finds them.’12 Put
differently, creditors holding formally similar claims under non-insolvency law
are to be paid back the same proportion of their debt in their debtor's
insolvency.13 The pari
passu principle, then, is one manifestation of formal equality in
insolvency law.
Objections of the
principles.
However, it is not
the only one. As explained in the following section, insolvency law itself enshrines various rejections
of the pari passu principle, the most notable for our purposes
being that in favour of preferential creditors. Some of the claims held by the
insolvent’s employees, and some tax liabilities owed by the insolvent, rank
ahead of general claims, such that all preferential debts must be discharged
in (p.95) full before general unsecured
creditors are paid anything.14 The factor which causes confusion is that preferential claims also abate
rateably as amongst themselves. Some commentators have therefore been
led to regard the treatment of preferential creditors inter se as
another application of the same pari passu principle.15 But this view is unsound in several different
ways. Most obviously, it ignores the received understanding of the nature of
the ‘equality’ principle, that the determination of ‘equality’ is to be made
by pre-insolvency law.16 Second, it reduces the principle to
triviality, since the principle now provides simply that those determined
by insolvency law to be equal are to be treated equally by
insolvency law. But now pari passu is not a rule or a
restriction or a standard. It neither imposes a requirement which insolvency
law must fulfil, nor does it shape that law in any way. It is merely a
description of what insolvency law actually does, and it fits perfectly with
whatever scheme of priorities that law might devise. As a triviality the
principle is harmless, but for the same reason it is also uninformative. It no
longer says anything about why insolvency law chooses to
declare certain creditors to be ‘equals’. Finally though, and confusingly, the commentators who regard the
distribution to preferential creditors inter se to be governed
by the pari passu principle, still accept that the existence
of preferential claims itself constitutes an exception to that principle.17 Viewed thus, their position becomes something
of a paradox: the
treatment of preferred claims is both an exception to, and yet an application
of the pari passu rules! It is difficult to imagine too many
other situations which both exemplify and contradict one and the same
principle.
It is suggested that this view of the
‘equality’ principle, which renders the principle both trivial and paradoxical,
is unhelpful and should be abandoned. A little care with terminology dissolves
the paradox and restores the principle to its roots. A distinction must be
drawn between the sort of formal equality represented by pari passu(the
equality of creditors as determined by the pre-insolvency form
of their claim) and other manifestations of formal equality introduced by insolvency
law itself (such as that which holds between certain employee-claims,
but not between these and claims held by a trade creditor, say). Accordingly,
references to pari passu in this chapter are to be understood
in line with this distinction. To break the monotony of recurrence, ‘the
“equality” rule (or principle, or norm)’ will sometimes be
employed as synonymous with pari passu. Formal equality other than
that enshrined in the pari passu principle will be clearly identified
by the context.
(p.96) 2. The myth of pari passu distribution
Despite the hold exercised by the
‘equality’ principle on the imagination of most insolvency lawyers,18 the principle is sometimes acknowledged, as a
descriptive matter, not to have too much application in the real world. After
proclaiming that the principle is ‘fundamental and all-pervasive’, Goode adds
that ‘This, at least, is the theory of insolvency law.’19 Fidelis Oditah, who also regards it as
‘fundamental’, explains at the same time that the pari passu norm
is ‘shallow’, since it is subject to numerous exceptions, and since it does not
in itself acknowledge the ‘obvious truth’ that insolvency law often exempts
those holding certain dissimilar pre-insolvency rights from having to submit to
an ‘equal’ distribution.20 The Cork Report noted that rateable
distribution among creditors is rarely achieved.21 And Keay and Walton state that the ‘equality’
principle is 'nothing more, and has little relevance, other than to act as a
convenient default principle.'22
It would be instructive to consider
just how extensive these deviations from the ‘normal rule’ really are. Disregard
for the moment the priority given to those with a consensual property right.
Goode explains that the treatment of secured creditors, suppliers of goods
under reservation of title (ROT) clauses, and ‘creditors for whom the [debtor]
company holds assets on trust’, all are not to be considered true exceptions
to the pari passuprinciple, since ‘such assets do not belong to the
company and thus do not fall to be distributed among creditors on any basis.’23 Some five categories of true exceptions
established by statute can still be identified.
The first category
consists of the rights of insolvency set-off, which are wider in effect than
those available outside insolvency. Set-off applies whenever there have been
mutual credits, mutual debits or other mutual dealings, before the onset of
liquidation, between the debtor and any of its creditors.24 The cross-claims need not impeach the debt
owed to the insolvent, so long as the requirement of mutuality is satisfied.25 ‘The right of set-off on insolvency
represents a major incursion into the pari passu principle’,
since to the extent that there are mutual credits, (p.97) debits or other dealings, the creditor
able to assert set-off rights gets a pro tantopriority over others.26 What is especially significant given our
focus, this priority is mandated by the Legislature,27 and operates automatically at the date of the
winding-up order without the need for any intervention by either party.28 Parties, in other words, are compelled
to breach the pari passu principle.
A second category is constituted by
pre-liquidation creditors who can compel payment by virtue of their ability to
inflict certain types of harm on the insolvent estate. This category covers
payments to avoid forfeiture of a lease, distress or termination of a contract.29 In general, creditors whose continued
cooperation is desired by the liquidator may be able to extract payments in
respect of pre-insolvency debts.30
Then there are preferential claims
themselves. These include certain debts related to the insolvent’s employees.
These include any sums in relation to occupational pension schemes,
remuneration of employees up to £800, accrued holiday pay, and any sums loaned
and used for the specific purpose of paying employees’ remuneration.31 Before the Enterprise Act 2002 came into
force, preferential status was also accorded to various taxes collected by the
debtor on behalf of the Crown, including some PAYE deductions, unpaid VAT,
unpaid car tax, general betting, bingo, and gaming licence duties, some pool
betting duties, and unpaid social security contributions. Levies on coal and
steel production, beer duty, lottery duty, insurance premium tax, air passenger
duty, and landfill tax had also been added to this list.32 These have now been abolished.33
Instead, the
Enterprise Act has created a ‘special reserve fund’ (also referred to as the
‘prescribed part’ and the ‘ring-fenced sum’) for unsecured creditors (including
the Crown in right of unpaid taxes).34 This fund consists of a particular proportion
of the company’s net property, which includes the proceeds of realization of
assets subject to a floating (though not a fixed) charge. The proportions are
at present as follows. If the net property of the company undergoing formal
insolvency proceedings is less than £10,000, then the prescribed part consists
of 50 per cent of that property. Where the company's net property is at least
£10,000, the prescribed part consists of 50 per cent of the first £10,000,
plus (p.98) 20
per cent of the property exceeding this sum, provided that the value of the prescribed
part shall not exceed £600,000.35 With respect to this fund, the claims of
unsecured creditors rank ahead of any claims secured by a floating charge. It
should be noted that the treatment of creditors eligible to make claims against
the special reserve fund is not governed by the pari passu principle.
As explained above, this principle requires the implementation within
insolvency law of the priorities to be found in the general law.36 Under the general law, the holder of a
crystallised floating charge would rank ahead of unsecured creditors with
respect to the proceeds of sale of the property subject to this charge. This
order is overturned with respect to the special reserve fund. It follows that
the claims eligible to being vindicated against this fund constitute another
exception to the pari passu principle.
Finally, various types of debt have
been deferred by statute. These include debts owed by the insolvent to a
director (including shadow director) found liable for wrongful or fraudulent
trading, and ordered to be deferred by the court.37 Claims held by the debtors shareholders or
other members qua members also fall under this head.38
Many commentators consider there to be
another statutory exception to the ‘equality’ principle.39 Creditors whose claims arise after the
winding-up order has been handed down are given a privileged position. Statute
provides that their claims are to be treated as part of the expenses of
liquidation, are therefore to be given ‘pre-preferential’ status (i.e. ranking
ahead of preferential creditors), and are to be paid, not proved.40 In addition, utility suppliers ‘may make it a
condition of the giving of the supply that the [liquidator] personally
guarantees the payment of any charges in respect of the supply’.41 However, it is submitted this type of claim
cannot properly be regarded as an exception to the pari passu principle,
since, as explained above, that principle governs the treatment of those
holding formally similar claims under pre-insolvency law. By
definition, post-liquidation creditors do not, in that capacity,
have any pre-liquidation claims, so pre-insolvency law simply has nothing to
say about the nature or treatment of their claims. It follows that they do not
fall within the ambit of the ‘equality’ principle.42
So the claims of
creditors able to assert set-off, utility companies, pre-liquidation creditors
with post-insolvency leverage, several different types of (p.99) preferential
claims, claims of unsecured creditors against the special reserve fund, and
claims of deferred creditors, all are exempt from the pari passu principle.
And even these ‘deviations’ from the ‘normal rule’, while apparently
substantial, might in fact be ‘something of a minor qualification’ to the
‘equality’ norm.43 There are numerous other types of creditor
not affected by it. Under certain circumstances, this includes claims held by
accountants, solicitors, stockbrokers, factors, and bankers, all of whom might
be able to benefit from common law liens which arise by operation of law.44 Statute gives the unpaid seller a lien on the
goods sold, and rights of stoppage in transit.45 If the insolvent was insured, a party injured
by its actions (a tort creditor) is subrogated to its rights against the
insurer.46 If the liability in question arose under
circumstances governed by the Road Traffic Act 1988, the insurer might be
liable to the tort creditor even in those circumstances where it would have
been able to avoid or cancel the policy as against the insured.47 This of course continues to disregard those
able to assert consensual property rights in some assets ostensibly within the
insolvent’s estate.
