We picked the good faith defence in the voidable preference regime as one of the big five insolvency issues for 2013 and so it has come to pass, with a wealth of case law on the topic.
We take a look at a recent decision of the Court of Appeal, where a payment recipient which traded closely with the company in liquidation successfully relied on the good faith defence when faced with a voidable claim.
Giant Engineering Limited (Giant) manufactured and supplied equipment to the scrap metal and rubbish collection industry, and provided certain services to Rapid Construction Limited (Rapid) over a number of years.
After a fire at Giant’s premises, Rapid agreed to help Giant trade through by entering an agreement under which it would net the value of the services Giant had provided to Rapid against the value of the materials Rapid had supplied to Giant.
At the relevant point in time, Giant owed Rapid $129,482.22 and Rapid owed Giant $90,713.50. For reasons of accounting simplicity and transparency, the parties swapped cheques for those respective amounts. Giant later became insolvent and liquidators were appointed.
The liquidators challenged the payment out of Giant as a voidable transaction in terms of section 292 of the Companies Act 1993 (the Act). Rapid relied on the good faith defence under section 296 of the Act.
Section 296 provides a defence to payment recipients faced with voidable claims, and in this case allowed Rapid to argue that the payment by Giant was not voidable, because:
it was made and received in good faith (which involves an inquiry into whether the recipient knew of the counter-party’s insolvency)
Rapid did not have reasonable grounds to suspect Giant was or would become insolvent, and
Rapid gave value for the payment or altered its position in the reasonably held belief that the payment was valid and would not be set aside.
The Court of Appeal upheld the High Court’s decision1 and confirmed that Rapid had successfully made out the elements of the defence. Key to the Court’s reasoning was that:
Rapid honestly believed the payment would not result in any undue preference, nor would a reasonable person suspect as much. This was so despite Rapid’s knowledge of the fire at Giant’s premises, email correspondence between the two companies regarding late payments, and the fact that Rapid had agreed to the cheque swap arrangement in order to assist Giant in meeting its payment obligations
there is a distinction between knowledge of liquidity issues and knowledge of actual insolvency. A company may well have other means of meeting its obligations even where it does not have sufficient cash to hand. The Court accepted that Rapid saw Giant’s problems as "primarily logistical and not financial", and
Rapid had altered its position (to its detriment) by making the payment in reliance on the validity of Giant’s reciprocal payment (see our earlier comment on this limb of the good faith defence here). Rapid had foregone the opportunity to ‘set-off’ the two companies’ mutual debts, which is allowed by section 310 of the Act. This was a contemporaneous alteration of position and the Court agreed that such an alteration could meet this limb of the section 296 test.
Chapman Tripp comment
We agree with the Court’s comment that there is necessarily a difference between a creditor’s knowledge of liquidity issues and knowledge of actual insolvency. Just because a company does not have current cash at hand does not necessarily mean it is on the verge of liquidation or has no other means to make good with its creditors.
However, we also think that this is quite a fine line and that subsequent decisions could go the other way on different but similar facts. Ultimately, non-payment is a tell-tale sign of, or a stepping stone to, a state of insolvency.
The case could be seen as an encouragement to businesses that are willing to stay the course when a counter-party experiences an adverse event. But we caution that these types of decisions turn on heavily factual arguments.
It was not fatal to the defence that Rapid had knowledge of Giant’s short term liquidity issues. Had the evidence shown real concern about Giant’s ability to meet its long term obligations, however, the Court may well have taken a different view.