When Can an IVA defeat a Mortgage? By David Schmitz Barrister, Ten Old Square.
In order to avoid unpleasant surprises on either side, an IVA should clearly state whether or not the secured creditors will continue to be able to rely upon their securities.
KEY POINTS ● Debtors who have successfully completed an IVA will often face unexpected claims from secured creditors to enforce securities which, though worth next to nothing at the commencement of the IVA, have since become valuable owing to rises in property prices. ● If the creditor has done no more than prove for a debt he will be unlikely to have put his security at risk, even if he declared it to be of no or of little value when the IVA began. ● The IVA proposal is interpreted in much the same way as a contract is interpreted, and the question of whether an IVA has precluded a secured creditor from enforcing the security will often be one of contractual interpretation. ● The terms of certain IVAs may be inconsistent with the continuation of the security, which may therefore be defeated in part or even in full. Other terms, in particular terms which permit the creditor to revalue its security, will often support the creditor’s contention that its security is unaffected by the IVA. ● Where the secured creditor has voted in favour of an IVA, instead of merely participating in it, he may have put his security at risk, because he may thereby have made an election which he could not later go back on without unfairly prejudicing others and because if the IVA is in its terms inconsistent with the continuation of the security, he may be deemed to have consented to its ceasing to have effect. ● Even if the security has not been permanently lost, it may not be possible for the creditor to act on it unless or until it obtains the leave of the court to do so or to revalue its security. This could affect the ability of the creditor to obtain possession of the property or sell it in the meantime.
The aftermath of an IVA can produce surprises. A debtor enters into an IVA. His house is in negative equity. One of the secured creditors values his security at nil (or at substantially less than the value of the debt) and accordingly participates in the IVA as an unsecured creditor. The IVA concludes and the house in the meantime has begun to increase in value. The secured creditor, sometimes years later, seeks to exercise his security and relies upon the principle that an IVA cannot affect or modify his right to enforce his security, except with his concurrence – Insolvency Act 1986 (“IA 1986”) section 258 (4). The debtor, however, believes that because he has
fulfilled all of his obligations the secured creditor ought not to profit from an unexpected windfall. Who wins? Surprisingly, the answer is often unclear because the authorities have not fully explored the consequences of the creditor (1) voting for an IVA upon the footing that his debt is unsecured or secured only to a nominal extent; and (2) voting for an IVA, which contains terms that are inconsistent with the continuation of the security. THE INSOLVENCY RULES 1986
The relevance of a creditor voting for an IVA arises out of Rule 5.23 (formerly Rule 5.18) of the Insolvency Rules 1986 (“IR 1986”) which provides that where the claim or part of it is secured, the votes of the creditor will be left out of account for the purpose of determining whether the requisite majority of the creditors has passed the resolution for the IVA. 1 If the creditor, notwithstanding his security, not only votes on the IVA but votes in favour of it, this will sometimes support an argument by the debtor to the effect that the creditor ought not to be able to act inconsistently. Moreover, if the IVA in its terms is inconsistent with the continuation of the security, the creditor will be deemed to have given the consent to the defeat of his rights, without which consent the IVA is precluded by S 258 (4) from having this effect. Other Rules which relate to bankruptcy are also relevant to IVAs. This is so, notwithstanding that statute does not make them directly applicable. The reasons why they are nonetheless relevant are that they are frequently incorporated explicitly in IVA proposals, they will often be deemed to be included implicitly, 2 and the Court will in any event lean in favour of treating IVAs similarly to bankruptcies – see Whitehead v Household Mortgage Corporation [2003] 1 All ER 319, 329. The Rules which relate to the position of the secured creditor are: Rule 6.115 which provides that a secured creditor may, with the agreement of the trustee or the leave of the court, at any time alter the value which he has put upon his security in his proof of debt. Significantly, however, Rule 6.115(2) provides that if the creditor has voted in respect of the unsecured balance of his debt he may revalue his security only with the leave of the court. Rule 6.116 which provides that if a secured creditor omits to disclose his security in his proof of debts, he shall surrender his security for the general benefit of creditors, unless the court, on application by him, relieves him from the effect of that Rule on the ground that the omission was inadvertent or the result of honest mistake. Rule 6.119 which provides that if a creditor who has valued his security subsequently realises it the net amount realised shall be substituted for the value previously put on it by the creditor and that amount shall be treated in all respects as an amended
1
If the creditor claims to be secured in part only, it is the part which is said to be secured, and only that part, which is left out of account. In Calor Gas v Piercy [1994] BCC 69.
