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insolvency

Creditor compromise regime

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Another option in insolvency

When a company is struggling to pay its bills, ‘insolvency’ and ‘reckless trading’ are frightening words that may be thrown around the table. On 3 April 2020, as the first wave of Covid lockdowns hit, the government introduced a brief ‘safe harbour’ regime. Its purpose was to protect directors of New Zealand companies from being held liable for trying to stay afloat and it permitted a company to trade whilst technically insolvent. This protection was removed on 30 September 2020. In this article we discuss an alternative to liquidation or receivership. Using the ‘creditor compromise’ regime can return better outcomes for both the company and its creditors.

When is a company ’insolvent’?

A company is considered insolvent when it cannot pay all debts as they fall due or the total debts of the company are greater than its total assets. The company could be recklessly trading if the directors allow the business to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors. Allowing a company to trade when it is insolvent can put the directors at risk of being held personally liable for reckless trading. The directors could also be personally liable if they allow the company to incur an obligation unless they reasonably believe the company will be able to perform that obligation when required. The consequences of reckless trading or breaching those director obligations can be significant. In the well-publicised and ongoing Mainzeal case, directors were found personally liable for $36 million after allowing the company to trade recklessly.[1]

Options for an insolvent company

When directors of a company establish that it is no longer solvent, few choices are available. The two most common options are liquidation and receivership. Either option can be voluntary (the company elects to go through the process to ensure compliance with the Companies Act 1993) or involuntary (a creditor or group of creditors may force the company into the process).

Receiverships and liquidations have very detailed processes and procedures, and need skilled independent advisors, including lawyers, accountants and insolvency professionals, to guide the company through the process and liaise with creditors.

There is, however, another choice that may be appropriate for a company facing insolvency.

What is a creditor compromise?

Creditor compromise is a lesser-known option that is available when a company cannot meet its debts. The company proposes an alternative (the ‘compromise’) to all creditors, such as forgiveness of part of the debt or extended timeframes for repayment, and then calls for all creditors to vote on the compromise. If passed, all the creditors are bound to that compromise, and cannot put the company into liquidation or receivership.

It is important when entering into a creditor compromise that the directors are confident the company can commit to the terms of the compromise; failing to meet the terms could lead to significant consequences for the company and its directors, including personal liability for reckless trading.

A creditor compromise can be preferable for a company and its directors for many reasons. No public notice is required, and the terms of the compromise are often kept private therefore reducing reputational damage to the company.

Aside from those obvious advantages, a creditor compromise also allows the directors to retain control over the company and its assets, the compromise is binding on all creditors, and it can provide a means for the company to slowly return to solvent trading. For the creditor, the compromise often allows them to receive more in the long run than they would have received under a liquidation.

The process

A creditor compromise follows this process:

  1. Directors drive the process: A creditor compromise plan is usually driven by the directors. They identify that the company is insolvent, or at risk of being deemed insolvent, and look for a ‘compromise’ that will allow the company to manage its debts.
  2. Appoint independent manager: The directors appoint a professional to manage the process and develop the creditor compromise plan. It can be an accountant, lawyer, or insolvency professional (or often, a combination) who are experienced in navigating solvency issues.
  3. Identify classes of creditors: A critical, and most often litigated, step, is the classification of all creditors into appropriate classes by the independent manager. This usually starts with secured creditors, followed by unsecured creditors. The grouping of creditors into ‘classes’ is not a straightforward process, and it is crucial to get this right to ensure the creditor compromise is binding.The manager must understand features of each creditor such as their dependency on the debt, size of the debt, size of the creditor, the financial strength of each creditor and more.As this step can lead to court action, incorrectly classifying the company’s creditors can lead to the entire compromise arrangement being overturned by the court and the company being placed into liquidation.[2]
  4. Present the creditor compromise plan for key creditor agreement: Whilst not a legislative step, once a preferred plan has been outlined most companies find it prudent to engage with their key creditors at this stage to ensure there is agreement to the plan. If key creditors aren’t satisfied the plan will give them a better result than liquidation or receivership, the creditor compromise is unlikely to succeed and there is no point progressing further. Sometimes key points of the agreement are negotiated at this point before a final version is circulated to all creditors.
  5. Formally notify all creditors: Once the creditor compromise plan is finalised, the key information is circulated to all the company’s creditors. It must include specific information including naming the acting parties, events that have led to the compromise situation, the compromise proposal itself, an assessment of what the creditors would receive in a liquidation (to allow them to compare their options), and a full list of all creditors and the estimated amounts owing. This key information also includes the method by which the creditors can vote. A minimum of five days’ notice must be provided to creditors to review the creditor plan and submit their votes.
  6. Vote: If the creditors vote to approve the plan, it will be binding on all creditors regardless of which way they voted. In order to ‘pass’, at least 50% of the number of creditors and 75% of the value of the creditors in each class must approve the compromise. If the compromise is not approved, a liquidation or receivership may result.

Regardless of whether you are a director of a company facing insolvency, or a creditor who has discovered a company which is indebted to you has, or may, become insolvent, seeking experienced legal advice on insolvency is key.

Directors will need a good legal or insolvency advisor to discuss all available options to get the best result for the company and its creditors, as well as ensuring there is protection from the risk of an accusation of reckless trading.

As a creditor, an advisor will ensure you are fully informed of all options that could lessen your total losses.

