The equitable doctrine of marshalling

 

In the recent case of Szepietowski v The Serious Organised Crime Agency [2013] UKSC 65, the Supreme Court has reviewed the equitable doctrine of marshalling. There are comparatively few reported cases in this area, and the Szepietowski case therefore provides useful guidance as to when a second secured creditor will be entitled to rely on the doctrine.

What is the doctrine of marshalling?

Marshalling comes into play where there are two or more secured creditors of a single debtor, but one of the creditors can enforce his claim against more than one security or fund and the other can resort to only one.

For the purposes of this article, the secured creditor who can enforce against more than one security will be called, “the Senior Creditor” and the other creditor, “the Junior Creditor”. The security or fund against which both the Senior and Junior Creditors can enforce will be called, “the Common Security”, the remaining security will be called, “the Other Security.”

In a situation where the Senior Creditor enforces against the Common Security, this necessarily leaves less available to satisfy the Junior Creditor’s claim. In a situation where there is insufficient remaining from the Common Security to satisfy the Junior Creditor’s claim, the doctrine of marshalling entitles the Junior Creditor to require (as between the Junior Creditor and the debtor) the Senior Creditor to be treated as having satisfied himself out of the Other Security to the extent necessary for both creditors to be paid. In practice, this is achieved by entitling the Junior Creditor to claim security over the Other Security to the extent that he has not been paid.

The principal question which arose in the Szepietowski case was whether or not the doctrine applies in a situation where the debtor does not owe a personal liability to the Junior Creditor (apart from a liability to apply the sale proceeds of the security to the sum claimed by the Junior Creditor).

Background facts to the case

The claim was brought by the Serious Organised Crime Agency (“SOCA”)(now replaced by the National Crime Agency). It was successful in the High Court (Henderson J) and in the Court of Appeal (Arden LJ, Sullivan LJ and Patten LJ), but dismissed in the Supreme Court. In 2005, the predecessor to SOCA, the Assets Recovery Agency, had obtained an interim receiving order against a number of properties held by Mr and Mrs Szepietowski. It was alleged that these properties had been acquired with the proceeds of criminal conduct, although no charges were brought against the Szepietowskis. Subsequent proceedings brought by the ARA to confiscate the properties were compromised by a settlement deed in 2008.

The consequences of that settlement subsequently gave rise to a lengthy application and a trial before Henderson J, followed by appeals in the Court of Appeal and the Supreme Court. It is therefore necessary to cover the material provisions of the settlement deed in some detail.

There were 20 properties in total. The general scheme of settlement was that 5 properties would be retained by the Szepietowskis, free of the receiving order (this included the family home, Ashford House) (“the Retained Properties”); 13 properties would be vested in the trustee for civil recovery outright (“the Transfer Properties”); and 2 further properties would be vested in the trustee, with a view to sale (“the Additional Properties”).

The settlement was complicated by the fact that all of the properties were charged to lenders. It was agreed that the Retained Properties and the Transfer Properties would be held subject to any existing charges. However, in respect of the Additional Properties, these were charged under an all monies charge to RBS together with Ashford House and 2 of the Transfer Properties. The parties therefore agreed a mechanism for the allocation of the debt owed to RBS as between the properties.

The parties having estimated the equity in each of the properties as at 2008, it was contemplated that the sale of the Additional Properties alone would enable the RBS charge to be repaid in full. Therefore as between the ARA and the Szepietowskis, it was agreed that the RBS debt would be paid out of the Additional Properties rather than the Transfer Properties (or, indeed, Ashford House).

However, since the Transfer Properties might be sold first (as, in fact, occurred), clause 4.5 of the settlement deed provided in the alternative for RBS to agree to its debt being transferred to the Additional Properties alone or for Mrs Szepietowski to grant a charge for any sums paid to RBS from the sale of the Transfer Properties.

This scheme was estimated to leave the total available to the ARA following sale of all of the Transfer and Additional Properties as £5.4m. Indeed, the settlement even contemplated that there might be a balance available after sale of the Additional Properties and discharge of the RBS charge, such that this balance would be due to the Szepietwoskis.

In the event, 2 things happened to upset the settlement scheme. Firstly, the Additional Properties were not sold first, and RBS refused to agree to its charge being transferred to the Additional Properties alone. Therefore when the trustee sold 2 of the Transfer Properties, the proceeds of sale had to be paid to RBS. Secondly, contrary to expectations in 2008, even the sale of the 2 Transfer Properties and the Additional Properties was barely enough to discharge the RBS charge.

In 2009, following the sale of the Transfer Properties but not of the Additional Properties, the Trustee required Mrs Szepietowski to grant a charge as contemplated by the settlement deed. A dispute arose as to whether the charge to be granted was solely over the Additional Properties, or also included the family home, Ashford House (which was also subject to the RBS charge). Henderson J determined this first issue in favour of the Szepietowskis – the charge was to be granted over the Additional Properties alone.