2
See Khan v Mortgage Express [2000] BPIR 433,where it was held that the Rules mentioned in this article were incorporated by the following wording which appeared in standard conditions, “'In accepting claims under the IVA the nominee and supervisor shall apply those provisions of the Act relating to admission for payment of proofs of debt by the trustee in bankruptcy …”
valuation made by him. The revaluation upon realisation is automatic, and does not, as in other cases, require the consent of the trustee or of the Court. THE CASE LAW
There are a number of cases which establish that merely by participating in and accepting payment of a dividend in an IVA, a secured creditor will not have given up his security. However, where the secured creditor has, in addition, voted on the IVA and voted in favour of it, the position is not so clear. Moreover, where the terms of the IVA are themselves inconsistent with the continuance of the security, the creditor may be deemed to have abandoned it. Johnson v Davies [1999] Ch 117 holds that the documents governing an IVA are to be interpreted in the same way as contractual documents. This is because the debtor makes a proposal (which serves as an offer), the specified majority of the unsecured creditors accept it and any dissenters are deemed “by a statutory hypothesis” to have accepted it (page 138). An IVA is therefore a contract and interpreted as such. In Khan v Mortgage Express [2000] BPIR 433, the IVA incorporated the IR 1986 provisions (see above) which permitted the creditor to revalue its security. The creditor placed a modest value on its security and proved in the bankruptcy for the expected shortfall, which was substantial. It does not appear that the creditor voted on whether to permit the IVA to take place, nor indeed on any other matter. When the value of the secured property later rose, it was held that even though the creditor had proved as an unsecured creditor in the IVA and been paid a dividend on the basis of a substantial shortfall, and even though the IVA had concluded, the creditor was not prevented thereafter from realising the security and taking the entire debt from the proceeds. In particular, the creditor was not to be treated as having given up the shortfall in exchange for the dividend which it had received in respect of it. In Whitehead v Household Mortgage Corporation (see above) the chargers, a married couple, had granted a charge over their house. The husband proposed an IVA. The chargee’s debt was stated to be unsecured to the extent of £25,000 odd, this being less than the 25% of the total indebtedness that would have entitled the chargee to block the IVA. The chargee voted against the IVA, but the IVA was approved notwithstanding its opposition. During the course of the IVA, the chargee proved for the unsecured portion of its debt and accepted dividends. After the conclusion of the IVA, a subsequent chargee obtained possession of the house, sold it, and accounted to the chargee for the whole of the debt which was owed to the chargee, not merely the part which had been treated as secured. The chargors claimed that the chargee should retain only the secured part and argued (as in Khan v Mortgage Express) that the portion of the debt which had been treated as unsecured should be regarded as having been satisfied in the IVA. Unlike Khan v Mortgage Express, however, Whitehead concerned an IVA which did not incorporate the IR provisions that enable secured creditors to revalue their securities. In construing the IVA documents, the Court of Appeal noted that the IVA proposal:
● listed the house as an asset and provided “In the event of there being a shortfall to secured creditors, such shortfall will constitute a further unsecured liability in the arrangement.” ● also provided, “It is not proposed that anything in this proposal should affect the rights of any secured creditor to enforce its security.” The Court accordingly refused to imply a contractual term that a secured creditor who accepted a dividend for part of his debt, could not thereafter rely upon his security for that part. To imply such a term would have been to ignore both the express provision that the security should be unaffected and the fact that the “shortfall” could only have concerned sums which remained owing after the security had been realised (page 330). The inference to be drawn from this second point is that if the indebtedness provable in the IVA is capable of being increased or decreased in the light of the proceeds of sale of the security, it must follow that the initial value given to the security by the creditor cannot have been intended to be final. The Court then went on to hold that it should be slow to infer any contractual term in an IVA which differed from the rules governing bankruptcy, whether or not those rules were actually incorporated in the IVA. Rule 6.115, as we have seen, permits a creditor to revalue his