Johnson Machine and Tool Co Ltd & Anor, Re

These cases both raise the issue of whether it is appropriate to order that the pre-appointment costs of an insolvency practitioner in the case of a “pre-pack” administration be treated as an administration expense. In each case a company controlled by or connected with the existing directors and owners was to purchase the existing business and assets from the administrator immediately following his appointment. In each case, I made an administration order but declined to allow the pre-appointment costs to be treated as an administration expense. I now give my reasons for declining to make that costs order.

The legitimacy of pre-packs and the jurisdiction to make an order allowing pre-appointment costs are not in doubt: see re Kayley Vending Ltd [2009] BCC 578. The jurisdiction, as that case demonstrates, is a discretionary one, founded not on any right of the applicant to treat the pre-appointment costs as his costs of the application, but on the discretionary power of the Court under para 13 of Schedule B1 of the Insolvency Act 1986 to make “any other order which the court thinks appropriate”.

In the case of an insolvency practitioner giving advice to a company prior to the commencement of an insolvency process, the liability to pay his fees (unless he is acting “on spec”) will, subject to anything else that may be agreed in any given case, be the company’s. If there is no advance payment, that leaves the insolvency practitioner at risk of having nothing but a claim as unsecured creditor in the ensuing insolvency process. Insolvency practitioners are able to protect themselves either by insisting on payment in advance, or by contracting personally with or taking a guarantee from the directors or others. If they do neither of those things, they are at risk, but the rewards of the ensuing appointment that often occurs are in many cases more than adequate to justify that risk. Those rewards are however less certain in the case of a pre-pack, involving an immediate pre-arranged sale of the business and assets, as the real work is most often done pre-appointment. That highlights the need for insolvency practitioners to take steps to protect themselves, if they feel in need of protection.

In Re SE Services Ltd (9^th August 2006) HHJ Norris QC (as he then was) drew a distinction between an administration that was plainly for the benefit of creditors and one where the balance of advantage appeared to lie heavily with the management. In the former but not the latter case, it would be appropriate to allow the pre-appointment costs. In that case, he was considering (as I am here) the situation in which the particular administration purpose was obtaining for creditors a better result than would ensue in a liquidation. It is thus clear that crossing that threshold (which, as is well known, is a relatively modest one) does not without more justify the treatment of pre-appointment costs as an administration expense.

There are many cases in which it is not clear one way or the other where the balance of advantage as between creditors and purchasing directors lies. In the present cases, there was evidence before the Court demonstrating compliance with SIP 16 (the details and significance of which are lucidly explained by Judge Cooke in the Kayley Vending case) and I was satisfied that the proposed administration and pre-pack would be reasonably likely to result in a somewhat better result for creditors as a whole than would be the case in a winding-up, though the outlook was still bleak for unsecured creditors, who would receive a modest return on a best case scenario in each case. The return would nevertheless be better than in a liquidation, not least because of the elimination of employee claims, as employees would continue to be engaged in the ongoing business which was being sold. However, in applying the test advanced by Judge Norris, a different comparison is called for. What the court is called upon to compare is whether the advantage to the purchasing directors in retaining a business shorn of debt is clearly outweighed by the advantage derived by creditors from the pre-pack. Where the directors (or a company which they control or have a substantial connection with) are the purchasers, it is rarely possible to establish clearly that the balance of advantage is in the creditors’ favour. As the onus is in my judgment on those seeking to treat pre-appointment costs as administration expenses to justify the appropriateness of that course, I did not consider it right to add what would appear to many creditors to be insult to the injury already suffered by them by subjecting them to the burden of such costs.

Mr Eyre in the Johnson Machine andToolcase pointed out that one of the directors was also a substantial creditor in the sum of £325,000 and would therefore share in the pain caused by the company’s failure. However, that failure had occurred and, to the extent that the result of the administration would be better for creditors, the pain (though still considerable) would be reduced. The director was understandably not offering to waive his debt. That factor therefore seemed to me to have no weight in favour of a pre-appointment costs order.

Mr Burden in the Empire Surfacingcase argued that the continued assistance to be given to the administrator (in the collection of book debts) and the likely savings to creditors as a result meant that the balance was not wholly in favour of the management but was also significantly weighted towards both the secured and unsecured creditors. I agree that the balance may not have been wholly in favour of the management but Mr Burden failed to persuade me that the balance was sufficiently, and clearly, in favour of the creditors so as to justify the proposed costs order. The court should be slow also to be seen to bargain with the existing management for assistance which may do no more than reflect management’s duty.