Even at the time it was granted, it was clear to the parties that the charge itself would not be worth very much, since there would likely be few proceeds of sale following discharge of the RBS charge. It was clear, therefore, that the charge was being sought by SOCA as a precursor to the marshalling claim to come. The argument would be that RBS was the Senior Creditor, SOCA the Junior Creditor and the Additional Properties were the Common Security. SOCA would seek to marshal to the Other Security, being Ashford House.

Under the charge which she granted, Mrs Szepietowski covenanted to apply the proceeds of sale of the Additional Properties, following discharge of the RBS charge, to payment of the amount paid by the Trustee to RBS from the Transfer Properties. The charge expressly provided that it did not include a covenant by Mrs Szepietwoski to pay the secured amount to SOCA.

Eventually the Additional Properties were sold and the amount paid to SOCA came to £1,324.16. SOCA therefore issued a further claim seeking to have its security over the Additional Properties marshalled with the remaining security held by RBS over Ashford House.

Decisions at first instance and Court of Appeal

Although Henderson J had previously held, on an earlier application, that Ashford House was excluded from the scope of the charge which Mrs Szepietowski was required to grant in favour of the trustee, he held that there was nothing in the settlement deed which excluded SOCA’s right to marshal against Ashford House: [2010] EWHC 2570. He accepted that marshalling is a doctrine of equity, and therefore was in the Court’s discretion [38]. Nevertheless, it is clear from his judgment that in his view only an express or implied exclusion of the doctrine of marshalling in the settlement deed would have been sufficient to prevent its application in the present case. He was also not impressed by the argument that since the charge granted by Mrs Szepietowski did not contain a covenant to pay the secured amount, there was no debt owed by her to SOCA upon which it could found a claim to marshal. His view was that the obligation to grant the charge presupposed the existence of a personal liability which was to be secured by the charge and that this was sufficient to establish the claim to marshal [45].

The Court of Appeal agreed with Henderson J that the terms of the settlement deed did not preclude marshalling: [2011] EWCA Civ 856. In a judgment given by Patten LJ (with whom the other LJs agreed), the Court concluded that the absence of an independent personal liability on Mrs Szepietowski to pay the amount secured by the charge was merely a factor going to the Court’s discretion in equity whether to allow marshalling [54]. Since the Court concluded that there was no contractual bar to the remedy, and there had been no representation to the contrary by SOCA, there was nothing to preclude the doctrine of marshalling [57].

Decision of the Supreme Court

The Supreme Court unanimously overturned the decisions of the lower courts. However, on their reasons for doing so, they were split 3:2 on an important issue as to when the doctrine of marshalling applies.

The Appellants advanced 2 principal lines of argument in support of the appeal: (1) that the absence of a debt owed by Mrs Szepietowski in the charge precluded marshalling and (2) that the construction of the settlement deed and the charge demonstrated that marshalling was precluded. A further line of argument that the right to marshal depends upon the Senior Creditor having equal access to the 2 securities (in the sense that one is not more difficult to enforce against than the other) was rejected by the Court. Beyond noting that Lord Neuberger held, “…it would require a contractually enforceable obligation, or something close thereto, on the first mortgagee to enforce against the common property in priority to the other property for the second mortgagee to lose his right to marshal” [75] this element of the decision will not be reviewed further here.

All of the Supreme Court Justices agreed with the second principal line of argument – viz. that marshalling was precluded having regard to the wording of the settlement deed, the charge and the material background to signing those documents. In particular, it should be noted that, contrary to the approach in the lower courts, the decision of the majority was not based upon a purely contractual analysis. Lord Neuberger (with whom Lords Sumption, Reed and Hughes agreed on this point) held that since marshalling is an equitable remedy, the question was whether it would be inequitable to allow it on the facts of the present case [61]. Accordingly, he held that in the absence of further material facts after the granting of the charge which would affect matters, the correct approach is to ask whether, in the perception of an objective reasonable bystander at the date of the grant of the second mortgage, taking into account, (i) the terms of the second mortgage, (ii) any contract or other arrangement which gave rise to it, (iii) what passed between the parties prior to its execution, and (iv) all the admissible surrounding facts, it is reasonable to conclude that the second mortgagee was not intended to be able to marshal [62]. It might be objected that the above test to decide whether or not it is inequitable to allow marshalling is not very different from the test one applies to interpret the contract (and hence determine whether marshalling is contractually excluded). Indeed, this was the basis for Lord Carnwath’s decision. He disagreed with the first instance and Court of Appeal judgments and held for Mrs Szepietowski, “…not so much on the basis that it would be ‘inequitable’ to allow marshalling against Ashford House, but that on the proper interpretation of the agreement in its statutory context that possibility is excluded” [92].

