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The following (longish) chunk from the current draft (so E&OE) of my thesis may help on the preferences aspect of Lionel Smith's recent query: in short, there is a dispute as to who gets the preference recovery in this context, the trust or the general creditors but on principle it should be the general creditors. Sorry that I haven't had time to distill the American cases directly on point: but I am trying to submit next month and am up to my neck in proofreading!!

(By the way, liquidators etc may sue to recover preferences though recovery only benefits the secured creditor - Kratzmann and Octavo say so more or less in Australia; I am not sure of the UK authority; in the US they can't.)

Simon Evans.
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Distributional patterns and policies.

While the previous Subsection has determined that the proceeds of an action for breach of fiduciary duty or another claim to proprietary relief by an insolvent company may be subject to a charge, this is not the case in relation to the proceeds of some at least of the statutory avoidance powers. The distributional patterns for property recovered by a liquidator differ according to the particular grounds of recovery. Whereas the proceeds of a misfeasance action(1) are held subject to the chargee's interest (since the misfeasance action does not confer any new right but merely creates a summary procedure by which the liquidator may vindicate existing pre-insolvency rights of the company),(2) some controversy attends the distribution of recovered preferences and transactions at an undervalue and the proceeds of wrongful or insolvent trading actions.(3) The question, therefore, arises, when conduct may be characterised either as giving rise to a proprietary remedy or as triggering various statutory avoidance or recovery powers which distribution policy should prevail.

Preferences.

The Yagerphone principle.

It was established in In re Yagerphone Ltd(4) that the proceeds of a preference action are held for distribution to the unsecured creditors and not subject to any securities. But, in Australia at least, it appears that, according to dicta of the High Court in N A Kratzmann Pty Ltd (in liq) v Tucker [No 2],(5) non-money preferences consisting of specific and identifiable property are, when recovered, subject to security interests attaching prior to the preferential disposition because the recovery is based on avoidance of the preferential disposition, and the security interest is treated as continuing throughout.(6) On the other hand, monies recovered in respect of a preferential payment are not the same monies as those paid away preferentially and title to them is not dependent on any prior rights in respect of the monies paid away so no security interest attaches.(7)

[Discussion of the Yagerphone principle in Australian law omitted]

The better view is that In re Yagerphone Ltd remains good law in Australia, an anomalous exception to the principle that insolvency law does not override proprietary entitlements determined by the general law.(16) [Omitted]

In summary, therefore, it appears that recovered preferences, except for specific and identifiable property charged prior to its preferential disposition and the proceeds of such property, are to be distributed among the unsecured creditors of the insolvent.

Applying the Yagerphone principle.

It follows from the previous discussion if the liquidator proceeds under the preference provisions against the recipient of a preferential payment in respect of which a proprietary remedy is also available, the proceeds of recovery will be available for the general creditors alone.(19) However, if the secured creditor has a charge on the company's right of action for breach of fiduciary duty, it may require the liquidator to sanction enforcement of that right of action by the company.(20) In such cases the liquidator ought to allow the secured creditor to proceed. The discretionary power contained in s 588FF of the Corporations Law is sufficient to ensure that the recipient will not be subjected to a double liability. However, s 241(4) of the Insolvency Act provides that the powers conferred under ss 238-241 operate without prejudice to the availability of any other remedy. Nonetheless, the power conferred in s 239(3) is one to restore the position to what it would have been if the company had not given the preference. Given that limitation, it is unlikely that an order will be made under s 241 if the recipient has already been forced to disgorge its receipt by the secured creditor.

It should not be thought surprising that the proceeds of recovery are applied in a different manner depending upon whether recovery occurs under the preference provisions or otherwise. In re Yagerphone Ltd is a policy motivated redistribution to unsecured creditors rather than a principled protection of their interests against preferential repayments. Recall that the "wrongfulness" of preferential payments is the distortion of the process of rateable distribution. On the other hand, recovery of preferential payments on the basis of lack of authority to make them or a breach of fiduciary duty is more directed to preserving the quantum of assets in the estate. In both cases, if absent the preference the secured creditor would have had the benefit of security in the property, that ought to remain the case. There is no basis for extending the In re Yagerphone Ltd principle to recoveries under proprietary actions.

