Annulment and Early Discharge from Bankruptcy

Annulment and Early Discharge from Bankruptcy

Introduction

Generally, bankruptcy lasts for a period of three years. During this time, a bankrupt is subject to onerous conditions imposed by the Insolvency Act 2006. These conditions include, but are not limited to:

  • The bankrupt’s property vesting in the Official Assignee;

  • The continued monitoring of the bankrupt’s financial affairs;

  • Prohibition from being involved in the management of a company or being self-employed without the consent of the Official Assignee; and

  • Prohibition from travelling overseas without the consent of the Official Assignee.

To learn more about the conditions imposed by the Insolvency Act 2006 on the bankrupt, go to: https://www.norlinglaw.co.nz/duties-of-a-bankrupt-and-consequences-of-failure-to-comply.

The Courts have frequently acknowledged that the three-year term allows the Official Assignee to properly administer the estate of the bankrupt and it also allows for the protection of the community from the bankrupt.

Parliament, however, has also recognised that a bankruptcy term of three years may in certain instances not be necessary and there is a provision in the Insolvency Act 2006 which allows a bankrupt to end their bankruptcy earlier.

There is also a provision under the Insolvency Act 2006 which allows the bankrupt to annul their bankruptcy in limited circumstances.

Early Discharge

Under s 294 of the Insolvency Act 2006, a bankrupt may apply for early discharge at any time. In making the application, a bankrupt should carefully consider the timing of the application. This is because if the bankrupt is unsuccessful, the Court will usually specify the earliest date the bankrupt may apply again, and the bankrupt may not be able to apply for a considerable period.

The Court, in making an order for early discharge, may immediately discharge the bankrupt or may discharge the bankrupt with conditions such as the order to pay a sum of money or report to a financial advisor.

Parliament has given the Court a broad discretion to discharge the bankrupt and the Courts have been careful to ensure that the discretion remains unfettered. Each application will be determined on the facts of each case.

Despite the broad discretion, a bankrupt will usually need to show some form of special circumstances which justify early discharge. This is because there is a public interest in a bankruptcy lasting three years.

For instance, in Re Kaye HC Auckland B2182/93, 9 May 1997, the court allowed an application for early discharge when the bankrupt was unable to find meaningful work without being discharged and there was no advantage to the bankrupt’s only creditor serving the full three-year term.

It is important that a bankrupt who wishes to apply for early discharge ensures that they are compliant with their obligations and prohibitions under the Insolvency Act 2006.

The Courts have been clear that punishment of a bankrupt is not a consideration for early discharge, rather, the Courts tend to look at whether the bankrupt poses a further risk to the commercial community.

Annulment

Section 309 of the Insolvency Act 2006 allows a bankrupt to apply for annulment of their bankruptcy under three grounds:

  • The court considers that the bankrupt should not have been adjudicated in the first place;

  • The court is satisfied that the bankrupt’s debts have been fully paid or settled;

  • The court considers that the bankrupt’s debts should be revived because of a change in financial circumstances; or

  • The court has approved a composition with creditors.

The court considers that the bankrupt should not have been adjudicated

An application under this ground usually relates to some form of defect in procedure, abuse of process or where a material fact was not drawn to the Court’s attention at the adjudication hearing due to human error. The essence of any application for discharge under this ground is that the bankrupt, because of a defect in procedure or abuse of process, should not have been adjudicated in the first instance.

The threshold for annulment under this provision is high and the Courts will not entertain an effective rehearing of a bankruptcy proceeding.

In Re Willis, ex parte Willis [2017] NZHC 2586, an interesting argument was raised regarding abuse of process. In that case, a wife was bankrupted by her husband for $12,000. At the time of the bankruptcy proceeding, the wife and husband were involved in an acrimonious relationship property dispute where the wife was due to receive $600,000 from her husband. The Court considered that the bankruptcy was couched in the context of the relationship property dispute. Associate Judge Sargisson held that the husband’s successful application to bankrupt his wife amounted to an abuse of bankruptcy proceedings and allowed the wife’s application for annulment.

