Winding-up applications: when to refuse a first order

There is a surprising lack of written judgments of the Scottish courts on such a common application as that by an alleged creditor to wind up a company, under the Insolvency Act 1986, on the ground that it is unable to pay its debts. In particular, there is very little written authority on the approach which the court has to adopt at the hearing for a first order for service and advertisement, when the company advances a defence to the application; that hearing will almost always result from a caveat having been lodged by the company.

One exception is the judgment of Sheriff Holligan at Edinburgh in the application by PEC Barr (Holdings) Ltd [2009] WL 1726060.

Strangely, given the lack of authority, the sheriff’s note has never been reported, although it is understood to be regularly cited in the sheriff court. In any case, the sheriff’s experience of insolvency work means that the decision must be treated with respect. Indeed, the sheriff said in his note that he was issuing a note because there had been a number of such applications before him.

In these circumstances, it is unfortunate that the decision in PEC Barr (Holdings) is not quite correct.

When to refuse?

The basis of the sheriff’s decision to make a first order is set out in the following passage at para 7: “If I were to refuse a first deliverance then it seems to me that I would, in effect, be prejudging the issue. I do not consider that there is sufficient material before me to enable me to do so with any degree of confidence. I would have to be satisfied at this stage that the respondent would be bound to succeed in their opposition to the petition and that I do not think I can do at this stage in the proceedings. In my opinion, the petitioners are entitled to a first deliverance” (emphasis added).

That reasoning, for which the sheriff cites no direct authority, is, in fact, contrary to a long line of authority as to the effect on a winding-up application of a substantive defence. The decision to make the first order is also contrary to the practice of the Court of Session, which gives practical effect to those authorities.

The correct legal position is that, at the hearing for a first order, the court must consider any defence which is then advanced to the application. In particular, the court must decide whether that defence is being advanced in good faith and on substantial grounds (“a substantial defence”).

The practice of the Companies Court in England & Wales is in substance the same, since a petition to which a substantive defence is advanced will be “struck out”. However, it is at least as common in that court for a company to seek, on the basis of a substantial defence, an injunction against a threatened application to wind it up or against the advertisement of such an application. The practice of the Companies Court is set out in great detail in French, Applications to Wind Up Companies (see paras 2.165, 3.75 and 7.529-7.555). The practice was also referred to, with approval, by the Privy Council in Paralmat Capital v Food Holdings [2009] 1 BCLC 274 at para 9.

In the Court of Session, the legal effect of a substantive defence was set out clearly by Lord Hodge, with his particular experience of company work, in Macplant Services Ltd v Contract Lifting Services (Scotland) Ltd 2009 SC 125, at paras 8 and 9. Unfortunately, neither that judgment, which would have been available, albeit unreported, nor indeed any other decision, was cited to the sheriff.

In particular, Lord Hodge said at para 8 of his opinion: “A winding up petition is not the process in which to establish the respondent company’s liability to pay a disputed debt. The petitioner will not be a creditor for the purposes of s 124 [i.e. of the Insolvency Act] if the respondent company shows that the debt is disputed in good faith and on substantial grounds. The court will normally dismiss the petition if it is clear that there is such a dispute.”

Those propositions do not perhaps make it entirely clear, for the good reasons which are mentioned below, that the court must decide at the hearing for the first order whether a substantial defence has been advanced. If the court does so decide, the first order is to be refused and the application dismissed, in the absence of very exceptional circumstances.

Risk of injustice

The overlapping reasons why that practice is correct, and indeed inevitable to avoid very serious injustice to a respondent company, are very straightforward. However, none of those matters was referred to by the sheriff in PEC Barr (Holdings) Ltd.

The first reason for the practice is that, as said in the above citation from Macplant Services Ltd v Contract Lifting Services (Scotland) Ltd, a winding-up application is not the correct process to determine claims to which a reasonable defence is advanced.

The second reason is the effect of s 127 of the Insolvency Act, which invalidates every “disposition”, unless the court directs otherwise. A disposition includes any sale and even every operation of a bank account in credit. If a winding up order is subsequently made, the effect of the section is retrospective to the date of the presentation of the petition (by the combination of s 127 and s 129(2) of the Insolvency Act).

Directors might be prepared to take the risk of s 127 ever coming into effect. However, the company’s bank would, in all likelihood, not do so but would, when it became aware of the first order, refuse further operation of its accounts.

Thirdly, advertisement of a winding-up application is necessary to warn third parties of the risk of s 127. However, that advertisement, combined with the risk of s 127, might well destroy the company’s business. Once informed of the application, by advertisement or word of mouth, suppliers will refuse further credit and customers will take their orders elsewhere. Employees might also depart to a safer berth.

Fourthly, the likely damage which would result from a winding-up application would enable an alleged creditor to put pressure on the company to pay a disputed debt.

Those second to fourth reasons for the practice explain very easily why a winding-up application is not the correct process in which to determine claims to which a reasonable defence is advanced.

If the company went on successfully to resist the winding-up application, but its business had by then been largely destroyed, that would be a somewhat pyrrhic victory. A claim against the unsuccessful applicant would hardly be a satisfactory remedy.

Instructive case

The consequences for the company of a winding-up application proceeding are recognised at para 8 of the opinion in Macplant Services Ltd, where Lord Hodge explains, with commendable understatement, why an application to which a substantial defence is advanced is refused:

“The reasons which the courts have taken for taking this approach include the disruption and potential damage which the presentation and advertisement of a winding up petition may cause to the business of a respondent company. But for this rule, this potential to damage would enable a petitioner to apply commercial pressure to obtain payment of a disputed debt.”

Macplant Services Ltd was, in fact, an example of a business collapsing as a result of the advertisement of the petition and, even more, of the appointment of a provisional liquidator (see para 65 of the opinion). After the business had in effect gone, the delay in determining the winding-up application did not matter. In short, the way in which the sheriff court dealt with Macplant Services Ltd was a striking example of how a winding-up application ought not to be handled.

It is important to bear firmly in mind that the statements at para 9 of Lord Hodge’s opinion on the court sisting the application, and exceptionally hearing oral evidence, have to be read in their most unusual context, which was not a motion for a first order.

In addition, it follows from the consequences of allowing a winding-up application to proceed that the very few exceptions to the practice tend to involve companies which are no longer trading, so there is no meaningful business to destroy.

For completeness, it is worth adding that the practice tries to give effect to the “rescue culture” in which legal processes attempt to preserve, rather than unnecessarily destroy, viable businesses.

The single decision cited by the sheriff in PEC Barr (Holdings) as providing his decision with “some support”, was Foxhall & Gyle Nurseries Ltd 1978 SLT (Notes) 29, a decision of Lord Kincraig, at that time the liquidation judge.

However, the facts with which that decision was concerned were crucially different. In short, the company did not advance any substantive defence to the application, in the sense of disputing that it owed the debt to the applicant. Rather, the company, which was already in receivership, contended through the receiver that the majority of the creditors did not wish a winding up order.

One final, general observation is prompted by PEC Barr (Holdings). Is it still realistic for the sheriff court, with all its other pressing business, to continue have jurisdiction over corporate insolvency work, such as liquidation and administration, which is now highly technical?