Liquidators David Levin & Viv Madsen-Ries (Deloitte Ltd) have failed to convince the Court of Appeal that they’re entitled to adopt the peak indebtedness rule to establish preferential treatment of a creditor.
The peak indebtedness rule is used in Australia, but in the 2 New Zealand cases the High Court judges had rejected its use. In one case that rejection made a $294,000 difference, and in the other an $18,500 difference in amounts recovered by the liquidators.
Writing the judgment in the combined appeal on the 2 cases, Justice Lyn Stevens said: “We are satisfied the peak indebtedness rule is not part of the law in New Zealand. If Parliament had intended to adopt it, it could have done so without difficulty. It chose not to do so. Any change to the legislative policy as we have interpreted it would be a matter for Parliament. We therefore dismiss the liquidators’ appeal & cross-appeal.”
Even so, the judge in another High Court case – heard & decided while the Court of Appeal was deliberating on these 2 claims – felt that New Zealand’s parliament had imported the language of Australian law on preference and that this should include the peak indebtedness rule.
In effect, the decisions boil down to how much of a copy & paste you accept.
The Court of Appeal heard both appeals together because each raised an important issue concerning the operation of section 292 of the Companies Act, relating to voidable transactions. The liquidators contended the High Court erred in each case by holding they weren’t entitled to adopt the peak indebtedness rule when calculating the start point for determining whether the creditors had obtained a preference. This rule would enable the liquidators to choose the point during the 2-year specified period when the relevant indebtedness was at its highest, as opposed to an earlier date taking into account transactions predating peak indebtedness.
The liquidators sought to apply this peak indebtedness rule to running accounts with the debtor companies. The specific issue in each case concerned the permissible starting point when assessing the existence & effect of a “single transaction” under section 292(4B)(c) of the Companies Act.
Mr Levin & Ms Madsen-Ries were appointed liquidators of Northside Construction Ltd in 2011 and Tarsealing 2000 Ltd in 2012. In the High Court, Associate Judge Jeremy Doogue dismissed the liquidators’ claim against Tarsealing 2000 creditor Z Energy Ltd for $293,555.86 plus costs & interest, said to comprise a voidable transaction under section 292. The parties agreed that if the appeal was dismissed, the claim would be at an end.
In the other case, Associate Judge David Abbott dismissed the liquidators’ claim for $47,963.95 made on the basis that there was a voidable transaction by applying the peak indebtedness rule. Instead, the judge found Timberworld received the sum of only $29,490.46 as a preference over other creditors, calculated by a straightforward application of the continuing business relationship provision, established in s 292(4B). In addition, the sum of $44,250 was obtained after the end of the running account, independently constituting a voidable preference. Timberworld also appealed, contending the judge erred in 3 respects in awarding these sums to the liquidators, but also had its appeal dismissed.
Justice Stevens wrote in the appeal decision released on Friday: “These appeals are significant for both liquidators & creditors generally. Where there is a continuing business relationship between the parties, such as with a running account, the provisions of section 292(4B) may protect a creditor at the suit of a liquidator seeking to prove the existence of an insolvent transaction.
“Section 292(4B)(c) allows for consideration of all the transactions forming part of the relationship ‘as if they together constituted a single transaction’. Thus it is necessary to identify a start point from which all transactions (both supplies of goods & services and corresponding payments) are to be combined & considered as a single transaction.
“Naturally liquidators will wish to use the point where the indebtedness of the company is at its highest. On that basis, any later transactions under which the creditor provides further value to the company will be exceeded in value by other transactions, reducing the company’s indebtedness. Liquidators could then point to the net reduction in indebtedness as amounting to a preference. Suppliers, however, will seek to use an earlier date so any increase in indebtedness is offset by earlier transactions through which the creditor supplier gave value to the debtor company.”
In the High Court decision on the Northside liquidation, Associate Judge Abbott said: “In the absence of any language suggesting that Parliament intended to allow more than one way of determining the single transaction giving rise to the preference, it must be assumed that a single method was intended. There is nothing in the wording of section 292 to support the availability of more than one method of determining the single transaction, and there is no good reason, in my view, to read that into the statute.
“Legal commentators have pointed out a number of arbitrary features to the single transaction concept. However, ultimately that is a matter for the legislature. As I construe section 292, the single transaction is determined by reference to all transactions in the continuing business relationship, within the specified period.”
On that basis Associate Judge Abbott found the preference Timberworld received from the single transaction created by the running account within the specified period was $29,490.46. Had the peak indebtedness rule been applied, the preference from the single transaction would have been $47,963.95.
Both High Court judges referred to the Australian case of Airservces Australia in their rulings. Associate Judge Doogue noted the majority in the Australian court suggested the start point of the running account wasn’t a matter to be decided by the liquidator. He also referred to Associate Judge Abbott’s judgment in Shephard and concluded that, for similar reasons, he rejected the contentions of the liquidators that they were entitled to nominate the starting point of the continuing business relationship.
