McLean & Anor v Trustees of the Bankruptcy Estate of Dent & Ors

This application by the joint administrators of Dent Company (a partnership) (“the Partnership”) affords the opportunity to consider the application of the equitable doctrines of marshalling and subrogation in relation to a fixed charge over a dog.

The members of the Partnership were Thomas Hugh Dent, Thomas Gordon Dent, and Christina Heather Dent. There was no partnership agreement. There were two limbs to the Partnership business: the Partnership operated a haulage business (which produced about 90% of its revenue) and also a conventional farming business. Some of the members of the Partnership were also shareholders in and directors of Dent Limited (“the Company”) which was one of the largest outdoor pig producers in the UK. Just under 20% of the income of the Partnership was derived from providing haulage services to the Company.

The working capital of the Company was provided by Barclays Bank PLC (“the Bank”) upon the security of an “all-monies” debenture containing fixed and floating charges over all assets of the Company. The Bank also took third party charges over two farms at Penrith (“the Penrith Farms”) which belonged to the members of the Partnership individually and which were used for the purpose of conducting the Partnership business but did not form part of the assets of the Partnership.

In early 2007 the Partnership and the Company suffered cash flow pressure. In particular the Partnership was in danger of being unable to obtain fuel supplies with which to conduct the haulage business of the Partnership (thereby also prejudicing the business of the Company). On 11 May 2007 Lady Morrison (who was the daughter of Thomas Gordon Dent and Christina Heather Dent and the brother of Thomas Hugh Dent) entered into a loan agreement with the members of the Partnership recording that she had lent £300,000 in April 2007 and was now advancing a further £150,000 (so making a total of £450,000) (“the May 2007 Loan Agreement”). Lady Morrison did not at this point take any security for her advances: but the May 2007 Loan Agreement contemplated that documents might be entered into with the consent of the Bank which granted such security as a result of a contemplated deed of priority in a form to be agreed between Lady Morrison, the Bank and the members of the Partnership in form and substance satisfactory to her.

This injection of loan capital was insufficient to sustain the businesses and a further round of funding occurred on 11 June 2007.

First, Lady Morrison loaned £350,000 to the Company upon the terms of an agreement I will call “the Company Loan Agreement”. The commercial object of this was to inject capital into the Company in order to encourage the Bank to advance further funds to the Partnership. The Company Loan Agreement was secured by third party security in the form of personal guarantees from the members of the Partnership and by legal mortgages over their Penrith Farms. Because Barclays also had a security interest in the Penrith Farms there was to be a deed of priority.

Second, the Partnership entered into an “all-monies” agricultural fixed and floating charge in favour of the Bank (“the Agricultural Charge”) under the provisions of the Agricultural Credits Act 1928 (“the 1928 Act”).

By clause 2 of the Agricultural Charge the members of the Partnership created a fixed charge over the “Farming Stock” and the “Agricultural Assets” belonging to the Partnership that were at that date at the Penrith Farms (and elsewhere). The Agricultural Charge also created a floating charge on all other “Farming Stock” and “Agricultural Assets”. The “Farming Stock” was described in schedule 2 to the Agricultural Charge and listed livestock (551 head of cattle and one dog), vehicles, tractors and implements. The other “Agricultural Assets” were not defined (but the expression is given context by the terms of the 1928 Act). The terms of the Agricultural Charge permitted the Bank to take immediate possession of any of the secured assets (and converted the floating charge into a fixed charge) if a bankruptcy order was made against any of the Partners.

Third, the Bank and Lady Morrison entered into an agreement relating to the Partnership dealing with the question of priority (“the Priorities Agreement”). This related both to the advances made by Lady Morrison governed by the May 2007 Loan Agreement (which in the Priorities Agreement was called “the Partnership Loan Agreement”) and the advance to the Company governed by the Company Loan Agreement.

