Uncertain security

Retail insolvencies in the current market have increased the profile of the landlord’s hypothec.

If on the date of insolvency there are rent arrears, the landlord has to establish whether there is any security for his hypothec; and if so, what it is and what value it has. The difficulty is compounded by the theoretical basis of insolvency proceedings. Creditors are expected to lodge claims with the insolvency practitioner (IP), and to value any security they have; the IP then adjudicates on the claim and makes payment of dividends based on those adjudications.

A landlord will be able to lodge a claim in respect of sums owed, and to claim a hypothec by virtue of rent being in arrears, but may not be able to state the nature, extent or value of that security. He may have to rely on the IP to assist him with his claim, and this will be influenced by the nature of the insolvency process and the facts of the case. An IP providing such assistance may have to consider the potential conflict of interest which may arise when he adjudicates on the claims lodged.

Some specific issues may arise from the different insolvency processes.

Receivership

A receiver owes his primary responsibilities to the appointing charge holder. Receivership is the enforcement of security, not a collective process in which the IP’s primary duties are to the general body of creditors. It may not be in the charge holder’s best interest for the landlord to be able to substantiate his claim.

The hypothec (as amended by the 2007 Act) applies only to property of the tenant. This excludes items on lease or hire purchase, or subject to a valid retention of title clause. Apart from the landlord’s difficulties identifying the extent of his security, such a situation will in practice reduce the value of the hypothec despite it ranking ahead of the floating charge (as a fixed security predating that created by the charge crystallising). However, crystallisation subordinates the hypothec to the floating charge in respect of arrears post-insolvency appointment.

Administration

The fixed security nature of the hypothec will give the landlord a prominent ranking in respect of pre-appointment arrears. However it will also extend to post-appointment arrears with the same ranking, because: (a) a floating charge does not crystallise on the appointment of administrators; and (b) the 2007 Act does not limit hypothec to arrears accruing prior to the date of appointment of the IP (s 208). However, if the IP decides that there is insufficient property to permit a distribution to unsecured creditors (other than under the prescribed part rules: Insolvency Act 1986, s 176A), and files notice to that effect, then the 1986 Act, sched B1, para 115(3) operates to attach the property subject to the floating charge. The ranking of a hypothec will then vary according to whether the landlord’s claim includes post-appointment arrears.

Liquidation

Most liquidations do not involve trading, and rent arrears are likely to accrue. Is the hypothec a right preferable to the liquidator’s rights in terms of the Insolvency (Scotland) Rules 1986, rule 4.66(6) (as amended)? If the hypothec arises in respect of pre-appointment arrears, it is suggested that it is preferable as a right created pre-appointment, but that cannot apply to post-appointment arrears. However, the hypothec is a security and the debts thereby secured must rank ahead of ordinary debts.

Should it be treated like any other fixed security, and if not, where does it rank in a competition with expenses and preferential debts in the rule 4.66 order of priority? Following Leyland DAF, where there is a hypothec claim, the liquidator should not pay fees or expenses from the proceeds of sale of the relevant moveables until the landlord has submitted its claim prior to the final distribution to creditors. Only then would it appear to be safe for the liquidator to take his fees and expenses if there are funds to meet them.

Might it ever be legitimate for an IP to remove items from the premises (and thus from the ambit of the hypothec), other than by way of sale? This might reduce the recovery to a secured creditor and increase the recovery to unsecured creditors. The answer is not necessarily straightforward. An administrator might reasonably decide that closing some premises, and consolidating stock in units that continue trading, would be in the best interests of the creditors as a whole. Prejudice to a secured creditor might then be justifiable. If the purpose in removing the stock was to defeat the landlord’s claim and enhance the returns to unsecured creditors, the administrator should think twice. A receiver contemplating the same situation might have fewer concerns, given his primary responsibility to the charge holder as potential beneficiary of the sale of the stock removed.

Alistair Burrow, Head of Recovery, Tods Murray LLP

I am indebted to a paper given by Ian Bowie of MacRoberts LLP for the inspiration for this article.

In brief: the right of hypothec

Put shortly, the hypothec is a security over the tenant’s goods on the leased premises, arising automatically whenever arrears of rent exist. When the arrears are paid, the hypothec disappears. Other than by way of hypothec it is not competent in Scots law to create security over moveable items (except by way of a floating charge), and since it arises by operation of law, it is not registerable as a charge. Landlord’s hypothec was amended by the Bankruptcy and Diligence etc (Scotland) Act 2007, and actions for sequestration for rent were abolished.