Associate Judge Doogue said: “I consider that would be inconsistent with the policy identified as underlying the running account-type cases, to allow enquiry about whether there had been a voidable transaction to focus upon the state of the account at one particular point during the duration of the continuing business relationship and to nominate the indebtedness at that point as significant in measuring whether or not there had been a voidable transaction. To do so would be to ignore the importance of assessing the overall effect of all of the transactions making up the running account which the parties maintained pursuant to their continuing business relationship.”
Associate Judge Doogue was satisfied the business arrangements between the parties amounted to a continuing business relationship in the form of a running account. Further, the continuous business relationship covered the entire course of trading between Tarsealing & Z Energy. Accordingly the case fell to be dealt with under the New Zealand voidable preference law in section 292(4B).
With respect to the application of section 292, the liquidators could only claim a preference if the net or overall effect of the continuing business relationship was to result in Z Energy being able to receive more towards a satisfaction of a debt owed by Tarsealing than it would receive or be likely to receive in liquidation. But Associate Judge Doogue concluded the transactions in the sequence making up the running account were of neutral effect. There was therefore no possibility of Z Energy receiving more than it was entitled to in the liquidation and so no preference was conferred.
Given the existence of a running account covering the entire course of trading between the parties, Associate Judge Doogue concluded: “The enactment of provisions relating to a running account during the course of a continuing business relationship has the practical effect, in a case of this kind, that if the result of trading was to return the parties’ accounts to a neutral position where neither party owes the other, then there cannot be any voidable transaction.
“If, on the other hand, there had been an antecedent debt that came into existence independently of the dealings that comprise the continuing business relationship, and if a payment was made in the course of the relationship which exceeded the liabilities of the company arising from the relationship, then an insolvent transaction would be a possibility.
“Such a transaction would have occurred if the excess payments made by the company to the creditor were retained by the creditor and applied in reduction of the antecedent debt. That, however, did not occur in this case. At the commencement of the trading relationship, the indebtedness of the company to the respondent was nil. The various transactions making up the running account all set each other off, so that even had there been antecedent debt, the running balance would have been neutral in its effect.”
Accordingly, Associate Judge Doogue found there had been no insolvent transaction.
Complicating the Court of Appeal’s consideration, between that court’s hearing in August 2014 and its decision released on Friday, a third High Court judge found in favour of the peak indebtedness rule.
In the case of Farrell v Max Birt Sawmills Ltd, Associate Judge Roger Bell was faced with supplies going both ways between the parties to a continuing business arrangement. The creditor was to supply logs to the debtor company, which processed them and returned sawn timber to the creditor of roughly equal value. But an imbalance developed over time. The debtor company was eventually put into liquidation and the issue to be determined was whether the liquidators could recover from the creditor an amount representing a preference over other creditors.
The amount to be recovered depended on the start point taken and the availability of the peak indebtedness rule. Associate Judge Bell held that s 292(4B) permitted the liquidators to use this rule, saying, in summary: “In Farrell v Fences & Kerbs Ltd, the Court of Appeal declined to follow the Australian approach to ‘gave value’ in section 296(3)(c) [of the Companies Act 1996] because of crucial differences with the Australian statute.
“But in the case of a continuing business relationship in which debt levels fluctuate with supplies & payments, where the identical words in the Australian statute have been inserted into section 292, it would be perverse for the meaning of the statute to change according to the side of the Tasman it is applied on.
“Peak indebtedness does provide a rational basis for establishing a point from which any preferential reductions in debt can be measured. Taking an earlier point entails allowing an earlier transfer of value to be brought into account in working out whether there is a preference: that is inconsistent with the general approach in an effects-based regime for preferential transactions. There is nothing in the text or the purpose of the act for making a special case for suppliers in a continuing business relationship to require them to be treated more favourably than other creditors. Aside from debt spikes for commercially simultaneous supplies & payments, the peak debt is to be used in measuring the extent of preference under s 292(4B). For these reasons, I regretfully decline to follow other cases which have not applied peak indebtedness.”
Justice Stevens, in the Court of Appeal decision, acknowledged that New Zealand’s parliament had adopted the language of Australia’s Corporations Act section 588FA(3), but that didn’t “of necessity” involve importing the peak indebtedness rule: “The [NZ] legislature was plainly aware of the principles of Australian case law governing the running account provisions, but it does not follow that the peak indebtedness rule must also be adopted.”