A bankruptcy application that was not served validly will also render the proceedings a nullity.

In Fredrickson Centurion Finance Ltd HC, Auckland B 259-01, 11 February 2005, a debtor who arrived late at Court and was adjudicated bankrupt in his absence had the adjudication annulled.

A successful application under this ground has the effect of annulling a bankruptcy from the date of adjudication. This means that the bankrupt is never considered to have been bankrupt. In relation to the other grounds, the bankruptcy is annulled from the date of the court order.

The court is satisfied that the bankrupt’s debts have been fully paid or satisfied

In order for an application to be successful, the bankrupt will need to have paid or satisfied all of their debts. The ground does not necessarily require that all debts be paid in full, rather, that the debts are satisfied. This provision allows the bankrupt to negotiate settlement of their debt with individual creditors.

The Courts have taken a broad approach in relation to the definition of debts and the definition extends to all known debts of the bankrupt and not simply the debts of creditors who have lodged a claim in the bankrupt’s estate. It is important that the bankrupt is able to provide sufficient evidence to the Court which shows that all known debts have been paid in full or satisfied.

The bankrupt will also need to show that the Official Assignee’s fees in relation to the administration of their bankruptcy have been paid.

The court considers that the liability of the bankrupt should be revived

This ground is related to the one above, however, it does not require the payment of debts prior to the application for annulment. Rather, it simply requires a change in a bankrupt’s finances which allows the creditors to be paid (e.g. inheritance, gift and etc.).

It is important that, when an application is made under this ground, that the bankrupt can provide cogent evidence that the bankrupt has the ability to repay their debts.

Similarities and Differences

Applications for annulment and early discharge are similar proceedings in that they generally release an individual from obligations under the Insolvency Act 1993. However, the two different processes import fundamentally different consequences for an individual. These consequences can be summarised below.

Annulment:

  • If application is made under the first ground, the individual is considered never to have been adjudicated bankrupt.

  • All property that vested in the Official Assignee at the time of adjudication re-vests in the individual.

  • The individual is not released from their debts.

Early Discharge:

  • The individual is still considered to have been bankrupt. The procedure simply ended prior to the general three-year term.

  • All property that vested in the Official Assignee at the time of adjudication does not re-vest in the individual.

  • The individual is released from their debts prior to adjudication (subject to limited exceptions).

Conclusion

A bankrupt who wishes to end their bankruptcy should carefully consider the best way to terminate their bankruptcy. Our professionals will be able to assist with choosing the right option and also making an application to Court (if necessary).

Voidable Transactions: The Rationale

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 favorite 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 favored 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 the period of 2 years before the liquidated company was put into liquidation; 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.

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 up to 2 years prior to liquidation.

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 abuse the process and 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 seek 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.

Reckless Directors of Mainzeal ordered to pay $36 million

Reckless Directors of Mainzeal ordered to pay $36 million

The Authors of this article are Brent Norling and Jeff Greenwood.

Introduction

Mainzeal Property and Construction Ltd (in liquidation) (“Mainzeal”) was a big domino. When it fell in 2013, it created a large domino effect across the industry with many still suffering today as a result of funds being unpaid.

The High Court’s recent decision in Mainzeal Property and Construction Ltd (in liq) v Yan and Others [2019] NZHC 255 is a significant development in the Mainzeal saga, one of New Zealand’s biggest corporate collapses, and represents an important contribution to the body of law surrounding breach of directors’ duties under the Companies Act 1993 (“the Act”).

At the liquidation date of Mainzeal unsecured creditors were owed approximately $110 million, which was owing to:

  •  Unpaid sub-contractors ($45.4 million);
  •  Construction contract claimants ($43.8 million);
  •  Employees not covered by statutory preferences ($12 million); and
  •  Other general creditors ($9.5 million).

