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Businesses sacrificed to lawyer-clericalism.

  • August 24th, 2013

Voidable preferences

Suppliers beware! You can now be made to repay many times more than you've ever earned from customers which go broke. Your money will go into the liquidators' pool for the benefit of the IRD, the banks and other secured creditors, Then after liquidator's expenses you'll share equally with other unsecured creditors in what is left. Often they include the people who've taken the company into insolvency. You have no entitlement to recover what you've supplied.
 

Our Court of Appeal confirmed this position late last month in Farrell v Fences & Kerbs Limited. More details appear later, but the decision means that the claw-back can apply to payments throughout the two years before insolvency of the customer company, even where:
a) there is no argument about the fair market value supplied,
b) you had nothing to do with the company's difficulties, and no knowledge or reason to know about them;
c) you've naturally passed on most of what you were paid, to your suppliers, subbies and employees; and
d) you are not an insider or in any position to direct the company's decisions, there is no question of any improper attempt to get unfair priority, or anything else out of the ordinary course of business.

How could the law be so stupid? Is this intentional, or an accident? Is this because we are copying other countries?
Answers – because we now routinely legislate by slogan, it is intentional and it is a foolishness all of our own. All the countries with which we usually compare ourselves have stayed with the soundly principled approach to voidable preferences inherited from the great English company law pioneers.

Sadly this is just one of many results of lawmaking by well-meaning people who think that the merit of law depends on the virtue of its intentions. Too many lawyers temperamentally cannot accept that the results depend on the practical incentives created by law's detail, not the nobility of the slogans they write into it. Lawyer/priests now infest the ranks of policy 'analysts' who guide and feed legislators, they infest the courts, and the law society (see Attorney General Chris Finlayson's recent exchanges on the Society's approach to the GCSB issues). Our Parliament is less infested than many, but only because we have a relatively low proportion of lawyers. On the other hand, astonishingly few of our legally qualified MPshave the education in reality of coal-face law practice, let alone any business law experience.

Unfortunately even practical experience does not convert people who are predestined to sacrifice others in the cause of noble slogans. In the case of the claw-back the slogan is "pari passu" or equal sharing. The small coterie of insolvency lawyers who serve liquidators contain too many who see nothing repellent in liquidators gouging penance payments from former creditors. Perhaps they think creditors deserve it for failing to recognise that they were dealing with a company heading toward liquidation.

In the past perhaps these worthy lawyer-clerics would have satisfied their clerical urges safely in the churches, or in other professions that rewarded ability to express 'feelings' and did not demand much mathematics or economics or other objectivity. For the past few decades they've been pouring into legal training.

Is there any way to protect yourself against such clericalism?
For most purposes the only practical protection against the claw-back exposure is to demand payment in advance. Third party guarantees could help, but even they have some technical fishhooks.
In many sectors a change in custom to requiring payment in advance could impose uncompensated cost for all concerned. There are powerful reasons for the near universal progress payment pattern in the construction industry for example.

Before the Court of Appeal decision in Farrell v Fences & Kerbs Ltd several lower court decisions had minimised the problem, by interpreting the relevant words to achieve a practical position close to what prevailed before the 2007 changes, and close to what prevails in Australia. The key distinction is whether the payment is in relation to a credit transaction, or is instead for value to be delivered after the payment. The lower courts held that a payment could be protected when it was to discharge a debt incurred for goods or services or other value already delivered. Our Court of Appeal says the exception from claw-back applies only to payments in advance of delivery of the value (good, services etc).

The Court of Appeal's approach is a legitimate and orthodox interpretation of the words introduced in 2007. But it would have been less worrying if the decision had shown some sign of recognition of the costs of the decision. Instead the Court appears to have felt it was doing God's work.

The 2007 law change finally abandoned the sound rationale for voidable preference law. Voidable preference provisions were first designed to reinforce the base structure of company law. That structure allows directors and management full control or so long as there is an equity shock absorber for the consequences of their good faith decisions in the interests of shareholders. When that shock absorber has gone, control must pass to representatives of the next tier stakeholders – the creditors.

Voidable preference law should discourage those who are about to lose their management powers, from abusing them to protect favoured creditors from the haircut they are all about to take. So most countries focus voidable preference provisions on transactions with insiders. The early terminology was direct. "Fraudulent preference" morphed into voidable preference, and now in NZ down to "insolvent transaction".

Worldwide, the orthodox approach to unfair preference¯ allows a relatively short period, 3 or 6 months, in respect of which all transactions are potentially reversible, and a longer period, typically several years, during which transactions with "insiders" can be reversed. For example, the Australian Corporations Law relation back¯ period is normally 6 months, but extends to 4 years if the payment was to a related party, or up to 10 years if the purpose was to defraud or delay the rights of creditors.

In New Zealand, the Court of Appeal has now held that the words used in our statute are not consistent with indications that Parliament thought it was broadly assimilating our law with Australian law.

The Court of Appeal intend to make the rule simple and predictable, without the need for future litigation. That has been achieved. With a few statutory exceptions most payments for goods or services supplied on credit can be clawed back if an insolvent customer goes into liquidation within two years.