Consider now the following case:

Example 2: T, a trustee, commits a breach of trust by paying trust funds into its general account. It then uses those funds to discharge its own debt to D. The balance of the general account is dissipated. T becomes insolvent and its liquidator recovers the amount paid to D as a preference. B, the beneficiary of the trust, claims that the recovered preference represents the proceeds of the breach of trust and is held on constructive trust for it.(21)

This case differs from Example 1 above in that the debt discharged is owed by, and not to, the fiduciary.

Two issues arise. First, whether B has a proprietary claim to the recovered preference at all. Secondly, whether that claim prevails over the principle derived from In re Yagerphone Ltd.

The decision of the Court of Appeal In re EVTR(22) supports B's argument that he or she should have a proprietary claim. The claimant lent money to a company for the specific purpose of enabling it to purchase a particular piece of equipment. The company went into liquidation before the equipment was supplied. The supplier repaid the purchase price to the company less some charges. The claimant asserted that the company's receivers held the repaid money on trust for him. On uncontroversial principles, typified by Barclays Bank Ltd v Quistclose Investments Ltd,(23) the borrower held the money received from the lender on trust to be applied for the specific purpose for which it had been lent. Again uncontroversially, one would expect that upon failure of the purpose for which the money was lent the borrower would hold the money on trust for the lender. Accepting the Court of Appeal's conclusion that the purpose had failed, is any difference made by the fact that at the time of the appointment of the receiver (or its decision not to proceed with the purchase) the borrower no longer held the money on the initial trust but had paid it to the supplier and financier? The Court of Appeal held that it did not. Dillon LJ applied what he described as "a long established principle of equity", namely, that if a trustee receives property "because of, or in respect of," trust property, he or she will hold in as a constructive trustee.(24)

"It is a long established principle of equity that, if a person who is a trustee receives money or property because of, or in respect of, trust property, he will hold what he receives as a constructive trustee on the trusts of the original property."

So when the supplier and financier repaid the balance of the money to the borrower, it was received "because of, or in respect of," the trust money and was held on constructive trust for the lender.(25) Bingham LJ said that the repayment was a "direct result" of the original holding of the fund as trustee and the balance "may reasonably be regarded s not having been paid out at all".(26)

"[T]the company certainly held the fund on trust in the first instance. The purpose for which the fund was paid out partially failed. The repayment to the [receivers] was a direct result of the company's original holding of the fund as trustee. The balance which was recovered may reasonably be regarded as not having been paid out at all."

It seems, therefore, that this case supports the possibility of reconstitution of the trust, seemingly in a remedial manner,(27) despite the fact that the trustee has become a mere debtor to the beneficiary. (It does not appear to have been argued that the constitution of the secondary trust was preferential. Presumably it would have been valid as a condition attached by the lender to the property when first disposed of to the borrower.) The reconstitution need not be as a result of repayment of the traceable proceeds of the former trust money; it is enough if money or property is received because of or in respect of the trust property.

