Insolvency and employees' rights: 1
In a series of two Guidance Notes we discuss the position of employees in the event of their employer entering into insolvency. This first article looks at what is meant by insolvency, the procedures that are applied to an insolvent company, and how insolvency affects the contract of employment. We conclude by stressing that account must be taken of the important rights of employees as preferential creditors of the insolvent company.
Insolvency figures from the Department of Trade and Industry reveal a sharp rise in the number of companies in England and Wales experiencing insolvency in recent years. In 1989, a total of 10,456 companies went into liquidation. By the end of 1993, however, this figure had reached 20,708. Other companies also felt the pinch of the recession, but may not actually have "gone bust". In the years 1989 to 1993, a total of 843 administration orders were made in respect of some of these companies, and 448 companies entered into voluntary arrangements (we look at these terms in detail below). The statistics make even grimmer reading in the case of small businesses.
An insolvency situation is without doubt a time of great upheaval for all concerned, not least the employees of the troubled company. They may have been aware of a worsening of the company's financial position: that is, major orders being cancelled; the banks threatening to withhold further credit facilities; talk of imminent redundancies; the sudden appointment of an insolvency practitioner to assume control of the company; the media picking up on the company's troubles; and negotiations taking place between the insolvency practitioner and interested purchasers.
It takes only the last potential sale to fall through for all their fears to be realised. If the company, or viable parts of it, cannot be sold as a going concern, there may be no option left but to appoint a liquidator to wind up the company. This involves not only the collection and realisation of the company's assets and the payment of its debts, but also the company's dissolution. In addition, the appointment of a liquidator means that, except where some employees are retained for a period to help with the "beneficial winding up", the entire workforce is issued with letters of dismissal and sent home.
What are the rights, if any, of employees in these situations? Against whom may those rights be enforced? In this and a further Guidance Note we focus on these issues. (Note: these articles are limited to the law as it applies in England and Wales, time and space not permitting a discussion of the law as it applies specifically to Scotland.) The main points to note in part one of this series are set out in the box opposite.
When is a company insolvent?
The major statutory regime dealing with insolvencies is the Insolvency Act 1986 (the IA). In addition, there are a number of accompanying statutory instruments such as the Insolvency Rules 1986 (SI No.1925). Both the Companies Act 1985 and the Law of Property Act 1925 also contain relevant provisions relating to aspects of insolvency.
The IA does not give a definition of the term "insolvency". What it does provide is a description of the circumstances in which a company can be said to be insolvent. Section 247(1) of the IA states that corporate insolvency "includes the approval of a voluntary arrangement ... the making of an administration order or the appointment of an administrative receiver". Clearly a company in liquidation is also insolvent. Section 247(2) defines a company going into liquidation as one which has passed a resolution for voluntary winding up or has had a winding-up order made by a court in respect to it. Similar provisions are to be found in ss.106(5)(c) and 127(1)(c) of the Employment Protection (Consolidation) Act 1978 (the EP(C)A). They describe corporate insolvency as the state of being in liquidation or receivership, or being subject to an administration order or a voluntary arrangement approved by the court.
Liquidation, receivership, administrative receivership, administration and voluntary arrangements are all procedures which may be applied to a company when it becomes insolvent. Clearly, therefore, a company must first find itself in a particular state which calls for the application to it of any of these insolvency procedures. A common view appears to be that this state is reached when a company is unable to pay its debts. Section 123 of the IA provides a definition of the "inability to pay debts". A company is deemed unable to pay its debts if it finds itself in any of the following situations: it owes a creditor more than £750, has been served with a written demand for payment, and has neglected to satisfy this demand within three weeks; it fails to comply with a court judgment in favour of a creditor in whole or in part; it is unable to pay its debts as they fall due; or the value of its assets is less than the amount of its liabilities.
The occurrence of any of these events is sufficient to set in train any of the insolvency procedures listed above. The appropriate procedure to be applied is often initiated by one or more of the main "players" in any insolvency situation, namely, the company itself, its creditors, or the courts. For example, the company may take the initiative to negotiate an arrangement with creditors to keep the company in business for a period (voluntary arrangement); the creditors may decide to terminate the company's existence and divide whatever assets are available among themselves in satisfaction of their debts (creditors' voluntary liquidation); or the court may intervene to allow an attempt at company rescue (administration order).
The particular procedure to be applied will depend on the nature and extent of the problems facing the company. But generally, insolvency procedures usually have one of two objectives: to save the business, if this is possible, and to return it to its former management or to sell it (or viable parts of it) as a going concern; or to close the business down. The appointment of a liquidator, for example, heralds the end of the company's existence. The liquidator may run the business for a while, but this is in order simply to allow the beneficial winding up of the company's affairs. On the other hand, where it is thought that the business, despite its financial troubles, can be saved, an administration order is more likely to be made. A particular feature of this type of insolvency procedure is to avoid liquidation if possible, and to seek the survival of the company.
The insolvency practitioner
Any of the insolvency procedures outlined above will inevitably involve the appointment of an insolvency practitioner. In a liquidation, the insolvency practitioner is known as the liquidator; in a receivership, the receiver; in an administrative receivership, the administrative receiver; an administration requires the appointment of an administrator; and, in a voluntary arrangement, the insolvency practitioner acts as supervisor (s.388(1) of the IA).
