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«Gabrielle Smith A dissertation submitted in partial fulfilment of the degree of the Bachelor of Laws (Honours) at the University of Otago October ...»

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In Search of Equality: New Zealand’s

Voidable Preference Regime

Gabrielle Smith

A dissertation submitted in partial fulfilment of the degree of the

Bachelor of Laws (Honours) at the University of Otago

October 2011

Acknowledgements

Thanks firstly to my supervisor, Struan Scott, for his invaluable guidance, patience

and encouragement throughout the year.

Thanks also my friends and flatmates for providing lots of laughs and for making my

last year at Otago a fantastic one.

Finally, thank you to mum and dad, for their love and support.

i Table of Contents Introduction

Chapter I – The Primacy of Equality

A. The Pari Passu Principle of Distribution

1. Overview

2. The practical significance of the pari passu principle

B. Exceptions to the Pari Passu Principle

1. Secured creditors

2. Other proprietary claims

3. Preferential creditors

4. Set-off

C. Reinforcing the Pari Passu Principle

1. The rule of invalidity

2. The anti deprivation rule

3. The statutory avoidance regime

(a) The relation-back period

(b) The avoidance test

(c) Defences to a voidable transaction

Chapter II - Competing Policy Objectives

A. The Creditor Equality Rationale

B. The Debtor Deterrence Rationale

C. The Creditor Deterrence Rationale

Chapter III - The New Zealand Avoidance Regimes

A. The 1993 Companies Act: Towards Equality

1. An effects-based test

2. The ordinary course of business exception

(a) Possible policy justifications

(b) The emergence of the creditor deterrence rationale

B. The Company Amendment Act 2006: Equality Achieved?

1. The running account principle

(a) Rationale and significance

(b) The statutory running account test

(c) The “continuing business relationship” or “running account”

(d) The United States “subsequent new value” exception

ii (e) The peak indebtedness rule

2. The alteration of position defence

(a) Justifications for the defence

Chapter IV - Recommendations for Reform

A. Repeal Section 296(3) for Voidable Preferences

B. Shorten the Vulnerability Period

C. Amend the Running Account Principle

Conclusion

Bibliography

Appendix One: Companies Act 1993 ss 292, 294 – 296

Appendix Two: Schedule 7 Companies Act 1993

–  –  –

This dissertation seeks to answer the question “what is the objective of voidable preference law?” and analyses whether the current legislative regime achieves that objective. While there is general consensus that voidable preference law is an essential part of a broader insolvency regime, the best formulation of the law has eluded legislators for well over a century. 1 The difficulties in creating a workable preference regime may be attributed to the fact that the preference law lacks a clear policy foundation. This failure to understand and clearly articulate the goals of the legislation has lead to oscillation between competing models and significant reform to the preference provisions with each overhaul of New Zealand’s insolvency legislation.

The scope of this dissertation is limited to voidable preference law as it relates to corporate as opposed to personal insolvency. The general nature and policy of preference law is the same for both forms of insolvency under the Companies Act 1993 and the Insolvency Act 2006.2 However, the liquidation of companies presents a more complex range of issues and a more diverse range of creditor claimants.

Further, the voidable preference provisions are one category of provisions within a larger avoidance regime. The other categories of fraudulent preference provisions and voidable charges are not considered in this dissertation.3 What then, is a preference? Simply put, it is a pre-liquidation transfer that favours one creditor over the general body of creditors. When a preference is given by a debtor company, whether motivated by kindness, a sense of duty, or entirely incidentally, the company is, in effect, “robbing Peter to pay Paul”.4 The recipient of the preference obtains an advantage because it receives payment of its debt before R Weisberg “Commercial Morality, the Merchant Character, and the History of the Voidable Preference” (1986) 39 Stan L Rev 3 at 10.

The 2006 reforms to the insolvency legislation harmonised the law of preferences for corporate and personal insolvency and only few minor differences now exist between the regimes. For the personal insolvency avoidance regime, see ss 192 – 216 Insolvency Act 2006.