The proceeding was brought by the Liquidators seeking orders against the former directors that they contribute between $32.8 and $75.3 million to Mainzeal.

The Liquidators of Mainzeal successfully argued that the directors breached their duties to Mainzeal under the Act. Cooke J’s detailed judgment canvases the events which lead to Mainzeal’s eventual demise and the subsequent breach of director’s duties.

At the time of this article it is not known whether the decision will be appealed to the Court of Appeal. Although, appeals are likely for cases of this magnitude.

Background

Mainzeal was incorporated in 1987 and soon became one of New Zealand’s largest construction companies building some of New Zealand’s most well-known structures.

In 1995 Richina Pacific Group (“RPG”) acquired the majority shareholding of Mainzeal and established a board with several board members holding appointments in Richina Pacific Group as well as Mainzeal. Members of the Board included Richard Yan, Dame Jenny Shipley and subsequently Sir Paul Collins.

RPG is a Chinese company with significant asset holdings base in China. In the decision, Mr Yan, who is also a board member of RPG noted that, through various business deals, RPG acquired substantial land rights which are now worth over than $700 million.

RPG’s ability to directly transact with Mainzeal was severely limited due to heavy restrictions imposed by the Chinese government. In order to get around this, RPG used several related entities as conduits to transact with Mainzeal.

These entities provided assistance to Mainzeal’s commercial projects through funding in the form of intercompany loans. Similarly, RPG used these entities to extract funds from Mainzeal through the use of intercompany loans. Importantly, the directors were not aware of the full extent of the intercompany loans and it was only in late 2009 that Dame Jenny Shipley requested a report to ensure full transparency of the intercompany loans. A core reason why the Board had not previously queried the intercompany loans was because of assertions made through Mr Yan and others that RPG would financially back the loans.

In 2005 Mainzeal experienced a significant loss of $7.5 million and in 2006 the financial statements indicated that Mainzeal was owed significant amounts totaling $39.4 million from entities related to RPG. A key problem with these receivables was that the related entities which owed the loans to Mainzeal were insolvent with one of the entities having a negative equity of over $44 million.

In 2012 Mainzeal experienced cash flow problems and was unable to secure funding from New Zealand Banks or RPG. Mainzeal was placed into receivership on 6 February 2013 and liquidation on 28 February 2013.

Breach of Director’s Duties- Reckless Trading

The breach of director’s duties centers around reckless trading under section 135 of the Act. The section makes directors liable if they take unreasonable risks with the solvency of the company or trade it when they know that it is insolvent.

Cooke J held that the essential pillars of the section are:

  • the duty which is imposed by s 135 is one owed by directors to the company (rather than to any particular creditors);
  • the test is an objective one;
  • it focuses not on a director’s belief but rather on the manner in which a company’s business is carried on, and whether that modus operandi creates a substantial risk of serious loss;
  • what is required when the company enters troubled financial waters is what Ross (above at [48]) accurately described as a “sober assessment” by the directors, we would add of an ongoing character, as to the company’s likely future income and prospects.

The sober assessment includes looking at whether a director has reasonable assumptions in relation to likely income streams.

Interestingly, section 135 of the Act is not a prohibition against trading while insolvent. Rather, it limits the ability for a director to trade a company while insolvent.

Cooke J held that the directors had breached their duty under s 135 of the Act for a number of reasons. These are discussed below.

Policy of Trading Whilst Insolvent

The directors disputed that Mainzeal was balance sheet insolvent due to the intercompany loans which were owed to Mainzeal.

This argument was rejected as the related entities were not in a position to repay the loans and there was no formal arrangement with PRG requiring them to repay the loans.

Cooke J did not accept the argument that the Financial Statements were audited and that the auditors had recorded the intercompany loans on the balance sheet. Cooke J noted that Mainzeal’s balance sheet insolvency meant that Mainzeal used cash flow advantage of cash flows associated with the construction industry as working capital and that, as a result, sub-contractors were left owed $45.5 million.