An insolvency practitioner must be an individual and qualified to act as one (ss.390-393). They are usually employees of accountancy firms and members of a recognised professional body (the Society of Practitioners in Insolvency). Their functions, powers and duties in any given insolvency situation will depend on the exact nature of their appointment.
Whatever the circumstances, the insolvency practitioner will, very early on in the appointment, wish to meet the employees of the insolvent company, explain the reasons for the appointment, and what it is hoped to achieve. Of course, where the appointment itself causes the immediate termination of all contracts of employment, as is the case with, for example, the appointment of court liquidators, this initial meeting may be somewhat overtaken by events. On the other hand, where the insolvency practitioner has in mind to continue carrying on the business for any length of time, it will be important to explain this to the employees, to provide them with whatever assurances may be necessary, and to gain their confidence.
The insolvency practitioner may appear to the employees to be busy at times with everybody else's problems but their own. At the very least, there may be creditors to be appeased, potential purchasers to be wooed, and litigation to be fended off. No matter what the crisis faced, however, an insolvency practitioner will be well-advised to avoid the temptation to consign the employees to the bottom of the pile. For, as we shall see, employees not only maintain their full statutory rights as employees during this period, but also acquire certain important "preferential" rights, guaranteed by statute, which rank high in the hierarchy of claims to which the insolvent company's assets must be applied.
Procedures for handling insolvencies
The IA provides for four main ways of dealing with insolvent companies.
Liquidation
The term liquidation is synonymous with the winding up of a company's affairs. It refers to the process of collecting in and realising the company's assets, discharging its liabilities towards creditors, distributing any surplus according to its articles of association, and finally, terminating its legal existence by dissolution. Upon completion of this process, the company ceases to exist, and its name is removed from the register of companies.
Liquidation can occur voluntarily by the company making its own arrangements, or compulsorily by the making of a winding-up order by a court (s.247(2) of the IA).
Compulsory liquidation. A compulsory liquidation results from a petition to the High Court or county court by the company, its directors, creditors or contributories for a winding-up order (s.124). The petition may also come from the Secretary of State for Employment or the official receiver. (A contributory is a person who is liable to contribute to the company's assets when it is being wound up (s.79), and includes the members of the company.)
Section 122(1) sets out the grounds upon which such an order will be made. They include where the company is unable to pay its debts as defined in s.123 (see above), or where, in the court's opinion, the winding up would be just and equitable.
After the winding-up petition has been presented, the court has a power, upon application to it by the company, its creditors and contributories, to order a stay or restraint on proceedings pending against the company (s.126). After the winding-up order is made, the liquidator, as well as creditors and contributories, may apply to the court for a stay of proceedings against the company either indefinitely or for a limited time (s.147).
In a compulsory liquidation, the official receiver becomes liquidator on the making of a winding-up order (s.136(2)). (An official receiver is nominated to every court with winding-up jurisdiction.) In later meetings, the creditors and members may be able to choose another liquidator. Within 14 days of appointment, the liquidator must publish in the Gazette, and send to the registrar of companies, a notice of their appointment (s.109).
The liquidator has powers of investigation of the company's affairs, and may require, for example, its officers and employees to submit a statement of the company's affairs showing, among other things, the company's assets and liabilities, and its creditors (s.131).
The liquidator also has the powers set out in Schedule 4 to the IA, some of which may be exercised only with the sanction of the court. These include the powers to carry on the business so far as necessary for its beneficial winding up; to bring or defend any action or other legal proceeding in the name and on behalf of the company; and to pay off any class of creditor in full.
The functions of the liquidator are set out in ss.143 to 146. They are "to secure that the assets of the company are got in, realised and distributed to the company's creditors, and if there is a surplus, to the persons entitled to it". A liquidator protects the interests of all creditors whether secured or unsecured (s.130(4)). Upon the appointment, all the company's property is taken into the liquidator's control or custody (s.144). And at the end of the appointment, the liquidator must summon a final general meeting of creditors to receive a report of the winding up.
Voluntary liquidation. There are two types of voluntary liquidation. A members' voluntary winding up often has nothing to do with the company being insolvent. The company may have been formed for a specific purpose which has been successfully achieved, or for a specific duration of time set out in its articles. In such cases it is appropriate to have a members' voluntary winding up whereby the directors swear a declaration of solvency which is filed with the registrar of companies ((s.89) of the IA), and then pass a special resolution to put the company into liquidation.
(An ordinary resolution will be sufficient where the company is being dissolved in accordance with its articles. However, an extraordinary resolution is required where the company comes to the conclusion that it is advisable to wind up because it cannot continue in business by reason of its liabilities.) These provisions are found in s.84.
Notice of the passage of a resolution for voluntary winding up must be advertised in the Gazette within 14 days of the resolution (s.85). Winding up commences at the time of the passing of the resolution (s.86).
The effects of a resolution are that trading ceases as from the commencement date, except if this is required for its beneficial winding up (s.87), and there may be no transfer of shares (s.88).
