Proving in liquidation as a guarantor - is it easy (like Sunday morning)?

Proving in liquidation as a guarantor - is it easy (like Sunday morning)?

Dominant, substantial or merely sufficient... When is a purpose not a purpose for section 423 of the Insolvency Act 1986?

It is not unusual for a company (the “Guarantor”) to guarantee a debt of a related company (the “Principal Debtor”) and subsequently to be asked to pay out sums owed by the Principal Debtor in the event of the latter’s insolvency to a third party creditor.

The starting point

Typically, under a standard form of guarantee, the Guarantor agrees to meet the obligations of the Principal Debtor owed to its contractual counterparty (the “Creditor”). It is settled law that if, for whatever reason, the Guarantor discharges some or all of the Principal Debtor’s liability under the guarantee, it has the right to claim the sums paid from the Principal Debtor by way of indemnity.

It would therefore follow that where the Principal Debtor enters into liquidation, and there is a distribution to be made to creditors, the Creditor and/or the Guarantor may have claim(s) in the liquidation, as considered further in the three scenarios below:

  1. The Guarantor has discharged the Principal Debtor’s liability in full either before, or during, the liquidation. The Creditor’s claim against the Principal Debtor has therefore been satisfied, in full and it will have no claim in the liquidation. The Guarantor however, has the right to claim the sums paid, pursuant to the indemnity as referred to above.
  2. The Guarantor has only partly discharged the Principal Debtor’s liability. Here, the Creditor is likely to claim in the liquidation for the shortfall. However, the Guarantor is also likely to claim in the liquidation for the sums it has paid to the Creditor on behalf of the Principal Debtor.
  3. The Guarantor has not yet discharged the Principal Debtor’s liability in full or in part, but a demand for payment under the guarantee has been made. Here, the Creditor is likely to claim in the Principal Debtor’s liquidation for the entirety of the unpaid sums. However, again the Guarantor is also likely to claim in anticipation of paying out under the guarantee i.e. it has a future contingent claim.

Rule against double proof

Now bring in the rule against double proof. This is a long-standing common law rule which states that an insolvent estate can only accept one creditor claim for each debt that the insolvent entity owes. So, back to our above three scenarios, what application does this rule have?

  1. In scenario 1, the rule has no application. The Creditor does not have a claim in the Principal Debtor’s liquidation, so the Guarantor will be the only creditor capable of submitting a valid proof.
  2. In scenario 2, the rule against double proof applies. The claims of the Creditor and  Guarantor cannot relate to the same debt. As a result, the Guarantor is prevented from making a claim, unless the Creditor’s claim is extinguished in full.
  3. You’ve guessed it, the rule also applies in scenario 3. Although in theory, the Guarantor can submit a proof of debt for the future contingent claim, the claim relates to the same debt as submitted for payment by the Creditor.

What was not clear from this common law doctrine, was how this interacts with the equitable principle of Cherry v Boultbee (1839) EWHC 3027 (Ch). The judgment in this case provides that an insolvent estate may make a distribution to a creditor, after netting off any sum the creditor owes to the insolvent estate. So, going back to our example, if the Guarantor was also a debtor of the insolvent Principal Debtor, Cherry v Boultbee would allow the Guarantor to set off the sum it owed to the Principal Debtor against sums due to the Guarantor it either had paid out, or was due to pay out, under the guarantee.

After a stream of conflicting case law in this area, the Supreme Court set the record straight in Re Kaupthing Singer and Friedlander [2011] UKSC 48. In summary, it held that the rule against double proof prevents a guarantor from applying any form of set off, until the guaranteed obligation has been discharged in full.

This rule against double proof is good news for the creditor, as it ensures the primacy of its claim in the insolvent estate, vis-a-vis the guarantor. It also lessens the importance of having to include “non-compete” wording in a guarantee, which usually seeks to expressly prevent the guarantor from proving in the principal debtor’s insolvency until the creditor is repaid in full.  Of course, insolvency practitioners should always bear in mind this rule before distributing assets in the insolvent estate to ensure that there are not multiple claims for the same debt, especially when considering a subrogated claim from a guarantor.

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