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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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advantage to the creditor. However, it is often the creditor who will seek to establish a running account in response to a notice by the liquidator seeking to set the transaction aside. The operation of the running account principle and the creditor defence are discussed in detail in the context of the 2006 reforms to the Companies Act.66

See Chapter III B Chapter II - Competing Policy Objectives

The previous chapter established that the voidable preference provisions exist to bolster the pari passu principle. Thus one would expect the rationale of creditor equality to underpin the voidable preference provisions. However, the legislative history demonstrates that the policy of equality has never been accepted as the sole objective at work. Two competing rationales can be identified, that of debtor deterrence and creditor deterrence, which have detracted from the primacy of creditor equality.

The debtor deterrence rationale was employed in the 1955 Companies Act and it is now widely accepted that this rationale was fundamentally flawed and in sharp conflict with the pari passu principle. However, the creditor deterrence rationale emerged in the 1993 Act through the ordinary course of business exception and it continues to compete with the creditor equality rationale in the current regime through the operation of the alteration of position defence. This chapter establishes that the creditor equality rationale, although not absolute, is paramount, and demonstrates that the policy reasoning behind the debtor and creditor deterrence rationales is both conceptually and practically unsound.

A. The Creditor Equality Rationale Under the creditor equality rationale, the principle of pari passu in the refined sense described earlier is seen as underpinning an avoidance regime. The Privy Council in Countrywide Banking Corp Ltd v Dean recognised that:67 “[T]he policy of voidable preference law is to secure the equal participation of creditors in such of the company's property as is available in the liquidation.” Like the pari passu principle, the creditor equality rationale can be upheld absolutely or in a qualified manner, through the creation of exceptions and defences. An absolute equality model creates a ‘super rule’ where all preferential transfers from the point of Countrywide Banking Corp Ltd v Dean [1998] 1 NZLR 385 (PC).

technical insolvency are set aside. Such a regime creates strict liability as the vulnerability of a transaction depends only on the factual assessment of whether a particular creditor received preferential treatment.68 A super rule achieves maximum equality between unsecured creditors but is not necessarily desirable. 69 Firstly, a super rule does not allow for a running account principle, which is an extension of an effects-based test that is consistent with the creditor equality rationale. 70 Secondly, there is force in the argument that setting aside all preferential payments from the moment of technical insolvency would disturb the finality of transactions to an unjustifiable extent. Setting aside transactions that fall within a set period, rather than from the moment of insolvency, helps to uphold the policy of finality of transactions.

Although an absolute equality regime is not recommended, the raison d'être of preference law is protection of the legislatively entrenched policy of equal sharing and it should be formulated in the manner that best achieves that policy. However, the debtor deterrence rationale was the initial foundation for voidable preference law. The focus on the state of mind of the debtor represented a failure to shrug off the last of preference law’s historical ties to fraudulent conveyances.71

B. The Debtor Deterrence Rationale

Under the debtor deterrence rationale, the objective of preference law is deterring debtors from setting themselves up as the lawmaker and judging the relative worthiness of creditors.72 The intention of the debtor to confer a preference is the crucial element in defining a preference. The following statement from Re Norris explains the reasoning behind the rationale:73 David Brown & Thomas G W Telfer “The New “Australasian” Voidable Preference Law: Plus Ça Change?” (2007) 13 NZBLQ 160 at 5.

Parliament briefly considered enacting a super rule when it reformed the personal bankruptcy regime in 1967. The rule would have given the Official Assignee the power to void any preferential payments to creditors made within six months prior to adjudication. However, the Parliamentary Committee examining the proposal stated that such a reform was undesirable because such ‘‘a power to upset payments made months ago could cause serious disruption to the business world.’’ See New Zealand Parliamentary Debates 20 July 1967 at 2071.

See Chapter III B for a discussion on the running account principle.

Lawrence Ponoroff and Julie C Ashby “Desperate times and Desperate Measures: The troubled state of the ordinary course of business defence – and what to do about it” 72 WALR 5 at 6.

