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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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The major exceptions to the pari passu principle are briefly described in the next section. The statutory distribution scheme is such that secured creditors receive first priority, followed by preferential creditors, and then the claims of unsecured creditors Goode, above n 7, at 177.

Rizwaan Jameel Mokal “Priority as Pathology: The Pari Passu Myth” (2001) 60 CLJ 3 at 581.

Goode, above n 7, at 79.

I F Fletcher, The Law of Insolvency (2nd ed, Sweet & Maxwell, London, 1990) at 2.

Tabb, above n 5, at 987.

are satisfied in accordance with pari passu. 21 A creditor can also surmount the pari passu principle to its own advantage by bringing itself within other recognised exceptions to the rule such as set-off, an agreed subordination of debt and other equitable claims. Although these exceptions represent an erosion of the pari passu principle, each is based on sound policy justification.

B. Exceptions to the Pari Passu Principle

–  –  –

The Companies Act defines secured creditors as those persons entitled to a charge on or over property owned by the company and the Act excludes property that is subject to a charge from the ambit of the liquidation. 22 The Act therefore expressly contemplates that secured creditors will operate independently of the liquidation,23 unless they decide to surrender their security.24 Despite the criticism of some commentators, 25 it is accepted that there are sound policy justifications for allowing the creation of charges. 26 However, it should be noted that the creation of some security interests or charges might be open to Leslie Theron “The Liquidation Process” in Paul Heath (ed) & Michael Whale (ed) Heath & Whale on Insolvency (online looseleaf, LexisNexis NZ) at [20.33]: if any surplus remains, it is used to pay deferred creditors and interest to creditors. If any surplus remains after satisfying all creditors, it is returned to the debtor or used to pay shareholders and other entitled persons according to their rights and interests in the company.

Section 2: “charge” is defined as a right or interest in relation to property owned by a company, by virtue of which a creditor of the company is entitled to claim payment in priority to preferential and unsecured creditors but does not include a charge under a charging order issued by a court in favour of a judgment creditor.

See Part 16 of the Act generally. S 240(1) makes it clear that secured creditors are excluded except for very limited purposes, s 248(2) states that liquidation does not limit the secured creditors' rights of enforcement, s 253 provides that the liquidator's principal duty is to take possession of the assets and distribute them or their proceeds to “creditors”, which, for this purpose, excludes secured creditors.

Section 305(1)(c).

For example, see R. Goode "Is the Law Too Favourable to Secured Creditors" (1983-84) 8 Can Bus LJ 53; Finch, above n 13, at 452 – 464.

Keay, above n 15 at 70. See also Australia’s Harmer Report, stating that the equality principle should not intrude upon the law as far as it affects security rights: Australian Law Reform Commission, General Insolvency Inquiry Report No 45 (Australian Government Publishing Service, Canberra, 1988) at [713].

challenge as either voidable transactions or voidable charges if the security was granted in the two year period prior to commencement of liquidation.27

2. Other proprietary claims

Claimants with proprietary rights are entitled to enforce their claims ahead of creditors with personal rights who are only entitled to claim a divided in competition with other ordinary creditors. Where a claimant holds proprietary rights in the company’s assets, those assets never form part of the pool of free assets available for distribution by the liquidator.28

3. Preferential creditors

Preferential creditors are unsecured creditors who receive priority status under Schedule 7 of the Companies Act. Such creditors include employees, the Commissioner of the Inland Revenue Department and creditors who are buyers under the Layby Sales Act 1971. The claims of these creditors must be satisfied after the claims of secured creditors and other holders of proprietary rights are met. Although the priority afforded to these creditors represents an exception to the pari passu principle, the principle retains some significance in that the claims of creditors within each class of preferential debt rate equally and rateably amongst themselves.30 Section 292(3)(a) includes the creation of a charge over the company's property as a type of transaction that may be subject to avoidance. A charge may also be avoided under s 293 if it was given during the specified period and immediately after it was given, the company was unable to pay its due debts. The charge must not have secured any new value provided to the company or have been in substitution for a charge given before the specified period.