Consider these
principles in the light of data on the sources of external funding for small to
medium sized enterprises (SMEs),48 which provide insolvency law with most of its
business.49 In a survey covering the period 1995–1997, 47
per cent of this was found to have been provided by banks (who often take
security), 27 per cent by hire purchase/leasing firms (proprietary rights), six
per cent by partners and shareholders (may or may not be deferred by statute),
six per cent by factoring businesses (liens and consensual proprietary rights),
four per cent by other individuals, four per cent by other sources, three per
cent by venture capitalists (equity claimants, hence ranking below debtors),
and one per cent by trade customers (who have the option of setting up Kayfordtrusts50). Also important, especially for small businesses,
is trade credit. By some estimates, stocks and flows of trade credit are twice
the size of bank credit.51 At least some of the credit in this category
also generally falls beyond the application of the ‘equality’ norm. One survey
found that well over half the suppliers surveyed (59 per cent) used ROT (p.100) clauses.52 This figure seems to rise dramatically, the
more troubled the debtor in question.53
These are of course the sources from
which firms raise capital while they are solvent. These figures do not directly
indicate the composition of the overall debt of firms which are in financial
distress, or which are undergoing some formal insolvency procedure.
Intuitively, however, it would be surprising if the debt outstanding when a
firm became distressed generally had a structure very different from the one
mentioned above. And in fact there are some fresh data which confirm this
intuition. Julian Franks and Oren Sussman have recently compiled a data set of
more than 500 firms which had bank debt, and which were in financial distress.54 This confirms that the structure of debt of
the firms in the ‘rescue units’ of the three banks studied is very similar to
that for solvent firms as a whole.55
Even more significant is the fact that,
in an overwhelming majority of formal insolvency proceedings, nothingsdistributed
to general unsecured creditors (the only category of claimant truly subject to
the pari passu rule56). It is estimated that there are zero returns to
them in 88 per cent of administrative receiverships, 75 per cent of creditors’
voluntary liquidations, and 78 per cent of compulsory liquidations. On average,
they receive 7 per cent of what they are owed.57
So while the matter
is an empirical one, and while the position would of course vary from debtor to
insolvent debtor, the discussion so far and these statistics show that most
types of claim either are or can be exempted from the application of the pari
passu principle. It is also likely that in most liquidations, hardly
any claimant is paid pari passu. Given these reasonable deductions,
one might perhaps be (p.101) forgiven for questioning whether it is
fair to describe the pari passu principle as ‘the normal rule
in a corporate insolvency’.58 In fact, it is the differing
priorities of claims which seem to represent the rule. What seems
certain is that, in the distribution of the assets of insolvent estates,
‘equality’ between different types of claim must be very much the exception. As
Dalhuisen has put it, ‘It is … the ranking… and not the
equality, that is the essence of bankruptcy and of creditors [’] relationships
more generally.’59 Put differently, even if unsecured claims
other than preferential claims form the bulk of the claims in
most liquidations, most of the available assets would not be distributed ‘equally’.
The pari passu rule is supposed to govern distributions. It
should be obvious, however, that distribution in accordance with this rule is
virtually non-existent.60
Some readers would object that the
discussion so far does little more than state the obvious, since everyone
knows that the current law leaves little room for anything to be
distributed pari passu in an overwhelming proportion of
insolvencies. These readers dramatically underestimate the extent to which
insolvency scholarship still clings to the pari passu myth. Leading
insolvency scholars (and courts) regularly assert that this jurisdiction has a
‘pari passu insolvency regime’, that the ‘equality’ rule has been
varied ‘only slightly [] in respect of personal claimants’, that
the ‘present law [] is disinclined to force particular classes of
creditors to shoulder greater burdens’ than others by causing derogations from
the ‘equality’ principle in favour of the latter (or against the former).61 With respect, such assertions very
mis-leadingly push the pari passu principle to the fore
as currently the dominant method for the distribution of
insolvent estates. They are then used as premises in further analysis which in
turn is often (though not always) distorted as a result. That is to be
regretted. Much of science could not progress till it had rejected the false
geocentric picture of the cosmos. In its rather more modest sphere, insolvency
scholarship must somehow tear itself away from the equally false view that the
‘equality’ principle occupies the centre of the insolvency law universe.62
(p.102) Still,
let us take seriously the objection noted above. Perhaps the discussion so
far has missed the point. The claim that priority is a
pathology might not be a descriptive one after all. Those making it might, on
reflection, be willing to concede that the pari passu principle
reflects little of reality, which (they might come to accept) consists of
widely divergent priorities accorded to different types of claim. The critics
of differential priority might now argue that the ‘equality’ norm constitutes
the ideal against which our existing insolvency law must be
judged, since it enshrines desirable goals that any reasonable insolvency
regime must attain. Deviations from pari passu are to be
condemned for making the attainment of those goals more unlikely, and they are
to be condemned even more precisely because they are so widespread. It is to
this claim that we now turn.
3. The
immunity/priority fallacy
For English lawyers, it seems the
primary attraction of the pari passu principle is its ability
to provide for an orderly liquidation. Goode makes the point firmly:
It is this
principle of rateable distribution which marks off the rights of creditors in a
winding up from their pre-liquidation entitlements. Prior to winding up each
creditor is free to pursue whatever enforcement measures are open to him … The
rule here, in the absence of an insolvency proceeding, is that the race goes to
the swiftest … Liquidation puts an end to the race. The principle first come
first served gives way to that of orderly realisation of assets by the
liquidator for the benefit of all unsecured creditors and distribution of the
net proceeds pari passu.63
Keay and Walton see the principle as
the embodiment of similar virtues:
the whole
idea of pari passu distribution is to ensure parity of
benefit, no matter what resources one has—if there were no pari passu distribution
we would return to the ‘first come, first served’ policy of mediaeval times,
which saw those with the greatest resources and power taking the debtor’s
estate.64
And for Finch the
‘equality’ principle ‘conduces to an orderly, collective means of dealing with
unsecured creditor claims and [] involves lower distributional costs than
alternative processes such as “first come, first served”.’65 For these commentators, the choice is clearly
between a free-for-all where weak creditors would inevitably be beaten into
last place by better-resourced competitors, and where (p.103) the advantages associated with an
orderly liquidation would be lost, and the pari passu principle
which alone stands as a bulwark against this.
What is more, and even given its less
than universal efficacy, the pari passu principle is said to
‘retain [] some practical importance, if only in a negative sense, in that it
may have the effect of invalidating pre-liquidation transactions by which a
creditor hopes to secure an advantage over his competitors.’66 The principle is widely seen to be Very much
at the heart of the rationale for the avoidance of pre-liquidation
transactions’.67 Oditah notes that ‘In one sense, avoiding
powers provide illustrations of insolvency laws commitment to the principle of
equality.’68 And Goode observes that ‘the principle of
equity among creditors which underlies the pari passu rule of
insolvency law will in certain conditions require the adjustment of concluded
transactions which but for the winding-up of the company would have remained
binding on the company’.69
Given
that the pari passu principle lies at the very heart of the
orderly liquidation regime, and given its role in justifying some of the most
distinctive and well-established aspects of insolvency law (its preference and
other adjustment provisions), any deviations from it must naturally be
considered odious at least prima facie. ‘Equality’ of treatment serves key
practical and justificatory purposes which bring social benefits, so
differential priority, its opposite, must result in a diminution of all those
benefits. Those defending the priority (say) of secured claims must therefore
bear a heavy burden of proof.
It is submitted that these arguments
are based on a misunderstanding of the nature of the liquidation regime. All
these arguments commit what will be referred to as the immunity/priority
fallacy. Once that fallacy is exposed and exploded, the rationales given by
those supporting the pari passu principle will be seen to
provide no justification for it. And that principle in turn is shown not to
play any role in bolstering the desirable properties of the liquidation regime.70
Let us start by understanding the
distinction between priority and immunity.71 Recall again the old image, that of the
debtor firm’s estate forming a pool of assets.
The
first come first served concept
(p.104) As
the firm approaches the stage where its assets are insufficient to meet its
liabilities,72 and in the absence of a special liquidation
regime, the firm’s creditors have an incentive to rush to enforce their claims.
The earlier they can get a judgment and execute it, the more likely they would
be to get paid in full, or at all. The tardy creditor would find that nothing is
left for him, the pool already having been drained of all its contents.
Further, and on the eve of insolvency, creditors aware of the firm's troubles
and able to influence its decisions might try to steal the first drink from the
asset pool by getting the debtor to repay them. Their gain is a collective
loss. The ‘first come, first served’ system encourages creditors to engage in
duplicative (hence wasteful) monitoring of their debtor in order not to be left
behind in any race to the pool. It adds uncertainty and therefore decreases the
utility of risk adverse creditors. And for the debtor whose assets are more
valuable if disposed of together as a going concern, the individualistic system
increases the possibility that those assets would be broken up nonetheless and
sold piecemeal to satisfy claims as they arise.73 It is this value-destroying activity that the
dedicated liquidation regime must prevent. Notice the cause of all the trouble:
each creditor faces the necessity, and has the ability, to act individually,
in disregard of the interests of all others. Hence the obvious solution: the
dedicated liquidation regime is collective, decisions being taken
on behalf of all those interested in the asset pool.