security. If a creditor can revalue his security, it therefore does not follow that merely by proving in a bankruptcy as an unsecured creditor and accepting dividends, the creditor waives his security for all time (page 329). As with bankruptcy, so with IVAs unless the contract/IVA proposal states otherwise. Whitehead, however, was a case where the creditor had merely proved in the IVA. It was not a case where the chargor could also rely upon the fact that the creditor had voted on the IVA as an unsecured creditor. Moreover, there was nothing in the IVA which was inconsistent, in any other respect, with the continuance of the security In Rey v FNCB Ltd. [2006] EWHC 1386 (Ch) the creditor had valued its security at nil and had then voted in favour of the IVA. Clause 22 of the IVA proposal, moreover, provided that: “On approval of this proposal ... the Creditors shall not be entitled to commence or continue any proceedings execution or other legal process in respect of the Debts and shall not be entitled to receive any payment in respect of the Debts save for such dividends as shall be payable by the Supervisor under the terms of the Voluntary Arrangement.”
The proposal, however, expressly incorporated Rule 6.115 (the rule permitting revaluation). The first instance Judge refused to grant a declaration that a charge had ceased to have effect in these circumstances. In refusing permission to appeal, Lightman J held that while Clause 22 precluded proceedings on the debtor’s personal obligations to pay his debts, it did not prevent the enforcement of securities. He went on to say that the express inclusion of Rule 6.115 was consistent only with Clause 22 having no effect on security. The creditor would always be able to revalue the security upwards, albeit the permission of the Court would be needed if the
creditor had voted for the IVA. No reasons were advanced in that case as to why the Court might refuse such permission. In Khan v Permayer [2001] BPIR 95, however, the chargee did lose the benefit of the charge by virtue of his conduct in connection with the chargor’s IVA. Two partners in a restaurant business entered into IVAs. The Defendant was the holder of a charge over the restaurant and was paid money, after the conclusion of the IVA, in order to obtain the release of the charge. The Claimant sued for recovery of the money as money paid under a mistake, the mistake being that the charge was enforceable whereas it had in fact been waived in the IVA. The Claimant succeeded firstly because the terms of the IVA were inconsistent with the maintenance of the security and secondly because the Defendant had voted for the IVA, thus providing that “concurrence” without which the secured creditor’s rights cannot be affected –IA 1986 section 258 (4). The features of the IVA were that it (1) made specific provision for the treatment of debts which were described as secured debts; (2) made no mention of the Defendant continuing to be a secured creditor; (3) provided for the Defendant to participate as an unsecured creditor; and above all (4) provided that the monies that were to be paid during the IVA (ie to the unsecured creditors) should come from the profits of the restaurant. This last feature was inconsistent with the survival of the security, because if the security had survived it would have been possible for the Defendant to enforce it even during the IVA, and because if he were to have done that, he would have destroyed the source of the very income which was to service the IVA that he had agreed to. Webb v MacDonald QC and Dakers Green Brett [2010] BPIR 503 was a lawyers’ negligence action in which the complaint was that the lawyers ought not to have advised that an argument was likely to fail, the argument being that a secured creditor had lost the benefit of its security by virtue of its participation in an IVA. The relevant facts were that rules permitting revaluation were not incorporated in the IVA, but that firstly the IVA expressly stated that the security would continue and secondly the correspondence relating to the creditor’s participation in the IVA expressly limited the effect of that participation to the IVA itself and excluded its relevance for all other purposes. It was held that the creditor was entitled to rely upon its security to the full extent of the debt and that in line with Whitehead (above) “in the absence of an express term in an IVA, the court should be slow to imply a term that, by participating in and accepting payment of a dividend, a secured creditor had agreed to treat part of his debt as unsecured.” Again, there is no suggestion in this case that the creditor voted for the IVA, as opposed merely to participating in it. DOES KHAN V PERMAYER SUPPORT A BROADER PRINCIPLE: THAT IF A SECURED CREDITOR VOTES FOR AN IVA IN RESPECT OF PART OF HIS DEBT, THEREBY TREATING IT AS UNSECURED, HE SURRENDERS HIS SECURITY OVER THAT PART AS A MATTER OF LAW?