It was the first principal line of argument which divided the Court. The fault line of this division was whether or not marshalling responds solely to the fact that a Junior Creditor might lose his security as a result of the arbitrary decision of the Senior Creditor, or whether there is also a requirement that marshalling should have no net effect on the assets of the debtor. All of the Supreme Court Justices agreed that there was no money owed by Mrs Szepietowski to SOCA on the interpretation of the charge, other than such sum as was payable out of the proceeds of sale after payment of the RBS charge. The question was whether this prevented the doctrine of marshalling applying.

Lord Neuberger described the basis for marshalling between [32] and [38] in his judgment. On the basis of existing cases, he agreed with the statement that “marshalling is neutral in its impact upon the residue available to the debtor following the discharge of its creditors’ claims.” In the common situation where there is a personal liability in respect of which the charge has been given to the Junior Creditor, then the debtor does not really lose out as a result of marshalling. If the Junior Creditor could not marshal to the Other Security held by the Senior Creditor, then the Junior Creditor would simply be put to the additional trouble of needing to seek a charging order against that security. That is no real detriment to the debtor.

As with many aspects of security, the doctrine is most important in the situation where the debtor is insolvent. If the Junior Creditor’s security were not protected on insolvency, then an adventitious benefit would otherwise accrue to the Senior Creditor were he able to auction his decision as to which security to enforce against between the Junior Creditor and the unsecured creditors of the debtor. Lord Neuberger’s view was therefore that the basis for the doctrine is “the arbitrariness of allowing the first mortgagee’s decision as to which asset to enforce against to affect the second mortgagee’s rights.”

In the present case, Mrs Szepietowski owed no debt to SOCA, at least once the Additional Properties had been sold and the balance had been paid to SOCA. Accordingly, Lord Neuberger (with whom Lords Sumption and Reed agreed on this point) held that, “there is simply nothing, in particular no debt due from the mortgagor, from which the right to marshal can arise, once the common property has been sold and the proceeds of sale distributed in accordance with the legal priorities” [50].

Lords Carnwath and Hughes disagreed with this approach. For them the rationale behind marshalling is the arbitrariness of the Senior Creditor’s decision, it effects natural justice as between Senior and Junior Creditor, rather than as between Junior Creditor and the debtor or his unsecured creditors [101] and [107]. Accordingly, issues of construction aside, the existence or not of a personal liability on the part of the debtor does not affect the injustice as between Senior and Junior Creditors arising from the arbitrary decision. On this basis, neither Lord Carnwath nor Lord Hughes were prepared to accept that the absence of a personal liablility alone on the part of the debtor would preclude the doctrine of marshalling.

Despite the disparity between the majority and minority in relation to the “no debt” argument, passages from Lord Neuberger’s judgment suggest that they might have been closer to agreement than first appears. Lord Neuberger held that where there is no debt, “at least in the absence of special facts” [54] the right to marshal should “not normally” [56] exist. Lord Neuberger intentionally used the word “normally” since marshalling is an equitable remedy and there might be special circumstances which should mean it applies [58].

Bearing in mind that the minority had already determined that on the construction of the documents marshalling was precluded on the facts of the case, the difference between majority and minority seems to focus on whether one can say for certain that in all cases where there is no underlying debt, the parties must be taken to have excluded marshalling, or whether there might still be room for an interpretation of the charge on the specific facts that preserves the Junior Creditor’s rights against the debtor despite sale of the Common Security. Given that it is relatively rare that one finds a charge without an associated covenant for payment of the debt, it is therefore unlikely that the difference between the majority and minority will be of much importance.

Highbury Pension Fund Mangement Co v Zirfin Investments Ltd

It is useful to compare the decision in Szepietowski with another High Court and Court of Appeal case from 2013 in relation to the doctrine of marshalling: Highbury Pension Fund Management Co v Zirfin Investments Ltd [2013] EWHC 238 (Norris J) and Highbury Pension Fund Management Co v Zirfin Investments Ltd [2013] EWCA Civ 1283 (Court of Appeal). As in Szepietowski, the decision in Highbury had unusual facts and, coincidentally, also arose out of a restraint order under the Proceeds of Crime Act 2002.

A summary of the pertinent facts is that Barclays had provided loans to a number of companies (“the Affiliates”) in return for charges over properties held by the Affiliates. Barclays had also taken a guarantee in respect of the loans to the Affiliates from another company (“Zirfin”). The guarantee given by Zirfin was in turn secured by a charge over Zirfin’s property. Zirfin had then received a loan from the claimant, Highbury, which was secured by a second charge over Zirfin’s property. When the Affiliates defaulted on their loans, Barclays enforced the guarantee and the charge over Zirfin’s property. Following sale of Zirfin’s property, there was no balance available to Highbury in respect of its loan; there was also a balance still payable to Barclays. However, there was sufficient equity in the Affiliates’ properties to pay both Barclays and Highbury.

