Voidable Transactions: The Rationale

If you have ever ‘stood-by’ a customer who is going through a rough patch by continuing to supply goods/services on credit and holding off on receiving payment, some of us will know there can be a happy ending to this story. With your goodwill and support your customer might manage to trade out of its difficulties, your relationship is stronger than ever and most importantly – you can be repaid in full.

Unfortunately, for some business owners, the story does not always end so happily when the liquidator comes knocking unexpectedly.

If the customer is later placed in liquidation, the liquidator may require the creditor to repay all or some of the payments (or other monetary or non-monetary benefits) received by the creditor from the liquidated company. This is known as the liquidator’s power to ‘clawback’ preferential transactions and is provided for under s 292 of the Companies Act 1993.

Sounds pretty unfair, right?

Voidable transactions (or liquidator’s ‘clawback’) regime is one of the most controversial features of insolvency law in New Zealand. It is designed to protect creditors against the tendency of the directors of troubled companies to pay themselves and their favourite or aggressive creditors before anyone else.

Because directors facing troubled waters typically pay the creditors they have a bias towards. Those creditors are usually the ones who hold personal guarantees. The director has a personal incentive to pay those creditors first. It may be friends or family.

Theory behind the regime

According to the pari passu principle, each and every creditor of the company should share equally and proportionately in the fruits of the liquidation.

The principle recognises that it is unfair to other creditors if an individual creditor can jump the queue and be paid prior to the liquidation because it is favoured by the director of the company or because it is being more aggressive than others in its demands.

If payment has been made and the queue is jumped, the law works to make these payments voidable and provides the liquidator with powers to recover these payments for the common pool of creditors in the liquidation.

Operation of the regime in New Zealand

Pursuant to s 292 of the Companies Act 1993, the payments (or other monetary or non-monetary benefit) that the creditor received from the liquidated company may be considered voidable if the following criteria is satisfied:

1. At the time of payment, the liquidated company was unable to pay its due debts;
2. The liquidated company was later put into liquidation (either voluntarily or involuntarily);
3. The payment was within a certain period before the making of the application to the court to commence liquidation proceedings (in case of a court ordered liquidation), or before the shareholder resolution placing the company into liquidation was signed (in case of liquidation initiated by shareholders). This period is 2 years for transactions with related parties and 6 months for transactions with all other parties; and
4. The effect of receiving the payment enabled the creditor to receive more than what they would have otherwise received had they waited for the liquidation to run its course.

The meaning of “related party” is defined under s 291A of the Companies Act 1993. It primarily concerns familial relationships, related trusts, and close business relationships.

These criteria affect liquidations commencing after May 2020, when changes to the Companies Act 1993 came into force. Liquidations which commenced prior to May 2020 are still subject to the old regime. Under the old regime, the period of 2 years applied to transactions with all parties (be it related or unrelated).  

Unfortunately, no matter how well intentioned the creditor was, at the time of accepting payment, the law in this area is only concerned with the “effect” of the transaction – if the liquidated company’s payment had the effect of favouring the creditor above other creditors, that payment is at risk of being clawed back.

This comes as a shock to most clients who come to see us after receiving a letter of demand from a liquidator requiring them to repay their hard-earned cash received 2 years prior to liquidation (for related parties), or 6 months (for non-related parties).

If a liquidator believes the above criteria is met, the creditor will be served with a voidable transaction notice attempting to void the payments (“VT Notice”). If no response is made to formally object to the VT Notice in compliance with the Companies Act 1993 within the strict time limit of 20 working days, the transaction is automatically set aside.

If an objection to the VT Notice is made, the liquidator could still seek to void the transaction by making an application to Court under s 295 of the Companies Act 1993. However, since this option is considerably costlier, it is not always pursued by liquidators (e.g. where there is limited funding and/or questionable prospects of recovery). Most liquidators will determine whether they will commence proceedings, settle, or abandon the claim based on the objection they receive to the VT Notice.

On that basis, a full and robust objection usually has a positive impact on the outcome for creditors.

In our experience, when business owners are faced with this situation, there are 3 mistakes they make. In particular:

1. They offer too much information to the liquidator when the liquidator investigates the transaction without obtaining any advice from an expert. Often, the liquidator’s enquiries are masked with a ‘friendly’ invitation to assist with the course of the liquidation, and the business owners volunteer information that is favorable to the voidable transaction claim;
2. They settle the claim without obtaining expert advice on potential defences and whether all criteria of the voidable transaction claim is satisfied under the Companies Act 1993.
3. They do not appreciate the importance of responding promptly to the VT Notice (liability for the full amount is automatic if no response is received on time, irrespective of the availability of defences).

Liquidators are often aware of these mistakes. Unfortunately, some liquidators might even issue VT Notices like confetti (as in the case of s 261 notices, please see here) in full knowledge that if no response is received in time, then the business owner is liable for the full amount.

Defences

There are several defences to the voidable transaction claim.

For example, the creditor will have a full defence to a claim if, at the time the liquidated company paid the creditor, the following criteria was met:

1. The creditor acted in good faith (e.g. honestly);
2. A reasonable person in the creditors shoes would not have suspected, and the creditor did not have reasonable grounds to suspect, that the liquidated company was, or would become insolvent; and
3. The creditor gave value for the payment or altered their position in the reasonably held belief that the payment was valid and would not be set aside.

In most cases, creditors will generally be able to satisfy criteria (1) and (3) above. The defence usually turns to whether (2) can be satisfied. The law in this area is not well settled and to run a successful defence requires careful consideration of the facts on a case by case basis.

Another commonly raised defence is the exception of the ‘running account’. This exception to the voidable transaction regime might apply where the parties to a transaction were in a continuing business relationship. In such circumstances, the Companies Act 1993 directs to view all of the transactions that are part of that relationship as a single transaction. In these circumstances, the ‘preferential’ effect of the transactions can be reduced or illuminated in full.

Conclusion

Creditors ought to deal with liquidators carefully. They ought not give information that liquidator seeks without first considering whether the information is helpful and or harmful and to consider whether the liquidator is actually entitled to the information.

A creditor needs to act quickly if they receive a VT Notice so that transactions are not automatically set aside.

Our lawyers at Norling Law are experts in this field and routinely act for both business owners and liquidators. If you are the recipient of a VT Notice, our experts can help you to craft a carefully structured objection, and/or negotiate with the liquidator to achieve the best possible outcome for you.

Alternatively, if you intend to receive payment from an ‘at risk’ customer, we can help you to re-structure the transaction to minimise the risk of a future clawback.

Because there are ways to minimise the risk of a liquidator pursuing the transaction as a voidable transaction at a later date.