Three times in the last 12 months, liquidators have been told by the High Court that they cannot choose the “point of peak indebtedness” as the start of the “continuing business relationship” in an insolvent transaction claim.
Of course, the three decisions are all from the High Court, and will not be binding in future cases. The law will not be settled until the appellate courts hear the issue, and they may yet come to a different conclusion.
If the continuing business relationship does not start at the point of peak indebtedness, then when does it start? We expect more litigation to come before we get a clear answer.
Continuing business relationship – the basics
Under section 292(4B) of the Companies Act 1993, 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.
Liquidators, and a number of creditors, will be very familiar with the basics of the “continuing business relationship” analysis in an insolvent transaction claim. We have previously written here about how it operates, and the general concept is uncontroversial.
However, 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 point of the debtor company’s inability to pay its debts (but no earlier than the start of the specified period), 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).
In 2010, the High Court indicated an early preference for option three, but with no real discussion.1
But in Levin v Z Energy,2 and across two earlier decisions, the Court has said that the peak indebtedness approach is 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”.
We agree. Denying the point of peak indebtedness as the starting point is consistent with upholding pari passu sharing as the primarily policy basis for New Zealand’s voidable transaction law. To arbitrarily exclude some transactions is to ignore not only the words of the statute (“all of the transactions”) but also to distort the comparison between what the creditor did get, and what it should have got.
So when should the continuing business relationship start?
In Z Energy, the Court said that the continuing business relationship started at the very beginning of trading between the creditor and the company in liquidation, when the running account was zero. In doing so, the Court followed the earlier decision in Shephard v Steel Building Products (Central) Limited.3
But the approach adopted in Z Energy and Steel Building was the result of the fact that, in each case, the trading relationship started within the specified period and at a time when the debtor was unable to pay its due debts.
That will not be the case in all voidable transaction claims. It is not uncommon in voidable transaction claims that the parties started their trading relationship years, if not decades, before the specified period. In that scenario, does the continuing business relationship include the entire trading history?
The November 2013 judgment in Levin v Timberworld Ltd4 answered that question. Unlike in Z Energy and Steel Building, the trading relationship had started before the specified period. In reaffirming that a liquidator cannot choose the point of peak indebtedness as the start of the “single transaction”, the Court expressly rejected the idea that the continuing business relationship should start at the very beginning of trading. It said that the single transaction should start from the beginning of the specified period (having already accepted that the debtor company was unable to pay its debts throughout the specified period).
The one point not addressed by the cases to date is when the continuing business relationship should start if the debtor’s inability to pay debts arises after the start of the specified period. In that scenario, we say that all debts and credits after the point of inability to pay debts must be counted, and none prior. That would give effect to the underlying pari passu sharing policy.
If transactions prior to the onset of insolvency (but after the start of the specified period) were counted, that could (if payments exceeded supplies in that period) result in the effective avoiding of a net payment that occurred when there was no insolvency to form a jurisdictional basis for the claim.
At the time of writing, it is not known whether any of the “peak indebtedness” decisions have been or will be appealed.
The Supreme Court is currently grappling with another significant insolvent transaction issue, namely the scope of the section 296(3) “good faith” defence. We have written about that litigation here, here and here.
At the root of that issue is policy-based balancing of interests of the wider body of creditors (represented by the liquidators), and the interests of the individual creditors who have received payments.
Whichever way the Court decides to balance those interests, it will determine the policy direction of insolvent transactions law in New Zealand, and could influence any further decision on the continuing business relationship.
We will keep you updated.
Chapman Tripp’s earlier articles on insolvent transactions cases are available here and here. Chapman Tripp’s paper on the state of insolvent transactions law, as presented to INSOL in March 2014, is available here.