The issue was whether Highbury was entitled to marshal the security it had over Zirfin’s property with the securities held by Barclays over Zirfin’s property and the Affiliates’ properties. Highbury therefore sought, via marshalling, to enforce its debt against the Affiliates’ properties.

The problem which arose was that in this case there were 2 debtors – Zirfin and the Affiliates – and only Zirfin was a debtor common to both Barclays and Highbury. Could marshalling nevertheless apply in this situation? Norris J held that it could. This was on the basis that there is a longstanding (if ill-reported) exception to the common debtor rule in circumstances where the debtor (eg a surety) who has been required to pay the senior debt has an independent equity that the debt should be paid by the other debtor (eg a principal). For example, a guarantor is entitled to an immediate equity of exoneration as between guarantor and principal debtor, which arises whether or not the guarantor has paid the debt. In this situation there is said to be an exception to the general rule that there must be a debtor common to the Senior and Junior Creditors for marshalling to operate.

Norris J quoted with approval a passage from Ex parte Kendall (1811) 17 Vesey Jun 514 which concluded that, “the equity of the creditors in these cases is worked out through the equity, which the debtors themselves have”.

He also quoted from a passage in “The Modern Law of Guarantee” by O’Donovan and Phillips (para 11-40) which explains the exception as follows: “[The common debtor rule] is qualified where there is an independent equity which requires one debtor to pay the debts of another. In this situation, it does not matter that there is not one common debtor because the court will enforce the duty of the principal debtor to exonerate the secondary debtor by subjecting the principal debtor’s funds to the discharge of the debt of the secondary debtor. In other words, it is sufficient for the doctrine of marshalling that, as between the persons interested, the two debts ought to be paid by the same person even though that person may not be directly liable to the creditors for the two debts.”

Thus the decision at first instance was that Highbury was entitled to marshal to the securities given by the Affiliates. However, Norris J also held that Highbury was not entitled to enforce its marshalling rights over the Affiliates’ properties unless and until Barclays had been repaid in full. This was because a clause in Zirfin’s guarantee prevented Zirfin from asserting its subrogation rights in competition with Barclays. Norris J held that Highbury could have no better right than Zirfin, and was therefore prevented from enforcing the security over the Affiliates’ property until Barclays was paid in full. Since Barclays (for unexplained reasons) did not wish to realise its securities at that point, Highbury would have to wait. This aspect of the decision was appealed to the Court of Appeal.

The Court of Appeal disagreed with Norris J’s reasoning and held that Zirfin’s right as guarantor to be subrogated to the creditor’s rights against the principal debtor was entirely separate from Zirfin’s equity of exoneration as against the principal debtor.

In the present case, the equity of exoneration was the “gateway” to the assertion of marshalling rights by Highbury against the Affiliates – in short, what made it just that marshalling should occur despite the Affiliates not being a common debtor. However, the principal basis for marshalling is the arbitrary effect of the conduct of the senior creditor on the junior creditor’s ability to enforce its security. On that reasoning, the fact that Zirfin had contracted with Barclays that any subrogation rights it might acquire against the principal debtor should not be exercised until Barclays had been paid in full, could not affect Highbury. Being a contract to which Highbury was not a party, it could not affect Highbury’s marshalling rights.

Accordingly, the Court of Appeal held that (although it did not affect Barlcay’s prior ranking status over the securities) there was no impediment on Highbury enforcing its marshalling rights over the Affiliates’ properties without first waiting for a decision from Barclays to do so.

Although Zirfin was decided without the benefit of the Supreme Court’s decision in Szepietowski, the judgment of Lewison LJ accords with the majority’s reasoning. This is that the primary basis for equity’s intervention where a senior creditor has executed against the common security of a common debtor, when he could have enforced against alternative security (as in Szepietowski) or when he could have enforced against another debtor entirely (as in Zirfin), is the arbitrary nature of the senior creditor’s decision. That is, a decision which is arbitrary as regards its affects on the junior creditor’s rights (rather than arbitrary in the sense that the senior creditor’s decision is not explicable for commercial reasons).

However, both cases suggest that there is an additional requirement: that the impact on the debtor against whom marshalling is allowed ought to be neutral. Thus, in Szepietowski, marshalling would not have been neutral in its impact on the debtor, because he owed no further debt to the junior creditor once the common security was sold; in Zirfin, by contrast, marshalling was neutral in its operation since, by virtue of the equity of exoneration as between principal and surety, Barclay’s debt ought to have been borne by the Affiliates in any event. These two criteria provide a useful guide for testing whether a client might be able to rely on the doctrine of marshalling where it otherwise stands to lose its secured rights as a result of the actions of a senior creditor.

Henry Webb
Selborne Chambers