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On 27 July, amidst the traditional flurry of judgments handed down at the end of the Trinity term, a 7 strong Supreme Court (Lords Phillips, Hope, Walker, Hale, Mance, Collins and Clarke) gave its ruling in the Belmont Park case, concerning the applicability of the principle of the common law on insolvency known as the ”anti-deprivation rule”.

The Belmont case, previewed on this blog here, arises out of the insolvency of Lehman Brothers, which caused competing claims to be made against collateral held under under a complex structured finance programme.  The commercial question for the Supreme Court was to determine who had priority to this collateral: LBSF (the apppellant Lehman Brothers financing vehicle), or the respondent noteholders (i.e the investors in the scheme, who were mostly Australian local authorities and pension funds).  This, in turn, depended on the legal question of whether the anti-deprivation rule applied, as LBSF argued that it should, to render the contractual terms granting the noteholders their priority unenforceable as a matter of public policy, because they had the effect of depriving creditors of assets which otherwise would have been available for distribution as part of the insolvent estate.

Both morally and legally this argument may sound at first blush like something of an uphill battle.  Lehmans had set this programme up, and had agreed that if any of the Lehmans entities involved went bust, the priority to the collateral would “flip” from LBSF back to the noteholders, who would then be entitled to recoup on their investments.  However, when Lehmans went under in late 2008 (triggering global financial meltdown), rather than honouring that commitment, the liquidators of the Lehmans estate sought to tear up the contract, and argue that all along the “flip” clauses in question were unenforceable thanks to the anti-deprivation rule.

The anti-deprivation rule was born in eighteenth century common law to prevent bankrupts from getting up to mischief and transferring out their assets to defraud their creditors and defeat the bankruptcy laws (the central principle of which is that assets of a bankrupt person or insolvent company are ring fenced, and must be kept available to creditors in accordance with the pari passu principle).  The most frequently cited summary of the rule comes from Ex p Jay; Re Harrison [1880] 14 Ch D 19:

“There cannot be a valid contract that a man’s property shall remain his until bankruptcy, and on the happening of that event shall go over to someone else and be taken away from his creditors“.

The principle in itself is uncontroversial, but there has been much confusion caused by its application in the modern world.  The “high water mark” of the anti-deprivation rule came in 1975, when the House of Lords ruled in British Eagle [1975] 1 WLR 758 that an airline clearing house arrangement was an attempt to contract out of the pari passu principle, and so was void against the liquidator of British Eagle (a failed British airline).  Since then, the anti-deprivation rule has been a useful weapon for insolvency practitioners, looking for a way to avoid contracts which inconveniently prevent angry creditors from accessing piles of loot, though a number of cases since the introduction of the Insolvency Act 1986 have struggled to define whether the rule is still needed any more, and if so exactly when does it apply.

It was against this context that LBSF issued its claim.  As Lord Collins pithily put it, “what is said, in effect, is that the parties have unlawfully extracted an asset belonging to LBSF, namely its first charge on the collateral, and passed it to the Noteholders“.  LBSF’s arguments were rejected by Sir Andrew Morritt VC at first instance; and then by a unanimous Court of Appeal (Lord Neuberger; Longmore and Patten LJJ), when the case was co-listed with Butters & Ors v BBC Worldwide, in which this firm were successful on behalf of BBC Worldwide (see here for a summary of the facts in Butters).  Their arguments were again rejected by the Supreme Court, who found that the “flip” provisions did not offend the anti-deprivation rule, and so did provide the noteholders with a valid and enforceable priority claim to the collateral (cue much rejoicing Down Under).

However, there are a number of interesting points emerging from the judgment:

1.  The basis of the Court of Appeal’s judgment was that Parliament had provided an all ecompassing regime to protect creditors, by way of IA86: and in this context, the purpose of the common law could only be to reinforce and back up the statutory rules.  Consequently, the anti-deprivation rule appeared to have very little relevance to modern commercial arrangements, if any at all (causing some commentators to suggest that the with careful drafting, parties would now be able to freely contract out of the insolvency regime).   However, the Supreme Court disagreed, and held that it did still have a life and relevance of its own.  Having considered 200 years of caselaw, Lord Collins concluded:

“the anti-deprivation rule is too well-established to be discarded despite the detailed provisions set out in modern insolvency legislation, all of which must be taken to have been enacted against the background of the rule“.

2.  So when should it apply?  Lord Collins gave a pragmatic and sensible answer: when there is a deliberate intention to evade the insolvency laws.  A commercially sensible transaction which is entered into in good faith should not be unwound because of the anti-deprivation rule (see paragraphs 78 to 79 of the UKSC’s judgment).  This gives clarity to practitioners attempting to draft commercial agreements (for example, joint ventures) that will hold water even if a counterparty goes bust, and indeed gives welcome support to the fundamental English law principle of freedom of contract.  It is also consistent with the trend adopted by the House of Lords and now the Supreme Court over the past 10 years (for example, in the Persimmon Homes and Sigma Finance cases) towards taking a purposive interpretation of contracts in order to uphold the parties’ intentions as far as possible.

3.  Lord Mance, though agreeing with Lord Collins’ conclusion, gave more detailed guidance in relation to what exactly would constitute deprivation (see paragraphs 151 to 165 in particular).  A 3 stage test should be applied (see paragraph 161): (i) is there any property interest capable of being deprived?  (For example, a licence which terminates on insolvency is a contingent interest only: it does not confer any actual property right that can be deprived. (ii) does the contractual provision in question deprive the creditors of any such property on the occurrence of insolvency?  (In the present case, Lord Mance considered that on a true reading of the contractual provisions, LBSF was not deprived of the property but simply prevented from acquiring it in the first place) (iii) if deprivation has occurred, did this amount to an illegitimate evasion of the anti-deprivation principle (i.e. the deliberate evasion test described above).

It is submitted that this 3 stage test is the best approach for commercial parties to follow when considering whether the rule is engaged or not.  Whilst good faith and good intentions will clearly be important, to avoid any issues with this rule occurring in Court, it is fundamentally important to consider at the outset what property there is, and thus what deprivation may potentially occur.

4.  Finally, in parallel US litigation, the US Bankruptcy Court for the Southern District of New York has reached the opposite conclusion to the three English courts, finding (on summary judgment) that the “flip” provisions were in breach of the US Bankruptcy Code.  For the time being, neither set of Courts has been asked to decide which system of law prevails on the facts of the LBSF programme (which is very “mid Atlantic” in structure).  Further litigation will surely follow.