Court of Appeal guidance as to adjudication by insolvent companies

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A Court of Appeal decision last week has broadly upheld previous TCC guidance as to the ability of companies in liquidation or those subject to CVAs to commence and enforce adjudication proceedings against their creditors. Although theoretically possible, adjudication proceedings commenced by companies in liquidation are now liable to be restrained by a court injunction. Adjudications by companies subject to a CVA are more likely to be appropriate and, depending on the circumstances, may be enforced without a stay of execution.

Insolvency set-off: a recap

Under the Insolvency (England and Wales) Rules 2016 (the “Insolvency Rules”), a mandatory set-off takes effect automatically upon a company’s entry into liquidation. The set-off applies where there have been mutual dealings between the company and a creditor. The effect of the rule is to set off those dealings so that only the balance is provable in the liquidation.

The rule is an exception to the pari passu principle (i.e. equal treatment) as the set-off provides the creditor with a full recovery of part of its claim. Without the exception, the creditor would be obliged to make full payment of any amounts owed to the company, whilst only being able to prove in the liquidation for its own claims. If the dividend from the liquidation is small, the creditor could well be required to pay more into the liquidation than it would receive in return despite the fact that its claims against the company exceed the company’s claims against it.

Bresco Electrical Services Limited (in liq) v Michael J Lonsdale (Electrical) Limited

In August 2014 Lonsdale entered into a sub-contract for the provision of electrical installation works by Bresco. Bresco ceased work in December 2014, with each party alleging wrongful termination against the other. Bresco entered into liquidation in March 2015. Lonsdale subsequently claimed for the costs of completing the works. In response, Bresco maintained Lonsdale had wrongfully terminated the sub-contract and was liable to pay damages to Bresco.

In June 2018, Bresco issued a notice of adjudication seeking a number of decisions in relation to its dispute with Lonsdale. Lonsdale objected to the adjudicator’s jurisdiction on the basis that the financial relationship between the parties was now governed by the set-off provisions of the Insolvency Rules. Part 8 proceedings were commenced for an injunction restraining the adjudication proceedings.

The TCC agreed with Lonsdale and restrained the continuation of the adjudication. The court provided a detailed analysis of the relevant authorities in relation to set-off and its relationship to adjudication arising from a construction contract. In summary, the court held that an adjudicator has no jurisdiction to deal with the contractual claim because that claim ceased to exist at the point of liquidation and was replaced by the net balance claim under the Insolvency Rules.

Court of Appeal

The Court of Appeal disagreed with the TCC that mandatory set-off under the Insolvency Rules deprived the adjudicator of jurisdiction. The claims and cross-claims between Bresco and Lonsdale continued to exist and could theoretically be referred to adjudication.

The court noted, however, that there was a basic incompatibility between adjudication and the Insolvency Rules. This was reflected in previous cases which have held that the court will not, save in exceptional circumstances, enforce adjudication decisions in favour of companies in liquidation where the responding party has a cross-claim. To do so would force the responding party to pay the amount of the adjudication decision, while being left to prove in the liquidation for its cross claim and receive only a partial recovery together with other unsecured creditors. In such circumstances the responding party would be deprived of the benefit it was intended to have through the mandatory set-off under the Insolvency Rules.

Accordingly, even though the adjudicator may technically have had the necessary jurisdiction, the adjudication would not lead to a meaningful or enforceable result. Lonsdale were entitled to an injunction and it was not sufficient for Bresco to claim that the adjudicator’s decision would be useful to the liquidator:

“… the court will grant such an injunction if the court concludes that the nascent adjudication is a futile exercise. This is an important power in the context of adjudication. Adjudication is a quick process which can require a responding party to spend a good deal of money in a short space of time, to defend itself from claims which may prove to be utterly hopeless, yet with no prospect of recovering those costs (because adjudication is cost-neutral). It is therefore important that, whatever the theoretical jurisdiction position may be, a responding party has the right to try and put a stop to the adjudication process at an early stage.”

Do the same rules apply to CVA’s?

The Court of Appeal also dealt with a related appeal concerning adjudication proceedings commenced by a company subject to a Company Voluntary Arrangement or “CVA”. A CVA is an alternative insolvency process to liquidation whereby an insolvent company proposes an arrangement for the payment of its debts. Importantly it is one where the corporate entity will survive the insolvency procedure. The CVA must be approved by 75% of the company’s unsecured creditors (by value) whereupon it will bind the remaining unsecured creditors. The aim of a CVA is to allow the company to trade out of its difficulties, rather than to wind it up.

The case before the court concerned contractor, Primus, who had received an adjudication decision finding that its employer, Cannon, was in repudiatory breach of a contract for the design and construction of a hotel. Some 8 months later, Primus entered into a CVA and subsequently referred to adjudication its claim for damages caused by Cannon’s repudiatory breach, receiving a decision in its favour. Primus then commenced proceedings to enforce this decision. The CVA included the same right of set-off as provided by the Insolvency Rules. Cannon resisted enforcement on the same principles noted above applicable to companies in liquidation.

The court considered Primus’ position to be very different. Not only was the CVA designed to allow Primus to trade out of its difficulties but it was clear that if the CVA was allowed to run its proposed course, Primus was likely to avoid liquidation altogether. More generally, the court noted that the use of adjudication by companies subject to a CVA was more likely to be appropriate:

“A CVA is, or can be, conceptually different. It is designed to try and allow the company to trade its way out of trouble. In those circumstances, the quick and cost-neutral mechanism of adjudication may be an extremely useful tool to permit the CVA to work. In those circumstances, courts should be wary of reaching any conclusions which prevent the company from endeavouring to use adjudication to trade out of its difficulties. On one view, that is what adjudication is there for: to provide a quick and cheap method of improving cashflow.”

Primus was therefore entitled to summary judgement against Cannon in respect of the adjudication decision. Cannon had also sought a stay of execution of any judgment on the basis of Primus’ financial position, but following established principles this was also rejected on the basis that Cannon’s repudiation was to blame for Primus' financial difficulties.

Conclusions and implications

This decision will have wide-reaching implications for insolvent companies in the construction industry and for their creditors. The Court of Appeal has confirmed that the position of a company in liquidation can be distinguished from a company under a CVA and in the former case, whilst a adjudicator will not lack jurisdiction altogether, a responding party is likely to be granted an injunction to restrain any adjudication issued by the company in liquidation save only in the rare case where the responding party does not have a genuine cross-claim. The case does not deal with the situation where it is the creditor that seeks to bring adjudication proceedings against the insolvent party, where different considerations apply.

The court’s comments in relation to CVAs provide welcome confirmation that the advantages of adjudication need not be lost to those companies (and their creditors) proposing to enter into a CVA. Careful attention should be paid to the circumstances and drafting of any CVA to ensure that adjudication remains available to the company. The court's comments in this regard may also carry across to other forms of insolvency process which seek to allow a company to avoid liquidation and trade out of its difficulties.

References: Bresco Electrical Services Ltd v Michael J Lonsdale (Electrical) Ltd [2019] EWCA Civ 27