Shortly before insolvency, financially distressed companies often receive monies which appear "morally" to be due to third parties, such as customer deposits or monies due to be received by the company as agent on behalf of its principal. If the company then enters an insolvency process, can it keep the money, leaving the customer/principal with no more than the right to prove, as an unsecured creditor in the insolvency? Or should the money be protected by some form of trust in favour of the "morally entitled" recipient?

Michael Fiddy and Catherine Burton consider a recent decision of the UK Supreme Court signposting the senior judiciary's desire to dissuade innovative judges from adopting equitable relief which interferes with wellestablished property rights.

One of the joys of being a lawyer is the occasional opportunity to bask in the quality of judicial prose. Last year, Justice Anthony Kennedy was widely praised for the eloquent words he employed when delivering the majority opinion of the US Supreme Court granting a constitutional right to same-sex marriage across the United States. Equal delight can be found in the last ever judgment of the Master of the Rolls, Lord Denning in a case concerning the supply of 30 pounds of Dutch winter cabbage seed. In inimitable style, he kicked off his dissent from the majority of the Court of Appeal, with a quote from Lewis Carroll's "Through the Looking Glass":

"The time has come', the Walrus said, `to talk of many things - of ships and shoes and sealing wax - of cabbages and kings'.

Today it is not "of cabbages and kings" but of cabbages and what-nots."

"There is much to be said for the notion of a remedial constructive trust displays equity at its flexible flabby worst. I will seek to show, at least arguably, that it is unprincipled, incoherent and impractical, that it renders the law unpredictable, that it is an affront to the common law view of property rights and interests, that it involves the court usurping the role of the legislature, and, as if that were not enough, that the development of the remedial constructive trust is largely unnecessary. Apart from that, it's a pretty good concept."

It was therefore with a degree of pleasure that when researching this article, we came across the facund words of Lord Neuberger from August 2014, speaking extrajudicially at the Banking Services and Finance Law Association Conference in Queenstown on "The Remedial Constructive Trust - Fact or Fiction:"

"There is much to be said for the notion of a remedial constructive trust displays equity at its flexible flabby worst. I will seek to show, at least arguably, that it is unprincipled, incoherent and impractical, that it renders the law unpredictable, that it is an affront to the common law view of property rights and interests, that it involves the court usurping the role of the legislature, and, as if that were not enough, that the development of the remedial constructive trust is largely unnecessary. Apart from that, it's a pretty good concept."

UNDERSTANDING REMEDIAL CONSTRUCTIVE TRUSTS

What is a remedial constructive trust and why are some members of the English judiciary so opposed to it? It is not an easy concept to explain. In reality it is not a trust at all but rather, a mechanism employed by the courts when exercising their equitable jurisdiction to provide relief from wrong-doing or fraud. Remedial constructive trusts are rarely explained in isolation, but rather by comparison with institutional constructive trusts.

Institutional constructive trusts arise by operation of law, for example where an agent receives a secret commission. At no point in time is the agent entitled to receive the money. The law therefore imposes a trust so that from the moment of receipt, the agent holds the money on trust for his principal. Once satisfied on the facts of a case that the commission was improperly paid, there is no scope for judicial discretion; rules of law clearly establish that the monies are received by the agent on trust for his principal. The court's role is simply to declare that that is the case.

By comparison, remedial constructive trusts lie wholly within the realm of the court's equitable discretion. A remedial constructive trust only arises when an applicant claims compensation which fails to fall neatly into any of the accepted categories of trust or other remedy. The circumstances of the case suggest to the court that in order for justice to be done, it should retrospectively impose a trust in favour of the claimant. The extent to which it operates and prejudices the interests of third parties, therefore falls entirely within the discretion of the court.

The distinction between the two is controversial in itself: both act as remedial mechanisms and the dividing line is not always clear to see. The English courts have long been inclined to reject the concept: first because the unpredictability of their imposition conflicts with the commercial desire for certainty, and secondly because in insolvency situations, they invariably result in a departure from the pari passu principle resulting in one party's rights being promoted at the expense of others.

Despite these factors, the desire of judges to do what appears to be right and fair in the circumstances of a particular case, has resulted in the deployment of the remedial constructive trust as a device of equity, on more than one occasion.

REMEDIAL CONSTRUCTIVE TRUSTS AND INSOLVENCY

In Neste Oy v Lloyds Bank plc [1938] the court held that a payment made to the bank's customer on the same day that its directors invited the bank to appoint receivers, should not, in good conscience, have been kept by the customer. Consequently the monies paid into the bank account should not have been available for the bank to set off against the customer's debt with the bank. Mr Justice Bingham held that the absence of "good conscience" gave rise to an inference of constructive trust.

Similarly, in Re Japan Leasing Europe plc [2000] Mr Justice Nicholas Warren, sitting as a judge of the Chancery Division, similarly resorted to the concept of a remedial constructive trust to bring about what appeared to be a fair solution. Japan Leasing acted as representative vendor for the sale of aircraft, receiving payments in instalments to pass on to the vendors. One such sizeable instalment was paid a month after Japan Leasing entered insolvent administration. The judge held that the agreements in question did not give rise to an express trust in favour of the paying parties, but rather that a constructive trust should be imposed "because it would be unconscionable for the Company, as agent, to receive money as agent knowing that it could not account for it to its principal."