The statutory declaration of insolvency is a declaration by the directors that they have made a full inquiry into the company's affairs, and that, in their opinion, the company will be able to pay its debts (plus interest) in full within a period (to be specified in the declaration), not exceeding 12 months from the date of the resolution. To be effective the declaration must be made within the five weeks immediately preceding the date of the winding-up resolution, and must include a statement of the company's assets and liabilities.
The company meets to appoint a liquidator to wind up affairs and distribute assets (s.91(1) of the IA). All the directors' functions cease on the liquidator's appointment. At the end of the winding up, the liquidator must make up an account of the conduct of the winding up, and how the company's property has been disposed of. This account is presented to a general meeting of the company. A copy is also sent to the registrar of companies (s.94).
If it turns out that the company is not able to pay its debts as declared, ss.95 and 96 provide for the winding up to be converted into a creditors' voluntary winding up. This inability to pay its debts as declared also raises a rebuttable presumption that a director or directors did not have reasonable grounds for making the declaration (s.89(5)). This is a criminal offence punishable upon conviction by imprisonment, a fine or both (s.89(4)).
A creditors' voluntary winding up may also result from the absence of a declaration (s.90) when the company's members meet to pass the winding-up resolution. In such circumstances the creditors must be summoned to a meeting to be held not more than 14 days after the members' meeting. At the creditors' meeting, the directors present a statement of the company's affairs together with a list of creditors and its debts (s.99).
The creditors may appoint a liquidator or, with the members, appoint a five-member liquidation committee. In most respects, the liquidator proceeds as for a members' voluntary winding up. The effect of a winding-up order is that the directors' powers cease (s.103).
Note also that the fact that a company is in voluntary liquidation does not prevent any creditor or contributory from having it wound up compulsorily (s.116). In the case of contributories, however, the court must be satisfied that the contributories' rights will be prejudiced by the voluntary winding up.
Receivership
The right to appoint a receiver to take control of and manage a company, its assets and property was originally a contractual right of a secured creditor of the company, such as a bank. This right arose out of the loan or debenture agreement between the creditor and the company. Typically, the debenture agreement created a fixed and/or floating charge over the company's property or assets as security for the loan.
For example, a fixed charge would attach to specific property or assets such as the buildings and machinery, land or shares of the company. This vested a proprietary interest in the property or asset in the creditor, and the creditors' permission was required before the property or asset could be sold or otherwise disposed of.
A floating charge, on the other hand, could cover virtually all the company's assets including stock-in-trade, work-in-progress and future book debts (see, for example, Secretary of State for Employment v Stone). This charge "floated" over the assets, as opposed to attaching to them, and so interest did not vest in the assets until something happened, usually a default of one or more of the conditions of the loan, to cause it to crystallise or become fixed. The appointment of a receiver could also crystallise a floating charge (Biggerstaff v Rowatt's Wharf Ltd).
Until a floating charge became fixed, however, the company could deal with the assets in any way without seeking the creditor's permission. In fact, because the floating charge covered all a company's assets, the entire business could be sold as a going concern. If it did become fixed, however, the creditor was entitled to enforce the security given by the floating charge, and the usual method of doing so was to invoke the power contained within the agreement to appoint a receiver and manager over the assets charged. (The creditor could also petition for the winding up of the company as we have described above.)
For the creditor, the main advantage in appointing a receiver was the safeguarding of its security - that is, the protection of the business and assets. The receiver also had wide powers of management over the company's business, and in effect, took over the running of the business from the company's directors. The receiver could also sell or otherwise dispose of the company.
The appointment of a receiver could arise out of other circumstances. For example, the courts have a little-used power to appoint a court receiver and manager. One instance in which this power may be exercised is during a period of dispute between the company's directors which leads to the neglect of the company's affairs (Stanfield v Gibson). And under s.101 of the Law of Property Act 1925, a receiver could be appointed by a debenture-holder under a mortgage or charge made by deed.
Administrative receivership. The IA created a new type of receiver called the administrative receiver. An administrative receiver is the "(a) receiver or manager of the whole (or substantially the whole) of a company's property appointed by or on behalf of the holders of any debentures of the company secured by a charge which, as created, was a floating charge, or by such a charge and one or more other securities; or (b) a person who would be such a receiver or manager but for the appointment of some other person as the receiver of part of the company's property" (s.29(2)).
The original basis for the appointment of a receiver is not disturbed, in that it still arises under a debenture agreement. The administrative receiver's powers will also be specified in the debenture agreement, but include those set out in Schedule 1 of the IA where these are not inconsistent with the powers under the debenture (s.42). Schedule 1 powers include the powers to: take possession of, collect and get in the property from the company; sell or otherwise dispose of the property; bring or defend any action or other legal proceedings in the name and on behalf of the company; employ and dismiss employees; do all such things (including the carrying-out of works), as may be necessary for the realisation of the property; carry on the business of the company; and establish subsidiaries and transfer to subsidiaries the whole or any part of the business and property of the company (hiving-down operations). There is also a specific power under s.43 of the IA to dispose of property free of security held by a third party.
Administration
An administration order is one of two other new procedures created by the IA to allow an insolvent company and its creditors to deal with the company outside liquidation (the other is the making of a voluntary arrangement). It is in many ways similar to an administrative receivership, and in fact arose out of the desire to extend the benefits of the latter procedure to creditors other than those holding a floating charge.
