«Gabrielle Smith A dissertation submitted in partial fulfilment of the degree of the Bachelor of Laws (Honours) at the University of Otago October ...»
The main goal of the repeal of the ordinary course of business was to remove uncertainties and inconsistencies. At the time of the reforms, it was stated that “it would be ironic if New Zealand were to jettison nearly eight years of jurisprudence on the ordinary course of business if only to replace it with a new source of litigation”.
However, the two-limbed test of suspicion involves the examination of the same issues only with different terminology and in the form of a defence, rather than an element of the cause of action.159
The MED in the Tier One Discussion Documents justified the alteration of position defence on the basis that the pursuit of collective justice for creditors as a whole must be tempered by individual justice for particular creditors in the circumstances of each case.
The concern is that without a creditor defence, there would be no flexibility to deny recovery in circumstances where forcing a creditor to return a preferential payment may be unjustifiability harsh on that creditor. Such an occasion would be rare as generally creditors have altered their position through the continuation of supply and Brown & Telfer, above n 69, at 10.
Ibid at 11.
are thus protected by the operation of the running account principle. Furthermore, as established in the previous section, the line between a successful and an unsuccessful defence is often marginal. Those creditors who are protected by the defence are not necessarily any more deserving than those creditors who are denied protection due to the arbitrary operation of the reasonable suspicion test.
Nonetheless a risk remains that without a creditor defence there is no opportunity to promote individual justice where the circumstances require it. However, it is important to remember that the legislation exists to protect creditors collectively.
Potential harm to an individual creditor cannot justify the erosion to policy creditor equality by allowing certain creditors to retain preferential payments. This idea was put succinctly by Baragawanath J in Re Anntastic Marketing Ltd:160 “It is to be remembered that the unfortunates who did not get paid are faceless, represented only by the liquidator. The inevitable sympathy for honest claimants who, having had the misfortune to deal with an insolvent now face the prospect of having to repay the money received from it long after the event, must not affect the judgment whether those who were never paid at all are entitled to equality of treatment”.
The fact is that if the aim of the avoidance provisions is to ensure that there is equality between creditors, then any preference which causes the debtor’s assets to be dissipated jeopardises that aim, regardless of whether the creditor can establish alteration of position or lack of knowledge of insolvency.161 If preference law is to uphold the fundamental principle of creditor equality and allow for a true pari passu distribution, and reduce the level of uncertainty and litigation surrounding voidable preference law, the alteration of position defence cannot be justified. The true nature of preference law is akin to strict liability and thus any attempt at distinguishing between ‘innocent’ and ‘guilty’ creditors on the basis of knowledge is misplaced.
Re Anntastic Marketing Ltd, above n 119.
Keay, above n 155, at 177.
Chapter IV - Recommendations for Reform The 2006 amendments to the voidable preference provisions meant that New Zealand came very close to achieving a regime that upholds the fundamental rationale of creditor equality. However, the current regime could work better than it currently does both in terms of ease of application and faithfulness to the underlying goal of a pari passu distribution. Firstly, the alteration of position defence is an unjustifiable erosion of the objective of creditor equality and it should be repealed in relation to voidable preferences.
However, an absolute equality regime is not recommended. There are two valid competing policy objectives that should be given weight within a voidable preference regime; the finality of transactions and the facilitation of credit to financially distressed debtors. The policy of preserving the finality of transactions can be effectively upheld by a shorter, single relation-back period. The current specified period of two years is excessively long and would upset the finality of transactions to an unjustifiable extent within the stricter regime proposed.
The policy of encouraging the provision of credit is encouraged through the existing running account principle. The running account test should be amended so that its operation is consistent with “ultimate effect” premise and to create greater certainty for creditors. These recommendations are consistent with policy of equality and also reduce concerns that the repeal of the alteration of position defence will be unjustifiably harsh to individual creditors. The implementation of these three recommendations would allow preference law to serve its fundamental purpose of bolstering the pari passu principle.
A. Repeal Section 296(3) for Voidable Preferences
Section 296(3) applies to any recovery made by a liquidator under the Companies Act
1993. The defence should only be repealed in relation to voidable transactions. This requires section 296(3) to be amended to state that the defence is not available in relation to any order made under section 295.
Repeal of the defence will result in an avoidance regime that is strict liability in nature. Avoidance will depend only on the liquidator establishing that the transaction occurred within the specified period and was of preferential effect. In the case of a running account or continuing business relationship, the liquidator may only allege a preference if ultimate effect of the dealings is to confer a net advantage on the creditor. It will still be open to a creditor to establish a running account or continuing business relationship where the liquidator has not done so or to prove that the company was solvent at the time of the transaction.
B. Shorten the Vulnerability Period
As previously established, the policy of finality of transactions is upheld through the use of a relation-back period as opposed to setting aside all transactions from the moment of technical insolvency. A set vulnerability period allows for greater certainty and prevents a costly factual inquiry in every case.
The cut-off point for any vulnerability period will always be arbitrary. However, the policy of repose is served by a defined preference period and the need for commercial certainty dictates that the period be a relatively short one. 162 In 2001 the MED recommended that there should be a single vulnerability period, as opposed to a restricted and a specified period, of six months from the date of commencement of liquidation.163 I support the MED’s prior proposal for a single, shorter vulnerability period. A single period that coincides with the presumption of insolvency is simpler and more certain.