Beneficiaries for whom the company holds assets on trust have proprietary rights and are entitled to enforce their claims ahead of ordinary creditors. For example, s 167(1) of the Tax Administration Act 1994 provides that every amount of tax withheld or deducted under the PAYE rules and the Accident Rehabilitation and Compensation Insurance Act 1992 (where applicable) shall be held in trust for the Crown and in the event of liquidation of the employer shall not form part of the estate in liquidation.





Where the employer has failed to deal with the tax in the required way, the amounts owing receive preferential status under Schedule 7 to the Companies Act 1993, see Appendix Two.

See Appendix Two.

Schedule 7, rule 2.1, see Appendix Two.

4. Set-off On liquidation, a creditor is able to set-off a debt owed to it by the insolvent debtor against a debt it owes to the insolvent. Only the balance remaining, if any, is either provable in the liquidation or payable to the liquidator. Section 310 of the Companies Act provides for a mandatory set-off upon liquidation where there have been mutual credits, mutual debts, or other mutual dealings between a company and an unsecured creditor.31 Set-off creates an exception to the pari passu principle because a creditor is able to resort to self-help by setting off the debts and thereby ensuring payment of his own claim ahead of other creditors. It is clearly preferable for that creditor to treat the debt as having been discharged by reason of set-off than to be required to meet the insolvent’s claim in full and then separately seek to recover as an unsecured creditor.32 The exception is justified on the grounds that insolvency law must assess obligations between a creditor and an insolvent on a net basis. The Supreme Court in Trans Otway Ltd v Shephard stated “it is regarded as unfair that someone who owes an amount to an insolvent person should have to pay it in full whilst exposed to the peril of receiving only a dividend, or nothing at all, from the estate in respect of an amount owed by the insolvent.” 33 A further justification is based on the need to uphold the legitimate expectations of the parties. Each party to the mutual dealings has extended credit on the basis that he can take what is due to him out of what he owes and this expectation must be upheld.34 Similar policy reasoning underpins the running account principle, which is effectively another form of set-off within the avoidance regime. The running account principle Section 310(1) Where there have been mutual credits, mutual debts, or other mutual dealings between a company and a person who seeks or, but for the operation of this section, would seek to have a claim admitted in the liquidation of the company, — (a) An account must be taken of what is due from the one party to the other in respect of those credits, debts, or dealings; and (b) An amount due from one party must be set off against an amount due from the other party;

and (c) Only the balance of the account may be claimed in the liquidation, or is payable to the company, as the case may be.

David Perry and Scot Abel “Set Off” in Heath and Whale on Insolvency, above n 30, at [30.1] Trans Otway Ltd v Shephard [2005] NZSC 76 [2006] 2 NZLR 289 at [15].

Goode, above n 7, at 190.

provides that where there is an ongoing relationship between the debtor and creditor so that the balance owed by the debtor is increased and decreased from time to time, the transactions are to be off-set against each other to determine if an overall preference has been created.35 Insolvency law’s acceptance of set-off and the running account test demonstrates that what the law is aimed at preventing is an overall diminution in the debtor’s assets and transactions or dealings that form part of wider series will be considered collectively rather than in isolation.

Set-off under section 310 is not open to challenge as a voidable preference. 36 However, the situation may be different where the parties carry out a set-off under their own agreement in the period prior to insolvency. In that case, a set-off may constitute an insolvent transaction as either a payment of money or a transfer of property.37

C. Reinforcing the Pari Passu Principle

Three mechanisms operate to swell the pool of assets available for distribution to unsecured creditors. The rule of invalidity and the anti-deprivation rule are sub-rules of the general common law principle that parties cannot contract out the insolvency legislation. These two rules continue to be applicable at common law. However, the voidable preference provisions are the liquidator’s real arsenal for making recoveries that will benefit unsecured creditors.