Clause 2 of the Priorities Agreement was in these terms:

“(2.1)

The Bank in consideration of the Lender making the Partnership Loan available to the Partnership and agreeing to make the Company Loan available to the Company…agrees that:

(2.1.1)

If the Bank takes any action to enforce…any mortgage guarantee or other security which it holds from the Partners or in relation to the business or assets of the Partnership…the Bank will take all steps reasonably requested by the Lender in connection with the Charge and enforcement of the Charge, subject to clause 2.3 below:

(2.1.2)

All amounts paid to the Bank pursuant to clause 2.1.1 shall be held by the Bank on trust:

(a)

FIRST in payment or satisfaction of the reasonably and properly incurred expenses of the Bank in taking Enforcement Action directly in relation to the Charge:

(b)

SECONDLY in payment or satisfaction of the liabilities of the Partnership to the Lender under the Partnership Loan Agreement PROVIDED THAT the amount to be paid to the Lender pursuant to this clause…shall be limited to the Partnership Loan;

(c)

THIRDLY in payment or satisfaction of the liabilities of the Partnership to the Bank: and

(d)

FOURTHLY as for the balance (if any) in or towards payment of the sums due but not paid under the Partnership Loan Agreement…”

Even this was not sufficient. In February 2008 in support of further funding the Company entered into a cross-guarantee and debenture: and the members of the Partnership granted further third party legal charges over the Penrith Farms. In March 2009 the members of the Partnership granted further personal guarantees to the Bank in respect of the debts of the Company to the value of some £8 million. In 2013 there were further loans by Lady Morrison to the Partners personally. But all this was to no avail.

In December 2013 the Company entered administration. On 21 January 2014 a bankruptcy petition was presented against Thomas Hugh Dent (but not by Barclays). On 18 February 2014 the members of the Partnership appointed the present applicants as joint administrators of the Partnership. In April 2014 bankruptcy orders were made against each member of the Partnership. Finally, also in April (on 11 and 28 April 2014) the Bank appointed Law of Property Act Receivers in respect of the Penrith Farms.

The Bank began a realisation of the securities. On 30 October 2014 its LPA Receivers completed the sale of the Penrith Farms (which belonged to the Partners individually and were not partnership assets). The Penrith Farms stood as security (a) for money owed by the Partnership and by the Company to the Bank; (b) for money owed by the Partnership and by the Company to Lady Morrison; (c) for money owed by the Partners to Lady Morrison. The proceeds of sale were sufficient to discharge all of the Bank’s lending (£4.166 million) and the majority of Lady Morrison’s lending. Lady Morrison was entitled to appropriate those payments to her best advantage as between sums due from the Partners personally, from the Company and from the Partnership, and as a result she is still owed £192,000 by the Partnership. Because the Bank was repaid out of the Penrith Farms it did not have to rely on the Agricultural Charge over the Farming Stock and the Agricultural Assets of the Partnership. So these were sold by the Joint Administrators and raised £187,634.

The Joint Administrators have also realised Partnership assets falling outside the scope of the Agricultural Charge (both from the farming business and the haulage business): and this has yielded £905,601. The expenses of the administration total some £276,502. So there are funds available to unsecured creditors (who total £1.277 million excluding Lady Morrison). The Joint Administrators wish to make a distribution. However, it is unclear whether the proceeds of the assets within the scope of the Agricultural Charge should be made available to Lady Morrison (as a result of marshalling) or to the trustees in bankruptcy of the Partners (as a result of subrogation) or to the unsecured creditors generally (including Lady Morrison in respect of any shortfall on her loans). The Joint Administrators now seek directions (under paragraph 63 of Schedule B1 to the Insolvency Act 1986). Whilst Lady Morrison and the trustees in bankruptcy are parties to the application for directions the unsecured creditors as a class are not. None of the three major unsecured creditors showed any enthusiasm for being joined as a representative. So the Joint Administrators (whilst remaining neutral) have undertaken the burden of advancing such arguments as can properly be advanced by the unsecured creditors.

The first issue for decision is whether the doctrine of marshalling applies in favour of Lady Morrison as regards the Agricultural Charge. I hold that it does.

The Bank had the right to resort to two securities in support of its lending to the Partnership: first the Agricultural Charge over Partnership assets, and secondly third party legal charges over the Penrith Farms. Lady Morrison had a right to resort to one security in support of her lending to the Partnership (and to the Company and to the Partners personally), namely the Penrith Farms. Because the Bank elected to look to the Penrith Farms for repayment of the Partnership indebtedness, the benefit of the Agricultural Charge went unused, and the proceeds of sale from the Penrith Farms that would otherwise have been available to Lady Morrison were taken by the Bank.

