Business Money – Finance and Banking for Business

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June 2006

The law setting out the duties of receivers and mortgagees to companies and their guarantors and reports on the recent case of Barclays Bank plc v Kingston and others

Lenders to small or medium sized companies will normally take security over their main assets, such as a fixed charge over its real property and a floating charge over its business, and then top this up by taking personal guarantees from its directors.

If it goes wrong, the lender will wish to extract itself and enforce all of its security with the minimum amount of hassle and expense. It can sell the charged property as mortgagee or appoint a receiver, and if there is any shortfall it can then come after the directors brandishing the guarantees.

The guarantee claim should be straightforward if the guarantee was taken correctly. Often the directors simply pay up, but if they are strapped for cash themselves (and very often they are since their fortunes may be tied to their businesses) then they might try to bog the guarantee claim down in detail in order to cut a deal with the lender.

One of the arguments most commonly deployed by guarantors to throw a spanner in the works is to claim that the charged property was sold by the lender at an undervalue (whether or not it was the case). They will argue that the lender is liable for this to everyone with an interest in the equity in the property (including guarantors) and therefore that the liability under the guarantee should be reduced.

Instead of selling as a mortgagee, the lender can instead appoint a receiver by virtue of its powers in the mortgage or debenture. This document will provide that although the receiver is chosen and appointed by the lender, he is to act as agent of the company at all times.

This is a key advantage of receivership, because it allows the lender to avoid liability for the receiver’s acts and omissions. Needless to say it does not get the receiver off the hook if he breaches his duties, but it should not prevent the lender from enforcing its rights against the rest of its security.

The problem occurs when the lender actively intervenes in the conduct of the receivership. This might happen in practice more than theory would suggest, because almost always the receiver will report to the lender on paper and at meetings, and will often look to the lender for some degree of approval for his decisions.

There is a fine line between the lender being informed (and expressing its views) and actually influencing the decision which is made by the receiver. It does not take much for the insolvent company or its guarantor to suggest that the lender is in fact directing the receiver, and therefore should be fixed with some liability for any perceived breaches of duty.

The courts must therefore weigh up the opposing factors – the need of the lenders to be able to enforce their security promptly and without undue cost, and the protection of guarantors against being short changed by lenders who take insufficient care to make sure that charged property is sold for a proper value.

So what duty is owed by the lender or the receiver to the company or the guarantor?

Until 1993 judicial authority was tending towards making life easier for the guarantors than for the lenders. The courts held that a guarantor could have a claim in negligence against a lender who sold (or allowed its receiver to sell) a property at an undervalue; see for example Cuckmere Brick Co Ltd and another v Mutual Finance Ltd [1971] 2 All ER 633 and Standard Chartered Bank Ltd v Walker and another [1982] 3 All ER 938.

Negligence claims are by their nature woolly and difficult to dispose of promptly. A duty of care in negligence might incorporate all sorts of duties: to sell quickly or not; to take steps to improve the property; in the case of floating charge security, to continue to trade the company, or some parts of the company.

That position changed with the most important case in this area of law: Downsview Nominees Ltd v First City Corp [1993] AC 295. In Downsview it was held that the mortgagee or the mortgagee’s receiver (and they are to be treated largely the same to the extent of their duties) does owe a duty to the borrower (and by extension to the guarantor), but that duty is a duty in equity, which is a more precise and confined duty than the duty of care in negligence.

This equitable duty is clear cut and restricted: the lender/receiver must act in good faith with the object of preserving and realising assets for the benefit of the lender; it must take reasonable care to sell the property for a proper price. No more and no less. If it carries out its duties in good faith, it cannot be criticised further, even if it is incompetent.

This may seem slightly harsh to the borrower or guarantor. The court did note that anyone interested in the equity of redemption, and unsatisfied with the way that the property or the receivership is being managed may buy-out the chargeholder, and therefore has little ground for complaint if he fails to do that and then raises concerns about the actions of the receiver. On the other hand, in many situations the parties with the legal ability to buy-out the chargeholder will not have sufficient money to be able to do so.

The cases after Downsview do not deviate from its principles, but they do explain that in some circumstances they may not be quite as rigid as they first appear. In Medforth v Blake [2000] Ch 86 a pig farmer was successful in finding a receiver of his business liable for failure to negotiate a bulk discount for the pig feed which he purchased. The equitable duty referred to in Downsview included a duty of due diligence as well as simply good faith.

In Silven Properties and others v The Royal Bank of Scotland and others EWCA [2003] Civ 1409 the equitable duty was explained further. The question was whether a receiver should improve the saleability of properties by obtaining planning permission and finding tenants. The court held (following an earlier line of cases including Gomba Holdings (UK) Ltd v Homan [1986] 1 W.L.R. 1301) that the receiver was entitled to give primacy to the interests of his appointor (for example with regard to the timing of a sale). However, to the extent that it does not conflict with his primary interest, he must also give some weight to the interests of the mortgagor (so that, whatever the timing of the sale, he should obtain the best price reasonably obtainable at the time he chooses).