In this regard, the appointment of an administrator arises as an order of the court, upon application by the company itself, or its directors or creditors (both secured or unsecured), or by the supervisor of a voluntary arrangement (ss.7(4) and 9 of the IA).
The order is made in relation to a company which "is or is likely to become unable to pay its debts" (s.8). Moreover, the insolvent company must not already be in liquidation or administrative receivership. The order will be made only if the court is satisfied that it is "likely to achieve" one or more of certain specified purposes (ss.8(1)(b) and 8(3)). These are: the company's survival, in whole or in part, as a going concern; the approval of a voluntary arrangement under the IA; the sanctioning of a scheme of arrangement under s.425 of the Companies Act 1985; or a more advantageous realisation of the company's assets than would be effected in a liquidation.
The court then appoints an administrator. Within three months of appointment, the administrator must submit to a meeting of creditors his or her proposals for achieving the purposes of the administration as set out in the order (s.23(1)). The creditors must decide by a vote whether or not to accept those proposals and to put them into effect. If the proposals are accepted, the administrator must put them into effect, and to do so, is given the powers necessary to manage the affairs, business and property of the company (s.14(1)). Of significance are the powers arising under s.15 which allow the administrator, without the consent of the court, to dispose of or otherwise exercise its powers in relation to property of the company subject to a floating charge as if it were no longer subject to the charge; and with the court's consent, to dispose of assets subject to other forms of security, or goods subject to hire-purchase agreements. The administrator's powers also include those set out in Schedule 1 to the IA.
If the administration succeeds, the company may be returned to its former management. If it fails, there may be no option left but to wind up its affairs.
The making of the application by itself is sufficient to preserve the company's assets during the hearing, and this prevents the company from being wound up, or without the court's leave, from having any security enforced over company property. It also prevents its goods from being repossessed, or execution or distress being levied on company property (s.11(3)).
Section 11(3)(d) states that "no other proceedings and no execution or other legal process may be commenced or continued, and no distress may be levied, against the company or its property except with the consent of the administrator or the leave of the court."
In Air Ecosse Ltd v Civil Aviation Authority it was held that the words "other proceedings" should be narrowly construed to mean proceedings of a similar character to those dealt with in the remainder of s.11(3)(d). This would confine it to proceedings taken by creditors which related to company debts. Based on this, an industrial tribunal later held in MSF and others v Parkfield Castings (a division of Parkfield Group plc (in liquidation), that s.11(3)(d) did not apply to industrial tribunal proceedings, and so the failure to obtain the court's leave or the administrator's consent did not render the employees' unfair dismissal and other claims null and void.
But a different attitude was taken by the EAT in Carr v British International Helicopters Ltd (in administration). The company became insolvent and went into liquidation. Although it continued to trade, work diminished, and Mr Carr and others were made redundant. He complained of unfair dismissal to a tribunal, in that he had been unfairly selected for redundancy. He sought reinstatement. The tribunal ruled his complaint a nullity because he had not obtained the consent of the administrators or leave of the court before lodging his application, as required by s.11(3)(d).
The tribunal took the view that an unfair dismissal complaint fell within the meaning of "other proceedings" in s.11(3)(d), being proceedings of a legal nature. In particular, if the tribunal were to order compensation, that order could be enforced by legal process.
But Mr Carr argued before the EAT that he was seeking reinstatement, a matter far removed from the situations to which s.11(3)(d) applied. He accepted that if and when the time came for an enforcement action for compensation, that might require the consent of the administrator or the court, but as yet, that remained a matter for the future.
The EAT held that industrial tribunal proceedings were covered by s.11(3)(d), but that this did not mean that Mr Carr's tribunal complaint was a nullity. What the tribunal should have done was to stop the proceedings from going any further while he sought the necessary consent, and so Mr Carr's appeal was allowed to that extent.
Voluntary arrangements
Because two of the four reasons for which an administration order may be made are to do with voluntary arrangements (either under ss.1-7 of the IA or under s.425 of the Companies Act 1985), these two procedures may be used in conjunction with each other.
A voluntary arrangement takes the form of the directors making a proposal to the company and its creditors for "a composition in satisfaction of [the company's] debts or a scheme of arrangement of its affairs". These are very important powers from the point of view of the troubled company. An example of such an arrangement would be an agreement for creditors to release claims against the company. The proposal for a voluntary arrangement must provide for a nominee who is a qualified insolvency practitioner to supervise its implementation.
The nominee considers the terms of the proposed voluntary arrangement and the company's financial affairs, and submits a report to the court.
Meetings of the company and its creditors may then be called to consider the report and to decide whether to approve the proposed voluntary arrangement. Any proposal which adversely affects the rights of secured creditors and preferential creditors must have their approval. If approved, the voluntary arrangement binds every person entitled to vote at the company's meetings. The result of the meeting must also be reported to the court.
A voluntary arrangement may be challenged on the ground that it unfairly prejudices certain interests, or that some material irregularity occurred during the meetings. The court may then decide to revoke or suspend the arrangement, or make other appropriate directions.
If the voluntary arrangement proposed is successful, the company may eventually be returned to its former management, but if it fails, the liquidator may be called in to wind up the company's affairs.
Note that where an administration order is in force, or the company is in the process of being wound up, it is the liquidator or the administrator who makes the proposal for the voluntary arrangement.