However, I recommend that the vulnerability period for voidable transactions be three months from the date of commencement of liquidation. The MED proposed a six month vulnerability period on the basis that the alteration of position defence would still be available to creditors. Australia uses a six month relation-back period but also has the alteration of position defence.164 The proposal for a stricter regime calls for a Ponoroff, above n 97, at 1516 Ministry, above n 7, at 65.
Section 588FE Corporations Act shorter time period. A three month period would be consistent with the 90 day vulnerability period employed in United States regime which is also more akin to strict liability.165 The current specified period of two years is excessively long and although there is limited empirical evidence in relation to New Zealand companies, it is unlikely to match the period of technical insolvency before liquidation commences.166
Presumption as to Insolvency
The presumption that the company was unable to pay its debts during the specified period should remain. It is very difficult for a liquidator to retrospectively establish insolvency, especially as there are often limited funds to challenge preferences. The presumption of insolvency considerably assists the liquidator in commencing proceedings when a creditor objects to a notice setting aside a preferential transfer.
In saying that, it is even more difficult for a creditor to prove solvency in the specified period given that creditors, unlike the liquidator, do not have easy access to the company’s financial records. Thus the presumption of insolvency could theorectically lead to some transfers being avoided when the company is actually solvent but the creditor is unable to establish this.
However, this risk is outweighed by the advantage to creditors generally from the presumption of insolvency. If the liquidator was required to prove insolvency in the specified period, costs would be significantly increased as a court case would generally always be required to establish insolvency. This increase in costs would reduce the pool of funds available to unsecured creditors.167 Furthermore, the risk that the company was actually solvent in the three months prior to liquidation is relatively s 547 Bankruptcy Code. Note, however, that the United States uses two relation-back periods, one is a one month period with no defences whatsoever and the other is a three month period where various exceptions are available.
United States research has shown that companies are generally insolvent for the period of 90 days before liquidation has commenced, see the Harmer Report, above n 26, at ; Elizabeth A. Orelup, "Avoidance of Preferential Transfers Under the Bankruptcy Reform Act 1978" (1979) 65 Iowa L Rev 209 at 217.
David Brown Voidable Transactions - A Report for the Ministry of Commerce, (Wellington, 1999) at 79.
low. The shorter vulnerability period is more likely to reflect the length of a de facto ‘cash flow’ insolvency prior to formal insolveny.168 The presumption should remain rebuttable by the creditor. If the company was solvent at the time of the transaction then the creditor is entitled to keep the preference because at that point in time the race of diligence is still permitted and the principle of pari passu is yet to take hold. Thus it should remain open to the creditor to establish solvency if it has grounds to do so.
C. Amend the Running Account Principle
The running account principle has been identified as a principled extension of the effects-based test. However, two problems currently undermine the efficacy of test.
Firstly, issues arise concerning the relationship between the alteration of position defence and the assertion of a continuing business relationship. Secondly, the operation of peak indebtedness rule is unfairly prejudicial to creditors.
If a creditor is found to have a reasonable suspicion of insolvency and is thus precluded from relying on the alteration of position defence, such a finding may also bring the continuing business relationship to an end. This means that payments and advances made after that point cannot be included in the series of transactions to be netted out.
The policy justification for the running account principle is that insolvency law generally is concerned with the net economic impact of the dealings between a creditor and a debtor. The knowledge or intentions of the parties is irrelevant to that assessment. The counter argument is that if purpose is treated as irrelevant then the running account principle may encourage collusion between a debtor and creditor.169 As liquidation draws near, the creditor may have an ‘unused balance’ of value and thus the company and the creditor may arrange for the company to make payment to the creditor in an amount equal to the un-used balance, thus ensuring that no net Brown, at 79.
W Stacy Jr Johnson “The Running-Account Creditor and Section 547(c)(4) of the New Bankruptcy Code” 16 Wake Forest L Rev. 962 (1980) at 973; Ponoroff, above n 97, at 1475.
preference is created but a payment has been made that did not have the continuation of supply as its predominant purpose. It is submitted that regardless of whether the parties had such an intention, the net economic impact on the company’s assets remains unchanged by the purpose of the payment.170 Thus suspicions of insolvency should not prevent the running account principle from operating. If the alteration of position defence was to be repealed, then this problem may be minimised. However, the common law on the running account principle still requires a predominant purpose of payment to be established and thus suspicion of insolvency would remain relevant.
The second concern is the operation of the peak indebtedness rule. This rule allows a liquidator to choose when the continuing business relationship begins and thus select the period of peak indebtedness. Such a rule permits the liquidator to ignore the true economic impact of a series of transaction and ignore the value of full supply advanced during the specified period.
These two issues could be addressed by amending section 292(4B) to specify which transactions must be considered as a part of a continuing business relationship. The transactions to be netted out would be those that occurred between the date of the commencement of the specified period and the date of commencement of the liquidation. This would allow for a true assessment of the net economic impact of the mutual dealings between a creditor and the company during the vulnerability period.
Furthermore, this strengthening of the running account test would offer greater protection to those creditors who continue to deal with a financially distressed debtor.
Thus amending the running account would achieve the dual goals of ensuring substantial equality among similarly position creditors while still promoting the continuation of trade with a distressed debtor.