In Voluntary Arrangements (2007) (at page 120) (page 120) HHJ Edward Bailey states that if a secured creditor votes for an IVA in respect of the secured part of his debt he impliedly, if not expressly, surrenders his rights as a secured creditor if he also
accepts dividends. Khan v Permayer is cited in support. In Personal Insolvency (2008) (para 6.188), however, the same author elaborates the point by stating that the question, surrender or no, is a matter of contract, and that the “Court will require clear language before interpreting the terms of the arrangement as interfering with a secured creditor’s rights.” But is clear language always essential? While, obviously, there can be no surrender of a security if the IVA provides that the security will continue – here Webb is particularly in point – it does not follow from this principle or from the authorities that the security will always continue save where continuation is clearly excluded. A secured creditor who chooses to vote on the IVA proposal (which he is only permitted to do to the extent that he declares his debt to be unsecured) has arguably made an election which will prevent him from acting in a way which is inconsistent with that for which he has voted. This is especially the case if the IVA proposal would have failed without his support, for then he would have bound even those IVA creditors who had not wanted it. He is to be treated in line with this principle: “[A] litigant may be shown to have acted positively in the face of the court, making an election and procuring from it an order affecting others apart from himself, in such circumstances that the court has no option but to hold him to his conduct and refuse to start again, on the basis that he has abandoned.”
Kok Hoong v Leung Chong Kweng Mines Ltd. [1964] AC 993, 1018. (The significance of the decisiveness of the creditor’s vote is noted in passing in Whitehead, page 329.) If this is right, it follows that a secured creditor who votes for an IVA may later, if his vote has been decisive, be able to rely upon his security only to the extent that he has asserted its value and thereby given up some of his voting rights. If he votes as an unsecured creditor for the whole of the debt and thereby values his security at nil, he may not be able later to rely upon it at all. In other words, it is, arguably, for the secured creditor to show that the IVA has preserved his security (for example by permitting its revaluation) rather than for the debtor to show that the IVA has done away with it. If no provision for revaluation is included, then the creditor should not be able to retract its election unless it can persuade the Court to act in accordance with Rule 6.115 notwithstanding its absence, on the lines discussed in Whitehead (though query whether or not the court would imply the Rule into the IVA as opposed merely to refusing to imply a term which was inconsistent with that Rule). It could, of course, be argued that this is wrong and that the security will always be unaffected by the IVA unless the terms of the IVA are inconsistent with its continuance. Earlier legislation provided that a creditor who voted as an unsecured creditor to the full extent of his debt, would be deemed to have surrendered his security unless the Court was satisfied that his failure to value the security had arisen from inadvertence (Bankruptcy Act 1914 Sched 1 paragraph 10).
By contrast, Rule 5.23 of the 1986 Rules contains no such express provision. (Rule 6.116 (above) does not concern the consequences of a creditor’s voting.) From this, it could be said that a change in the law was intended. It is submitted, however, that this omission in the present legislation is of little help in determining whether there has been such a significant change in the law. WHAT KINDS OF TERMS IN THE IVA WILL BE RELEVANT?
