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Insolvent companies and their creditors will soon face significant changes to New Zealand's liquidation laws. The voidable transaction regime has been overhauled, affecting all parties’ dealings with insolvent companies in the two years prior to liquidation. New restrictions on the use of phoenix companies should better protect creditors and shareholders, but may disadvantage companies with considerable value in their company name. These reforms are expected to come into force by mid 2007.
Voidable Transactions
Currently, under the Companies Act 1993, payments to creditors made by an insolvent company in the two years prior to liquidation are 'voidable transactions'. Liquidators may reclaim these payments if the creditor received more than he would have in a liquidation. The exception is payments made by the company 'in the ordinary course of business'.
Charges given by companies in the year prior to liquidation may also be set aside. There is no 'ordinary course of business' exception.
The Court has discretion under s292 to prevent liquidators reclaiming voidable transactions or charges from creditors who received the property in good faith and altered their position as a result of the transfer. Creditors objecting to a voidable liquidation. Any decrease in the amount owing is voidable. The provisions governing voidable charges will remain relatively unchanged, except that charges given by the company in the two years prior to liquidation can be set aside.
The new laws will be considerably different. 'Voidable transactions' will be termed 'insolvent transactions' and there will no-longer be an exception for transactions in the ordinary course of business.
Instead, a running account test will be adopted. This applies to transactions forming 'an integral part of a continuing business relationship', whereby the company's indebtedness is increased and decreased throughout the relationship. Common examples are overdrafts and continuing supply accounts between businesses.
The series of payments will be treated as a single transaction, recoverable only to the extent that it amounts to an insolvent transaction. Australian experience has shown that this can be judged in two ways, both producing slightly different results.
Under the 'ultimate effect approach', only payments (within the running account) that were made to discharge past indebtedness rather than ensure a continued business relationship are voidable.
Under 'the peak indebtedness rule' the peak amount of indebtedness over the prior two years is compared with the outstanding debt at the time of liquidation. Any decrease in the amount owing is voidable.
The provisions governing voidable charges will remain relatively unchanged, except that charges given by the company in the two years prior to liquidation can be set aside.
The s292 discretionary remedy has also been removed. Instead, recovery will be prevented outright where a person:
- acted in good faith; and
- gave value for the property or altered their position in the reasonable belief that the transfer was valid and would not be set aside; and
- did not have reasonable grounds for suspecting, and a reasonable person in their position would not have suspected, that the company would become insolvent.
Transactions will be set aside automatically, 20 working days after the liquidator serves notice, unless the creditor objects. Creditors no longer need to apply for a Court order. Instead they must give written notice to the liquidator specifying reasons for the objection, substantiated by documentary evidence. The liquidator may then take judicial action to have the transaction set aside.
Practical Implications
Creditors with knowledge of a company's poor financial position will be more vulnerable when conducting one-off transactions that cannot be classified as a running account. Isolated transactions which would currently fall under the 'ordinary course of business' exception will be set aside unless they can be brought within s296. As this provision will not apply if there were grounds for suspecting that the company would become insolvent, creditors with knowledge of a company's financial difficulties will have no recourse.
The effect of the 'continuing business relationship' test will depend on the approach used to determine the extent of the preference. Potentially, a liquidator's attempts to reclaim voidable transactions may be restrained. However, the 'peak indebtedness rule' may result in higher recovery by the liquidator, disadvantaging individual creditors in favour of the general creditors.
Requiring the liquidator rather than the creditor to initiate legal proceedings may disadvantage the general body of creditors. The onus of proof is effectively reversed, making it more difficult for liquidators to challenge transactions, as they risk creditors' money by commencing proceedings.
Phoenix Companies
Where a failed company sells its business as a going concern to a new company, this new company is a phoenix company. The sale as a going concern is more profitable than liquidation, so creditors will generally benefit from these arrangements unless the business is transferred at below market value. This problem mostly occurs prior to liquidation, while the directors are still responsible for the company.
The new reforms address this issue by preventing directors of a failed company from becoming directors of a similarly named phoenix company. Any person who was a director of a failed company in the 12 months prior to liquidation will be prohibited from directing, promoting or managing, any company or business with a name similar or identical to any name (including trading name) used by the failed company in the 12 months prior to liquidation. This prohibition continues for five years following liquidation.
This will prevent directors of failed companies setting up phoenix companies with a name that makes creditors think they are dealing with the former business. It will also prevent directors from profiting off the goodwill associated with the company name, reducing the incentive to abuse phoenix arrangements. The criminal penalties and possibility of personal liability for contravening the legislation will provide a further deterrent.
There are three exceptions to the prohibition:
- Where the phoenix company was known by the name of the failed company for at least one year prior to the failed company's liquidation, and was not dormant during this period.
- Where a successor company acquires the business under arrangements made by a liquidator, receiver, or deed of company arrangement, and names the director in a 'successor company notice'.
- Where a director applies for exemption from the Court within five working days of liquidation, the prohibition will not apply for the first six weeks or until an order is made.
Practical Implications
Any value in the company name will be lost at the point of insolvency. Purchasers acquiring businesses from insolvent companies (that are not in liquidation, receivership or administration) must be aware of this and ensure they do not pay for good will associated with the company name. It may also affect the likelihood of the business being rehabilitated.
As the prohibitions are concerned only with directors of companies in insolvent liquidation, they will not apply to directors of companies in receivership. Creditors with the right to appoint a receiver should consider the risk of phoenix companies being used to defeat their interests and may prefer liquidation.
This newsletter is produced by Simpson Grierson. It is intended to provide general information in summary form. The contents do not constitute legal advice and should not be relied on as such. Specialist legal advice should be sought in particular matters.
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