The analogy and the insight can be
taken further. The individualistic pre-insolvency debt-collection regime is a
mad race to the asset pool. Since that race is undesirable, the collective
insolvency system steps in to stop it. The creditors are now forced to queue
up to have access to the pool. Voidable preferences and post-petition
dispositions of assets, etc. can now be seen as attempts by some creditors to
bypass this queue. In other words, they represent efforts to gain immunity from
the collective system. Insolvency law deploys various mechanisms to deny them
this immunity.74 So long as there is no race to the pool, no
one succeeds in stealing a drink from it, and creditors await their turn to
have access to the debtor’s resources; decisions can be made systematically and
in the common interest. Crucially, though, note that ensuring that creditors
take their place in the queue is one thing. The order in which they
line up is, in general, quite another. Each creditor's priority is
their place in the queue relative to each other creditor. But espousing the aim
that creditors all line up does not entail any particular order in which they
should line up. It does not commit the system to placing all creditors (as it
were) unidistant from the asset pool. The pari passu principle would put each
(‘similar’) creditor side by side rather than (say) one after the other.
But this arrangement is not a necessary concomitant to the absence of the
value-destroying race. So long as there is a queue (with creditors standing
side by side, one after the other, or in whatever order), there is no race.
(p.105) Consider
now the various comments noted at the beginning of this section. It can be seen
that they represent the immunity/priority fallacy. This can be defined as the
attribution of the benefits resulting from the absence of immunity from a
collective insolvency system, to an imaginary and irrelevant state of equal
priority (the realm of pari passu). If the pre-insolvency ‘first
come, first served’ system is objectionable in a firm’s insolvency, it is so
because of the monitoring, uncertainty, administrative, and loss of synergetic
value costs described above. All these costs result from an individualistic
regime, and all of them are avoided by a collective one. As long as all
those creditors whose actions would inflict those costs participate in
the collective regime or submit to collective decision-making, how their claims
are ranked relative to each other within the collective scheme of distribution
is (for these purposes) irrelevant.75
Similarly, if certain attempts to gain
preference are undesirable, that is because they undermine the benefits
associated with collective decision-making.76 Consider the following situation. In the
liquidation of a particular company, there is only one general unsecured
creditor (say a trade creditor without the benefit of an effective ROT clause)
and one preferential creditor (the Crown). Suppose the former engineers a
(voidable) preference in her favour, so that both she and the preferential
creditor finally get back the same proportion of their debts.77 Now the situation here simply cannot be
objectionable on the basis that the pari passu rule has been
breached. In fact, the outcome would probably be perfectly in accord
with this rule, since the general creditor is likely to hold the same sort
of non-insolvency claim as the preferential one. So if the rule applies, she should
get back the same proportion of her debt as the latter. However, the
voidable preference provisions have been violated nevertheless. So the pari
passu principle could not possibly underlie these provisions, at least
as they apply here. If this much is accepted, then the argument can be pressed
further. It would not help to suggest that the principle justifies the
preference avoidance provisions as they apply to a trade creditor who has been
paid a greater proportion of his debt than another (say), but not when they
apply to a trade creditor and an employee who both get the same proportion of
what they are owed. To advocate this position would again be to create
something of a paradox: that the need to provide ‘equal’ treatment legitimates the
avoidance of a preference in the first situation, but actually providing such
treatment constitutes the objectionable preference in the latter!
In fact, to
understand the basis of the preference avoidance provisions, we must switch to
the perspective suggested above. The party given the voidable preference (p.106) has
been allowed to leave the place assigned to her by the insolvency system. She
has been allowed to skip the queue for the insolvent’s assets. This is the
factor which creates the preference.78 This example should make it clear that pari
passu is not simply irrelevant to understanding the preference (and
several other) avoidance provisions. In fact, the focus on the ‘equality’
principle can be positively misleading in this regard.79
4. The pari
passu principle in action?
It is to be noted that the argument
here is not one for a change in the law, for example to abolish the pari
passu rule. The point is rather that the alleged manifestations of the
principle are nothing of the sort. The law as it stands today is
better understood by adopting the analysis in the previous section. That the
veneration of the pari passu principle is false becomes clear
when one examines some of the case-law said to support it.80 It must be emphasized that the only purpose
of discussing these decisions is to show reliance on them in support of the
pari passu principle is misguided. Note also that the order in which
these cases are discussed is thematic, not historical.
Goode seems to
cite Ex parte Mackay81 as authority for the proposition that
‘The pari passu rule may not be excluded by contract’.82 In this case, A and B entered into an
agreement for A to sell a patent to B. B promised in return to pay (p.107) over
to A the royalties received, and in addition, lent A £12,500. It was also
agreed that, for satisfaction of this debt, B would have a lien over one-half
of the royalties received, except if A became bankrupt, in which case B might
retain all the royalties. A became bankrupt. It was held on appeal that the
provision allowing for B to have additional security in the
event of A’s bankruptcy was void as being a fraud on the bankrupt laws.83 Goode quotes the following parts of the
judgment in support of the inexcludibility of the pari passu rule:
… a man is not allowed, by stipulation with a
creditor, to provide for a different distribution of his effects in the event
of bankruptcy from that which the law provides.84
… a person cannot make it a part of his contract
that, in the event of his bankruptcy, he is then to get some additional
advantage which prevents the property being distributed under
the bankruptcy laws.85
However, neither of these dicta (nor
any other portion of the judgments) make any reference to the pari
passu principle. What they do indicate is, simply, that the bankrupt’s
property is not to be distributed except under the rules of the bankruptcy
system. Crucially, a creditor can not, even ex ante, ‘get some
additional advantage’ in any way not itself allowed by that system. To resort
to the analogy introduced above, he may not skip his assigned place in the
queue, whatever that place might be. The decision provides absolutely no
support for the very different proposition that under the liquidation system,
the places assigned to creditors are all unidistant from the asset pool.86 Quite the reverse is in fact true. Remember
that pari passu was almost as rare in practice at the time of
this judgment as it is now. The decision must be seen against the background of
a system which (for example) gave extensive preferences to the Crown, including
by section 32 of the Bankruptcy Act 1869. The Crown also had statutory liens
over various types of property by virtue of the different Excise Acts. And
section 32 of the same Act had enhanced the pre-existing preference for certain
debts owed to the bankrupt’s servants and clerks.87 In addition, section 39 of the Act provided
for mandatory set-off in bankruptcy in the appropriate circumstances.88
(p.108) It
should be clear that distribution according to the bankruptcy laws was not distribution pari
passu. The bankruptcy laws did not place all creditors side by side. The ‘equality’
principle was part of that regime, but it was by no means the only part (it
might not even have been the most important one). Note in addition, of course,
that on the facts of this case, the priority provided to B by way of the lien
over one-half of the royalties was upheld as perfectly proper in the same
judgment.89 So to cite ex parte Maekay as
an authority supporting only equal distribution is, with respect, quite wrong,
since it is at least as much an authority for the prior inexcludibility
of unequal treatment of claims, also provided for by the same laws.
The only proposition this decision can be said to support is that one may not
bargain for immunity from the collective bankruptcy regime (except as provided
by the law).90
The sceptical reader should turn
to National Westminster Bank Ltd. v. Halesowen Presswork
and Assemblies Ltd.91 The House of Lords held (by a majority of
three to one) that since the regime for the administration of insolvent estates
embodies important elements of public policy, and since the rights of
insolvency set-off form part of that regime, the creditor given such set-off rights can not contract
out of them. This despite the fact that the agreement which precluded
insolvency setoff, and which was struck down by their Lordships, seemed specifically
to have been concluded (inter alia) to ensure that ‘certain large
payments which were due to the [now-insolvent] company should be available for
distribution pro rata amongst its creditors.’92 The liquidators view—that the party now
asserting set-off should be ‘in no better position than any other creditor’ in
the debtor company’s insolvency—was noted,93 but rejected.
So an exception to
the ‘equality’ principle—the contractual disapplication of which might have led
to a more ‘equal’ distribution—is as mandatory as any other part of the
liquidation regime. What can not be contracted out of (in an unacceptable way)
is not the pari passu principle, but the whole collective
system for the winding-up of insolvent estates. Not only is it forbidden for a
creditor to leave his (p.109) assigned place in the queue and step
ahead of others, he can not even leave his place ahead of others and stand in
line with them. The inequality inherent in the system (in this case by way of
insolvency set-off) is every bit as binding as the equality. Note again that
the focus is on attempts to frustrate (some of) the rules of the liquidation
regime. Whether that would lead to an increase or decrease in the ‘equality’ of
distribution is simply irrelevant.94
Consider British International
Air Lines Ltd. v. Compagnie Nationale Air France.95 British Eagle (‘BE’) was a member of a
clearing house scheme operated by the International Air Transport Association
(‘lATA’). Sums due from participating airlines to each other were netted out at
the end of every month. Those with a net credit balance would then receive a
payment from the clearing house, while those with a net debit balance were
required to pay into the system. BE having gone into liquidation, it was found
that it owed money to various airlines, but had a claim against Air France
(AF'). A bare majority of their Lordships allowed the liquidator to recover
that sum on the basis that the netting arrangements contravened the pari
passu principle. The Lords rejected AF’s contention that the
liquidator’s only claim lay against the clearing house, and that it could only
be for the amount (if any) which remained to BE’s credit after the netting-off.