Insolvency and the contract of employment
In the majority of cases, it will be clear from the insolvency procedure adopted, or from the particular insolvency practitioner appointed, what the future of the employees with the company is going to be. Where it is not so clear, the employees' fate may be determined by the decisions taken by the insolvency practitioner once in office. For example, for various business reasons, the insolvency practitioner may decide to terminate some of the employees' contracts of employment. This could be where it is thought possible to retain some aspects of the business, and to close down others. On the other hand, the insolvency practitioner may find that the company's already precarious financial position worsens, all rescue attempts fail, and that trading must cease and all employees be dismissed.
But even where the company is to be wound up, some employees may need to be retained in order that the assets may be realised in an orderly manner. Moreover, the status of the employee involved may prove incompatible with the insolvency practitioner's appointment, and lead to the dismissal of the particular employee (see, for example, Griffiths v Secretary of State for Social Services).
An insolvency practitioner will either be an officer of the court or an agent of the company. The effect of the former is that the appointment per se of the insolvency practitioner is sufficient to automatically terminate all contracts of employment, and to dismiss all employees. On the other hand, the appointment of an insolvency practitioner who is deemed an agent of the company does not have this effect.
That said, it is worthy of note that the "public policy" objective of the IA is seen to be one of corporate rescue, rather than just the cessation of trading. Carrying on the business so that it can be sold, in whole or in part, will mean that jobs are maintained rather than lost. Moreover, it is usually more profitable to sell a business as a going concern than to break up and dispose of it asset by asset. In order to carry on a business, employees must be retained in employment, and, if a business is sold as a going concern, the Transfer of Undertakings (Protection of Employment) Regulations 1981 apply to transfer existing employees along to the new purchaser.
Officer of the court or agent of the company?
In a court liquidation, the result of a winding-up order is that from the date of the publication of the order, all contracts of employment are terminated, and all employees are automatically dismissed. This includes the contract of employment of the managing director (Fowler v Commercial Timber Company Ltd). In Re General Rolling Stock Company the Court of Appeal said that publication constituted notice of the discharge of all contracts of employment on that day.
However, where a liquidator decides to carry on the business, and wishes to retain one or more of the employees, Re English Joint Stock Bank suggests that there is no automatic termination of those employees' contracts of employment, except where the company had for all practical purposes ceased trading, and the employees continued in employment only to help the liquidator wind down the company (Re Oriental Bank Corporation).
A voluntary winding up, however, does not operate to automatically terminate contracts of employment (Midland Counties District Bank Ltd v Attwood). But s.87(1) of the IA provides that "the company shall from the commencement of the winding up cease to carry on its business, except so far as may be required for its beneficial winding up", and so the practical effect of the appointment of a liquidator in these circumstances is that trading will cease shortly, and this will bring to an end all contracts of employment (Fox Brothers (Clothes) Ltd v Bryant).
A court-appointed receiver is an officer of the court, and not an agent of the company or of the debenture-holders (Moss Steamship Co Ltd v Whinney). According to Reid v Explosives Co Ltd this appointment automatically terminates all contracts of employment. The receiver may re-employ them but then becomes personally liable for their statutory claims.
Receivers appointed out of court under a debenture agreement are agents of the company (the debenture agreement will usually state this), and their appointment does not result in the automatic termination of contracts of employment (Nicoll v Cutts and Re Mack Trucks (Britain) Ltd).
Administrative receivers are, by virtue of s.44(1)(a) of the IA, deemed to be the agents of the company, and therefore, their appointment does not result in automatic termination of contracts.
An administrator owes his or her appointment to the court (s.8), but is deemed to be an agent of the company by virtue of s. 14(5). The administrator has similar powers under Schedule 1 to the IA to dismiss employees. The administrator's main function is to carry on the business of the company (s.8(3)(a)), and, therefore, the appointment does not operate to automatically terminate contracts of employment.
Adoption of contracts
Where the appointment of an insolvency practitioner does not result in the automatic termination of contracts of employment, employees will, at least for some time, be retained in employment. From the insolvency practitioner's point of view, retaining employees in employment could hold particular dangers. By virtue of ss.37(1) and 44(1)(b) of the IA, receivers and administrative receivers are made personally liable for new contracts of employment entered into after their appointment, as well as those "adopted" by them in the carrying-out of their functions.
Adoption is not defined by the IA, but ss.37(2) and 44(2) go on to say that no act or omission of the receiver or administrative receiver done within 14 days of appointment shall be taken to mean that there has been an adoption of contracts of employment. (Sections 37(1)(b) and 44(1)(c) entitle the insolvency practitioner to indemnity from the company's assets in respect of this liability.)
In Re Specialised Mouldings Ltd, the High Court accepted that, if, shortly after their appointment, receivers or administrative receivers sent a letter to all employees stating clearly that they were not to be taken to have adopted their contracts of employment, or as being personally liable in respect of retained employees, this was sufficient to prevent adoption and personal liability.
Until recently, it was further assumed that administrators were also entitled to issue letters to employees disclaiming adoption and personal liability. The case of Powdrill and another v Watson and another effectively laid to rest what was held to be a "ritual incantation" amounting only to "mere wind with no legal effect".
