Trustees in bankruptcy are routinely required to investigate pre-bankruptcy transactions which result in unfair treatment of creditors with a view to restoring the position to what it would have been had that transaction not taken place.

The most common of these transactions are preferences, where the debtor pays a creditor ahead of other creditors to ensure that they do not lose out in a subsequent bankruptcy: the preferred creditor.

The preference regime has always operated on a ‘no fault’ basis which means that the preferred creditor need not be at any fault but simply subject to a statutory insolvency regime which seeks fairness and equality amongst all creditors. The essential quality which makes a payment to a creditor a recoverable preference, is a desire on the part of the debtor to ensure that creditor does not lose out in bankruptcy. The preferred creditor may not be aware of the debtor’s precarious financial position or that the debtor has the requisite desire. The preferred creditor is an innocent party to a transaction which can be reversed following the debtor’s bankruptcy, leaving the preferred creditor as an unsecured creditor.

Indeed in the same way as creditors lose money when they extend credit to a debtor who is then subject to bankruptcy proceedings, the preferred creditor may subsequently be subject to the same loss in the event that the trustee seeks to recover a sum representing that preference payment from the innocent – but preferred - creditor.

The most common features in such preference claims are that (i) the preferred creditor is innocent insofar as they did not know of the debtor’s financial difficulty or that they were being preferred over other creditors and (ii) repaying sums to a trustee will cause hardship to the preferred creditor. On the latter point, no longer having the funds for repayment to the trustee – the so called ‘change of position’ defence – is not available to a preferred creditor.

It is vitally important that trustees in bankruptcy have certainty when they are incurring the cost and risk of litigation which seeks to give effect to these restorative provisions which were until Wilson reasonably clear in terms of setting out what is required of the trustee to obtain such an order, and reasonably clear to a preferred creditor when they should pay that money back without the need for expensive and lengthy court proceedings. 

The closing words of the judge that ‘there is no danger of this decision opening the flood gates to wash away the importance of s340 of the Act to the statutory scheme and policy of equal distribution’ somewhat recognises the adverse impact of the judgment on the statutory regime.

The crux of the decision was that whilst the step-daughter of the bankrupt had received £47,675.51 as a preference prior to bankruptcy (all required ingredients had been established to the satisfaction of the judge) the step-daughter pleaded ‘change of position’ in her evidence at trial, in that she had used the money to repay funds she owed her father and was unable to get it back. Whilst the judge acknowledged that her ‘change of position’ could not amount to a defence (as it may do with other types of claim) nevertheless it was central to the exercise by the judge of his discretion not to make any order on the trustee’s application. This was despite the fact that the judge accepted that the step-daughter had equity in her solely owned property of £225,000. 

The judge considered that the impact on the step-daughter (and her children) in requiring repayment to the trustee took this case ‘out of the norm’ to justify what should be an extremely rare discretion not to make any order despite a preference payment having been established. 

Many practitioners in the profession will take a different view as to whether this was ‘out of the norm’.

The judgment was compounded by a finding that:

‘In my judgment notwithstanding the purpose of s340 of the Act and the importance of the statutory scheme and policy of equal distribution of assets which are or should otherwise be part of bankruptcy estate [sic], the right-thinking person representing the current view of society would not consider it right to exercise legal rights resulting from a preference in this case. Not when the result will be to achieve the sale of the family home of a mother without any other significant assets when she received the Payment as a commercial debt payment without knowledge ...’. 

The judge was referring to the established principle of ex parte James which requires all officeholders to act reasonably notwithstanding their strict legal rights.

This judgment will almost certainly affect the appetite of trustees to take the risk of litigation to recover payments from preferred creditors. Preferred creditors who would otherwise be required to repay such funds to the bankruptcy estate will no doubt use this uncertainty to frustrate trustees’ attempts to recover such payments. 

This case can just as easily be applied to preferred creditors in the context of corporate insolvency such as administration and liquidation.

The good news is that the trustee is appealing this decision, and so watch this space.