–  –  –

It is a long standing principle that parties cannot contract out of a pari passu distribution on liquidation. The English High Court recently stated that the principle of pari passu:38 Section 292(4B).

See Finnigan v He [2010] 2 NZLR 668 at [19] where Duffy J concluded that s 310 automatically extinguishes any debts that are subject to it and thus any amount set-off no longer exists and is unavailable for use as a payment for the purposes of a voidable transaction under s 292.

See Trans Otway v Shephard, above n 33, at [15] – [20].

HM Revenue and Customs v The Football League Ltd [2012] EWHC 1372 (Ch) at [64]. See also Stotter v Equiticorp Australia Ltd (in liq) [2002] 2 NZLR 686.

“applies not only to the basis on which the relevant office holder carries out the distribution, but importantly it also applies to any contractual or other provision which has the effect of distributing assets belonging to the insolvent estate on a basis which is not pari passu”.

The court has the power to strike down any contract or provision that has as its object or result a distribution of assets that it is inconsistent with pari passu.39 The intention of the parties is irrelevant and thus the principle applies to any agreement that undermines pari passu regardless of whether or not it is expressly triggered by the relevant insolvency procedure.40 Contracts that will be struck down are those that confer a benefit on a particular creditor and operate to divest the estate of an asset belonging to it at the time of liquidation.41 However, some agreements that adjust distribution upon liquidation are not considered to offend the pari passu rule. A creditor can validly agree to subordinate its own debt to those of the general body of creditors. 42 The legitimacy of debt subrogation agreements demonstrates that the law only seeks to prevent those adjustments to pari passu that prejudice the general body of creditors. A distinction is recognised between an arrangement that confers a preference on the general body of creditors by a single creditor agreeing to subrogate its debt and an arrangement where the general body of creditors, without assenting, is disadvantaged by the creation of a preference for a particular creditor or group of creditors.43

2. The anti deprivation rule

The anti-deprivation rule is aimed at a different mischief to the rule of invalidity in that it focuses on deliberate “attempts to withdraw an asset on bankruptcy or British Eagle International Airways Ltd v Cie National Air France [1975] 1 WLR 758 (HL) Ibid, at [14].

For example, contracts that provide for the transformation of unsecured debt to secured debt upon liquidation or an increase in security upon liquidation; contracts that confer a higher priority on a particular creditor; contracts that contain vesting clauses, such as a building contract that that provides for the vesting of the builder’s materials in the building owner in the event of the builder’s liquidation, see Re Cosslett Contractors Ltd [1998] Ch. 495.

s 313(3) Companies Act provides that where before the commencement of a liquidation a creditor agrees to accept a lower priority in respect of a debt than that which it would otherwise have had under the Act, nothing prevents the agreement from having effect according to its terms.

Stotter v Ararimu Holdings Ltd (in statutory management) [1994] 2 NZLR 655 at 8.

liquidation or administration, thereby reducing the value of the insolvency estate to the detriment of creditors”.44 The debtor must have a deliberate intention, assessed on objective grounds, to evade the insolvency laws45 and thus the rule will only apply if the deprivation is triggered by the insolvency proceeding.46 The rule is not necessarily concerned with an unfair advantage being conferred upon a particular creditor, but rather attempts to diminish the asset pool available for creditors generally. Thus the policy behind the anti-deprivation rule is broadly evident in the fraudulent preference provisions such as transactions at undervalue and transactions with insiders, while the policy behind the rule of invalidity is evident in the voidable preference provisions. However, the enactment of these provisions has not displaced the application of either the anti-deprivation rule or the invalidity rule at common law, which are broader in scope and application than the avoidance provisions.

3. The statutory avoidance regime

The statutory avoidance regime is the primary mechanism for upholding the pari passu principle. The operation of the avoidance regime can be best explained by focusing on its three key components: the relation-back period, the avoidance test, and exceptions and defences available to creditors.



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