If you would like to know more about how a creditor compromise works, or if your company is heading towards insolvency, please don’t hesitate to contact us.

[1] Mainzeal Property and Construction Ltd (in liq) v Yan and Others [2019] NZHC 255

[2] Trends Publishing International Ltd v Advicewise People Ltd [2017] NZCA 365

 

DISCLAIMER: All the information published in Fineprint is true and accurate to the best of the authors’ knowledge. It should not be a substitute for legal advice. No liability is assumed by the authors or publisher for losses suffered by any person or organisation relying directly or indirectly on this newsletter. Views expressed are those of individual authors, and do not necessarily reflect the view of Edmonds Judd. Articles appearing in Fineprint may be reproduced with prior approval from the editor and credit given to the source.
Copyright, NZ LAW Limited, 2022.     Editor: Adrienne Olsen.       E-mail: [email protected].       Ph: 029 286 3650

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Business troubles? Bet you haven’t thought of these options…

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overwhelm

Sometimes it makes no sense for creditors to shut down a business. In these instances there are legal mechanisms available to companies and business owners to make compromises with creditors possible and, to an extent, put the fate of the company or the business owner/s in the hands of common sense.

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The difference between ‘misrepresentations’ (which may support a claim for damages) and ‘mere puffery’ (being statements no reasonable person would take seriously) isn’t always clear. Enticing a purchaser into a contract by misrepresentations was a costly mistake by the vendor in a recent case. (1)

Aldrie Holdings Ltd (through its director Ms Laboyrie) purchased a farm for $2,900,000, but failed to make proper investigations before confirming the contract. Instead Aldrie chose to rely on statements made by Mr Prout, the vendor’s agent. Mr Prout boasted that the level of pasture, milking shed and water at the property were ‘excellent’. Given Ms Laboyrie’s general business experience, the judge held that these statements were clearly puffery as a reasonable purchaser would have made further enquiries to validate those claims.

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The Fences & Kerbs case may help you

As we approach the first anniversary of the Supreme Court’s decision in what is known as the Fences & Kerbs case (1) where three appeals were heard and ruled on together by the Supreme Court, we revisit the significance of the decision for creditors of insolvent companies and voidable transactions.

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What happens to Kiwisaver funds in bankruptcy?

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Voidable Transactions – Can be a significant risk for businesses

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When an insolvent company goes into liquidation it’s accepted that not all creditors will get paid 100 cents in the dollar. However it often comes as a shock to creditors when the liquidator requires them to refund payments that had been made up to two years before the company was liquidated.

The liquidator of a company has an obligation under the Companies Act 1993 to fairly distribute the company’s assets to its creditors. In doing so the liquidator may choose to claw back payments which the company made from up to two years before the liquidation. The liquidator then makes those funds available to the general body of creditors. The payments that are clawed back are called ‘voidable transactions’.

Voidable transactions pose a significant risk for businesses that trade on a credit basis; the construction industry is a particularly good example. In the last six years following the 2008 property market collapse, there have been numerous liquidations of companies throughout the construction industry and, consequentially, many demands for repayment of transactions considered ‘voidable’.

It’s about fairness to all

The voidable transaction regime, as contained in ss292-296 of the Companies Act, operates on the assumption that a liquidated company trades while insolvent for some time before it’s placed into liquidation. It’s therefore considered fair that all parties who traded with the company during that period of insolvency bear an equal burden of having traded with an insolvent company. While a demand from a liquidator to refund a, usually long overdue, payment may not seem that fair when you receive it, the overall objective of the voidable transaction regime is not to penalise creditors but to achieve fairness to all. This fairness is achieved by, in the words of the Court of Appeal, “swell[ing] the pool of funds available to the company to be shared rateably amongst all creditors”1.

Transactions are considered voidable under s292 if two criteria are met. First, the payment must have been made when the company was unable to pay its debts. Second, the payment must allow the recipient to receive more than they would have received in the company’s liquidation. During the six months immediately preceding the start of the liquidation, the company is presumed unable to pay its due debts. In other words, the first criteria is presumed to be met. Outside this period the liquidator must show evidence that the company was unable to pay its bills. Whether a payment allows the recipient to obtain more in a liquidation than they would have otherwise received is a straight comparison between the amount the recipient actually received and the amount that the recipient would have as part of the general body of creditors in the liquidation, had the payment not been made.

Transaction perhaps not voidable?

Under s296(3) transactions are not voidable if the recipient can demonstrate all three of the following when they received payment: they acted in good faith, a reasonable person in their position would not have suspected that the company was (or would become) insolvent, and they gave value for the property or altered their position in the reasonably held belief that the payment was valid.

While there‘s no sure way to avoid having payments clawed back under the voidable transactions regime, the following may limit your exposure:

  • If you supply goods on credit, ensure that those goods are the subject of a security interest properly registered on the Personal Property Security Register, and
  • If you have any reason to suspect that a company is facing financial difficulties, insist that all future transactions are conducted on a cash on delivery basis.

 

It’s also important that you respond promptly to a demand for repayment of a voidable transaction. If you don’t file and serve an objection notice within the statutory period of 20 working days, it may result in the liquidator’s decision being unchallengeable2 and, by default, you will required to make the repayment.

 

1 Farrell v Fences & Kerbs Limited [2013] NZCA 91

2 Bond Cargo Ltd v Chilcott (1999) 13 PRNZ 629