The principle of marshalling is an equitable principle. In its classic form it applies where two creditors are owed debts by the same debtor, one of whom can enforce his claim against more than one security but the other can resort to only one. In those circumstances the principle gives the second creditor a right in equity to require that the first creditor be treated as having satisfied himself as far as possible out of the security to which the latter has no claim. The law was so summarised by Lewison LJ in Highbury Pension Fund Management v Zirfin [2014] Ch 359 at paragraph [1]. As Lewison LJ went on to point out in paragraph [15]:-

“One consequence of the application of the principle is that if the first mortgagee with more than one security satisfies his debt out of the property over which the second mortgagee has his only security, the second mortgagee is entitled to stand pro tanto in the place of the first mortgagee in relation to the property over which the second mortgagee has no legal security… It is in this sense that we can say that the second mortgagee is in effect subrogated to the rights of the first mortgagee.”

He continued in paragraph 18 to explain that

“.. the way in which the original principle in its classic form is framed fastens on the conduct and conscience of the doubly secured creditor. It is the fact that he has the choice which fund to resort to and the power at law to disappoint the singly secured creditor which brings the equity into play.”

Thus far the principle of marshalling would appear to apply to the circumstances existing as between the Bank and Lady Morrison. The Bank chose to look to the Penrith Farms exclusively, although it could have looked to the Farming Stock and the Agricultural Assets mortgaged by the Agricultural Charge as well. Had the Bank looked to the Agricultural Charge it would have received £187,000, and reduced its claim against the Penrith Farms by that amount, so reducing the shortfall suffered by Lady Morrison when she in turn looked to the Penrith Farms for repayment of the secured debts.

It is in the interests of the trustees in bankruptcy of the Partners to argue that Lady Morrison is not entitled to appropriate the proceeds of the assets subject to the Agricultural Charge. If she did so she would obtain 100p in the £1 for the amount of her debt. The trustees want to argue that the doctrine of marshalling does not apply so that Lady Morrison remains an unsecured creditor. This would mean (a) that the proceeds of the Agricultural Charge would be added to the pot for distribution amongst the unsecured creditors claiming in the administration of the Partnership, and (b) that Lady Morrison would receive only a dividend. To achieve that end they argue that the nature of an agricultural charge is such that it cannot be the subject of the doctrine of marshalling.

The long title to the 1928 Act says that it was passed

“to secure, by means of the formation of a company and the assistance thereof out of public funds, the making of loans for agricultural purposes on favourable terms, and to facilitate the borrowing of money on the security of farming stock and other assets, and for purposes connected therewith.”

Apart from the foundation of the Agricultural Mortgage Corporation (with most of the major quoted banks as subscribing shareholders) the object of the Act was to facilitate the grant of credit to tenant farmers by making it simple to charge farming stock and other agricultural assets.

Section 5 of the 1928 Act provided that it would be lawful for a “farmer” (who might be an owner or tenant) to create an agricultural charge in favour of “a bank” over farming stock and other agricultural assets as security for loans. The definition of “a bank” changed over the years: but by 2001 it extended to authorised deposit takers: see s.5(7) of the 1928 Act as consequently amended following the Financial Services and Markets Act 2000.

Section 6 of the 1928 Act conferred on a bank to which a fixed charge had been granted by a farmer the right to take possession of the security and (where possession of any property had been taken) the right after an interval of five clear days (or such a lesser time as might be allowed by the charge) to sell the property by auction, or by private treaty for a lump sum or for payment by instalments. The farmer was obliged under s.6(2), whenever he sold or otherwise received any money in respect of agricultural assets comprised in the charge, to pay the proceeds or money so received to the bank (except as the bank otherwise allowed). Similarly, in the case of a floating charge, the farmer had to pay over the proceeds or money to the bank, save that he did not have to comply with that requirement if and so far as the amount so received was expended by the farmer in the purchase of farming stock which on purchase became subject to the charge.

The trustees accepted that there was nothing in the 1928 Act which forbade the application of the doctrine of marshalling. But they argued

I do not accept either argument. First, the 1928 Act authorises the creation of securities (in particular over livestock and growing crops and agricultural assets such as manures and machinery and compensation rights): but it does not say that securities so created are not assignable by “banks” to persons or entities that are not “banks”. I see no reason to read into the Act a limitation which Parliament could have imposed but did not impose. In fact, in the instant case the Agricultural Charge provides in clause 12 that the term “the Bank” includes “persons deriving title under the Bank”. If the security is assignable why cannot it be marshalled?

Second, the principle of marshalling fastens on the conduct and conscience of the doubly-secured creditor, and the equity it creates arises between the two creditors (not between the creditor and the debtor). That has two aspects.