Section 19(5) of the IA states that when an administrator vacates office, "any sums payable in respect of debts or liabilities incurred, while he was administrator, under contracts entered into or contracts of employment adopted by him ... in the carrying-out of his ... functions shall be charged on and paid out" of the company's property which is in the administrator's custody or control, in priority to the administrator's own remuneration and expenses. Since s.19(4) provides that the administrator's own remuneration and expenses rank ahead of any security - that is, they are recoverable from the company's assets in priority to any floating charge over those assets - liability under s.19(5) meant that employees' claims thereunder would be superior to, and rank above every other creditor's claim, with the possible exception of those secured by fixed charges.
In Powdrill v Watson, the administrators sent letters to all employees explaining that administrators had been appointed, confirming that salaries would continue to be paid, and asking for the employees' cooperation. The letters ended by stating that "we wish to make clear that the joint administrators act at all times as agents of the company and without personal liability. The administrators are not and will not at any future time adopt or assume personal liability in respect of your contracts of employment."
The High Court held, in a decision subsequently upheld by the Court of Appeal, that adoption by a receiver or administrator may be brought about by "any act or acquiescence (after the expiry of the 14-day period) which is indicative of his intention to treat the contract as on foot". Therefore, where the insolvency practitioner was aware of the existence of contracts of employment, but did not take steps to terminate them within the first 14 days, where the insolvency practitioner issued a statement saying clearly that contracts were being adopted or that employees are being retained, or, where in the absence of such clear statements, the company continued to use employees' services and to pay them for those services, there would clearly be adoption.
The Court said that the administrator could contract out of adoption, but that it was not enough simply to send the type of disclaimer used in this case. The disclaimer should be drafted specifically with s.19(5) in mind, and reflect the difference between the exclusion of personal liability imposed by s.44(1)(b), and the exclusion of the priority given to adopted employment contracts by s.19(5).
The Court went on to hold that the administrators had adopted the contracts of employment of the employees in this case, and that the liabilities incurred under those contracts during the administration were to be charged on the assets of the company in priority to the administrators' own remuneration and expenses. Those liabilities included: accrued holiday pay; pay in lieu of notice; and pensions contributions; but not a monthly loyalty bonus or compensation for unfair dismissal.
When this decision was upheld by the Court of Appeal in February 1994, it generated an outcry among insolvency practitioners. They concluded that they would have no choice but to dismiss a company's whole workforce within 14 days of appointment and close down the business, or negotiate new contracts, if they were not to be held personally liable. This caused the Government to act quickly to counter its effects. Receiving Royal Assent within a month of the Court of Appeal decision, the Insolvency Act 1994 restricts the sums payable in priority to all other claims to "qualifying liabilities" incurred during the administration under contracts of employment adopted by an administrator. "Qualifying liabilities" are defined as wages or salary, sickness and holiday pay and contributions to occupational pension schemes, in respect of services rendered after the adoption of the contracts.
Non-qualifying liabilities are treated as unsecured claims against the company. Similar restrictions are placed on the extent to which administrative receivers are personally liable under contracts of employment adopted by them in the carrying-out of their functions.
The Insolvency Act 1994 is not retrospective, and so apparently allows employees to make backdated claims arising before 15 March 1994. There is concern that such claims, many of them running into hundreds of thousands of pounds, could go back even to 1986.
The meaning of "adoption" in respect of administrative receivers has also been considered recently by the High Court in Re Ferranti International plc and Re Leyland DAF Ltd. The effect of that decision is to bring receivers and administrative receivers into the same boat as administrators.
The High Court held in this case that the word "adopted" in s.44(1)(b) was to be given the special meaning of "treated as continuing in force". Therefore, where administrative receivers, appointed before the coming into force of the Insolvency Act 1994, wrote to employees saying that they would continue to pay remuneration in accordance with their contracts of employment, but did not and would not adopt those contracts, this was of no effect. The administrative receivers none the less adopted those contracts of employment.
The Court went on to find, however, that the administrative receiver and the employees could come to an agreement to limit or exclude that liability, for example, where the receiver's only option would be to dismiss. Nothing in the wording of s.44 prevented this exclusion of liability. In order to exclude liability, however, the Court said that nothing less than a contract between the parties would do, and in any event the Court would be slow to find that employees had entered into and surrendered their statutory rights in this way unless it was plain that they had given a "full and informed consent". The Court found that the usual type of disclaimer from insolvency practitioners, which had been given in this case, was not such a contract, but "unilateral declarations of non-liability".
With regard to the extent of liabilities covered by adoption under s.44, the Court held that liability was "coextensive with that of the company". In short, all liabilities were covered, "whenever incurred and of whatever kind under the adopted contract". Liability attached at and from the date of adoption, but was not retrospective to the date of appointment.
The High Court has allowed the administrative receivers of the Ferranti and Leyland DAF companies to bypass the Court of Appeal and appeal straight to the House of Lords where Powdrill v Watson is awaiting decision. It is expected that any decision of the Lords will also settle the issue of backdated claims.
Recently, the Government has invited views from interested parties as to whether it would be appropriate to extend the 1994 Act restrictions to cover receivers and managers appointed under charges other than floating charges.