According to the majority, the netting arrangements captured for the benefit of
the members of the clearing house an asset (the claim against AF) which, but
for those arrangements, would have been available for distribution among BE’s
general creditors.
That this case has been described as
‘[undoubtedly the] leading modern authority on the pre-eminence of thepari
passu principle’96 is not without irony. The case could not
possibly provide any support for the pari passuprinciple. Recall
that this principle requires ‘equals’ to be treated ‘equally’.97 And the determination of ‘equality’ is
generally left to non-insolvency law:
The Act of Parliament unquestionably says that
everybody shall be paid pari passu, but that means everybody after
the winding up has commenced. It does not mean that the Court shall look into
past transactions, and equalise all the creditors … It takes them exactly as it
finds them.98
But even Lord Cross,
speaking for the majority, accepted that AF, and other members of the clearing
house, were never equal to BE's general creditors outside (p.110) liquidation.99 During BE’s solvency, the members of IATA
could not (unlike BE’s non-IATA creditors) just have ignored the clearing house
arrangements and sued BE for any sums owed. Correspondingly, BE could not,
while solvent, have jproceeded directly against AE It could only have claimed
against the clearing house for any net balance due to it.100 And yet BE’s liquidator was allowed to do
precisely what BE would not have been able to. By the same stroke, BE’s IATA
creditors were forced to claim directly against BE (by proving in its
liquidation) while they would have been neither required nor even allowed to do
so before the commencement of its winding-up. Pre-insolvency unequals were
forcibly equalised’ in insolvency This hardly constitutes a vindication of
the pari passu principle, no matter what the judicial
rhetoric. And in any case, the sums recovered as a result of this decision
would not have been distributed pari passu. Pre-preferential and
preferential creditors, etc. would have taken the first bite.101
Perhaps a better way
of understanding the disputed issues in British Eagle would be
to look at the netting arrangements simply as an attempt on the part of IATA to
prevent its members from having to submit to the collective liquidation regime.
Or at least this is how they seem to have been viewed by the majority of their
Lordships.102 That such contracting-out (i.e. immunity) was
not objectionable per was also accepted. Lord Cross implied
that, had the IATA arrangements created charges in favour of the IATA creditors
with effects equivalent to the disputed netting scheme, those would have been
effective against the liquidator if duly registered.103 So the objection was not to the granting of
immunity to only some of BE's creditors (or indeed to granting them priority
over others). Rather, the majority were of the view that the advantages
associated with recognising this novel way of acquiring
immunity were not sufficient to outweigh (what they (p.111) saw as) the costs of such a significant
derogation from the collective regime.104 This conceptualization of the majority's
decision then also allows one to make sense or the strong dissenting speech by
Lord Morris, who emphasized the benefits which flowed from having the netting
arrangements.105 On the arguments made here, the thrust of the
dissenting speeches would of course have to be that these benefits (of allowing
the arrangements to prevail) would outweigh any associated costs.
Unfortunately,
however, there seems to have been no suggestion in the arguments that the issue
should be regarded thus, as a question of balancing the commercial advantages
of recognizing this novel way of gaining immunity from the liquidation regime,
against any lessening of the advantages associated with having a collective
system. As already mentioned, the latter include the ability to preserve the
going concern surplus if there is one, and the minimization of uncertainty, monitoring,
and administrative costs. The IATA netting system should have been upheld if
the costs to the actors resulting from any increases in uncertainty,
monitoring, and administrative costs, in the risk that a going concern surplus
would be lost, and in the diminution of the pool of assets entailed by the
existence of immunity for LATA creditors, were outweighed by the benefits it
brought to the same actors.106 (Note that this is a sufficient but not
necessary condition, since the initial distribution scheme provided (p.112) by
the liquidation regime is not self-evidently appropriate and therefore must
itself be argued for.) The pari passu red herring served
massively to confuse this issue. In failing to consider it clearly, it is
submitted that the British Eagle decision is deeply
unsatisfactory.107 Be that as it may, for the reasons discussed,
the leading modern authority on the pre-eminence of the pari passu principle
actually stands more for its hollowness than its hallowedness.
Ex parte Barter; Ex parte Black108 is another interesting decision cited in
support of the pari passuprinciple.109 Simplifying the facts somewhat, X, a
Portuguese steamship company, entered into an agreement with Y, who were
shipbuilders. Under the agreement, Y were to build and sell to X a steamship,
the price for which was to be paid in instalments as the construction work
progressed. On payment of the first instalment, the agreement provided that the
steamship, its engines, and all associated materials were to be vested in X,
the buyers (the Court of Appeal referred to this as the Vesting clause’). It
was also agreed that X would have the right to seize all these materials if the
construction work remained discontinued for a specified period, or if the ship
was not delivered on time, or if Y became insolvent or bankrupt (the ‘seizure
clause’). Finally, the agreement stipulated that should any of the events
mentioned above occur, X would have the right to employ alternative builders to
complete the ship, and to use Y’s shipyard, premises, machinery, plant, tools,
and any other materials present on Y’s premises suitable to the purpose (the
‘user clause’). The work commenced and the first instalment was paid.
Subsequently, on Y’s insolvency, X exercised its rights under the ‘seizure
clause’ and took possession of the ship, engines and related materials. This
was upheld by the Court of Appeal: X was merely seizing property which already
belonged to it by virtue of the ‘vesting clause’.110 However, the ‘user clause’ was struck down,
since ‘a power upon bankruptcy to control the user after bankruptcy of property
vested in the bankrupt at the date of the bankruptcy is invalid.’111
The Court’s decision
is hardly surprising, in view of the extravagance of the terms of the ‘user
clause’ if for no other reason.112 But in any case, the relevant issues are very
clear on the facts. Note the two most important points. First and yet again,
there was no absolute bar to the parties bargaining for immunity from the
collective regime. This was quite obviously the effect of the ‘vesting’ and
‘seizure’ clauses. Instead of lining up with the rest of Y’s creditors and
submitting to the collective decisions made by Y’s trustee, X was able to
remove itself from the (p.113) queue to the extent of the value of the
materials covered by the two clauses. But second, the user clause’ was an
attempt to commandeer Y’s remaining estate for the sole benefit of X, removing
that too from the ambit of the trustee’s decision-making.113 This was regarded as unjustifiable. Even as
to the ‘user clause’, X had argued that it would redound to the general good of
all of Y’s creditors, since the completion of the ship would reduce pro
tanto the amount for which X would prove in the bankruptcy for Y’s
breach of contract.114 The Court of Appeal disagreed: in the absence
of the clause, the trustee would have decided whether to complete the ship and
claim the contractual price, or to abandon the contract, and this decision
would have been made for the benefit of all of Y’s creditors. But the ‘user
clause’ removed the trustee’s ability to make that choice, and instead vested
that choice in X.115 To the extent to which X was a creditor for
damages for Y’s breach of contract, the clause purported to grant X immunity
from having to participate in the collective bankruptcy regime. This attempt
to gain immunity was regarded as unacceptable.
Now whatever one might think of the
distinctions made in the Court’s judgment about acceptable and unacceptable
ways of by-passing the collective regime, note once again that the pari
passu principle was not at issue. The ‘user clause’ would have
by-passed the inequality of the regime (inherent in the rules governing set-off,
pre-preferential and preferential claims, etc.) before it
evaded its ‘equality’. The crucial issue was not X’s place in the queue
relative to other creditors but the fact that he would not have had to queue up
at all, and—if that was not enough—would have prevented the trustee being able
to make a collective decision about much of the remaining pool of assets.116
The same point can be
made again and again. Cases cited in support of the ‘equality’ principle either
support that principle only as part of a significantly ‘unequal’ insolvency
regime, or more frequently, show nothing except the law’s intolerance towards
attempts to gain immunity from the collective liquidation system in
unacceptable or unfamiliar ways. In view of all this, the pari passu principle
could not possibly be necessary for there to be an orderly liquidation. In
addition to all the arguments above, to the extent that the current liquidation
regime is accepted as fulfilling the requirements of orderliness and as
replacing the value-destroying rush for an insolvent’s assets, and given
that pari passu is a very (p.114) partial feature of the system, the
present liquidation regime itself constitutes a rebuttal of any such claim.117 What is more, the very significant departure
from this principle represented by insolvency set-off has been regarded at the
highest judicial level as itself necessary for a ‘proper and orderly’
administration of the estates of insolvent companies.118 But then, since ‘equal’ treatment of
different types of claim is not required to gain the practical advantages
associated with the orderly winding up of insolvent estates, and since it is
not necessary to justify insolvency law’s peculiar features (e.g. its
collectivity, and the avoidance of preferences and post-petition dispositions),
the existence of differential priority—including that of secured creditors—can
not be impugned on the ground that it interferes with the attainment of these
goals.
