In the present fi nancial climate, customers are increasingly asking for business critical software or other assets to be transferred to the customer should the supplier become insolvent, for the legitimate reason that the customer needs security of supply. Two recent Court of Appeal cases remind us that customers who outsource to and contract with potentially vulnerable service providers need to take account of the “anti-deprivation principle” when doing this. Set against the concern of the customer is the equally legitimate concern of the supplier (and, in particular, its creditors) not to be deprived by any such transfer. If the transfer is not dealt with properly, a customer may lose its contractual right to gain control of business critical assets (such as software) should its supplier go insolvent, as a result of the anti-deprivation principle or the restrictions relating to reviewable transactions under the Insolvency Act 1986.
The anti-deprivation principle
The anti-deprivation principle is a common law rule prohibiting contractual provisions which result in one party gaining an advantage on the insolvency of the other party which then prevents the property of the insolvent party from being distributed under relevant insolvency laws1. To put it another way, on grounds of public policy, parties to a contract cannot contract-out of the relevant insolvency legislation so as to “deprive” the insolvent party’s creditors.
Butters v BBC Worldwide2
The Butters case arose out of the Woolworths Group insolvency. Woolworths Media Plc had formed a joint venture with BBC Worldwide Limited (the 60% majority shareholder in the JV) to distribute BBC Worldwide’s DVDs. BBC Worldwide granted a licence to the JV company, which contained a termination clause such that the licence was automatically terminated if:
- Any Woolworths Group company became insolvent
- BBC Worldwide served notice to acquire Woolworth Media’s shares in the JV company.
The following events occurred: Woolworths Group Plc (a group company of Woolworths Media but not a party to the joint venture) became insolvent and BBC Worldwide served notice to buy out Woolworths Media’s shares in the JV company. The licence then terminated automatically (as per the termination clause). BBC Worldwide acquired the shares in the JV company at the price fi xed by the pre-agreed formula in the JV agreement. BBC Worldwide then granted a new licence to the JV company (which it now owned entirely).
Incidentally, Woolworths Media Plc (ie the JV partner) did itself become insolvent eventually, but the above events were triggered by Woolworths Group Plc’s insolvency. This is important when applying the anti-deprivation principle, as we will see later.
The administrators of Woolworths Group claimed that the antideprivation principle should apply because of the termination of the licence by BBC Worldwide. They claimed that this withdrawal reduced the value of the JV company, and of the acquired shares, at the expense of Woolworths and Woolworths’ creditors.
Perpetual Trustee v BNY Corporate Trustee3
This case involved a dispute arising out of the insolvency of the Lehman Bank Group. Perpetual Trustee was a note-holding creditor in a complex web of arrangements. Under the Trust Agreement, the priority of the creditors and the responsibility for “unwind costs” depended upon who defaulted by becoming insolvent fi rst.
Key points and principles
The Court of Appeal heard both cases together at the end of 2009. The Master of the Rolls set down some useful general principles relating to the anti-deprivation principle:
1. The anti-deprivation principle is based on public policy, but only to the extent that one cannot contract out of insolvency legislation (following the case of British Eagle4).
2. The English courts should not extend the anti-deprivation rule any further, unless this is logically or practically required. As such, there is little risk of the anti-deprivation principle materially widening in scope.
3. In principle, the English courts should try to keep the law in this area clear and should respect parties’ contracting autonomy, particularly where they are likely to be commercially sophisticated and expertly advised such as in:
- Cases involving complex fi nancial instruments (like in Perpetual Trustee); and/or
- Contracts involving large corporate groups (like in Butters). In effect, the anti-deprivation rule may not apply in favour of a potentially “deprived” party if it agreed to be involved in such arrangements.