An similar approach was adopted in the United States of America by the Court of Appeals for the Tenth Circuit on the first hearing of In re First Capital Mortgage Loan Corporation.(28) A trustee deposited trust funds in its general account and then used them preferentially to discharge its existing debts. The court accepted the argument for the beneficiary that the recovery of the preference by the trustee in bankruptcy amounted to a return of the trust property to the debtor-trustee's successor, revived the trust and created an equitable obligation on the bankruptcy trustee to return the funds to the beneficiary. (It is important to recall, however, that unlike In re EVTR the debtor-trustee's payment was a breach of trust.) The result would be similar if the trustee's creditor knew that the trustee's indebtedness was being discharged with trust money. Then, the money received is subject to a charge in favour of the beneficiary and if the money repaid to the liquidator comes from the charged fund the liquidator would on general principles hold the recovered funds subject to a charge in favour of the beneficiary. This was essentially the situation that faced the United States Court of Appeals for Fourth Circuit in Angeles Real Estate Co v Kerxton.(29) Simplifying somewhat, the insolvent assigned one-half of the proceeds of a promissory note to one of its creditors but, despite the assignment, when the note was collected, paid all the proceeds of the note to a third party in discharge of an antecedent debt. It does not appear that the third party knew of or had notice of the assignment. The payment was recovered as preferential and the assignee claimed that the trustee in bankruptcy held a one-half interest in the recovered proceeds for it. The court agreed, emphasising that "recovery of the preference was a recovery of those same funds" in which the assignee had at least an equitable lien as a result of the assignment(30) and, therefore, that there was a charge over the recovered preference in favour of the beneficiary. However, on the subsequent rehearing en banc of In re First Capital Mortgage Loan Corporation,(31) the Court of Appeals for Tenth Circuit reversed its earlier decision and distinguished Angeles Real Estate Co v Kerxton. It was held that the recovered preference was held for the unsecured creditors and the beneficiary had to prove as such because the Bankruptcy Code stipulated that the property was recovered "for the benefit of the estate".(32) The court pointed out that outside bankruptcy neither the trustee nor the beneficiary had any remedy against the company to which the payments had been made as it was a purchaser in good faith without notice. Moreover, to confer priority on the beneficiary, now an unsecured creditor, would frustrate the Congressional purpose of facilitating the prime bankruptcy policy of equality of distribution.(33)

" As a practical matter ... we do not think it equitable that one general unsecured creditor of the bankruptcy estate should be made whole by virtue of the exercise of the trustee's avoidance powers while others must make do with their share of the bankruptcy estate ... Indeed, if such a result attended the exercise of the trustee's preference powers, Congress' purpose in granting the power [that is, facilitating the prime bankruptcy policy of equality of distribution among creditors of the debtor] would be frustrated".

Returning, then, to the facts of Example 2, is the preference recovered, in the language of Re EVTR, "because of ... or in respect of" or as "a direct result of" the original trust property?(34) The better view must be that the preference is recovered by exercise of specific statutory powers that leave no room for the operation of the principle identified In re EVTR. (This may be a somewhat problematic distinction in the context of provisions that render the preferential payment void or treat it as never having occurred.)

This must be so, because outside insolvency, B had no proprietary remedy against T once T paid the traceable proceeds of the trust funds(35) to D (and no proprietary remedy against D unless D had knowledge of the source of the money he or she received).(36) B thereupon became a unsecured creditor of T and ought to be treated as such in the insolvency. Outside insolvency, B's proprietary claim against T would be revived only if T repaid money into the account (or segregated a fund) with the intention thereby of reconstituting the trust.(37) So, in the absence of such a repayment, no proprietary remedy is available and the relationship between trustee and beneficiary in respect of the misappropriated money, as recognised in In re First Capital Mortgage Loan Corporation, is merely that of debtor and creditor. Were the position to be different in insolvency, B would have an inappropriate incentive to commence insolvency proceedings.(38)

But suppose, then, that T had made such a payment into the account with the appropriate intention to reconstitute the trust. If this payment were effective to reconstitute the trust, it would have the effect that B would recover more on the insolvency than it would have done had the payment not been made. Therefore it would be a preference if the other statutory conditions were satisfied.(39) It follows that, as no action by T would be effective to reconstitute the trust,(40) B would be an unsecured creditor of T and there is no reason why recovery of the preference should change this.(41)

Consider, now, a third case:

Example 3: T, a trustee of a trading trust, uses trust funds to discharge debts owed to D that were incurred in the management of the trust business. T becomes insolvent and its liquidator recovers the amount paid to D as preferential. G represents the general creditors of T and D represents the trust creditors.

This example is directly comparable with Example 2 except that the debt discharged with trust assets is a trust debt. The issue is among whom the recovered preference ought to be distributed, the trust creditors alone or all the creditors of the trustee. Normally, the non-trust creditors have no right of recourse to trust assets for the payment of their debts.(42) It follows that if the recovered preference is distributed among them they will receive a benefit they could not otherwise have received. In principle, therefore, the preference should be distributable among the trust creditors alone. this will have the additional effect of reducing the claims of the trust creditors on the non-trust assets. The principal problem in this context will always be the liquidator's unwillingness to fund the action, because it cannot have recourse to the recoveries and the costs of recovery are not costs of the liquidation having priority.(43)