Finally and in the interests of
completeness, a decision which allows parties to bargain for a priority
different from the one they would have had without that agreement—but without
allowing immunity from the rules of the liquidation regime—is Re
Maxwell Communications Corporation.119 This case concerned an agreement whereby
certain bonds issued by M Ltd. (held by parties referred to hereafter as ‘the
Bondholders’) were guaranteed by M Plc. ‘on a subordinated basis’.
Subsequently, M Ltd. being insolvent, M Plc. was placed in administration. The
administrator applied for an order to exclude the Bondholders from
participation in a scheme of arrangement under which, secured and preferential
creditors having been paid, the remainder would be distributed pari
passu among M Plc.’s other unsecured creditors. In accordance with the
subordination agreement, the Bondholders would only be paid if these other
unsecured creditors were first paid off in full. It was clear on the facts
that, if this scheme was approved, the Bondholders would get nothing.120
It was argued on
behalf of the Bondholders that the subordination agreement was void as being in
breach of thepari passu principle: ‘the liquidator ought not to be
required or entitled to look behind a proof to determine whether a creditor
submitting a proof was entitled to payment pari passu with other unsecured
creditors ’121 In effect, the submission was that the
pari passu principle should be (p.115) given effect with respect to all those
general creditors who submitted a proof, the liquidator being required to turn
a blind eye to the pre-insolvency dealings between the debtor and (some of) its
creditors. This was rejected. Vinelott J pointed out that ‘There are situations
under the Insolvency Act 1986 in which an unsecured debt is postponed to other
unsecured debt.’122In these situations, the liquidator might well need
to have regard to the pre-insolvency status of different unsecured creditors.
So if the liquidator had no difficulty in determining the pre-insolvency
positions of various unsecured creditors and giving effect to statutory
subordination, he would face no greater hurdle in dealing with contractual
subordination.123 The judge read British Eagle as
laying down the rule that ‘a creditor cannot validly contract with his debtor
that he will enjoy some advantage in a bankruptcy or winding-up which is denied
to other creditors.’ However, he held that this did not preclude an agreement
between A and B Ltd. for the latter’s debt to A to be subordinated in B’s
insolvency to that owed to B’s other unsecured creditors.124
For the reader who is still not
convinced, this decision should make it clear that the pari passu principle
is far from sacrosanct. It is obvious that Re Maxwell allows
parties to avoid it. The Bondholders, who would have ranked pari passu with
M Plc.’s other creditors, were relegated because of the terms of their
agreement with M Plc. to a position inferior to those other creditors. But this
aspect of the decision should not tempt one to the hasty conclusion that the
inexcludibility confirmed by British Eagle ‘applie[s] only to
those rules the infringement of which would give one creditor an advantage
denied to other creditors.’125 Resorting once again to the analogy of the
common pool, this would amount to saying that the rule is that within the
insolvency regime, one can contract out of one’s assigned place in the queue if
the result would be to increase the insolvency value available for the
remaining unsecured creditors,126 but not if it would decrease that value. But
this interpretation would be quite inconsistent with the House of Lords’
judgment in Natwest v. Halesowen.127That case shows that one is not allowed to change
one’s place in the queue for the pool of the insolvent’s assets simply because
that would increase the insolvency share of the remaining creditors. As already
noted, the Lords there struck down an agreement which, by altering a creditor’s
priority position, would have brought about just such an increase.128
(p.116) So when should
parties be allowed to change their priority position within the collective
liquidation regime, in other words, to alter their relative places in the queue
to the pool of the insolvent's assets? Most obviously, an agreement to alter
the priority position of creditors within the liquidation regime should be
allowed when—for all the creditors whose priority position in their debtor’s
insolvency would be made worse off because of the agreement—the expected overall benefits
of the agreement (i.e. not merely those accruing if and when the debtor does
become insolvent) to those same creditors outweigh its expected overall costs.129 (This again is a sufficient but not necessary
condition, and is discussed further in the next section.) More abstractly, it
is submitted that such an agreement must be upheld if it would be sanctioned by
principles acceptable to all the affected parties bargaining with each other in
the choice position of the Authentic Consent Model (‘ACM’).130
We have considered—and rejected—the
claim that the ‘equality’ principle is essential for the orderly liquidation of
companies, and that it underlies important and distinctive features of the
collective insolvency regime. This section challenges the other main role often
assigned to it. The pari passu principle requires that all
creditors (in positions of relative equality as determined by pre-insolvency
law) should be paid back the same proportion of their debt in their debtor’s
liquidation. Since this type of ‘equality’ represents fairness, runs this
argument, the pari passu rule ensures that all creditors are
treated fairly. Keay and Walton are of the view that ‘The underlying aim behind
the use of the equality principle is to produce fairness, so that every creditor
is treated in the same way.’131 As noted above, they argue that to abolish
this principle would be to return to the ‘mediaeval’ policy of allowing those
with the greatest resources and power to deprive poorer and weaker creditors of
everything in their debtor's insolvency.132 This would be normatively unattractive.
Several other commentators have suggested in a similar vein that the ‘equality’
principle enshrines fairness in liquidation.133
(p.117) The
debate about equality as a political ideal is complex and ongoing.134 The discussion here will have to be quite a
summary one. However, it is respectfully suggested that even this should
suffice, at the very least, to cast serious doubt on the claim that the pari
passu principle conduces to fairness in liquidation.
There can be no doubt that real
equality is a—some would say the only—form of fairness. But a set of laws enshrines
real equality only when it treats all those subject to it as equals. However,
‘There is a difference between treating people equally, with respect to one or
another commodity or opportunity, and treating them as equals.’135 It is this crucial distinction which is
universally overlooked by supporters of the pari passuprinciple.
Let us distinguish,
in a rough and ready way, between formal and real equality. In the relevant
context, formal equality holds when the same rule applies to
all people. That everyone must stop at a red traffic light is an example. This
type of equality, while undoubtedly important, results in a fairly superficial
form of fairness, the limits of which are easy to expose. It is not obviously
fair to insist that an ambulance should be obliged to wait at the red signal
just like any other vehicle, even though carrying a seriously ill patient. That
access to a building is provided ‘equally’ to all by way of a steep staircase
does not necessarily prevent those using wheelchairs from being treated
unfairly Or think of a flat-rate income tax: regardless of how much you earn,
let us say 25 per cent of your annual income is to be paid over to the State.
Many (perhaps most) readers would intuitively find this method of taxation
normatively unappealing. That you are to be deprived of the same proportion of
your income, whether you earn £10,000 or £10 m per annum, would not strike them
as particularly fair. Note here the parallel with the pari passu rule,
which represents the decision that all creditors are to be deprived of the same
proportion of their debts, should their debtor become insolvent. The problem is
that a rule based on formal equality does not take into account important differences between
people, even though those differences are relevant to any consideration of the
rule’s fairness. Of course equals must be treated as equals, but who is to be
considered equal to whom, and in what respect? Merely formal equality might
resolve these vital questions by reference to trivial, or irrelevant, or
meaningless attributes. But for equality to result in fairness (a morally charged
concept), the determination of who (p.118) constitutes an equal must be based on
characteristics which themselves are morally significant. So in important ways,
a rule based on formal equality is empty of normative content. To treat people
with only formal equality often is not to treat them as equals.
How do we treat
people, then, in order to treat them as equals? One attempt to describe what
this entails in the specific context of corporate insolvency is of course the
ACM,136 and we can bring this to bear upon the
analysis of the status of the pari passu principle. The
peculiar insolvency issue is the distribution of assets in a corporate
liquidation, and the proposal is that all those who hold a claim which
non-insolvency law determines to be formally similar, are to get back the same
proportion of what they are owed. Would the parties in the choice position,
bargaining in Dramatic Ignorance about the governing principles appropriate to
this situation, be tempted by formal equality of this sort?137 It is submitted that they would not. The
reason is straightforward. Non- in solvency law does not need to
determine the priority status of different types of creditor, since for most
solvent debtors, all creditors get everything they are owed.138 For that reason, non-insolvency law makes few
formal distinctions between various types of claimant. The unsecured claim of a
bank, a tax liability owed to the Crown, and the unpaid wages of an unskilled
worker, all have the same pre-insolvency form. Non-insolvency law often does
not resolve an issue which is (almost by definition) peculiar to insolvency
itself—who should bear how much loss when a company is rendered terminally
unable to meet its obligations?139 So when an actor does become insolvent, to
seek guidance from non-insolvency law to determine how different claimants
ought to be treated—as the pari passu principle purports to
do—is to commit the old formalist error identified above. The ‘equality’
principle determines who counts as an ‘equal’ by reference to an attribute of
the claimants (i.e. the non-insolvency form of their claim)
which is irrelevant or meaningless as regards the appropriateness of any method
of distribution of an insolvents estate.
Here is a simple
demonstration that parties conceived of as equals would not choose the pari
passu rule. Let us isolate the issues of interest to us by making
three assumptions. First, suppose there are only four types of creditor:
commercial banks, the Crown, weak trade creditors,140 and the debtor’s employees. Second, we also
ignore for the moment the employee-creditors’ rights under the (p.119) Employment
Rights Act 1996.141 And finally, pretend that the parties in the
choice position are allocating the bankrupts estate without reference to their
own pre-insolvency interests and commitments.142 In Dramatic Ignorance, parties do not know
whether they would turn out to be an employee, or to have their relevant
interests represented by a bank or the Crown. They are aware, though, that
banks lend to thousands of companies (or more) and are therefore
well-diversified. Banks can balance the harm of receiving somewhat less in the
insolvency of some of their debtors, against the profit they make from lending
to the many more who pay back every penny with interest. By virtue of being
repeat players, they have accumulated expertise in assessing the
credit-worthiness of their borrowers. And since they are strong commercial
players in an under-diversified market for the provision of credit,143 they have a strong influence on the terms on
which they lend. So bank-creditors are very well placed to deal with being paid
back less than they are owed in any individual insolvency.