Employees' claims against the insolvent company
An insolvent company may face a number of different claims from employees. Firstly, whether employees are retained or have been dismissed, there may be a claim for wages or salaries relating to the period before the appointment of the insolvency practitioner. Secondly, where employees are retained in employment after the appointment of the insolvency practitioner, the remuneration and benefits which would normally arise as a result of the employment will fall due. Thirdly, where employees are dismissed, either upon the appointment of the insolvency practitioner or afterwards, the usual termination claims will arise. These could include wrongful dismissal claims giving rise to damages for breaches of contract, or claims for unfair dismissal awards and redundancy payments.
Clearly, therefore, employees may have rights, in respect of the first two types of claims, as creditors of the insolvent company, as well as maintaining their employment protection rights under the third type of claim, as employees of the insolvent company.
Rights as creditors
Problems arise when debts cannot be met in full by the insolvent company. As much as possible, the law aims to put creditors on an equal footing. For example, s.107 of the IA states that on a voluntary winding up (and subject to the provisions regarding preferential payments), the company's property is to be applied in satisfaction of its liabilities pari passu (that is, ranking equally and without preference). Nevertheless, it is also accepted that the claims of certain creditors must have priority over those of others, and this is reflected in the legislation which sets up a strict hierarchy of claims to which the company's assets must be applied.
The majority of employees' claims against the insolvent company are ranked with those of unsecured creditors. These include arrears of wages, termination payments such as redundancy payments or damages for breach of contract, and benefits such as medical cover and pensions rights. Being unsecured creditors means that claims will be met only if there is anything left from the sale of the company's assets after the claims of secured creditors have been met.
This state of affairs is remedied to some extent by the IA, which, by virtue of ss.175 and 386 and Schedule 6, endows certain claims of the employee as creditor with the status of "preferential debt". The effect is to enhance the status of these debts so that they become payable ahead of unsecured claims, and even of claims secured by a floating charge, but after insolvency expenses and secured claims under a fixed charge. Therefore, in respect of their claims as creditors of an insolvent company, employees may at the same time rank both as preferential and unsecured creditors.
Preferential debts
Section 386 of the IA points to Schedule 6 for the categories of preferential debts. These include debts due to the Inland Revenue (national insurance and VAT), customs and excise and social security contributions. The preferential debts of relevance to employees are: category 5, remuneration; category 4, contributions to occupational pension schemes; and categories 1 and 3, PAYE and national insurance.
The existence and amount of a preferential debt is determined by reference to a "relevant date". This is defined in s.387 and depends on the type of insolvency proceedings. For example, in relation to a receivership, it is the date of the appointment of the receiver, whereas in a compulsory winding up, it could be the date of appointment of the liquidator, or the date of the winding-up order.
With regard to remuneration, category 5 refers to two sub-categories of preferential debt. Firstly, it covers remuneration in respect of the whole or any part of the period of four months preceding the relevant date. Not only is the employee's preferential claim in respect of unpaid remuneration limited to work done only in the preceding four months, but it is also made subject to a maximum limit of £800 (the currently prescribed limit under Article 4 of the Insolvency Proceedings (Monetary Limits) Order 1986 SI No.1996). Therefore if the employee's claim is greater than this amount, the excess loses preferential status, and becomes an unsecured claim.
The second sub-category of remuneration is accrued holiday pay in respect of any period before the relevant date. There is no limit imposed on this amount.
Holiday pay is deemed to have accrued if the employee would have become contractually (or, by virtue of an enactment) entitled to it had the contract not been terminated.
Apart from wages or salary (which includes commission), remuneration as defined in paras. 13 and 15 of Schedule 6, includes the following:
Overtime payments have been held to be remuneration (Northland Fisheries Ltd v Scott), as well as contractual living or other expenses (Re R McGaffin Ltd).
The hierarchy of claims
In a winding up, the liquidator must first group the claims made against the company into their respective categories and then, starting with the first group in rank, pay in full every creditor in that group before moving to the next group in rank. The liquidator must meet every claim in every group in full. If the funds are insufficient to go round, preferential debts "abate in equal proportions" (s.172(2)(b)). This means that debts will then be payable by fixed percentages of the total amount. All other claims ranking subsequent to this may not be met.
The order in which claims are satisfied is as follows:
(1) The expenses of the winding up. Section 115 provides that in a voluntary winding up, these, including the liquidator's remuneration, rank "in priority to all other claims". In respect of compulsory liquidations, s.156 states that in the event of insufficient funds, the court may make an order as to the payment out of the assets "in such order of priority as the court thinks just". Moreover, s.175(2)(a) puts the expenses of a winding up ahead of preferential debts. Expenses include supplies of public utilities such as gas, electricity, water and telecommunications; rent on premises used to store the realised assets during the liquidation (see, for example, Re ABC Coupler and Engineering Co Ltd (No. 3)); and any costs incurred in the carrying on of the business for the beneficial winding up (Re Great Eastern Electric Co Ltd.)
(2) The claims of secured creditors under a fixed charge. This is because s.175(2)(b) states that preferential debts have priority over debenture-holders of floating charges, but does not mention fixed charges.
(3) Preferential debts. Section 175(1) ranks preferential debts "in priority to all other debts", but then goes on in subsection (2) to explain that they "rank equally among themselves after the expenses of the winding-up ..."