Now, if as in Example 3, that the trustee makes the payment from trust assets to discharge a debt owed to a trust creditor preferentially,(44) it is unclear whether the recovered preference should be available for all the creditors of the insolvent or bankrupt or merely for the trust creditors.(45) It follows from the previous paragraph that if the recovered preference is available for distribution among the general creditors of the trustee, they receive a benefit they could not otherwise have received, that is, recourse to (the proceeds of) trust assets for the payment of their debts. In principle, therefore, the recovered preference should be distributable among the trust creditors alone. McPherson JA of the Queensland Court of Appeal, writing extrajudicially, has justified this conclusion by reference to Re Suco Gold Pty Ltd (in liq)(46) and noted that to the extent that trust liabilities are reduced by recovery of the preference and distribution, non-trust assets are freed from the claims of trust creditors should the trust assets be insufficient to meet the claims of the trust creditors.(47) However, against this it must be observed that if the recovered preference is available only for the benefit of trust creditors then it has no impact on the net assets of the trust and liabilities to trust creditors. (McPherson JA does, however, observe that trust creditors may prove for a dividend from non-trust assets so long as the dividend paid to the general creditors equals or exceeds that paid to the trust creditors out of the trust assets. (ibid.%%%McPherson (1985), p 158.) To that extent alone non-trust assets are freed from the claims of trust creditors.) Moreover, there is scant statutory warrant for limiting the distribution of the recovered preference to the trust creditors.(48) It is also difficult to reconcile such a limitation with the construction of preference provisions In re Yagerphone Ltd requires. Accordingly, it appears to have been held In re McLernon; ex parte SWF Hoists and Industrial Equipment Pty Ltd v Prebble (49) that the recovered preference is available for distribution to the general creditors. This is to be regretted for the reasons of principle given above and here trust principles should prevail over insolvency principles.

Preferences and the Yagerphone principle: conclusion.

Except in the anomalous situation considered in Case 3, the In re Yagerphone Ltd principle prevails over other principles that might make recovered preferences available for proprietary claimants. But the secured creditor will generally be entitled to the benefit of the company's proprietary claim as part of the subject matter of its charge and may proceed against the recipient of the company's property. However, in such proceedings, it will not have the benefit of the presumptions of insolvency available to the liquidator and will have to prove an actual breach of duty if its claim is based on such a breach.

(1) Insolvency Act, s 212; Corporations Law, s 598.

(2) Coventry and Dixon's Case (1880) 14 ChD 660; Re Asiatic Electric Co Pty Ltd [1970] 2 NSWR 612. See Oditah (1992a). This was regarded as "an unwholesome state of things" in In re Anglo-Austrian Printing and Publishing Union [1895] 2 Ch 891, p 895.

(3) [Omitted]

(4) [1935] 1 Ch 392. Similarly, it appears that the United States, courts have rejected the argument that property recovered as a preference is the proceeds of a right to avoid a disposition, a right to which the security attached before the commencement of the insolvency: see Sanborn (1990), pp 1387-1388. One obvious reason is that the right to avoid preferences is not the company's right but the liquidator's. Another is that the right is not merely contingent on insolvency but does not come into existence until the insolvency commences: compare Prentice (1990), p 272. Because of 11 USC ¤522(a) (see above, n 174) it could be only by regarding the recovered preference as the proceeds of such a right that the recovered preference could be subjected to prior securities. For discussion of the theoretical doubts surrounding In re Yagerphone Ltd, see Wheeler (1993).

(5) N A Kratzmann Pty Ltd (in liq) v Tucker [No 2] (1968) 123 CLR 295, pp 301-304. See also Re Margart Pty Ltd (in liq); Hamilton v Westpac Banking Corporation (1984) 9 ACLR 269; Bayley v National Australia Bank Ltd (1995) 16 ACSR 38; Starkey v APA Transport Pty Ltd (1993) 12 ACSR 15.