On the other hand, employee-creditors
might often be dependent solely on their salaries, might be unable to diversify
by working for more than one employer, might have no insurance because they are
not able to join a trade union which would buy such insurance for its members,
might have had no influence over the terms on which they were employed and
therefore became creditors, and might be unable quickly to find work on being
deprived of a job by virtue of their employer's insolvency.144 Employees might be owed wages for several
weeks or months, having supplied services to their company while it was in
financial distress without demanding payment on time, in the hope that the
company would recover. Such employee-creditors might suffer serious detriment
if they were to lose too great a proportion of their outstanding debts.
In the choice
position of the ACM, parties bargaining about the appropriate rule for the distribution
of the insolvent’s assets would find the suggestion that bank-creditors and
employee-creditors both be treated ‘equally’ by being paid back the same
proportion of what they are owed, simply absurd. That the two types of creditor
hold claims judged under non-insolvency law to be formally similar to each
other would not carry too much weight. The parties do not know whether they
would turn out to be (or to be represented by) bank- or employee-creditors, so
they accord equal concern to the sets of interests associated
with each. But this requires that those in a more vulnerable position in their
debtor’s insolvency be given greater protection than those
better able to deal with the loss. Knowing that they could deal quite well with
being paid back less on any (p.120)individual loan if they turned out to
be represented in the real world by a bank, all the parties would agree to
provide greater protection to employee-claimants, just in case they found
themselves vulnerable to great harm as one themselves. The construction of the
choice position allows us to see this as one morally relevant factor here.
Fairness does not result from treating the two types of
creditor ‘equally’, so the pari passu principle would be
rejected outright as applied to bank-and employee-creditors with claims similar
to each other under non-insolvency law. The same reasoning holds mutatis
mutandis for the various types of creditor different in this morally
significant way, regardless of the formal legal nature of their claims. So for
example, the principles of distribution resulting from this exercise are more
likely to give employee-creditors at least a degree of priority in their
employer’s insolvency over most other types of claimant.145
Note that the extent to which creditors
are vulnerable to serious harm in their debtor’s insolvency is only one of
several relevant considerations for the parties in the choice position. The
point here is not to identify all such factors (or even to defend the
preferential debts regime as it stands today), but rather, to cast doubt on
the pari passu principle as the guardian of fairness in
liquidation. It should be obvious its crude ‘equality’ is almost entirely
unattractive to parties treated as equals.
What about the
alleged additional role of the pari passu principle, that it
applies within the categories of creditor created by insolvency
law itself? Some of the problems with this suggestion were noted in the first
section of this chapter. But most importantly, this interpretation of the
principle again can make no reference to fairness. Consider the example of the
special reserve fund, against which claims held both by the Crown and by the
weak trade creditors are to be vindicated. Again reasoning subject to the three
assumptions stated above, there can be no question of the parties in the choice
position accepting the same treatment for these two types of creditor. Weak
trade creditors, somewhat like employee-creditors, are often unable to
influence the terms on which they lend, and are also bad monitors of their
debtor’s financial prospects. So the parties in the choice position might be
minded to pay attention to an argument that the claims held by such trade
creditors should be accorded some priority. However, there is little that can
be said on the grounds identified so far for the Crown to enjoy the same priority
as them. While the Crown does not choose its debtors, it is still maximally
diversified (by being the universal creditor within its domain) and obviously
therefore, is able to absorb a greater share of the loss than
employee-creditors. Unlike them, it also has the ability to vary the rates at
which it lends’, and can decide for itself how to use that ability. For
example, it could put in place a mechanism to judge the risk of non-payment by
some of its debtors, and to charge rates of interest on due but unpaid taxes
accordingly.146 For the parties bargaining in (p.121) Dramatic
Ignorance, its decision not to do so does not render it any more worthy of
protection. It also has access to privileged information about its debtors, and
enjoys immense economies of scale in keeping track of their financial
prospects. Such mechanisms are of course not even remotely available to weak
trade creditors. It should be clear that even if the parties decided the Crown
should receive some sort of preference over creditors who choose their debtors
freely, this priority would be likely to be lower than that accorded to the
sort of trade creditors described above. ‘Equality’ does not conduce to
fairness even within the category of those able to press claims against the
special reserve fund, since these two types of claimant are notequal
in crucial ways.147
This concludes the argument that
the pari passu principle has little to do with fairness. But
to leave the discussion at this point would be profoundly misleading. Recall
the third assumption made above, that parties deciding on the choice of
principles to govern distribution of an insolvent’s assets are unconcerned
about theirpre-insolvency rights and obligations. This assumption
allowed us to focus narrowly on whether ‘equality’ of distribution in corporate
liquidation is normatively attractive. But while useful for that purpose, this
assumption is problematic and of course entirely counterfactual. Creditors of a
firm which becomes insolvent do not suddenly develop a completely new set of
interests without link or connection with the interests they had before this
particular debtor became unable to pay its debts. In their capacity as actors
on the commercial stage, they do not undergo a rebirth which purges them of
pre-insolvency commitments. Their interests and obligations within liquidation
flow from their pre-liquidation ones, and the former are inextricably linked to
the latter. So for example, to accept the very existence of claims against the
now-insolvent company is to acknowledge this inseverable link with the
pre-insolvency commitments of the actors. And one of the reasons why employees
are more deserving of protection in their employer’s insolvency is their
pre-insolvency inability to diversify, and (for many employees) to have an
appreciable say about the terms of their employment, etc.
It follows that, while the
pre-insolvency form of claims might not matter, the
pre-insolvency interests and obligations of all the parties
must always be taken into consideration when deciding about the priority of
certain types of claimant over others. Fairness demands that each claimant be
accorded equal care and concern. But this involves looking at the totality of
the interests and obligations of each. So the principles of insolvency law,
though dealing exclusively with peculiar insolvency issues, should not focus
exclusively on the interests of parties once a relevant actor is
already insolvent. Rather, they should affect the parties in a way which
pays equal attention to both their pre- and post-insolvency interests and
obligations, conceived of as the continuities that they actually are.
(p.122) In
the ACM, the parties may be Dramatically Ignorant, but they are not hemianopic.148 They do not lose sight of their own
pre-insolvency lives (though none of them knows which of these lives is
their’s). They realize that actors in the real world often interact with each
other in the shadow of insolvency law. So they select those principles to be
part of that law which would uphold any pre-insolvency priority arrangements
which, for example, serve the entirety of the interests of
each of them. This despite the fact that those arrangements do not serve
the post-insolvency interests of some of them.149
So parties in Dramatic Ignorance might
approve principles of insolvency law which allow Creditor A and Debtor to agree
that in Debtor’s liquidation, A would rank higher than Creditor B. They would
accept this situation even though each of them has an equal chance—as against
each other party—of turning out to be B. This is because the agreement to grant
A priority might nevertheless bring B greater, countervailing benefits, for
example by reducing the risk that their mutual debtor would become insolvent in
the first place. And parties in the choice position care about their
non-insolvency lives as much as about their post-insolvency ones, since
(because of the construction of Dramatic Ignorance) they do not know if their
debtor would in fact become insolvent. So one of insolvency law’s more
challenging tasks is to distinguish between pre-insolvency priority
arrangements which are mutually advantageous to all the relevant parties, and
those which are merely exploitative.150 The latter must of course be ruled out, but
it would conduce to fairness actually to give effect to the unequal
distribution resulting from the former.151
We should note the
implications. The fact that creditor X receives 10 per cent of his claim in the
winding-up of its debtor and creditor Y receives 50 per cent is, by itself, no
reason at all for reaching any conclusion on the appropriateness of the result.
One must peer behind these figures, since they are meaningless in isolation.152Similarly, arguments which, for example, bemoan the
fact that there are so many security and quasi-security devices that little is
left for distribution to (p.123) unsecured creditors in their debtor’s
insolvency, are by themselves of little consequence in the debate about the
fairness of according priority to secured claims. That the liquidator in most
proceedings has little to dole out to certain types of creditor may or may not
be regrettable. For an answer, we would have to sift through the totality of
dealings amongst all the concerned parties. We might find, as a result, that
the existence of priority for secured claims does lead to the exploitation of
unsecured creditors, or to other undesirable consequences. But that conclusion
is not an a priori truth, nor can it be discovered simply by
looking at the treatment in insolvency proceedings alone of unsecured
creditors.153
This discussion provides normative
support for Dalhuisen’s observation that:
The equality of creditors is often presented as a
justified concern and as an argument against the [priority implications of ]
the proprietary effects of all kinds of financial schemes … However, this
equality … is not truly the basis of the system of creditors’ protection or a
fundamental legal principle, although endlessly paraded as such. If it were, it
would only be honoured in the breach and it distorts the discussion. In my
researches of bankruptcy law I have always found that it is equitable, not equal,
distribution that is the key, and what is equitable in this respect is now
mostly a matter of statutory definition in domestic bankruptcy acts.154
In the terms adopted here, what matters
is real equality of treatment of all the creditors (in other words, that they
be treated ‘equitably’), not formal equality. The next section asks in what
circumstances the latter is and should be resorted to.
