Supreme Court rules on insolvency adjudication debate

A Supreme Court judgment issued yesterday has overturned a Court of Appeal decision heavily limiting the ability of insolvency practitioners to commence and enforce adjudication proceedings against their creditors. The court’s decision allows much greater flexibility in the use of adjudication for the administration of construction insolvencies, however some uncertainty remains over the basis on which decisions obtained in such adjudications will be permitted to be enforced against creditors. The decision is likely to lead to an increase in adjudications commenced by insolvent companies, particularly in the wake of the Covid-19 pandemic, and may also spur growth in the secondary market for the funding and/or assignment of adjudicable claims.

Adjudication by insolvent companies: what is the fuss about?

Under the Insolvency (England and Wales) Rules 2016 (the “Insolvency Rules”), a mandatory set-off takes effect 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 net-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 rule, the creditor would be obliged to make full payment of any amounts owed to the company, whilst only being able 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.

Insolvency set-off takes place automatically upon liquidation and overrides all other set-offs or contract terms to the contrary. Parties cannot contract out of insolvency set-off or waive its operation.

The interaction between the Insolvency Rules and construction adjudication was considered recently by the TCC and Court of Appeal in Bresco v Lonsdale (see our Law-Nows on these decisions here and here). In summary, the TCC initially held that mandatory set-off under the Insolvency Rules deprived an adjudicator of jurisdiction to determine disputes under a construction contract involving the company in liquidation. That was because the rights under the construction contract were said to be replaced by the set-off mechanism under the Insolvency Rules.

The Court of Appeal overruled this finding, considering that adjudications could still be validly commenced by companies in liquidation, but held that there was a basic incompatibility between adjudication and the Insolvency Rules. This was reflected in previous cases which had 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 set-off under the Insolvency Rules. Accordingly, the Court of Appeal found that, save for exceptional circumstances, an adjudication by a company in liquidation would be liable to be stopped by the court as an exercise in futility where the other party has a cross-claim (i.e. because any adjudication decision would not be enforceable). The court rejected the suggestion that such an adjudication , even if not enforceable, might nevertheless be useful in allowing a liquidator to value and resolve outstanding claims.

The Court of Appeal’s decision was subsequently elaborated by the TCC in Meadowside Building Developments Ltd v 12-18 Hill Street Management Company Ltd. There the court found that as an exceptional case, adjudication by an insolvent company would be allowed where it would determine the final net position between the parties under the relevant contract, subject to the giving of security as to (i) the repayment of any amount awarded by the adjudicator and successfully enforced if subsequently challenged in court or arbitration proceedings; (ii) security for any adverse costs order in respect of an unsuccessful application to enforce the adjudication decision; and (iii) security for any subsequent court or arbitration proceedings brought by the responding party seeking to overturn the adjudication decision. The satisfaction of these conditions would mean that enforcement of any decision could be granted and the decision would not be futile.

The Supreme Court

In a decision published yesterday, the Supreme Court has overturned the Court of Appeal’s decision. Although agreeing that the Insolvency Rules did not deprive an adjudicator of jurisdiction, it disagreed with the Court of Appeal’s approach as to futility. In the Supreme Court’s view, the Court of Appeal had focused too heavily on the ability of a liquidator (or other insolvency practitioner) to enforce an adjudication decision and had failed to appreciate the broader dispute resolution role fulfilled by adjudication:

“it is simply wrong to suggest that the only purpose of construction adjudication is to enable a party to obtain summary enforcement of a right to interim payment for the protection of its cash flow, although that is one important purpose. In the context of construction disputes adjudication has, as was always intended, become a mainstream method of ADR, leading to the speedy, cost effective and final resolution of most of the many disputes that are referred to adjudication. Dispute resolution is therefore an end in its own right, even where summary enforcement may be inappropriate or for some reason unavailable.”

The right to adjudicate mandated by the Housing Grants, Construction and Regeneration Act 1996 (as amended) (the “Construction Act”) was a valuable tool available for the administration of an insolvency process. There was no requirement for a liquidator to resolve a disputed account by a single set of proceedings. Rather, a liquidator might, “untangle a complex web of disputed issues arising from mutual dealings between the company and a third party by picking some as suitable for adjudication, others for arbitration and others for disposal by an application to the court for directions, or by ordinary action.”

