Payments by Insolvent Companies: The Curse of the Voidable Transaction

Payments by Insolvent Companies: The Curse of the Voidable Transaction
Wednesday December 9, 2015

The commercial world can produce some odd and outright unfair results and outcomes.  A trader who provides an acceptable good or service is entitled to be paid the agreed price.  Receipt of payment concludes the bargain and the wheels of commerce move forward.  However, that all assumes the solvency of the company making the payment.  The assumption is, in most cases, practically if not actually impossible to confirm. So what happens when a payment is received from a company that is subsequently placed into liquidation?  The trader who received the money, which as a matter of law is by that stage the trader’s money, may be forced to pay an equivalent sum back to the company which has been placed into liquidation.  This not only seems, on the face of it, unfair, but it can also cause the trader (and others who have dealt with the liquidated company) to themselves become insolvent.

So why does the law allow this to happen? Section 292 of the Companies Act 1993 provides that payments made by an insolvent company to any of its creditors within two years of the company going into liquidation are “voidable” if, by way of that payment, the creditor received more than they would have received (if the payment had not been made) as a creditor in the liquidation of the company.   If a payment is void, then the creditor is obliged to repay the payment to the company’s liquidators so as to increase the total amount available to the liquidators to distribute to the company’s creditors (and to meet the liquidators costs).

Two recent rulings of the Supreme Court and Court of Appeal have significantly altered the manner in which the Courts will interpret and apply section 292 (and its related section 296).  In the process the Courts have greatly reduced liquidators’ ability to claw back payments made to creditors. The rationale behind section 292 is that fairness requires that, when a company has become insolvent, all of its creditors should share equally (in proportion to the amounts they are owed) in such funds, as are available to the company.  

To that end, if any creditors have in the lead-up to the liquidation been paid a greater proportion of what they are owed, than the other creditors are likely to receive in the liquidation, the payments should be clawed back into the liquidation so that the total pool of money can then be divided equally between the creditors in proportion to the amounts they are owed. Section 296 does provide a defence to such claw-back, but that defence is only available to a creditor in specific limited circumstances.

In practice, the goal of equal treatment of creditors is one which has, likely, never been achieved and will never be achieved.   This is because, in order to achieve such equal treatment, all preferential payments made by a company in the two years prior to its liquidation would need to be clawed-back into the company.   

In practice it is invariably neither cost effect nor affordable for liquidators to undertake the multitude of legal proceedings that would be required to claw back every preferential payment.   Instead liquidators have tended to cherry-pick, and seek to recover, only those payments where:

  • the amount involved is very large, so as to justify the costs of legal proceedings; or
  • the amount involved is so small that a creditor is unlikely to choose to (or unlikely to be able to afford to) take legal steps to oppose the claw back of the payment(s).

Arguably the use of section 292 in such a selective manner causes as much, if not more, unfairness and hardship for creditors than section 292 was meant to address.  

Equally arguable is the proposition that section 292’s primary use in practice is as a means for liquidators to obtain funds to meet their own costs, rather than to materially increase the funds available to the insolvent company’s creditors. Those problematic aspects of section 292’s operation have been exacerbated, until recently, by the manner in which the Courts have interpreted and applied sections 292 and 296: The Peak Indebtedness Rule Under section 292 where a creditor has had a “continuing business relationship” with the company (for example “running account”) all of the transactions taking place as part of that relationship are required to be consolidated and considered as one combined transaction.  I.e. the value of the goods and services supplied by a creditor are required to be set off against the amounts paid by the company to the creditor, and if the company has paid more than the value of the goods and services supplied, that difference is voidable.

Section 292 expressly requires all of the transactions to be considered as one consolidated transaction.  Liquidators had since the late 1990’s successfully argued (and the Courts had agreed) that liquidators could nominate any point of time they chose (so long as it was within the two year period prior to the company’s liquidation).  Once a liquidator made the point in time nomination, only the transactions from that point onward were considered as a consolidated whole for the purposes of section 292.  This has meant, for example, that liquidators could nominate a starting point for the consolidated transaction just after a creditor had made a large supply to the company, so that the value of that supply would not be included in the single consolidated transaction, but any subsequent payment by the company in respect of the supply would. In short, liquidators could choose as a starting point, the point of time at which the company owed the creditor the greatest amount, and on this basis argue that any reduction in the amount owing, from that point of time onward, should be voidable.  This was known as the “peak indebtedness” rule.

Section 296 Under section 296 a creditor cannot be ordered to repay a payment they have received if they can prove that, when receiving the payment, they had no knowledge of (or grounds to know) the company was insolvent, and they “gave value” for the payment. Again, since the late 1990s liquidators had successfully argued (and the Courts had agreed) that “giving value” for a payment required that the value be given at the same time as the payment was made or after the payment was made, but not before.   In other words, if (as is the norm) a creditor supplied goods and invoiced the company for later payment, the creditor could never rely on section 296.  Conversely, if the creditor obtained payment immediately upon delivery, or obtained payment in advance of delivery, the creditor could rely on section 296, but only if they could show that they had no knowledge of (or cause to suspect) the company’s insolvency.   

 In practice this approach meant that very few, if any, creditors could rely on the defence contained in section 296. Fortunately, the law has not remained static and two recent rulings in the Supreme Court and Court of Appeal have sought to significantly alter the playing field by providing some relief for creditors. Fences & Kerbs v Farrell [2015] NZSC 7 In February the Supreme Court reassessed the application of section 296, and in particular whether the provision by a creditor of goods and/or services prior to receiving payment should be sufficient to allow a creditor to avail themselves of the defence in section 296.    The Court held that such prior supply was sufficient. The situation has consequently now changed from it being very rare for creditors to be able to avail themselves of section 296, to being very commonplace.   Now, so long as creditors have actually supplied the goods and/or services they were paid for, and so long as they did not know (or have cause to suspect) the company’s financial difficulties, they will have a defence to any claw back under section 292. This very much returns the legal position to that which prevailed up until the mid-late 1990’s, where it was only rare payments that would be able to be voided, and in particular those where the creditor was tainted with knowledge that they were being preferred ahead of other creditors. Timberworld Limited v Levin & Ors [2015] NZCA 111 The Court of Appeal has in April held that the peak indebtedness rule is not good law, and has no proper basis on the wording of the statute.

While not expressly determined by the Court of Appeal, it now appears that all transactions forming part of a continuing business relationship must be considered, at least as far back as the period two years prior to the commencement of liquidation (i.e. the period within which transactions are potentially vulnerable to being voided under section 292).  This is not a perfect solution, in that there will still be many instances where a creditor’s supplies, and the subsequent payments, straddle that two year cut-off mark.    

However, this ruling does as with the change to the manner in which section 296 is interpreted, greatly reduce creditors’ exposure to claw back payments under section 292.

 

By Chris Patterson