The argument so far has concentrated on
what the pari passu principle in particular, and formal
equality in general, do not do. It would perhaps be useful to
add a word here about what is in fact their actual role. Formal equality
operates in three types of situations in liquidation, always for the same
reason. First, consider the pari passu principle itself.
Commonly understood as governing the claims of general unsecured creditors, it
is submitted that this is not primarily a rule of distribution at all. To the
contrary, it is a rule of non-distribution. The argument here can be
broken down into four steps.
First, certain types of claim are
considered ‘important’, in the sense that they should be met to a significant
degree in most insolvencies. To ensure that this is the case, they are allotted
special priority positions, either by the parties to commercial transactions,
or (where the parties cannot be trusted to reach the right result) by
Parliament itself Second, not to provide a particular priority position for a
type of claim is to ensure it will receive little or nothing in most
insolvencies.
(p.124) Third
and following from that, there must still be a fall-back provision which
covers the treatment of these latter claims. In view of the paucity of value to
be distributed to those holding such claims, it is especially important that
the implementation of this fall-back provision be cost-effective. The
conclusion is that the pari passu principle is the ideal
fall-back provision. This is the basic structure of the argument, and it must
now be fleshed out.
Note once again that in any formal
insolvency proceeding, different claims are treated according to different
priority rules, depending both on who holds those claims, and the sort of
assets to which the claims are being applied. Creditors able to assert set-off
rights created and mandated by insolvency law beat all others to the extent of
those rights. Assets subject to fixed charges are governed by the appropriate
priority rules.155 The trade creditor with the benefit of an
acceptable ROT provision can reclaim the goods supplied. For property subject
only to a floating charge, parties holding claims arising after the initiation
of a formal insolvency proceeding rank ahead of preferential creditors who rank
ahead of the claims of unsecured creditors (up to the full value of the special
reserve fund) who in turn rank before the floating charge holder, and so on. All
these priority rules are thought to have different rationales. For example,
insolvency set-off is said to be based on consideration of fairness.156 The priority of (some) secured creditors
arguably stems from strong efficiency considerations and being mutually
advantageous to all, would be upheld by parties bargaining in the ACM’s choice
position.157Post-liquidation creditors are given precedence
because they can not be expected to subsidise pre-existing claimants.
Preferential creditors are said to be worthy of special treatment because they
do not choose their debtor in any meaningful sense, do not negotiate the terms
of their loans, and (in the case of employees) might be undiversified.158 The creation of the special reserve fund
reflects the conviction that unsecured creditors are more worthy of protection
from the loss flowing from insolvency than are the holders of claims secured by
a floating charge (qua floating charge holder159). The list goes on. The different priority rules
are all complex. It takes time, resources and effort for Parliament on the one
hand, and debtors and creditors themselves on the other, to decide what types
of claim should rank in what order, with respect to different types of asset.
Of course, however,
the state of insolvency is by definition one where the debtor can not fulfil
all its obligations. (As already suggested, priority rules are really crucial
only against this background of insolvency.) Neither Parliament nor commercial
parties themselves have provided specific rules of distribution for that (p.125)portion
of unsecured claims not capable of being vindicated against the special reserve
fund. View this in the context that generally, only secured, post-liquidation
and preferential creditors get anything in their debtor’s insolvency. There is
little or (much more frequently) nothing for those ranking below them.160 So the interests regarded as more worthy of
attention (and therefore arguably more important) by the rule-makers (public
and private) are given precedence with respect to particular types of asset, in
certain situations, to a specified extent. To decide not to provide for such a
priority for a type of claim is in fact to decide not to have it met at all in
most insolvencies. And it is this reasoning which provides the crucial insight
into the true role of the ‘equality’ norm. It was suggested above that pari
passu should not be viewed as a default rule. It can
not accurately be regarded as the starting position, departures from which must
be explained. Instead, it is now submitted, the rule is best seen as a
fall-back provision. It is the rule which takes over when it would be pointless
to provide any other.
Look at the argument again. Some types
of claim are regarded as important, and rules are provided to govern how they
should be dealt with in insolvency. But once this is done, nothing (or not
much) would be left for distribution to other creditors. Recall that most
insolvency proceedings (75 per cent of them or more) yield nothing for general
unsecured creditors. And when they do bring some returns, the yields are fairly
small (about 7 pence on the pound on average). So there simply is no point in
deciding how these claims should rank vis-Ã -vis each
other. For such claims to be governed by the pari passu rule
makes very good sense, since the costs in terms of time, effort, and resources
required to determine their appropriate (fair and efficient)
rankings would far exceed any benefits. Why waste resources identifying and
laying down different priorities, when it is obvious hardly any assets are
likely to be distributed according to them? For such a situation, in fact,
‘equal’ treatment is ideal. In most instances, this simply means some types of
creditor equally get nothing. In the remaining minority of insolvencies, the
tiny amounts available for distribution are all distributed proportionately,
rather than being wasted in ascertaining the claimants’ correct rankings. The
pari passu principle applies, then, whenever the costs of providing
for different rankings for different claims would exceed the benefits.161 The claims it governs mostly—and
necessarily—constitute something approaching a distributively null set; they
are held by those who will not receive anything. If they do receive something,
it would not be much.
Now for the second
application of formal equality in corporate liquidation, which lies in the
treatment of the same ‘type’ of claimant. For example, claims of all employees
are treated ‘equally’ and given preferential treatment over most other (p.126) unsecured
creditors. It was argued above that employees might be more deserving of
protection in their employer’s insolvency than other types of creditor, since
they are more vulnerable to greater harm in these circumstances. But of course
this is not equally true of all employees. It is not obvious that computer
engineers, software designers, commercial lawyers, and others with scarce
skills are in need of the same protection as unskilled workers. And one
Information Technology expert might be much better placed to deal with the
insolvency of his employer than another, perhaps because the former is younger
and therefore considered more (re-)employable in that young industry.
But it makes sense nevertheless to
treat all of them the same, simply because it would be too expensive to require
the liquidator to investigate the relative positions of all the claimants in
terms of vulnerability to serious detriment. What is more, it would be next to
impossible for her to determine whether a particular employee was more
vulnerable than others in this insolvency because, for example, he had been
less cautious in planning for such a contingency than all the others, or
because he had more expensive tastes for consumables like holidays, etc.162 Most liquidators asked to embark upon such an
exercise would necessarily exhaust all available assets along the way, and no
one would get anything. Apart from being inefficient, wastage of this nature
does not lead to fairness either.163 Again, then, ‘equality’ is resorted to
because the costs of employing any more appropriate method of distribution
(including one which is fairer in the abstract) would outweigh its benefits.164
(p.127) Before
the coming into force of the Enterprise Act 2002, a third manifestation of
formal equality used to hold between preferential tax and preferential employee
claims. As already noted, tax claim preferences have now been abolished.
However, an analysis of this type of formal equality nevertheless proves
illuminating. Notionally, of course, employees and the Crown were the two types
of preferential claimant. But the employees of an insolvent firm, in
recognition of their especially vulnerable position, have been accorded rights
which—in their capacity as creditors—make them rather less concerned
about their employer's insolvency. This is because of the provisions of what is
now the Employment Rights Act 1996 CERA). This regime ‘provides for different
and generally more extensive protection for an employee than under the
Insolvency Act.’165 Under it, the Secretary of State, through the
Redundancy Payment Service, makes payments to employees from the National
Insurance Fund. The ERA scheme covers (inter alia) up to eight weeks of
unpaid wages and salaries, wages during the statutory minimum notice period, up
to six weeks of holiday pay, and a basic award for unfair dismissal. These payments
are likely to be larger than those given preferential status by the Insolvency
Act. For the payments made, the Secretary of State is subrogated to the
employees’ rights.166
Relevant to our discussion is the fact
that, ‘once employees’ rights under ERA are factored into the overall picture,
[] the Crown, by subrogation, takes over the claims of employees in a very
large proportion of cases and is often the sole preferential creditor.'167 Again, then, we have an excellent explanation
(though historically perhaps a partial one) for the fact that preferential tax
claims used to rank ‘equally’ with preferential ‘employee’ claims. Most of
these claims were held by the same actor, the Crown. So again it would simply
have been pointless to provide for different priorities for these claims. Why
expend resources differentiating these claims both ex ante and ex
post, when in most cases any such differentiation would merely have been
nominal? It is submitted that this provides further support for the proposition
that formal equality in insolvency law (including that enshrined in the pari
passu rule) is resorted to only when the costs of providing otherwise
would outweigh the benefits. It is for this reason that the pari passu principle
is best regarded as a fall-back provision. It is submitted that it plays no
other role in insolvency distributions.168
Finally, note that
even if analytically accurate, this claim is incomplete from a historical
perspective. To plug this gap, here is one hypothesis. The search costs for
ascertaining optimum rankings for different types of claim depend either
on (p.128) the
availability of a theory of finance, or on a process of trial-error-adjustment
by the parties themselves. When the former method is unavailable or
underdeveloped, the time component of search costs (incurred during
trial-error-adjustment) is high.169 So initially, only the more obvious methods
of distribution (e.g. pari passu), and of bargaining for priority
(e.g. rudimentary forms of security), which have therefore been developed
earlier and employed for longer, would be cost-effective. So after 1543, when
statute first provided for claims against bankrupts to be paid in ‘a portion
rate and rate like, according to the quantity of their debt’,170 this initially might in fact have been a rule
of almost universal application, perhaps only secured and Crown claims being
exempt.171 Again, this would have been so not because
Parliament and the parties themselves at that time were fairer than they are
now, but simply because no better method of distribution had then been
discovered (i.e. none was cost-effective). But as better (fairer and more
efficient) methods were discovered both through trial-error-adjustment and the
development of theories of finance, pari passu would quickly
be relegated to a mere fall-back provision even as applied to unsecured claims.