Weisberg, above n 1, at 41.

Re Norris [1997] 2 S.C.R 168 (Can) at [21].

…[the fraud lies in] the accompanying intent of the insolvent debtor who in the face of imminent bankruptcy is moved to prefer or favour, before losing control over his assets, a particular creditor over others who will have to wait for and accept as full payment their rateable share on distribution… The debtor deterrence rationale is at odds with the pari passu principle as regardless of the state of mind of the debtor, a transaction that has the effect of preferring one creditor undermines the goal of creditor equality. However, the early avoidance regimes of most common wealth jurisdictions were based on a debtor intention test and the test has persisted in the English74 and Canadian systems.75 The emphasis on the debtor’s intention can be traced back to the beginnings of preference law in England where preference law developed as a branch of fraudulent conveyance law and a preference was thus viewed almost as a species of debtor fraud.76 In the 1758 case of Worseley v Demattos, Lord Mansfield first explained the policy behind avoiding preferential payments:77 If a bankrupt may, just before he orders himself to be denied, convey all, to pay the debts of favourites; the worst and most dangerous priority would prevail, depending merely upon the unjust or corrupt partiality of the bankrupt.

In that case the debtor retained possession of his stock after giving a deed and thus committed fraud under the famous Twyne’s Case. However, Lord Mansfield reasoned that even if possession had been given, a preference would still exist because it was an act performed in contemplation of bankruptcy. Thus preference law as a developed as a gloss on fraudulent conveyance law and a fraudulent intent on the part of the debtor was necessary in order to establish a preference.

The English regime requires that the company, in giving the preference, must have been influenced by a desire to improve the position of the person preferred, see s 239(5) Insolvency Act 1986.

E.g. Alberta Fraudulent Preferences Act, s. 2, Ontario Assignments and Preferences Act, s. 4(2) providing that the debtor must have intended an “unjust” preference”.

Charles Tabb “Panglossian Preference Paradigm?” (1997) 5 Am Bankr Inst L Rev 407 at 410.

(1758) 97 ER 407 at 412. A decade later Lord Mansfield cemented this policy in Alderson v Temple (K.B. 1768) ER 384.

The avoidance regime in the Companies Act 1955 was based on the debtor deterrence rationale. In order to set aside a preferential payment the liquidator had to establish that the debtor made the payment “with the view…to giving a preference.” 78 This required proof that the debtor had the “dominant intention to prefer a particular creditor” although “it need not be the only intention”.79 This presented a significant hurdle to the liquidator and the Court of Appeal in Tyree Power Construction v DS Edmonds Electrical stated “it has not often been thought worthwhile for the Official Assignee to invoke the section, whether in bankruptcy or in a company winding up”.80 The fallacy of the debtor intention test was acknowledged in the 1988 Insolvency Law Reform and its repeal was recommended.81 The Ministry of Economic Development (MED) acknowledged in the Tier One Discussion Documents that “any test that uses the debtor’s intention to prefer one creditor as the basis for setting aside transactions is at odds with the primary objective of voidable preference law, which is to achieve equality between creditors.” 82 The Companies Act 1993 abandoned the debtor deterrence model and the new legislation was a significant shift towards the creditor equality rationale. However, the reformers were unwilling to let go of the idea that there are some “vague, undefined transactions worth preserving”. 83 Thus after a debtor intention inquiry had been rejected, it was a natural progression to then consider the creditor’s state of mind under the creditor deterrence rationale.

C. The Creditor Deterrence Rationale

The creditor deterrence rationale emerges when the focus is on the race of diligence described earlier. 84 The argument is that, in the absence of preference law, those creditors who are aware of the debtor’s insolvency, and thus the looming equal sharing regime, will seek to ‘opt out’ of the collective proceeding and race for the Section 309 Companies Act 1955.