(6) Note that if the recipient was a purchaser in good faith for value and without notice of the charge the security interest will not be enforceable against him or her. But if he or she knew or ought to have known that the company might become insolvent, the transaction will be avoidable as a preference. And arguably the security ought to be enforceable against the property in the company's hands: see Lowther v Carlton (1741) 2 Atk 242 [26 ER 549] and Wilkes v Spooner [1911] 2 KB 473 for the limitations of the good faith purchaser defence.

(7) N A Kratzmann Pty Ltd (in liq) v Tucker [No 2] (1968) 123 CLR 295, pp 301-304. [Omitted]

(16) [Omitted]

(17) See also Keay (1994), p 570; O'Donovan (1993), p 67. Compare Goode (1990), p 54.

(18) Starkey v DFC of T (1993) 11 ACLC 558, p 567 per McPherson JA; cited in Bayley v National Australia Bank Ltd (1995) 16 ACSR 38, pp 42-44. Both decisions concerned the legislation prevailing before the enactment of Pt 5.7B of the Corporations Law.

(19) No case appears to hold that traceable money preferences recovered as such are subject to the principle of N A Kratzmann Pty Ltd (in liq) v Tucker [No 2] (1968) 123 CLR 295.

(20) If the payment caused crystallisation of the charge, the money paid does not form part of the company's estate. It is then a question of priorities between the company and the chargee. On the traditional approach, because the company's entitlement depends on its having the payment set aside, its right will be characterised as an equity and the company's equitable interest will prevail. But see Linter Group Ltd v Goldberg (1992) 7 ACSR 580, above, text at n 51. Arguably the secured creditor will not need the liquidator's or court's leave to proceed, as the stay on actions in relation to the property of the company does not apply to actions by a secured creditor to realise its security: Corporations Law, ss 471B and 500(2).

(21) Compare, generally, Sherwin (1989), p 327, n 121.

(22) Re EVTR; Gilbert v Barber [1987] BCLC 646. Similarly, if a solicitor acting for a company in administration and holding a lien for unpaid costs on the proceeds of an action taken on behalf of the company transfers that sum from the client account to the office account, and, recognising that this is a contravention on the action to enforce a security without the consent of the administrator, retransfers the sum to the client account, the solicitor acquires a lien on the new balance of the client account: Euro Commercial Leasing Ltd v Cartwright and Lewis [1995] 2 BCLC 618. The case is, perhaps, explicable on the basis that the administrator's leave would have been given as of course.

(23) [1970] AC 567.

(24) [1987] BCLC 646, p 651b-c

(25) Presumably, however, it was held on a constructive trust on the terms of the secondary trust (not the initial trust) which would arise on the failure of the purpose: see Barclays Bank Ltd v Quistclose Investments Ltd [1970] AC 567.

(26) [1987] BCLC 646, p 652g.

(27) However, it is difficult to see that there had been a breach of trust.

(28) In re First Capital Mortgage Loan Corporation 872 F 2d 335 (10th Cir 1989).

(29) Angeles Real Estate Co v Kerxton; In re Construction General Inc 737 F 2d 416 (4th Cir 1984).

(30) id 737 F 2d 416 (4th Cir 1984), pp 419, 420. Compare N A Kratzmann Pty Ltd (in liq) v Tucker [No 2] (1968) 123 CLR 295 on recovery of the same property as that paid away preferentially.

(31) In re First Capital Mortgage Loan Corporation 917 F 2d 424 (10th Cir 1990), p 429.

(32) id 917 F 2d 424 (10th Cir 1990), p 427, quoting from 11 USC §550(a). See also 11 USC §541(a)(3).

(33) 917 F 2d 424 (10th Cir 1990), p 428.

(34) It should make no difference that in a personal bankruptcy the preference is repaid to the trustee in bankruptcy.

(35) This remains true even if the swollen assets theory of tracing explored in Chapter 4 is accepted, then. For if T retains property that that theory identifies as traceable proceeds of B's funds, then a proprietary claim should be possible in respect of them. But if T retains no such proceeds, that is, no assets of his or her own out of which he or she might have discharged the indebtedness to D, then there should be no proprietary claim. See below, Chapter 4, Section V.

