With the increase in Covid-19 related litigation, and the impact of the virus on the world economy, many businesses are suffering in these difficult times and many companies are, or are at risk of, going insolvent.
In the UK, a company will generally be considered to be insolvent if: i) it is unable to pay its debts when they fall due; or, ii) its balance sheet has a negative net asset position. However, it is not always easy to tell whether a company is, or is at risk of, going insolvent.
In the absence of precognition, parties to litigation may wish to take steps to ensure they assess the risks of insolvency of other parties in their matter.
So, what can they do?
Before commencing arbitration, the parties should conduct a thorough risk analysis of whether it will make commercial sense to pursue arbitration based on the distressed or insolvent party’s financial position. This is particularly important given the absence of a “default judgment” mechanism in arbitration as, if an insolvent party elects not to engage with the proceedings, the parties will still have to proceed with the arbitration and establish the merits and quantum of their claim. This can result in significant time and cost expense for parties at the risk of minimal return. However, there are “fast-track” procedures in arbitration which, in the right circumstances, can be a very useful tool to streamline costs and may facilitate a more expeditious disposal of the claim.
During arbitration, in addition to the lack of funds available to the insolvent party, insolvency law may make it difficult and sometimes even prevent distressed and insolvent companies from making payments to a third party; impacting costs and their recovery. Payments to third parties could be clawed back by insolvency practitioners (e.g. as a preference if the parties are connected or there has been an intention to prefer them) and even paying one creditor ahead of others may also raise questions of breach of directors’ duties.
Once an insolvency process has started, the appointed insolvency practitioner will often determine whether the insolvent party can commence or continue arbitration proceedings and/or the extent to which costs or an award can be paid. For administrative costs, each party is normally liable to pay half and, if one (potentially insolvent) party cannot pay, the other party normally will have to make up the other half to be able to continue the arbitration.
In this context, obtaining an order for security for costs (“SFC”), which may require the respondent in an insolvency process to set aside a sum of money to pay for, for example, a potentially adverse costs order made against it, or third party funding, which focuses more on insuring cost risk based on an assessment of recoverability of claimed sums by insurers, may offer some protection against insolvency risk.
Stays being used in arbitration proceedings, such as a moratorium (effected if the party is in financial difficulties and goes into administration), can prevent the commencement or continuation of proceedings against an insolvent company without the consent of the administrator or the court.
When seeking interim relief, the arbitral tribunal, a court and/or emergency arbitrator (where permitted), may be able to grant urgent temporary relief against distressed and insolvent parties – especially relevant when a distressed party is close to entering an insolvency process, as there is a heightened risk that the distressed party may dissipate assets.
Looking to Enforcement in the insolvency process, parties should remember that an arbitral award is an unsecured debt that ranks the same as all unsecured creditors. As such, from the outset and periodically throughout the arbitration, the parties and their solicitors should make efforts to measure and monitor the risk of insolvency to the arbitration – a “one eye on enforcement” approach.
It should also be remembered that even if the parties are ultimately able to obtain a favourable award, they will have been 100% responsible for the insolvent party’s share of the arbitrator fees which they may be unable to recover through enforcement if the insolvent party has entered into an insolvency process. Of course, if the insolvent party has already been dissolved at this stage, or at any earlier stage before enforcement, recovery of any sums may be impossible.
Some concluding thoughts…
There are great risks when arbitrating against a distressed or insolvent party and to mitigate this risk is crucial to being able to recover owed sums. There may be scope during the arbitration process to have informal discussions, mediate or even use the insolvency proceedings to leverage a favourable settlement. There may also be circumstances where the arbitration may be continued (for example, if the seat of the arbitration is different from the locus of the insolvency proceedings) to provide more options for recovery by the parties.
In any event, if the insolvency of a debtor presents as a possibility, careful consideration should be given to whether arbitration is the right next step.
Restructuring & Insolvency Partner
M: +44 (0) 2033 711 143
Dispute Resolution Associate
M: +44 (0) 757 210 4690