Whether or not an adjudication decision obtained by a liquidator would be capable of enforcement was a separate question which ought to be considered on a case by case basis as and when enforcement proceedings were commenced. Where cross-claims exist, enforcement might nonetheless be granted where the cross-claim is shown to be of no substance or it has been determined by the adjudicator as part of the same dispute. The court acknowledged, however, that enforcement may still risk depriving the responding party of the benefit of the insolvency set-off as any claim to overturn the adjudication decision and for the return of money paid would rank alongside other unsecured creditors in the liquidation. In such circumstances, “the court will be astute to refuse summary judgment” unless the arrangements can be made to protect the responding party’s interest such as the provision of security in relation to the adjudication award as ordered in the Meadowside case.

Aside from the adjudication award itself, the Supreme Court appeared to be less concerned about the irrecoverable costs which a responding party may incur in seeking to defend enforcement proceedings or in overturning an adjudication decision which has been successfully enforced. As noted above, in Meadowside the TCC had required security to be provided for these costs as a condition of permitting an adjudication to proceed. In the Supreme Court’s view it was inherent in the adjudication regime that a party may incur irrecoverable costs in seeking to overturn an adjudication decision, even if successful: “that cannot of itself be a reason for preventing by injunction the statutory right to adjudication.”

Multiple disputes?

As part of its case in relation to jurisdiction, Bresco argued that the rule which required only a single dispute to be referred to adjudication would prevent an adjudicator from determining the net balance arising as a result of the mandatory set-off under the Insolvency Rules. For example, the responding party may have a cross-claim arising under a different contract or on an entirely separate subject matter such as personal injury. Such claims would ordinarily give rise to separate disputes which could only be adjudicated together by consent.

In considering this issue, the Supreme Court considered arguments for a narrow interpretation of the Construction Act right for a party to refer a dispute “arising under” a construction contract. In an arbitration context, those words would ordinarily be given a wide interpretation to cover any dispute arising out of the relationship governed by the contract. Although not deciding the issue, the court expressed doubt about a narrow interpretation.

The court noted that set-off effected by the Insolvency Rules would allow unrelated cross-claims to more easily form part of a single dispute for the purpose of adjudication. This is because an adjudicator’s jurisdiction will extend to any defences to the relief sought in the notice of adjudication. The effect of the Insolvency Rules means that even entirely separate cross-claims are able to be set-off and provide a defence to a claim by the liquidator. This in turn enables them to form part of a single dispute before an adjudicator.

Conclusions and implications

This decision will have wide ranging consequences for the administration of construction insolvencies providing insolvency practitioners with a much greater ability to resolve disputed claims through adjudication and realise greater value for creditors. With the industry anticipating an increase in insolvencies in the wake of the Covid-19 pandemic, the clarity brought by this decision could not be better timed.

The court’s comments as to what constitutes a single dispute ought to provide significant scope for insolvency practitioners to pursue a resolution of the total net balance due to or from a creditor through a single adjudication. This in turn is likely to maximise the ability to enforce a decision if favourable, subject to an agreement to ringfence or provide security in respect of amounts payable. The court’s comments on this issue are also likely to be of relevance to other areas of adjudication law, where “multiple dispute” issues arise.

Although the decision makes clear that insolvency practitioners may pursue adjudications in respect of any aspect of a disputed account, the position as regards enforcement is less certain. In particular, it remains to be seen whether the stringent security for costs requirements imposed in the Meadowside case will continue to apply.

The adjudication proceedings in both the Bresco and Meadowside cases were pursued by a third party who had entered into an arrangement with the liquidator of the companies in question, such as an assignment of the claim or an agreement to fund the prosecution of the claim in return for a share of the proceeds. The Supreme Court’s decision is likely to lead to growth in this secondary market as liquidators seek to hedge against the risk of unfavourable adjudication decisions.

References:

Michael J Lonsdale (Electrical) Ltd v Bresco Electrical Services Ltd [2018] EWHC 2043 (TCC).

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

Meadowside Building Developments Ltd v 12-18 Hill Street Management Company Ltd [2019] EWHC 2651 (TCC).

Bresco Electrical Services Ltd v Michael J Lonsdale (Electrical) Ltd [2020] UKSC 25.