The fraudulent preference provisions govern transactions at undervalue and transactions for excessive or inadequate consideration with insiders, see Companies Act 1993, ss 297 – 299. Voidable charges are governed by s 293. However, the creation of a security interest may also be considered a voidable transaction, see s 292.

John Farrar "The Bankruptcy of the Law of Fraudulent Preference" (1983) JBL 390 at 390.

other creditors who may go on to receive little or nothing at all in the company’s liquidation. In essence, voidable preference law intervenes to ensure that the basic insolvency objective of equal treatment among creditors is not undermined by preferential transactions.





However, the mere fact of a preference is not treated as sufficient grounds to justify avoidance. Instead, the conventional wisdom is that there are ‘good’ preferences and ‘bad’ preferences, and only those of the bad variety are subject to avoidance and recapture. 5 Parliament’s search for the “plus” factor that will distinguish between ‘good’ and ‘bad’ preferences is ill founded and has caused unnecessary confusion in this area of law. A re-focusing on the fundamental objective of voidable preference law is required so that the destruction of equality is treated as sufficient to justify the avoidance of a preferential transaction.

Chapter One examines voidable preference law in its wider context of insolvency.

The primacy of the principle of pari passu is established and the voidable preference provisions are introduced as the primary mechanism to uphold that principle. Against this background, Chapter Two demonstrates that preference law has lost sight of its fundamental objective to protect the equality of distribution. Two competing rationales are examined: debtor deterrence and creditor deterrence. It is established that both rationales are based on flawed policy justifications and have served merely to distract from the creditor equality rationale that forms the true basis of voidable preference law.

Chapter Three analyses New Zealand’s voidable preference regimes since 1993 in light of the overriding objective of creditor equality. The legislative history demonstrates consistent shifts towards a more certain regime that treats creditor equality as paramount. However, various aspects of the present voidable preference regime are either inconsistent with the policy of equality or still incorporate the creditor deterrence rationale.

Charles Jordan Tabb “Rethinking Preferences” (1991-92) 43 SCL Rev 981 at 987.

After concluding that the current exceptions to the creditor equality rationale cannot be justified, Chapter Four proposes recommendations for reform to create a regime that affords the best protection to the principle of pari passu. The implementation of such recommendations would create a regime that is closer to strict liability which is the true nature of voidable preference law.

Chapter I – The Primacy of Equality

This chapter examines the voidable preference provisions in the wider insolvency law context. The pari passu principle is the fundamental principle of insolvency law.

However, this chapter establishes that various statutory exceptions to the notion of absolute equality between creditors means that there is often little or nothing left to be distributed amongst the general body of creditors in accordance with pari passu. The voidable preference provisions are the most powerful tool at a liquidator’s disposal to set aside those payments or transfers that have illegitimately subverted the equality of distribution and swell the pool of assets available to unsecured creditors.

A. The Pari Passu Principle of Distribution

–  –  –

One of primary aims of insolvency law is to ensure that the assets of the debtor are distributed amongst creditors in a fair and equitable manner that avoids conflict between creditors.6 The collective regime and the principle of pari passu lie at the heart of this objective.7 A pari passu distribution means all creditors share equally and rateably in the assets of the debtor. 8 The principle is well established and has been adopted in every substantive insolvency statute in England since the sixteenth century.9 The pari passu principle operates within a compulsory collective proceeding, such as liquidation, which requires each creditor to forfeit his right to take individual action to enforce the debt owed to him and participate equally in the debtor’s downfall.

Law Reform Division, Department of Justice Insolvency Law Reform: A Discussion Paper (Wellington, 1988) at 94.

Roy Goode Principles of Corporate Insolvency Law (3rd ed, Sweet & Maxwell, London, 2005) at 79.

Ministry of Economic Development Insolvency Law Review: Tier One Discussion Documents (Wellington, 2001) at 58.

‘Rateable’ here means in common proportions according to the extent of the pre-insolvency claims.