Decisions in this vein have attracted interest in the restructuring arena. Shortly before insolvency, financially distressed companies often receive money which appears "morally" to be due to third parties, such as customer deposits or monies due to be received by the company as agent on behalf of its principal. In Farepak Food & Gifts Limited [2006], the court accepted that a constructive trust might arise if it could be established that customers paid their monies to Farepak after it had decided to cease trading and after it indicated that no further payments should be received. However, on the facts, the court could not clearly identify that all the monies that were the subject of the application, fell within that class.

UNCONSCIONABLE BEHAVIOUR AND THE IMPOSITION OF A CONSTRUCTIVE TRUST IN INSOLVENCY SITUATIONS

In the light of these authorities, would a company that enters an insolvency process, always be obliged to return the monies which it might otherwise be considered "unconscionably" to keep or could it resist attempts to do so, leaving the customer/ principal with no more than a right to prove its monetary claim, as an unsecured creditor in the insolvency?

Last month, in Bailey v Angove's PTY Limited, (Re D&D Wines International Ltd) the Supreme Court seized the opportunity to stray beyond the issues strictly needed to decide the case and sought to limit the scope for remedial constructive trusts to spread further into the common law of England and Wales. While obiter dicta is not legally binding, the importance in the restructuring arena of five senior law lords (one of whom was Lord Neuberger) unanimously rejecting the scope that remedial constructive trusts could play in English law, should not be underestimated.

BAILEY AND ANOTHER V ANGOVE'S PTY LIMITED

FACTS

D&D Wines worked with Australian winemaker Angove's PTY Limited ("Angove"), acting both as agent for Angove, entitled to commission for wine it sold on Angove's behalf, as well as buying stocks of Angove's wine outright, which it would then sell to customers on its own account. Both activities were governed by an agency and distribution agreement.

When D&D went into administration, Angove terminated the agreement and D&D's authority to collect money on its behalf as its agent. Angove said it would directly collect Aus$840k due from two UK retailers in respect of wine which D&D had already sold to the customers, and then account to D&D for the commission it earned on the sales.

However D&D (now acting by its liquidators) claimed that it sold the wine to the retailers not as Angove's agent, but rather on its own behalf i.e. these were direct sales, meaning that D&D was entitled to collect and keep the money, leaving Angove with an unsecured claim in the liquidation for the

price of the wine supplied. The parties agreed that all monies paid directly to D&D as well as those collected directly by Angove should be held in escrow pending the resolution of the dispute.

HAD ANGOVE CORRECTLY TERMINATED D&D'S RIGHT TO ACT AS ITS AGENT?

The Supreme Court noted that as a matter of general law even if parties agree that an agency agreement is "irrevocable", that word carries no particular magic - the authority of an agent may always be revoked by its principal, unless a permitted exception applies. The main such exception is where the agent has an interest of his own in the exercise on his authority. For this exception to apply:

1. the agreement must provide for the agent's authority to be irrevocable; and

2. the authority must be given to secure an interest of the agent either a proprietary interest (eg a power of attorney enabling the holder of an equitable interest to perfect that interest) or to secure a liability owed to him personally (eg for commission due in respect of historic transactions - though it would not be enough for his only interest to be his endeavours to earn commission in respect of the current transaction.

In this case, neither condition was satisfied. Consequently Angove was entitled to terminate the agency, collect the debts itself and merely account to D&D for the commission due to it.

At this point, the judgment could have come to an end and indeed the clarification alone of the circumstances in which an agent's authority is irrevocable, renders it valuable for future cases. However the court was not content to leave matters there. Lord Sumption (who delivered the leading judgment with which the other four Law Lords agreed) explained that as the possibility of a remedial constructive trust coming into play had been fully argued and as it is of general importance, he felt it was right to deal with it. The court therefore examined the issue, approaching it as if it had not already concluded that the agency agreement had been terminated.

WERE MONIES RECEIVED BY D&D HELD ON CONSTRUCTIVE TRUST FOR ANGOVE?

An agent has a duty to account to his principal for money received on the principal's behalf. The duty does not necessarily give rise to a trust of the money in the agent's hands. It depends on the intentions of the parties and in some cases, on their conduct. As a broad generalisation, the agent should not be at liberty to treat the money as his own but should segregate it from his own money.

When this case was before the Court of Appeal, the Court considered Neste Oy and Japan Leasing and accepted that money received by an agent, though not held on an express trust for his principal, nor on a special purpose trust, may be held on a constructive trust for his principal on the ground that it would be unconscionable for the agent to assert title to the money. The example given was where the agent receives money under a contract that he knows he will be unable to perform because of his pending insolvency. However the Court of Appeal held that in this case, as D&D had a contractual right to collect the proceeds of the invoices from which it was entitled to deduct its commission, it would not have been unconscionable for D&D to retain the money and as such, there was no constructive trust.