The following would help the creditor: ● a term that the secured creditor’s rights are not to be prejudiced (which would generally be decisive). ● a term referring to negative equity or to a shortfall of the security. ● a term incorporating rules 6.115 to 6.119 of the Bankruptcy Rules, or a term to similar effect permitting the creditor to revalue. See Rey (supra). Such a term would probably be overridden, however, by any term which was inconsistent with the survival of the security. ● a description, in the IVA proposal, of the property as secured. Such a description will not, however, be decisive where the creditor then describes its debt as unsecured when proving in the IVA. The debtor’s offer would not match the creditor’s acceptance. Even if revaluation is permitted, the creditor would not necessarily be free to enforce. If for example, Rule 6.115 has been included and if the secured creditor wishes to undo his election, the creditor would need to apply to the Court for permission to revalue the security if it has voted in favour of the IVA. If other persons would be prejudiced, however, the Court could refuse to allow a revaluation. Because the Court’s discretion is unfettered, there is no reason why the Court should not consider the position of the debtor if, for example, the security is his home, it was excluded from the IVA, he fulfilled his obligations under the IVA for several years and he suddenly faces an application which was brought on only by an unexpected increase in the value of the property.
The following would help the debtor: ● a term recognising that the property will be used to generate the income for servicing the IVA. ● a term securing on the property the debtor’s obligations under the IVA. (Both of these are inconsistent with the continuation of the security, because the rights of the participants in the IVA – ie the rights of the unsecured creditors – would
be destroyed if the security were to be exercised. The creditor may argue that the right to enforce the security is merely suspended until the end of the IVA, but query: for while it is commonplace for charges to be postponed in their priority, such postponement does not carry with it a suspension of the right to enforce. An arrangement for the survival of a charge and for the mere suspension of the right to enforce it is unusual and should not be lightly inferred.) â—? a term expressly excluding the property from the assets in the IVA. Though not conclusive, such a term is consistent with an intention that the debtor should keep something of the property. IF THE SECURED CREDITOR HAS VOTED FOR AN IVA AND HAS ATTACHED A LOW OR NIL VALUE TO HIS SECURITY, CAN THE DEBTOR RESIST A POSSESSION ACTION EVEN IF THE SECURITY REMAINS VALID?
The debtor could argue that under the IVA the debtor and his creditors have agreed to treat the debt as unsecured until the creditor applies successfully for leave to revalue his security under Rule 6.115 (whether this rule is incorporated expressly or applied by the Court by analogy), and that until then the Court should treat the debt, for all purposes, as unsecured or as secured only so far as the creditor abstained from voting. If the debtor is able to pay that part of the debt at a rate which the court finds acceptable under the Administration of Justice Act 1970, a possession order should, it is submitted, be refused or suspended. Against this, the creditor could argue that, as a matter of construction of the IVA, Rule 6.115 would only govern relations between the secured and unsecured creditors, and would not be relevant to an action between a secured creditor and the debtor. Yet again, the position is uncertain. However, it is submitted that the creditor should not be able to enforce the security without first obtaining permission to revalue it, because of the fundamental point that, following an election by a creditor to treat a debt or part thereof as unsecured, the creditor cannot then rely upon its security, unless absolved from its election.
HOW CAN UNCERTAINTY BE AVOIDED?
A secured creditor who wishes to reserve the right to enforce a worthless security which may later become valuable, should stipulate that the IVA will not prejudice its right to enforce the security to the full extent of the indebtedness and that the creditor is to be free to revalue it at any time with the leave of the supervisor or of the Court. If, on the other hand, the terms of the IVA are attractive enough to induce a creditor to give up the prospect of profiting from a later increase in value of the secured property, the debtor should seek to include a provision that upon the conclusion of the IVA, the debtor shall retain the property free of any claims in the IVA or from the secured creditors.
Whatever expectations the parties may have, they should regard the law as uncertain in this area and they should therefore spell out the effects on the creditors’ securities which the IVA is to have. © David Schmitz – June 2011.
This article first appeared in Corporate Rescue and Insolvency (2008) 3 CRI 76-78 and has since been updated.