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Expenses for insolvency practitioners relating to the liquidation of a business have been identified and given the attention they deserve. But is it all good news? asks Alison Klarfeld

The issue of liquidation expenses has been in the spotlight for some time now and there have been two new developments in this area worthy of note.

The governing principle is that, where a liquidator incurs an obligation to pay a legitimate expense necessary for the winding up of the company, that expense should be payable out of the company's assets in priority to all other claims (except for sums due to fixed-charge creditors). However, certain recent decisions, which rendered liquidators personally liable for costs of unsuccessful proceedings, left office-holders reluctant to pursue potentially asset-swelling claims, which if successful would benefit the company's creditors. To remedy this problem, an amendment to the Insolvency Rules 1986 was introduced on 1 January 2003. The second interesting development is the decision in the recent case of Re Demaglass Limited and Re Demaglass Holdings Limited, which considered the extent to which a liquidator can recover their costs out of receivership assets.

Amendment to the Insolvency Rules

The problem which resulted in the recent amendment to the Insolvency Rules stemmed from the November 2000 decision in Re Floor Fourteen. In that case, the Court of Appeal held that where a liquidator unsuccessfully brought proceedings in their own name and had a costs order made against them, those costs could not be recouped out of the company's assets as an expense of the liquidation, as they did not fall into any of the categories of recoverable liquidation expenses as set out in Rule 4.218 of the Insolvency Rules 1986. Although there had been previous first instance decisions to this effect, the existence of a Court of Appeal ruling on the point made liquidators wary of pursuing potentially strong claims for fear that they might be left personally liable to fund the costs of such litigation in the event that the action was not ultimately successful. This was clearly an undesirable state of affairs.

To settle the difficulties caused by this decision, Rule 23 of The Insolvency (Amendment) (No 2) Rules 2002 was introduced with effect from 1 January 2003. It expands the heads of expenses under Rule 4.218 to include as a legitimate and recoverable expense, payable as a first priority out of the assets, costs relating to the conduct of legal proceedings which the liquidator has power to bring or defend, whether in their own name or in the name of the company. Huge sighs of relief all round, particularly from insolvency practitioners and their professional indemnity insurers.

Re Demaglass Limited and Re Demaglass Holdings Limited

While the amendment to the Insolvency Rules has provided some clarity in terms of the recovery of costs of litigation brought by liquidators, there remains some debate as to whether floating charge assets realised by administrative receivers should be made available to fund the expenses of a subsequently appointed liquidator. This was the question before the court last July in the Demaglass case. In his comprehensive judgment, Anthony Mann QC, sitting as a deputy judge in the High Court, provided some useful guidelines for insolvency practitioners.

The case involved applications in relation to each of the two Demaglass companies, both of which were in administrative receivership and liquidation. In each case, the liquidator was seeking funding out of floating charge realisations held by the administrative receivers for anticipated future expenditure to be incurred in the liquidation, including costs arising from the investigation of potential transactions at an undervalue and preferences.

In rejecting the liquidator's application, the judge's starting point was that Rule 4.218 sets out in categories (a) to (q) a complete statement of liquidation expenses recoverable out of floating charge assets. He reasoned that, as a matter of normal language, 'expenses' are sums of money which have been expended and that the language of the rules cannot be construed as referring to prospective expenditure or liabilities that have not yet arisen. On that basis, there could be no justification for releasing funds to the liquidator before any liability relating to that money had been brought into existence.

Given his decision on this point, although it was not strictly necessary for him to consider the issue, the judge went on to examine whether the costs of undervalue or preference actions could come within the ambit of Rule 4.218 and thus be treated as recoverable expenses. The judge looked at the wording of the various categories under Rule 4.218 to examine whether such expenses might be covered, and in particular whether they could properly be classified as “costs in preserving, realising or getting in any of the assets of the company”. He concluded that they could not.

Finally, the judge declined to award the liquidator his costs of bringing these unsuccessful applications on the basis that, as the expenses that he had sought to recover were not expenses for the purposes of the liquidation, neither were the costs of making the application.

The only glimmer of hope in the Demaglass decision for liquidators in a similar position is that the judge was of the view that, provided there is sufficiently detailed supporting evidence, there is no reason in principle why a liquidator could not seek declaratory relief to determine in advance whether they would be entitled to reimbursement of future expenditure as liquidation expenses if and when they are actually incurred.

The Demaglass decision clearly supports the adoption by administrative receivers of a strict line in relation to a liquidator's request for payment of expenses. However, there have been concerns as to how the decision will operate in practice, and whether the receiver will need to keep the receivership open unnecessarily while waiting for the liquidator to finish their investigations so that their costs can be assessed. The most sensible commercial approach in order to avoid the time and expense of a court hearing will be for receivers to set aside an agreed sum to be retained for liquidation expenses, the amount of which will be a matter for commercial negotiation between the receiver and the liquidator.

Finally, it will still be open for liquidators, in an appropriate case, to ask the courts for a declaration as to whether specific prospective expenses will be recoverable, providing they can show sufficiently detailed evidence in support of the application.

These recent developments are not likely to be the end of the expenses debate in the insolvency arena, and in particular we can expect to see some interesting developments in the area of administration expenses, when administrations come to the fore once the provisions of the Enterprise Act 2002 come into force later in the year.

Alison Klarfeld is a solicitor in the corporate recovery department at Berwin Leighton Paisner'