Liquidators’ ability to recover funds for unsecured creditors has been strengthened in one context and weakened in another by two recent court judgments.
The Court of Appeal in Farrell v Fences & Kerbs Limited1 has overturned previous decisions from the High Court, which had considerably widened the availability of the “good faith” defence for creditors. But the finding is interim only, subject to a further hearing on a closely related issue.
In contrast, the second decision (from the High Court) has increased creditors’ access to the “continuing business relationship” defence to minimise their insolvent transaction liability.
“Good faith” defence – value must be provided at the time of payment, but what is “value”?
Prior to October 2007, a creditor could rely on the “good faith” defence to an insolvent transaction claim only if it had acted in good faith and relied to its detriment on the validity of the transaction (most commonly, a payment by a debtor).
In 2007, the defence was expanded so that it now also protects a creditor who had acted in good faith and who “gave value” for the allegedly voidable payment.
It had been commonly understood that that “value” must have been provided at the time of, or after, the allegedly voidable payment.2 However, the High Court last year in the Farrell and Meltzer cases, found that value given prior to the payment by the debtor would also be enough to satisfy the defence.
Because every creditor will have provided value (by advancing the credit in the first place), a payment to a creditor would never be voidable where the creditor acted in good faith and had no reason to suspect insolvency.
The main reasons for the High Court’s decisions were that:
- the October 2007 amendment to the New Zealand statute was intended to align our law with Australia. In Australia, it is well-established and widely accepted that a creditor who gave value prior to the voidable payment will be able to rely on the “good faith” defence, and
- it would be “inequitable” to allow the company in liquidation to keep what it has received (goods or services supplied) and to recover what it paid for those goods or services, in order to increase the distribution to other creditors who have provided other goods or services but received no payment – in essence letting the general body of creditors have their cake and eat it too.
The Court of Appeal has now overturned those decisions. From a policy standpoint, the Court made it clear that the rationale for the insolvent transaction provisions is to “swell the pool of funds available to the company to be shared rateably amongst all creditors of the same class in accordance with the pari passu principle”. The interests of each unsecured creditor are to be superseded by the interests of the body of unsecured creditors as a whole. The analysis adopted by the High Court would undermine that policy.
The Court essentially found that there was no evidence of Parliament, in October 2007, intending to expand the good faith defence in line with Australia. Although Parliament may have generally indicated its intent to harmonise New Zealand’s insolvent transaction law with that of Australia, it did not go so far as to suggest that it intended to follow the Australian Corporations Act provisions in every respect. In particular, the Court noted that the terms of the Corporations Act provisions were substantially different, and in particular did not stipulate a temporal link to the time when payment is received (unlike the New Zealand provisions).
Further, the Court looked at the fact that section 296(3), prior to the 2007 amendments, and its predecessors all required proof of detriment to the recipient of the payment (i.e. the creditor). The recipient typically had to show that the order for repayment would render the recipient worse off than if the payment had never been received. Allowing creditors to avail themselves of the good faith defence where value had been given prior to payment would be a significant policy shift. None of the materials provided to the Court signalled that Parliament had intended such a shift.
All that said, the Court has left the door ajar for the creditors in these appeals. The Court noted that the creditors could argue that value was given following the payment by either forbearing to sue or by the creditor discharging the antecedent debt.
On that analysis, the creditor would give value by:
- forbearing to sue for unpaid parts of the debt in question, or
- forbearing to sue for other debts the debtor owes to the creditor, or
- forbearing to sue for losses suffered by the creditor as a result of the unpaid debts, or
- discharging the debtor from its liability for the debt.
If the Court accepted that argument, it would once again make the defence widely available to creditors.
Although the argument is technical and very closely related to the arguments already run, the Court declined to rule on it as the liquidators had not addressed it in their submissions, and the creditors had only addressed it briefly. The Court left those issues open until further argument could be heard.
We will continue to monitor developments in relation to any further submissions to the Court of Appeal and a possible appeal to the Supreme Court.
“Continuing business relationship” – “peak indebtedness” rule not adopted
Before October 2007, an insolvent transaction was not voidable by the liquidator if it took place in the “ordinary course of business”. That defence was necessarily dependent on the facts of each individual case, and generally created uncertainty for both creditors and liquidators.
In 2007, the ordinary course of business defence was repealed, and Parliament instead introduced the concept of a “continuing business relationship”, a well-established element of Australian insolvent transaction law.
Under section 292(4B) of the Companies Act, when a set of transactions is an integral part of a continuing business relationship between a company and its creditor, and the company’s indebtedness fluctuates (for example, as part of a running account), then all of the transactions together must be considered as one single transaction. The effect is that, if that single transaction may be classified as an insolvent transaction, then the liquidators can only claim the difference by which the balance of the company’s account has been reduced over the period of those transactions.
Determining the start of the continuing business relationship has been hotly debated by insolvency practitioners and lawyers in the last few years. In theory, there are three possible options:
- at the time of the very first transaction between the creditor and the company in liquidation (when the running account balance is $0), or
- at the start of the specified period (typically two years before the application to put the company into liquidation is filed), or
- at the point of “peak indebtedness”, as chosen by the liquidator, to maximise returns to unsecured creditors (by maximising the difference between the opening balance and the closing balance).
The High Court in Shephard v Steel Building Products (Central) Limited has, for the first time in New Zealand, issued a decision on this point. In short, the Court did not allow the liquidators to choose the point of “peak indebtedness” as the starting point of the continued business relationship. In the Court’s view, the peak indebtedness approach would be inconsistent with the basic principle of the continuing business relationship test, which is to place the transaction in the wider context of “all the transactions forming part of the relationship”.
On the facts of that particular case, the only payment that fell outside of the continuing business relationship was a final payment of $12,000 by the company made one day before liquidation took place. The Court’s view was that the purpose of that final payment could not have been to induce the creditor to provide further goods or services (given that it was made one day before the company was put into liquidation), and was therefore merely intended to reduce the debt. For that reason, the last payment could not be part of a continuing business relationship.
The Court’s approach of starting the continuing business relationship at the very start of trading between the creditor and the company in liquidation, when the running account is zero,3 will limit the quantum of a liquidator’s claw backs if it is followed in future. It would likely restrict liquidators to recovering, at best, only final payments made to a creditor immediately prior to liquidation, like the $12,000 payment in Shephard.
At the time of writing, it is not known whether the decision in Shephard will be appealed.
However, much like the Farrell and Meltzer decisions in the High Court (before being overturned), this is a decision with significant implications for liquidators in their recoveries of insolvent transaction payments. We will keep you updated about any developments in this case.