Goode, above n 7, at 78. s 313 Companies Act enshrines the principle by stating that after paying preferential creditors, the liquidator must apply the assets of the company in satisfaction of all other claims, which rank equally among themselves.

Outside of insolvency and the collective proceeding, a creditor is free to use whatever means are available to it to recover its debt. The principle of ‘first come first served’ prevails, creating a ‘race of diligence’ where the most vigilant and aggressive creditors are rewarded.10 This race is accepted when the company is solvent because each creditor can still expect full payment eventually. However, when the company becomes insolvent, payment of one creditor necessarily prejudices others because there are insufficient assets to satisfy all.11 Allowing the race to continue would result in the swiftest creditors dismembering the company’s assets and little or nothing would remain to be distributed amongst unsecured creditors generally. Such a result is viewed as inequitable. Liquidation appears in the law in response to this potential prejudice. The pari passu principle replaces the race premise as the defining principle and this shift is justified on the basis “equality is equity”.12 A pari passu distribution is not only equitable but also efficient. The pari passu principle provides an effective and orderly means of differentiating between the claims of creditors.13 This system keeps costs and delays to a minimum and prevents the need for courts to make difficult decisions based on the individual merits of each claim. 14 A pari passu distribution can also be explained on the basis of a wider objective of business survival. A debtor’s liquidation can have a ripple effect where the non-payment of a particular creditor may contribute to that creditor’s financial collapse, creating broader social and economic costs. This effect is particularly true for weaker creditors who are often unable to exert significant pressure to secure preference payments. 15 A rateable distribution spreads the effects of liquidation amongst all creditors, giving each an equal opportunity of surviving the debtor’s downfall.

Tabb, above n 5, at 988.

John C. McCoid ‘‘Bankruptcy, Preferences and Efficiency: An Expression of Doubt’’ (1981) 67 Va L Rev 249 at 260.

Tabb, above n 5, at 989 citing John N. Pomeroy A Treatise on Equity Jurisprudence (5th ed, Bancroft-Whitney and Lawyers Cooperative, San Francisco, 1941) at 144-59.

Alternative distribution rules could be based on the time at which the claim was established or the ability of the creditor to sustain loss, see Vanessa Finch Corporate Insolvency Law: Perspectives and Principles (Cambridge University Press, Cambridge, 2002) at 423.

Ibid, at 423.

Andrew Keay “In Pursuit of the Rationale Behind the Avoidance of Pre-Liquidation Transactions” (1996) 18 Syd LR 55 at 68.

2. The practical significance of the pari passu principle Despite the theoretical significance of the principle, a rateable distribution between creditors is rarely achieved in practice.16 There are two major reasons for this. Firstly, the law allows creditors to legitimately avoid the principle’s operation through the creation of security interests and other real rights. Secondly, statutory priority is conferred upon certain creditors. When the claims of these creditors have been satisfied, there is often very little remaining in the debtor’s estate for the pari passu principle to attach to.

The erosions to the notion of equality have lead to the argument that the principle of pari passu in distribution is a myth.17 It is argued that what the law disallows is not evasion of the pari passu principle but evasion of the collective proceeding generally.

The law would operate to avoid any arrangement that illegitimately evades the collective regime irrespective of the distribution rule on liquidation and therefore the real concern is to prevent creditors from using individual remedies to enforce their debts. This argument has force if the pari passu principle is taken literally to mean absolute equality between creditors. However, the principle is really invoked as a term of shorthand to describe what is in fact the general statutory rule of distribution.18 The principle of pari passu has been modified by statutory intervention, resulting in a stratified system of distribution whereby defined groups of creditors are given preferential status or enjoy some kind of priority.19 Thus the achievement of a pari passu distribution refers to the pro rata treatment of creditors who share the same priority claim to the debtor’s assets, not absolute equality. 20 If equality in this qualified sense is achieved, then the pari passu principle is a reality upon liquidation, not a myth.



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