(4) The claims of secured creditors who are holders of floating charges. Section 175(2)(b) ranks preferential debts above such claims.
(5) Unsecured and other claims. Unsecured creditors rank equally, and their debts abate proportionately under the pari passu rule (s.107) if there are insufficient funds left to make payments in full. Pre-liquidation supplies of gas, electricity, water and telecommunications which remain unpaid fall under other claims. Note that continued supply of these utilities to the company in liquidation cannot be made conditional upon the payment of outstanding charges (s.233(2)(b)) because of the application of the pari passu rule. No creditor may be preferred ahead of others. However, the supplier may make it a condition of continued supply that the liquidator makes a personal guarantee of payment of the outstanding charges (s.233(2)(a)).
(6) Interest on debt. Section 189 provides that interest is payable on any debt proved in the winding up from the time of going into liquidation. Interest is payable from any surplus remaining after the payment of debts proved in the winding up "before being applied for any other purpose". The pari passu rule applies to interest, all of which ranks equally whether or not the debts on which they are payable rank equally. The rate of interest is that payable on judgment debts unless the debt carried interest at a higher rate, in which case it is that higher rate (s.189(4) of the IA).
(7) The members of the company. Section 107 provides that after the satisfaction of the company's liabilities, and unless the articles of association provide otherwise, the company's property is to be distributed among the members according to their rights and interests in the company.
Proof of debts in a liquidation
In a liquidation, only the debts which are provable and which are proved, are paid. By virtue of s.153 of the IA, the court may fix a time within which creditors must prove their debts or claims. Those not proving in time may be excluded. Therefore, together with other creditors, employees must seek to recover their debts by submitting a proof of debt (and in a court receivership, by putting in a claim for payment). The Insolvency Rules 1986 require a creditor of a company in a compulsory liquidation to submit a claim for recovery of its debt in writing to the liquidator. In a voluntary winding up there is no such requirement, unless the liquidator requests it.
A debt includes a liability, and is broadly defined as one "to which the company is subject at the date on which it goes into liquidation", or one "to which the company may become subject after that date by reason of any obligation incurred before that date". It includes interest (rule 13.12).
A debt must be proved on a written document made for such purposes called a "proof" (rule 4.73). It is the duty of the liquidator to send out forms for proving debts to "every creditor of the company who is known to him, or is identified in the company's statement of affairs". The forms are usually sent out with the first of the notices required to be sent out to creditors, such as the notice informing them of the liquidator's appointment, or the notice informing creditors of a creditors' meeting (rule 4.74).
In a proof of debt, a creditor must state its name and address; the total amount of the claim as at the date of liquidation; whether or not the amount includes interest or VAT; whether the whole or part of the debt is preferential; how and when the debt was incurred; details of any security held, the date given and the value which the creditor places on it; and, if the proof is signed by someone other than the creditor, the name, address and authority of the person signing it (rule 4.75(1)).
The creditor must also provide details of any supporting documents. In investigating these claims, the liquidator may call for additional verifying evidence, including an affidavit. Creditors will normally bear their own costs of proving debts, whereas the liquidators' costs will be treated as an expense of the liquidation (rule 4.78).
The rules of set-off apply to the proof of debts. Debts owed by a creditor to the insolvent company must be set off against the debts owed to the creditor by the company, so that only the balance can be proved for (rule 4.90).
Case list
ABC Coupler and Engineering Co Ltd (No 3), Re [1970] 1 All ER 650
Air Ecosse Ltd v Civil Aviation Authority [1987] SLT 751
Biggerstaff v Rowatt's Wharf Ltd [1896] 2 Ch 93
Carr v British International Helicopters Ltd (in administration) [1994] IRLR 212
English Joint Stock Bank, Re (1867) 3 Eq 341
Ferranti International plc, Re and Leyland DAF Ltd, Re 26.7.94 High Court
Fowler v Commercial Timber Company Ltd [1930] 2 KB 1
Fox Brothers (Clothes) Ltd v Bryant [1978] IRLR 485
General Rolling Stock Company, Re (1866) LR 1 Eq 346
Great Eastern Electric Co Ltd, Re [1941] 1 All ER 409
Griffiths v Secretary of State for Social Services [1974] QB 468
Mack Trucks (Britain) Ltd, Re [1967] 1 WLR 780
Midland Counties District Bank Ltd v Attwood [1905] 1 Ch 357
Moss Steamship Co Ltd v Whinney [1912] AC 254
MSF and others v Parkfield Castings (a division of Parkfield Group plc (in liquidation)) 14.4.92 Case No.22180/90
Nicoll v Cutts [1985] BCLC 322
Northland Fisheries Ltd v Scott [1975] 56 DLR (3d) 319
Oriental Bank Corporation, Re 1886 32 ChD 366
Powdrill and another v Watson and another [1994] IRLR 295
R McGaffin Ltd, Re [1938] NZLR 764
Reid v Explosives Co Ltd (1887) 19 QBD 265
Secretary of State for Employment v Stone 15.2.94 EAT 239/93
Specialised Mouldings Ltd, Re 13.2.87 ChD
Stanfield v Gibson [1925] WN 11
Insolvency and employees' rights 1: the main points to note
