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The Nuclear Option pays off

The recent case of COD Hyde Ltd v Space Change Management Ltd [2016] EWHC 870, in the Chancery Division of the High Court, concerns when it is permissible to use insolvency proceedings – i.e. a winding up or bankruptcy petition, or the threat of them - to obtain payment of an interim payment application.  There are not that many reported cases on their use in the construction field, and it is gratifying that now and again the courts get the opportunity to remind us that, where there is a clear debt – not simply a claim - this remains a viable course of action.

Insolvency proceedings will, in the case of a company, result in its winding up and their appointment of a liquidator to bring its financial affairs to an orderly end.  The ‘presentation’ of a winding up petition at court (insolvency speak for issuing proceedings), and their advertisement in the London Gazette should result in bank accounts being frozen, notification to other creditors, and any dispositions the company makes are potentially void unless validated by the court. The repercussions mean that this step must be preceded by a written warning, usually a statutory demand. The debtor has 21 days in which to pay the demand and, if it fails to do so, there is a presumption that the debtor is unable to pay its debts as and when they fall due, so paving the way for insolvency proceedings.  Using a statutory demand against a company debtor is not compulsory, but an unpaid one gets the benefit of the presumption.

The debtor company may seek to prevent the proceedings on a number of grounds.  The most commonly deployed are that the debt is disputed on substantial grounds which are ‘real not frivolous’, or that the debtor company has a cross-claim or ‘set-off’ which is genuine and based on ‘substantial grounds’.  The debtor company should apply for an injunction to restrain the creditor from presenting its petition, and getting its injunction will depend on the veracity of its defences or cross claims.

COD was the employer and Space Change was contractor under an amended JCT Design and Build Contract 2011.  Three interim payment applications went unpaid, without Pay Less Notices, between October and December 2015, totalling £680,629.27. Space Change wrote to COD, firstly giving 7 days’ notice of its intention to suspend work under cl.4.11.1. if payment was not made within 7 days, and secondly specifying the failure to pay as a breach of contract under cl.8.9.  COD failed to pay within 14 days of that letter, so once a further 21 days had elapsed, Space Change exercised its contractual right to terminate the contract.  Space Change also served a statutory demand on COD, which it still failed to pay. 

COD refused to pay and applied for an injunction, contending that the debt was disputed, accusing Space Change of suspending works without reasonable cause and of failing to put a performance bond in place, and failing to diligently proceed with the works.  It rolled these belated claims into its own default notice under cl8.4. COD also employed alternative contractors.  Tit for tat solicitors’ letters then followed concerning who had rightfully terminated the contract; COD’s ability to deploy cross-claims depended on Space Change’s termination being judged unlawful.

The court held that Space Change had been entitled to rely on the provisions of the contract concerning interim payment, suspension and ultimately termination, and had properly exercised its rights.   COD on the other hand, had only made ‘general assertions’ concerning alleged breaches, had served no contemporaneous default notices in respect of them, and the interim applications were not answered by valid Payment Notices or Pay Less Notices. Moreover, COD had not, at any time prior to Space Change’s termination of the contract, contended that Space Change had repudiated the contract by walking off site.  COD also contended that it had cross-claims arising out of Space Change’s failure to diligently proceed with the works, and which exceeded the amount of the statutory demand.  However, COD adduced no credible evidence to justify that assertion or demonstrate what quantum of loss COD had sustained. The judge refused COD permission to rely on further evidence to bolster its own application for an injunction. 

In contrast to previous cases, the judge did not rehearse at length the tests by which defences might be judged to be ‘real not frivolous’, or cross claims are to be regarded as based on ‘substantial grounds’.  He  simply referred to a single previous Court of Appeal case,  Tallington Lakes Ltd v South Kesteven District Council [2012] EWCA Civ 443, in which Etherton LJ said

“I have to emphasise,…that it is well established that the threshold for establishing that a debt is disputed on substantial grounds in the context of a winding-up petition is not a high one for restraining the presentation of the winding-up petition, and may be reached even if, on an application for summary judgment, the defence could be regarded "shadowy".”  

Basically, COD’s claims against Space Change rang hollow because it had taken no steps to protect its position prior to the service of the statutory demand or Space Change’s termination of the contract.  COD’s injunction application lacked veracity in terms of both its allegations of breaches by Space Change and the quantum of its own alleged cross claims. Its case was judged so weak that it was not even credible, let alone coherent but ‘suspect’ (if that is what is meant by ‘shadowy’).  The injunction was refused, and Space Change would have a clear run to presenting a winding up petition.

Statutory demands are the prelude to insolvency proceedings, and can force prompt payment by the payer of an interim application which fears being wound up.  However, they should not be used lightly, and only with the expectation that an injunction application may well follow. Generally, courts charged with enforcing an adjudicator’s decision only seek to ensure that that decision was properly arrived at, whereas insolvency courts are obliged to consider all defences and cross claims raised by the payer of an interim application. It is not enough for the payer to have failed to serve Payment Notices or Pay Less Notices; defeating an application for an injunction will also depend on destroying the payer’s supposed defences and cross-claims too.  The victor at the application hearing is highly likely to obtain a costs order in its favour.  If the payer/applicant’s defences and/or cross claims are sufficiently clear and well evidenced, then the insolvency court will conclude that there is no clear debt, but a dispute which should not have been brought before it. The court is likely to award the payer/applicant its legal costs on an indemnity basis, i.e. the payer/applicant gets nearer to 100% of its legal costs.  Costs are typically ordered to be paid within 14 days, thereby increasing the payee/respondent’s losses, in addition to its unpaid interim application. 

Resorting to a statutory demand is, therefore, a high risk strategy. In COD Hyde, it paid off for Space Change because COD had no credible defences or cross-claims.  However, where there is some truth in, say, an employer’s allegation of contractor delay which, when made out with sufficient veracity, reveals the existence of a dispute, it would not be prudent to risk incurring an application for an injunction.   Often at this point, ‘discretion is the better part of valour’, and the payee resorts to adjudication and/or the paying party takes the matter to court, as in In  Jawaby Property Investment Limited v The Interiors Group Limited [2016] EWHC 557 TCC which I covered last month.

If you are a contractor considering to resorting to a statutory demand, it is recommended that you seek legal advice on how to ‘shape’ the situation (as Space Change did in terminating the contract) and receive a sound evaluation of the robustness of the ‘debt’ and any potential rebuttals, given the risks and penalties if the process is instigated without a sound foundation.

Employers can reduce the risks of a statutory demand by ensuring that valid Pay Less Notices are served on time. Correct use of default notices, plus robust delay analysis and loss calculations, will enhance employers’ prospects of obtaining an injunction. The sooner the defences and cross-claims are communicated, the more credibility they will have.

If you are unsure whether it is appropriate to serve a statutory demand, or have one served on you, then speak to us.

These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.

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