(36) It is clear that a secured creditor of the trustee has no proprietary remedy in respect of the repaid preference if the security became fixed after the preferential payment was made: In re Yagerphone Ltd [1935] 1 Ch 392. However, it is impossible to argue that by parity of reasoning the beneficiary ought to have no proprietary remedy because In re Yagerphone Ltd depends not on analysis but on policy considerations.

(37) James Roscoe Ltd v Winder [1915] 1 Ch 62.

(38) Prentice argues, in relation to Insolvency Act, s 238, that such incentives may be discounted because the fact of insolvency is a precondition of the avoidance power vested in the liquidator: Prentice (1987), p 77. However, this misses the point of the argument of Jackson (1986), Chapter 6, and others. The problem with such incentives to bring on insolvency proceedings is not that they exist -- an argument which might legitimately be met by Prentice's argument -- but that they are differential incentives for different creditors or classes of creditors, thus undermining the insolvency legislation's attempt to solve the common pool problem. In relation to s 238 there is no differential incentive so Prentice's conclusion, if not the reasoning, is correct.

(39) These are likely to be satisfied as a matter of course. The intention to prefer (if one is required) is almost certainly to be found in the reconstitutive intention.

(40) In the unusual circumstances where T could recover the money from D, it is arguable that the money should be held on constructive trust for B.

(41) It has been suggested that the preference provisions do not apply to such a case because the trustee and beneficiary are not in a relationship of debtor and creditor, a precondition for the operation of the preference sections. The competing authorities are discussed in Ashburner (1933), p 149. The Insolvency Act appears to resolve the matter in favour of the view that such repayment may constitute a preference: ss 382(1) and 382(4) in the case of personal insolvency and Insolvency Rule 13.12, paras (1) and (4). In Australia, following dicta of Lord Halsbury in Sharp v Jackson [1899] AC 419, p 426, the matter has been settled in favour of the view that such a repayment may constitute a preference: see, for example, Re Donovan; Ex parte ANZ Banking Group Ltd (1972) 20 FLR 50, pp 68-69 (Fed Ct of Bankruptcy) [etc]

(42) See, generally, McPherson (1985); Re Suco Gold Pty Ltd (in liq) (1983) 33 SASR 99; Octavo Investments Pty Ltd v Knight (1979) 144 CLR 360. Nor do the trust creditors have any such direct right. (The trust creditors as between themselves are entitled to the trust assets in the order applied in administration actions, not the order specified by the bankruptcy or insolvency legislation (because these do not apply to assets held on trust, but see Re Suco Gold Pty Ltd (in liq) (1983) 33 SASR 99) or in order of the creation of the debts (McPherson (1985), pp 154-155).) If the trustee discharges such a debt with his or her own funds, then he or she has a right of recourse to the trust assets for that amount and a lien on the trust assets to secure that right. A trust creditor may succeed to that lien by subrogation (McPherson (1985), p 150, n 87) and that lien constitutes property available for distribution amongst the trustee's general creditors in bankruptcy or insolvency. If, however, the trustee has not discharged the debt, he or she may have recourse to the trust assets but only in order to pay trust debts. That right may be exercised by the trustee in bankruptcy or liquidator. However, the funds recouped are not divisible among the trustee's general creditors but only among the trust creditors.

(43) See Anderson (1992), pp 183-192.

(44) [Omitted]

(45) As a procedural matter, in an insolvency the recovered preference should be paid to the corporate trustee, but it was left unclear in Octavo Investments Pty Ltd v Knight (1979) 144 CLR 360, pp 371-372, to whom the recovered preference should be paid in the case of a bankruptcy. However, In re McLernon; ex parte SWF Hoists and Industrial Equipment Pty Ltd v Prebble (1995) 130 ALR 609, it was held that the preferences should be paid to the trustee in bankruptcy and not to the trustee of the trust.

(46) (1987) 33 SASR 99 (see McPherson (1985), p 157).

(47) McPherson (1985), p 158.

(48) Though s 588FF(1)(g) of the Corporations Law allows for an order "providing for the extent to which, and the terms on which, a debt that ... was released or discharged to any extent by ... the [preference] may be proved in the winding up of the company", this does not allow an order providing for the terms on which the other debts of the company may be proved.

(49) (1995) 130 ALR 609.

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