More specifically a receiver is under a duty to expend money to maintain the value of the security, but not to improve it. He therefore need not take active steps to improve the security by obtaining planning permission or tenants.

The decision in Barclays Bank plc v Kingston and others [2006] EWHC 533 (QB) should give lenders more reason to pause for thought.

In this pre-trial hearing the court was asked to accept as a premise that the sale by the administrators of the company was at an undervalue and that they were acting at the direction of the bank (and therefore the bank was in the same position as if receivers were acting at its direction – i.e. as a mortgagee). The bank (while not agreeing that these premises were correct) asked whether it could escape liability for any undervalue sale nonetheless, and pursue the guarantors regardless. It put forward two grounds:

I should explain the second argument first. A guarantor who pays the creditor in full will have a right to stand in the creditor’s shoes (“subrogation” as it is called) to enforce his claim for indemnity against the principal debtor. This will put him in a better position to expect payment where the creditor has security on the debtor’s assets.

Counsel for the bank argued that the 1998 decision in Burgess v Auger [1998] 2 BCLC 478 showed that the source of the guarantor’s rights set out in Downsview was simply an aspect of the subrogation doctrine, and therefore should only be available to paying guarantors. The judge gave that argument short shrift. The Downsview duties were entirely independent of any right of subrogation.

Exclusion of liability The bank’s principal argument was on the exclusion clauses in the guarantee. It hoped that the clauses would either exclude in its entirety its liability for any sale at an undervalue; or at least prevent the guarantors setting-off any liability of the bank against the liability to the bank. The result of excluding set-off would be that the bank would get judgement on its claim, but that the guarantors would be able to proceed with their cross claim.

The leading case on excluding rights of set-off is The Fedora [1986] 1 Lloyds’s Rep 441. This decided that clauses excluding set-off should not normally be treated with the disdain that courts normally express for attempts to exclude liability for breach of contract.

The judge did not explicitly deal with whether the exemption clauses prevented the guarantors from setting off their cross claim against the bank’s claim. However, he said that he did “not approach the provisions of the guarantee with the hostility traditionally shown to exemption clauses. I shall seek to interpret the guarantee as a whole as a commercial document and to give it a sensible meaning”. He then went on to tear the bank’s exclusion clauses apart.

The exclusion clause which would seem to be the most appropriate went as follows: “From time to time we may:

… (e) take or deal with any security, guarantee or other legal commitment for the customer liabilities; or

(f) release, enforce or not enforce our rights under any such security, guarantee or commitment.

If we carry out any of the above acts, or do or fail to do anything else, this will not affect our rights under the guarantee, even if it would have done so if this condition did not exist.”

This might be taken to include the sale of charged property. But the judge held that it did not apply. The reference to the “above acts” does not help the bank: the complaint was not that it sold the property, but that it did so at an undervalue. Not what the bank did, but how it did it.

In the same way, the words “fail to do anything” were insufficient to exclude the cross-claim against the bank. Again, it was not that the bank failed to do anything (said the defendants), but that what it did do it did badly. The words were not clear enough to be effective.

Another clause provided that the guarantors “unconditionally guarantee that all customer liabilities will be paid or satisfied” and will “immediately have to pay the amount guaranteed when we demand payment”. This too failed to assist the bank. If the bank had sold at an undervalue, then the customer liabilities and the amount guaranteed would have been reduced accordingly.

You can understand the bank’s reluctance to be too specific. There are reputational reasons why it would not wish to say (even if this were effective) in its guarantee documents “our rights under the guarantee will remain unaffected, and we shall not be liable to you even in the event that we, negligently or otherwise, fail to take reasonable care to sell secured property for a proper price”.

Perhaps a specific clause against set-off would be appropriate, for example, “you shall make payment free from set-off, counterclaim, cross-claim or deduction of any kind”. Even then there might be grounds for dispute, as there is authority which suggests that any exclusion clause (even a set-off clause) must pass a reasonableness test or the court will refuse to give effect to it. In Bank of Scotland v Reuben Singh LTL 22/9/2005 the judge appears to accept that a clause which would be capable of excluding set-off even in the event of fraud by the claimant, or an admitted overpayment to him, should be completely struck through whether or not it is relied on for these purposes; although he did hold that the particular set-off clause in question was reasonable.

So what can the banks do? This will depend on a number of factors, including the amounts at stake and in particular the likely attitude of the guarantors. The case itself suggests that it may be better to enforce the guarantees before realising the security. This is not practical:

Even if these guidelines are stuck to, no doubt guarantors will continue to create difficulties. However, it should be easier to prevent most guarantee claims being bogged down expensively.

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