4. Automatic termination of an IP licence on the licensee’s insolvency is not a deprivation in itself. It is very common, indeed essential, in any well-drafted licence. In Butters, it did not matter that there was a variation on this theme (ie that the licence terminated on the licensee’s co-owner’s group company becoming insolvent rather than the licensee itself). Rather than demonstrating an intention to “deprive”, there is a sound commercial rationale for this (the insolvency of a group company may be an indication that the licensee itself is fi nancially unstable). The relevant principle the Court of Appeal elucidated was that where it is the property of the third party (eg the licensor) which is being transferred back to the third party in the event of the other party’s insolvency, the anti-deprivation principle is not engaged. The licensor is merely limiting the rights of the licensee. This is quite different from the example where the party which becomes insolvent agrees with a third party that property belonging to the party will be transferred to the third party upon the former becoming insolvent5.
5. An obligation on a shareholder who becomes insolvent to sell his shares to the other shareholder(s) (as in Butters) would offend the anti-deprivation principle. After all, the intention was for the insolvent party’s own assets (ie the shares) to be transferred to the third party. However, the redeeming factor there was that the predetermined price of the shares amounted to a fair market value6. The Court of Appeal held that, in Butters, on the facts, the “fair price” set out in the JV agreement mechanism actually was better than market value. As such, there was no deprivation.
6. In principle, if two provisions do not offend the anti-deprivation rule separately, then they would be unlikely to offend when read together. Even if linked, one must look at the practical effect. In Butters, BBC Worldwide’s right to terminate the licence was dependent on its buying the insolvent party’s shares (at a fair value). There appeared to be no intention that the combined effect was to deprive Woolworths’ creditors.
7. The Court of Appeal also found on the particular facts of the two cases that the anti-deprivation occurred before winding up or administration (ie on the earlier Chapter II insolvency proceedings in the US). On that basis too these particular agreements did not fall within the scope of the anti-deprivation rule. If the transfer occurs at the time of commencement of the administration or liquidation, however, it then runs the risk of challenge by creditors (as in British Eagle). The relevant point in time is the winding up/ administration, and not whether the company was technically insolvent.
If circumstances permit, it might be preferable for a customer to provide for the transfer prior to the actual winding up/ administration of the supplier; for example, on a technical insolvency or even a “pre-insolvency event” (such as a signifi cant drop in share price or credit rating, for example).
8. The anti-deprivation rule does not apply where a transfer is triggered as a result of the insolvency of a third party (however closely connected to the relevant company); it only applies to the insolvency of the relevant contracting party. Each group company is to be considered separately. The court cannot treat even a closely integrated group of companies as a single economic unit7 for the purposes of the anti-deprivation principle.
This suggests the question: might this restriction be used by a customer concerned about having a transfer set aside under the anti-deprivation rule. In principle, the answer is yes: if the transfer from the relevant party can be triggered by the insolvency of a group company (as in Butters) and this takes place before any insolvency of the relevant party, then the anti-deprivation rule cannot apply to that transfer.
Transactions at an undervalue or at a preference
This article focuses on the recent Court of Appeal cases and the anti-deprivation principle. For completeness, it must be noted that even if an asset transfer to a customer avoids offending the antideprivation principle, it may still be set aside if it is a transaction at an undervalue or as a preference8 in connection with any administration or liquidation of the supplier.
The threshold requirement for these Insolvency Act restrictions to apply is that the transaction must be made when the supplier is technically insolvent or if the transfer made the supplier technically insolvent.9
In purely legal terms, the most risk-free route for a customer to avoid falling foul of the Insolvency Act restrictions (and, usually, the antideprivation principle) is for the customer to pay a fair market value for the asset being transferred.
An alternative, higher risk route is for the customer to opt to pay less than fair market value on the basis that the transfer will occur before the supplier is insolvent and that it will not take the supplier into insolvency. How appropriate this is will depend on fact and degree; for example, the size and relative fi nancial stability of the supplier at the time of the transfer (notwithstanding the concerns of the customer), the trigger for the transfer and the value of the asset being transferred. The practical issue for the customer is legislating for such future variable factors at the time of entering into the contract, in such a way that the transfer, if the time comes, will not fall foul of the Insolvency Act.
With both the anti-deprivation principle and the Insolvency Act restrictions to be negotiated, a customer needs to take care (and usually specialist advice) in fi nding the most appropriate, effi cient and effective way of obtaining any necessary assets to ensure security of supply and business continuity should its supplier enter into future fi nancial diffi culty.