I have one other consideration in mind. Most administrations are out-of-court appointments. I enquired of Mr Burden in the Empire Surfacingcase what happened to pre-appointment costs in the case of an out-of-court appointment and was told that their payment is often approved as part of the administrator’s proposals under para 49(1) of Schedule B1. If that is correct, the approach seems misconceived, as the proposals to be considered under that paragraph are “for achieving the purpose of the administration”. This has nothing to do with pre-appointment costs. Whilst the basis of the administrator’s remuneration forms part of the proposals, remuneration may only be fixed as a percentage of the value of the property with which he has to deal (which may or may not be sufficient to cover the pre-appointment costs) or by reference to time properly spent in attending to “the matters arising in the administration”: rule 2.106 of the Insolvency Rules 1986. Pre-appointment costs do not reflect time spent on any matter arising in the administration, but on matters arising pre-administration. Nor do I see any basis for treating such costs as an administration expense under rule 2.67(1) of the Insolvency Rules 1986, which sets out a complete code as to the priorities in an administration. It does not seem to me, therefore, that it lies within the power of the creditors to approve any payment to the administrators in respect of pre-appointment costs which would not otherwise count as an administration expense.

Given, therefore, the difficulties that I perceive in ever treating pre-appointment costs as an administration expense in an out-of-court appointment, it would be wrong to allow such costs just because (as in the present cases) there happened to be administration applications to the court in the context of pending petitions for winding-up.

This observation highlights one other point. In the SE Services case, the order that Judge Norris was asked to make (as recorded in Kayley Vending) related to “considering and completing form 2.2B”. In cases such as the present, there are also costs associated with the preparation by the insolvency practitioner of a witness statement complying with the guidance given by Judge Cooke in the Kayley Vending case. Even where it is appropriate to make a costs order in respect of this pre-appointment activity, a distinction may, and often will, need to be made between the costs associated with advising the directors as to the appropriate way of dealing with the insolvency and the subsequent costs of the proposed administrator in considering and preparing the form 2.2B and any necessary witness statement, following the advice that administration is the appropriate route. It may be in any given case that the appropriate course is not that administration is the appropriate route, but that the company should go into liquidation, or enter into a voluntary arrangement (as had previously occurred in the Empire Surfacing case, though the arrangement failed), or even continue to trade out of its difficulties. In those cases, the same costs of obtaining advice as to the appropriate course of action would have been incurred, and the burden of costs would have followed whatever arrangement the insolvency practitioner made with his appointors. Where the decision is made to seek an administration order, the subsequent costs may in an appropriate case properly be treated as an administration expense, but the prior costs burden of seeking insolvency advice should in cases such as the present ordinarily lie where they fall.

It follows that the scope of a costs order in a case such as the present (when appropriately to be made) should in my judgment ordinarily be to deal, and deal only, with those additional costs that the bringing of the administration application occasions, and not advice given before any decision to seek administration has been made, or the pre-administration costs of considering and arranging the pre-pack. If the costs occasioned by insolvency advice would have been incurred in any event, even if no decision to go down the administration route had been made, it will rarely (if ever) be appropriate to order those costs to be paid as an administration expense. The justification for ordering such costs to be treated as an administration expense is that it is unfair that the applicants should bear those costs which are in truth costs occasioned for the benefit of creditors generally.

It follows also from this that there should ordinarily be evidence confirming that the applicant (rather than the company itself) is personally liable for the costs, and as to the amount of and justification for the relevant costs, bearing in mind the distinctions I have drawn in the previous paragraph. The court should be in a position to assess the costs summarily in most cases.

In addition, it will commonly be the case in cases such as the present that the largest element of costs incurred by potential administrators will be referable to the negotiation of the terms of the pre-pack sale, ascertaining what assets are to be sold, arranging any valuation advice and considering whether to market the business or go for a pre-pack. These are not really costs of preparing the Form 2.2B or witness statement; they produce the factual situation reported on by those documents. Ordinarily, therefore, they would not fall properly to be treated as an administration expense.

The evidence in the present cases did not in terms identify who (if anyone) was liable for the pre-appointment costs (the company or its directors) though it was implicit in the applications for costs (and I was told) that the directors were liable. Nor was there a breakdown of the costs into their constituent elements. Had I been minded in principle to make the costs orders sought, I would have required elucidation on these points. As it happens, the point did not arise, as I was not persuaded that it was appropriate to make the requested orders at all.