This hypothesis predicts that unless
all creditors in real life are truly equal in all relevant
respects, there would always be an increasing tendency for a fair and efficient
insolvency law system to develop different priorities for different types of
claim, to the full extent of all the assets generally available in liquidation.172 This then implies that attempts to ‘equalise’
distributions to creditors who are different in relevant respects are
misguided, since they impede the development of a fairer and more efficient
system.
7. The
removal of tax claims preferences
The analysis in the
previous section allows us to examine the recent removal of the preferential
status enjoyed by certain tax claims (discussed above).173 This step (p.129) was conceived of as ‘an important and
integral part’ of a package of reforms to corporate insolvency law, which also
included the virtual abolition of administrative receivership and changes to
the administration procedure to make it more ‘streamlined’, and thus the
successor to receivership. The Government predicted that the removal of tax
claim preferences would bring ‘major benefits to trade and other unsecured
creditors, including small businesses’.174 Importantly, however, the preferential status
of ‘employee’ claims was retained, ‘as [were] the rights of those subrogated to
them’.175 It will be argued in this section that the
removal of the preferential status of tax claims is unlikely to bring any
significant benefit to unsecured creditors, and thus may not fulfil its stated
objective. In addition, the manner in which the categories of preferential
claims have been reformed lacks coherence.
In order to evaluate the effects of the
abolition of tax claim preferences, we should begin by trying to estimate the
quantum of the additional benefits to unsecured creditors which can be expected
to result from its implementation. Even a very rough estimate requires a
lengthy calculation, and because of the imprecision of the data available, the
estimate here will indeed be rough. But it will soon become apparent that this
does not matter to the point being made here. Unless otherwise stated, any
doubts in the figures are resolved so as to maximize the expected additional
benefit to unsecured creditors from the proposed change.
At the moment, total
liabilities of companies that undergo a formal insolvency procedure during a
year are estimated to be about £42b.176 Of this, about 35 per cent is owed to banks.177 Let us suppose that 80 per cent of bank debt
is secured by the company’s assets.178 So secured creditors are
owed, roughly, 28 per cent of the total outstanding debt. Preferential creditors
get back about 30 per cent of what they are owed.179 The amount actually paid out as dividends in
right of tax claims preferences is around £ 100m.180 So preferential tax claims themselves amount
to some £333m. The amount owed in right of employee preferences is an estimated
£200m.181 Altogether, then, preferential debts
constitute about 1.3 per cent of the total debts owed by insolvent companies.
It follows that (p.130) unsecured creditors are owed about 70.7 per cent of the
total outstanding debt of companies in insolvency proceedings. This amounts to
around £29.69b. They get an average of 7 pence on the pound,182 or about £2. lb (£2100m) today.
Now the Government estimates that the
removal of tax claims preferences would bring ‘up to’ £100m more for unsecured
creditors.183 So after the removal of preferential status
for tax claims, unsecured creditors can be expected to receive £2,200m.184 In other words, their recoveries should go up
to 7.4 per cent once the proposal is implemented. This is of course an increase
of less than one-half of one penny over what they currently get! And that does
not take into account that all tax claims would then also rank alongside other
unsecured claims (and would be vindicated against the special reserve fund).185
It should be obvious, then, that even
if these calculations are wide of the mark (so that the actual increase will be
twice, thrice, or even five times this much), the average recovery rates for
unsecured creditors in an overwhelming majority of formal insolvency
proceedings are unlikely to go up to the extent that such creditors would be
appreciably better off. The Government’s claim that this ‘important and
integral’ part of its reform package will bring ‘major benefits’ to them
therefore seems somewhat implausible.186 In addition, and in line with the analysis in
the previous sections, it should be noted that it makes very obvious sense to
subject to a distributive rule based on formal equality the tiny additional
sums which will become available in many formal insolvency proceedings because
of the proposed change. For these additional sums, it would be entirely
wasteful to attempt to think up some other set of priorities. The costs of
doing that would be quite unjustified in view of the size of the expected
benefits.187
(p.131) So
much for the suggestion that the change is likely to be inefficacious. To
understand why its implementation is incoherent, we should recall that because
of the rights of employee-creditors of insolvent companies under the ERA, the
claims apparently held by them and given preferential status, are mostly vested
in the Crown by way of subrogation. So preferential tax claims and preferential
‘employee’ claims are in most cases held by the same actor. Nor did this fact
go unnoticed in the White Paper. As already mentioned, the Paper not only
stated that certain employee claims would retain their preferenrial status, but
also explicitly included within this reservation ‘the rights of those
subrogated to them’,188 or in other words, of the Crown itself. Now
the supposed rationale for removing the preferential status of tax claims is
presumably the well-rehearsed one that the Crown is better able to absorb the
loss of not being paid by some of its debtors, than are some other categories
of creditor, for example, weak trade creditors.189 But if this is accepted, it surely follows
that ‘employee’ claims, also generally held by the Crown, should have lost
their preferential status for exactly the same reason. Employees might deserve
greater protection in their employers insolvency than other types of claimant,
but if they have already been reimbursed from the National Insurance Fund, then
the competition is no longer between them and other unsecured creditors, but
between the latter and the Crown. So there seems little sense in abolishing
only one category of preferential claims, when the reason why that change was
considered desirable is equally a reason to reform the other category as well.
This is especially relevant given that the stated aim of improving the
prospects of unsecured creditors is expected to be fulfilled to a negligible
degree in any case.190
At the very least, the Government bore
the burden of showing what makes preferential tax claims different from most
preferential ‘employee’ claims. One way in which it might have attempted to do
so would have been to provide better data than are currently available in order
to rebut the premise of this argument, that the Crown holds, by subrogation,
most preferential ‘employee’ claims. But even then, the obvious solution would
have been to adopt the approach enshrined in the US Bankruptcy Code, which
provides that an entity subrogated to the rights of, inter alia,
the employee-creditors of a bankrupt company, is not entitled to enjoy the
statutory preferential status provided to some of their claims.191 This would have ensured that the preferential
stattis of ‘employee’ debts was retained only to the extent that employees
themselves would benefit from it. Since the Government has failed to explain
why this was considered unacceptable, it seems difficult to avoid the
conclusion that its approach to this issue was based on an arbitrary and thus
unjustifiable distinction.
Some years ago, Bridge concluded his
brief review of the clash between pari passu distribution on
the one hand, and the freedom of contract which allows parties to grant and
take security on the other, by framing the issue thus:
Is the pari passu principle so
strong that the burden of proving efficiency rests upon those who support
secured credit, or is freedom of contract paramount so that the burden falls
upon those who oppose security?192
Even without invoking freedom of
contract,193 here (it is submitted) is the answer. The
first premise of those attacking the priority accorded to secured claims—that unequal
treatment of claims is anomalous, somehow a deviation from the ‘strong’
‘equality’ norm—is quite false. If anything, it is the pari passu principle
which constitutes an isolated enclave of ‘equality’ in a (formally) unequal
insolvency world. In that real world, its status—considered as a rule governing
distribution of assets—hovers somewhere between falsehood and tautology. So
with respect, assertions that this principle is all-pervasive in the
liquidation regime, that it underlies some of the best-known adjustment
provisions of that regime, or that it provides the only alternative to an
undesirable free-for-all, all stand rebutted as based on a fallacy. They must
all be abandoned. So must the argument that the pari passu principle
is necessary to ensure fairness in liquidation.
It is submitted that it is the critics of differing priorities for different types of claim, including those attacking the full priority of secured claims, who must now be on the defensive, at least on these grounds. The general rule in insolvency law, its deeply-embedded norm, seems to be that the assets available in insolvent estates are to be distributed ‘unequally’, unless attempting to do so would be wasteful because pointless. It might be that the different priorities afforded to different types of claimant are sometimes arbitrary. It might be that this area of the law could do with extensive rethinking and rationalization. Even then, it would not follow that what should replace the current system is one which crudely ‘equalizes’ all creditors in their debtor’s insolvency. Formal equality of that sort is not the natural alternative. It will not win by default. Not only is it rare and unnecessary in the real world, it is also useless as an ideal. So it must be argued for as much as any other system of priorities—whether the one we now have, or any proposed as a replacement—and it would be at least as contentious as any of them. Those arguing for (a more) ‘equal’ treatment of all claims must therefore bear the heavy burden of showing why moves towards formal equality are desirable.
BY
Rizwaan Jameel Mokal
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