Re Northridge Properties Ltd, Supreme Court Auckland, M 46 - 49/75, 77/75 13 December 1977 at 36.

Tyree Power Construction Ltd v DS Edmonds Electrical Ltd [1994] 2 NZLR 268 (CA) at 273.

Law Reform Division, above n 6 at 94.

Ministry of Economic Development, above n 7, at 58.

Thomas G.W. Telfer “Voidable Preference Reform: A New Zealand Perspective on Shifting Standards and Goalposts” (2003) 12 Int Insolv. Rev 55 at 61.

See Chapter I A.

debtor’s assets in order to ensure payment in full. 85 However, if preference law reaches back to recapture preferential payments then creditors will be deterred from taking advantage of their superior knowledge and engaging in the race to dismember the debtor’s assets. The avoidance provisions, in effect, remove the incentive of “first come, first served”.86 Under the creditor deterrence rationale, the avoidance of preferences is further justified on the basis that a race of diligence upon insolvency is ultimately to the detriment of all creditors. Fisher J explained in Re Modern Terrazzo that if the race is left unchecked then the law “would encourage each creditor to try and steal a march on the others.... time and energy would be spent upon a communally unprofitable race to see which creditors would carry off the carrion first.” 87 The race is communally unprofitable because it imposes high monitoring costs upon creditors who must ensure that they have adequate information to not only know when the race has begun but also to secure a head start.88 The creditor deterrence rationale focuses on the creditor’s state of mind when receiving a preference.89 Only those creditors who have knowledge of the debtor’s insolvency are motivated to grab at the debtor’s assets and must be deterred while unsuspecting creditors would have no reason to engage in the race to dismember.90 Preference regimes based on the creditor deterrence rationale incorporate creditor knowledge as either an element of the cause of action or as a consideration in an exception or defence. Under the first approach, the liquidator must prove that the recipient creditor intended to receive a preference or knew that the debtor was insolvent.91 Under the second approach, the preferential effect of the transaction may be established but the transaction is protected if the creditor can prove a lack of Anthony Duggan and Thomas G.W. Telfer, “Canadian Preference Law Reform” (2006-2007) 42 Tex Int'l LJ (forthcoming) at 664; Thomas H. Jackson The Logic and Limits of Bankruptcy Law (Harvard University Press, Cambridge, 1986) 126 at 124-125 Keay, above n 15, at 75.

[1998] 1 NZLR 160, at p 174 Thomas H. Jackson “Bankruptcy, Non-Bankruptcy Entitlements, and the 
 Creditor's Bargain" (1982) 91 Yale U 857 at 857.

Duggan and Telfer, above n 86, at 665.

Tabb, above n 76, at 411.

The United States adopted this approach and employed a test that asked, in part, whether the creditor had reasonable cause to believe the debtor was insolvent at the time of the transaction. This test survived until 1978 when it was abandoned in favour of an effects based test.

intention to receive a preference or, more typically, lack of knowledge of the debtor’s financial circumstances. 92 New Zealand has followed the latter approach and the creditor deterrence rationale is evident in both the ordinary course of business exception under the 1992 Act and in the alteration of position defence after the 2006 reforms.

The Fallacy of Deterrence

If the creditor deterrence rationale is accepted as the correct foundation for voidable preference law, then the avoidance regime is an unqualified failure. There are overwhelming reasons why the provisions are not capable of achieving a deterrent effect. Firstly, there must be knowledge of the avoidance provisions in order for them to deter creditors. There is evidence to suggest that many creditors do not know the provisions exist, especially small creditors and non-lending institutions who are likely to be the unsecured creditors affected by the operation of the provisions.93 Secondly, the deterrence effect presupposes knowledge of insolvency. Only those creditors who are aware of the debtor’s financial position can know that the race of diligence has been superseded by the equal sharing regime and thus be deterred by the operation of the preference provisions. It is incorrect to assume that all creditors monitor the financial health of a debtor closely enough to know if insolvency has struck.

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