On Timberworld’s appeal, Associate Judge Abbott concluded the liquidators had proved Northside was insolvent at the relevant period and rejected Timberworld’s challenges to that effect. Timberworld contended the court failed to distinguish between a company being “unable” to pay its debts as they fall due, as opposed to “choosing” not to pay its debts. Timberworld contended Northside simply chose not to pay its debts, but it was capable of doing so. The Court of Appeal didn’t accept those contentions.
Timberworld said it would be unfair to order it to repay the money because Northside’s insolvency arose out of its debts to Inland Revenue, which Inland Revenue allowed to accumulate from 2004 and took no steps to recover until 2011. At that stage the debt had accumulated significantly, with more than half constituting penalties & interest.
Timberworld said it had no knowledge of this worsening tax position, was prejudiced by Inland Revenue’s inaction, and it would be unfair in the circumstances that Inland Revenue should be the sole beneficiary of any repayment of debt.
However, Justice Stevens said Associate Judge Abbott considered that Parliament had specifically prescribed, in section 296(3), conditions under which a payment must not be set aside in liquidation, on the basis of unfairness to the creditor. “He considered, therefore, that although there was some discretion to be exercised in section 295(c) in making orders, given the prescription set out in section 296(3), the threshold for invoking this residual discretion in section 295 ought to be very high. Anything less would undermine the statutory scheme established through section 296(3) and would be an unprincipled departure from the basic principle of fairness between creditors. While the judge accepted an element of unfairness in the situation before him, he did not consider it to reach the threshold required to invoke section 295. We see no reason to depart from the reasoning of Associate Judge Abbott.”
Justice Stevens said the central policy justification for the peak indebtedness rule was predicated on the pari passu rule: that insolvency law is based on equal treatment of equal creditors. It is contrary to that rule to allow trade creditors, who are paid, to receive a benefit over other trade creditors, who are not paid.
“This is a benefit at the expense of other trade creditors (or even all other unsecured creditors generally), and must be disgorged & returned to the pool for distribution generally. The High Court [Associate Judge Bell] in Max Birt Sawmills accepted this policy argument as the key basis for peak indebtedness. Trade creditors should not be treated as a separate class of creditors entitled to an absolute defence to preference claims. The solution, then, is the peak indebtedness rule. We reject this as a matter of both practicality & policy.
“First, on a practical level, there is simply no correlation between the quantum of the amount calculated as a preference taken from the peak indebtedness of one creditor and any entitlement of any other creditor. By definition, that is driven by the circumstances of the trading between the company and each individual creditor. Any payment to a particular creditor harms other creditors only to the extent of the bare fact that value [is] taken out of the general pool of resources. Of itself, this is not an injustice to other creditors, nor does it disadvantage them. This is because, by definition, trade creditors either return the value they receive in supplies, or must return the value of their preference over & above supplies provided as an insolvent transaction.
“Second, on a policy level, it was the purpose of enacting section 292(4B) to give effect to Parliament’s intention to set apart certain trade creditors from the general pool of unsecured creditors. That is not a problem with the operation of section 292(4B) – that is a problem with its existence. We set out above the principled basis for the running account & its adoption.
“As was emphasised in Allied Concrete [another liquidation case], the reforms intended to extend protection to trade creditors and eliminate the ‘ordinary course of business’ test to promote certainty. Trade creditors would have an incentive to continue providing value to companies in financial distress, and recourse for ordinary creditors fell under section 296(3). [Counsel] Ms Murphy’s submission that it is unfair to prefer certain trade creditors is a matter for legislative concern and not a matter for judicial intervention.
“Finally, to the extent there is a concern about the potential ‘over-inclusion’ of commercial relationships in the definition of ‘trade creditors’ to unjust effect, we consider that is assuaged by a careful application of running account principles to individual cases.”
Justice Stevens said one final factor supported the Court of Appeal’s rejection of the peak indebtedness rule, and that was the case of Allied Concrete Ltd v liquidator Jeff Meltzer, one of 3 cases involving voidable preference which the Supreme Court ruled on in February.
Justice Stevens said: “The Supreme Court was faced, in interpreting section 296(2), with what it described as a stark choice between competing policies. While the discussion focused largely on the issue of commercial certainty, the court noted the difficulty in balancing the interests of promoting collective realisation of assets in liquidation against the interest in ensuring fairness to individual creditors, giving value in good faith. The Supreme Court concluded that section 296(3) was one way in which Parliament had expressly provided for mechanisms to ensure fairness to individual creditors could be achieved where necessary, alongside the general principle of promoting collective realisation of assets to all creditors.
“The distinct treatment of trade creditors is, in our view, a similar mechanism. Parliament took the decision to set aside a particular group of creditors who continue to provide credit & goods on the assumption of future trade. That is seen as having distinct commercial benefits in the context of liquidation. It is a policy choice consistent with New Zealand’s insolvency scheme generally.”
Link: 2015 NZCA 111, Timberworld Ltd v Levin (pdf)