The Court appears to regard the increased certainty of the law as self-evidently valuable, without appearing to weigh it against the consequential increased uncertainty over suppliers' income. With up to two years past payments at risk, uncertainty is unavoidable as business scrambles to change contracts. They will have to nullify the dire effects of the law. Perhaps auditors will have to take an interest in this. Should there be a claw-back contingency for businesses, as a part of their revenue for each preceding two year period if they work in sectors with high insolvency risks?

This is not a trivial problem. Consider for example a contractor with a long running building contract that consumes most of his capacity for two years. He might take all reasonable precautions to limit credit exposure, such as stopping work past payment deadlines until paid. Nevertheless he could face a claim for up to two years total revenue (not just profit), notified long after the job is finished.

Lawyers too are exposed. Not many clients would want payment in advance to become standard practice. I would not respond well. I find it more satisfying to work in expectation of being paid by a satisfied client after the outcome is known. There are rumours that the legal profession might help fund the certain appeal of the Court of Appeal decision to the Supreme Court.

In our opinion the Supreme Court could find it easy to reverse completely the Court of Appeal's approach to the issues but that is unlikely. It may need a substantially different theory of the case, and the legislative history is of decidedly mixed usefulness if the Supreme Court is minded to grant the appeal. A legislative solution could be better even if an appeal succeeds.

Business should be gearing up to ensure that government (as well as the Supreme Court) understands the differences between dynamic and allocational economic efficiency. Understanding that would make it less easy for sermons to pass for law reform 'analysis'. In this case a legislative solution could be very simple. Despite the customary Australian complexity, adoption of the Australian provisions would be less costly for New Zealand than extended years of pious legal service to our extremist equal sharing doctrine.

Comments

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  • Brendan
  • August 24th, 2013
  • 5:10 pm

Stephen

Is it possible to have indemnity insurance against this outcome?

Kind regards
Brendan

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  • peterquixote
  • August 25th, 2013
  • 3:06 am

thanks Stephen,
you continue to be the best advocate for ordinary New Zealanders. I sincerely believe that people will recognise your contribution
soon enough. I am me and I recognise.

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  • Tauhei Notts
  • August 26th, 2013
  • 11:11 am

This decision seems to be totally illogical, or I am getting the wrong end of the stick.
Would it be possible to give a hypothetical example of exactly how this decision could work.
The idea of trying to quantify the contingent liability for voidable preferences that might come out of the clouds in the next 24 months, it is just bloody silly.

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  • Stephen
  • August 26th, 2013
  • 7:46 pm

Yes Tauhei, and I cant tell how far that goes. Fortunately most of us do not work, most of the time, for companies that go broke

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  • Stephen
  • August 26th, 2013
  • 7:47 pm

I doubt it Brendan because of the moral hazard for the insurer. Having people become indifferent to whether they contracted with customers at risk of insolvency would be too problematic.

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  • Nikki Pender
  • August 26th, 2013
  • 10:14 pm

I’ve been trying to work out the full reach of this decision.

Eg Company B and its subcontractor C do work for Company A.
B is paid and pays C.
But for that payment, B would not have been able to pay C.
Company A goes into liquidation, B is forced to repay money and also goes into liquidation. Two year period not yet expired.
Does C then have to repay money on basis that A’s payment to B was contingent for two years meaning B was strictly unable to pay debts at time it paid C?

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  • Michael Arthur
  • September 20th, 2013
  • 9:15 am

Stephen, a small correction to your article. Proceeds of these claims go to liquidators fees, preferential creditors such as employees and IRD (in that order) and are then applied pro-rata to the pool of unsecured creditors. The Bank and other secured creditors can’t use their security to obtain these proceeds ahead of unsecured creditors. That may be cold comfort in many cases of course, as large IRD debts are common.

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Congratulations on your article Stephen; it is time this un-commercial nonsense was exposed for what it is. If I may extend Michael Arthur’s analysis of the priorities for payments in a liquidation. The reality is that most of the proceeds from voidable preference actions are fully absorbed by liquidators’ fees and those of their lawyers. It is rare for the ordinary unsecured creditor to receive a dividend from a liquidation. Since the law in this area was changed in November 2007, an industry has grown up of liquidators feeding on this stuff with significant negative impact on the businesses of innocent business owners. Bully-boy tactics are regularly used to coerce settlements on the back of threats of legal action (I have first-hand knowledge of this). If you would like to see an example in action, have a look at the liquidators’ reports in TSSN Limited. The first Statutory Report records the company had one creditor (IRD) and no assets. As of the latest report, two years later, the liquidators have received $124,000 from voidable preference claims and paid themselves and their lawyers $120,000 and the company now has five creditors. Nothing has been paid to IRD, let alone any other creditors!! Where is the commercial sense, or pari passu in that?

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  • Mark Thompson - Accountant
  • September 30th, 2013
  • 3:41 pm

Stephen
A sobering read! I fear for all SMEs supplying other SMEs and will immediately alter my own credit practices.
It seems ludicrous we would not follow Australia’s lead – their rules seem quite sensible.
Thank you for sharing this. I have suggested this be a matter of concern Tenby Powell’s SME lobby group pick up on…

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