Third, the principle of marshalling is not identical with the doctrine of subrogation. The process which produces the required result of Lady Morrison being treated as if the Bank had claimed against the assets secured by the Agricultural Charge is described by saying that Lady Morrison is “in effect” subrogated to the Bank’s rights. As Lewison LJ explained, the principle is that the second mortgagee “is entitled to stand pro tanto in the place of the first mortgagee”: and “it is in this sense that we say that the second mortgagee is in effect subrogated to the rights of the first mortgagee” (emphasis added). The imagery must not distort the reality.

Fourth, there is of course no question in the instant case of an unscrupulous lender wrongfully enforcing the Agricultural Charge. No enforcement is involved, and no policy questions relating to enforcement are engaged. The secured assets have been sold (some before and some after the completion of the sale of the Penrith Farms) by the Joint Administrators and whilst the Agricultural Charge remained in force; and under section 6(2) and 7(1)(b) of the 1928 Act and under the terms of the Agricultural Charge itself the Partners were obliged to pay the proceeds to the Bank. The theoretical risk postulated by the trustees does not in fact exist in this case. Lady Morrison is not enforcing and is not seeking to enforce the Agricultural Charge: she is simply saying that because of an equity that exists between herself and the Bank she is entitled to claim the surplus proceeds receivable by the Bank from the sales effected by the Joint Administrators of the Partnership. It is (as Mr Doyle put it) an accounting exercise.

For these reasons I hold that Lady Morrison may claim the proceeds of the assets subject to the Agricultural Charge by the application of the principle of marshalling, and is entitled to prove as an unsecured creditor in the administration for any shortfall.

The next issue for determination is whether the trustees in bankruptcy of the Partners are entitled to claim in the administration of the Partnership by operation of the doctrine of subrogation. The trustees in bankruptcy say that the Penrith Farms (which belonged to the Partners personally and ought to have been available to satisfy the claims of their personal unsecured creditors) have in fact been used to satisfy the claims of creditors of the Partnership (whose claims ought to have been satisfied out of the assets of the Partnership). So the creditors of the Partnership have been unjustly enriched at the expense of the creditors of the Partners: and that must be corrected.

As Mr Sellers explained in argument, the trustees in bankruptcy do not rely on any principle of marshalling. They rely only on subrogation. They do not claim any contract-based subrogation: they do not say they were ever intended to be treated as secured in any way or otherwise to step into the shoes of the Bank. What they claim is “restitutionary subrogation by operation of law”. I hold that they are not so entitled.

The starting point of the argument of the trustees in bankruptcy is section 39 of the Partnership Act 1890. This provides:-

“On the dissolution of a partnership every partner is entitled, as against the other partners in the firm, and all persons claiming through them in respect of their interests as partners, to have the property of the partnership applied in payment of the debts and liabilities of the firm, and to have the surplus assets after such payment applied in payment of what may be due to the partners respectively after deducting what may be due from them as partners to the firm”.

The trustees in bankruptcy say that this means that the partners also have the right as against non-partners (e.g. creditors of the partnership) to have the property of the partnership applied in payment of the debts and liabilities of the firm in exoneration of their own individual assets.

Reliance was placed on Re Ritson [1898] 1 Ch 667 and [1899] 1 Ch 128 for the proposition that joint debts are payable out of joint assets if sufficient even though secured on the separate property of one partner. But that case is of no assistance here where joint assets are not sufficient to pay joint debts. Both Romer J at first instance (at p.670) and Lindley MR on appeal (at p.131) were careful to say that if the joint assets were insufficient (as here) “a very different question would have arisen” and “it would have been quite another thing”.

The trustees in bankruptcy then say that if the individual assets of partners are in fact applied in payment of the debts and liabilities of the firm this unjustly enriches creditors of the partnership at the expense of creditors of the individual partners. If the Bank had looked to partnership assets (the £905,601 yielded by assets falling outside the Agricultural Charge) then there would have been more in the individual estates of the Partners.