The Supreme Court agreed that there should be no constructive trust but reached its conclusion on different grounds. In doing so, it reflected The Court of Appeal's interpretation of the circumstances when a remedial constructive trust might arise. Insolvency law requires all claims to be assessed as at the date of the insolvency. This results in many harsh consequences. Those who make advance payments will find that an intervening insolvency will leave them with nothing more than a right to prove in the liquidation for damages for breach of contract. Similarly, unless it is agreed that an agent will hold money received on behalf of his principal on trust, the money will form part of the agent's insolvent estate. In Neste Oy, the court held that the position is different when, at the time of receipt of the money, the recipient knew that there was bound to be a total failure of consideration. In those circumstances, a constructive trust would arise. The Supreme Court disagreed with this approach and in doing so, stated that the decision in Neste Oy cannot be justified on the ground on which it was decided (though suggested that the same conclusion might have been reached by relying on the law of mistake).

In English law, one of the essential requirements for a trust is that the trust property must be identifiable in the hands of the recipient and that the property must not be available to the recipient as part of its general assets. The only true exception to this is when a person becomes liable to account as a constructive trustee because of his dishonest assistance in a breach of trust:

"where money is paid with the intention of transferring the entire beneficial interest to the payee, the least that must be shown in order to establish a constructive trust is:

1. that the intention was vitiated, for example because the money was paid as a result of a fundamental mistake or pursuant to a contract which has been rescinded; or

2. that irrespective of the intentions of the payer, in the eyes of equity the money has come into the wrong hands, as where it represents the fruits of fraud, theft or breach of trust or fiduciary duty against a third party."

The court held that the prospect of a total failure of consideration would not satisfy these criteria and thus would not be sufficient to elevate a simple contractual claim to the creation of a proprietary restitutionary right.

WIDER COMPARISON

The USA, Canada, New Zealand and Australia all accommodate some concept of a remedial constructive trust. Justice Cardoza's (as he then was) dicta from Beatty v Guggenheim Exploration Co (1919) is often quoted, that the constructive trust is "the formula through which the conscience of equity find expression". In England, in London Allied Holdings Limited v Lee [2007] Mr Justice Etherton (as the Master of the Rolls) explained his understanding of the US and Canadian model: in cases of unjust enrichment, and regardless of any fiduciary relationship, the court has a discretion to grant relief by way of constructive trust if it concludes that other proprietary and personal remedies are inadequate. He noted that whilst there was strong opposition to courts liberally being able to grant relief by way of a constructive trust (he quoted Professor Peter Birks, Regius Professor of Civil Law at Oxford University, who described it as "a nightmare trying to be a noble dream") there may nevertheless be scope to debate a model more suited to English law. The law lords deciding Bailey v Angove's did not appear to agree.

Methods to provide other forms of protection have also been raised. In the UK, in July 2016, the Law Commission reported on "Consumer Prepayments on Retailer Insolvency" and recommended the introduction of a general power for Government to require prepayment protection in sectors which pose a particular risk to consumers, changes to the rules determining when consumers acquire ownership of goods and changes to the insolvency payments hierarchy to provide protection for "the most vulnerable category of prepaying consumers". However there are currently no indications that the proposals will be accepted by the UK Government and embodied in appropriate legislation.

The issues confronting a financially distressed company in the twilight period before formal insolvency are complex. Where the company relies on customer pre-payments and "third party" monies for its working capital, it is often impossible to ring-fence those monies. To do so would bring an end to any prospect of potentially trading through the difficulties to save the company. An appropriate balance must be found between pulling the plug too early, continuing to accept payments to try to trade out of difficulties and risking claims for wrongful trading, fraudulent trading, personal liability and disqualification as a director.

CONCLUSION

This latest UK Supreme Court judgment in Bailey v Angove's highlights that insolvency unavoidably gives rise to some unfair results. The courts should not extend their equitable jurisdiction to create some new form of protection for those who have only recently entrusted their money to a now insolvent company - and for those who do so after the commencement of insolvency proceedings, more appropriate remedies may be found in the law of mistake or estoppel. If the courts were to take the opposite approach, similarly difficult questions would arise such as why this type of claimant should be more favourably treated than other unpaid creditors and how far back in time one should go to identify those who should receive such preferential protection.

Two clear points arise from this judgment. First, one should never assume that an irrevocable agency agreement cannot be revoked. In short, unless one of the exceptions applies, it can. Secondly when considering whether a financially distressed company can keep property that appears "morally" to belong to a third party, while being mindful of all other twilight trading risks, one should not assume that the company is compelled in equity to hold the property for the benefit of that person as a beneficiary. While equity treats as done that which ought to have been done, in the opinion of the five law lords who considered this case, the scope of the maxim should not extend to allowing the courts to adjust the statutory order of priority by elevating one set of creditors to a position where they are given a proprietary interest in the assets of the company. To return to Lord Neuberger's address in Queenstown, "the remedial constructive trust represents an unnecessary weapon in the judiciary's armoury, a book too many in equity's library, and a discretion too many in a Chancery judge's locker."