The next step in the argument is that this unjust enrichment founds the claim to subrogation. Reliance is placed on Menelaou v Bank of Cyprus UK Ltd [2016] AC 176 at paragraph [18] for the propositions (a) that subrogation is a restitutionary remedy which reverses unjust enrichment, and (b) that to establish unjust enrichment four questions must be asked. Has the defendant been enriched? Was the enrichment at the claimant’s expense? Was the enrichment unjust? Are there any defences available to the defendant? The trustees in bankruptcy say that the Partnership creditors have been enriched. The Bank has taken the proceeds of sale of the Penrith Farms: that has discharged claims against the Partnership out of assets which do not belong to the Partnership. They say that that enrichment is at the expense of the unsecured creditors of the individual Partners. They say that the enrichment is unjust because partnership claims should be satisfied out of partnership assets. They say that the remedy for this unjust enrichment is that the unsecured creditors of the Partners should be subrogated to the Bank’s rights under the personal covenant for repayment of its debt and that they should be entitled to prove in the administration of the Partnership as unsecured creditors in the sum of £905,601 (the amount of the Partnership assets to which the Bank could have looked for repayment under the personal covenant instead of taking the proceeds of the third party security provided by the Partners individually by charges over the Penrith Farms).

I do not accept this analysis. First, I consider that care is needed when comparing the position of unsecured creditors in the administration of the Partnership with that of unsecured creditors in the bankruptcy of the Partners. The trustees in bankruptcy are claiming in the right of the Partners themselves i.e. they are asserting claims of the Partners which are vested in the trustees in bankruptcy by virtue of the bankruptcy of the Partner. They are accordingly asserting that the Partners themselves may compete with the creditors of the insolvent Partnership in the distribution of its assets. But it is a long established principle that a partner in a bankrupt firm may not prove in competition with the creditors of the firm. As Lindley & Banks on Partnership 19^th edition records at paragraph 27 – 112, the view of Lord Lindley was:-

“If… a partner is a creditor as of the firm, neither he nor his separate creditors (for they are in no better position than himself) can compete with the joint creditors against the joint estate…..”

Yet this is precisely the position for which the trustees in bankruptcy argue by their use of the doctrine of subrogation.

Second, even if there were “enrichment” I do not accept that such was at the expense of the Partners or was “unjust”.

As a matter of detail I disagree with the starting point of the argument of the trustees in bankruptcy. S.39 of the Partnership Act 1890 sets out the rules for distributing realisations in a solvent partnership and deals with entitlement to the surplus. The Partnership is insolvent. The rules for distributing realisations are now to be found in the Insolvent Partnerships Order 1994 as amended. On this application the trustees in bankruptcy rightly accept (either as a matter of construction of the 1994 Order or because it would be a result properly achieved under s.303(2A) of the Insolvency Act 1986) that the new priority rules laid down in the 1994 Order apply. Under those new priority rules (a) the joint debts of the partnership are payable out of its joint estate: and (b) where that joint estate is insufficient the deficiency is a claim in the estate of each of the partners ranking equally with that partner’s separate creditors. In applying these priority rules one cannot look at individual debts (such as that due to the Bank). Taking an overall view, here the joint estate of the Partnership is insufficient to meet its joint debts, but the deficiency is smaller than it otherwise would have been because the Bank has resorted to its security to satisfy its claim and has so reduced the call on the joint assets. That reduction in the deficiency otherwise claimable against the Partners individually is what the trustees in bankruptcy term “enrichment”.

On the assumption that the unsecured creditors of the Partnership have been “enriched” by the fact that the Bank has had resort to its third party security rather than to the assets of the Partnership, I do not agree that that enrichment was at the expense of the Partners or is properly described as “unjust”. The Partners covenanted to pay the Bank and secured their promise by charges over the Penrith Farms. The Bank called on that security when the Partners did not perform their promise to pay. There is no injustice to the Partners in that. The Partners simply cannot say: “You satisfied your claim against us out of some of our assets rather than others: so we want to be subrogated to your claim against ourselves under our personal covenant to pay”.

Nor can there be any injustice to persons claiming through the Partners, such as creditors. Such creditors can be in no better a position than the Partners themselves, whose entire assets were always available to satisfy creditors of the Partnership. In any event, such creditors dealt with people who granted security to the Bank over the Penrith Farms, in consequence of which the Penrith Farms might be unavailable to satisfy other claims. But that is simply a consequence of the Partners having granted security. The exercise by the Bank of the rights so granted cannot constitute unjust enrichment at the expense of the Partners or those claiming through them.

I therefore hold that the trustees in bankruptcy of the Partners are not entitled to prove in the administration of the Partnership for a sum equal to the realisation of Partnership assets falling outside the scope of the Agricultural Charge.

I express my appreciation of the quality of the argument.