Reliance on Group Support

The courts are skeptical when directors rely upon shareholder or related parties support in order to maintain solvency. In these circumstances the Courts will carefully assess whether a director can reasonably rely upon such support. Provided that it is reasonable for a director to rely upon shareholder support then section 135 of the Act may not be breached.

It was argued that the directors were able to rely upon the financial assistance of RPG and, accordingly, did not breach section 135 of the Act. Cooke J rejected this argument because the directors placed unreasonable reliance upon RPG’s representations for the following reasons:

  • RPG’s financial assistance was not clearly formulated and it was not entirely clear what assistance RPG was willing to provide.
  • RPG never expressed their assistance in an unlimited form and it was unreasonable for the directors to presume that their support would be unlimited.
  • RPG never entered into any legally binding agreement with Mainzeal regarding their financial support.
  • The directors should have made enquiries in relation to Chinese law and the ability of RPG to pay funds to Mainzeal.

Financial Trading Position

Liability under section 135 of the Act will only arise if there is a substantial risk of serious loss to creditors. The Court noted while Mainzeal had hoped to generate income from the Christchurch Earthquake Rebuild and various new contracts, Mainzeal’s trading position was poor and that, without group support, vulnerable to substernal loss to creditors.

Outcome

Cooke J held that the directors had breached section 135 of the Act and were ordered to contribute to the liquidation. In determining the quantum of the directors’ contribution, Cooke J discussed a number of different approaches in quantifying the directors’ liability to repay company debts.

Interestingly, Cooke J rejected the Liquidators’ and defendants’ various approaches to calculating the quantum for the directors’ breaches.

Cooke J rejected the Liquidators’ view that the directors should be liable for company debts from the date the Liquidators considered that Mainzeal should have been placed into liquidation. Cooke J held that the Liquidators’ approach was not appropriate because the breach arose from the way the directors traded Mainzeal, with financial reliance on RPC, rather than from a notional date where Mainzeal, in the view of the Liquidators, should have ceased trading.

It was also held that the starting point for assessing the directors’ liability was $110 million. Cooke J then reduced this sum to $36 million. This figure was close to the amount that RPG would have been legally liable to pay Mainzeal.

Once the quantum had been decided, Cooke J went on to discuss each directors’ individual liability. Cooke J held that Mr Yan should be liable for the full $36 million. This was due to his conflict of interest, him misleading the directors and his personal profiting as a result of funds extracted from Mainzeal.

In determining the other directors’ liability, Cooke J held that each should be liable for $6 million. This discount was due to a number of mitigating factors discussed in the judgment.

Implications for Directors

The decision reiterates that the risk to directors who are reckless is high. Directors need to carefully evaluate a company’s position once it becomes insolvent and to soberly consider the prospect of continuing to trade.

Directors will also need to ensure that their reliance on representations made by shareholders or related parties is not unreasonable. It would be prudent for directors to formalise and verify any representations made by third parties to reduce the risk of breaching section 135.

Further, directors should be careful to contextualise financial statements and not place undue weight on financial reports.

Practically, the shield of trading as a ‘limited liability’ company will only remain a shield if the directors remain compliant with their ongoing obligations under the Act.

Injunctions to stop a Company Receivership

Injunctions to stop a Company Receivership

The Authors of this article are Brent Norling and Anna Cherkashina (who were also successful Counsel in the decisions analysed below).

Receivership is a process in which a secured creditor appoints a receiver to collect and sell the debtor’s assets over which the secured creditor has a security.

A private receiver (as opposed to a Court appointed receiver) cannot be appointed unless there is a contractual power to do so. Such contractual power is generally set out in the security agreement which creates security over all or some of the debtor’s assets. The security agreement would also prescribe when and in which circumstance such power can be exercised.

Only the occurrence of the default specified within the security agreement will give the right to the secured creditor to appoint a receiver. Failure to make payments on time is the most common default after which secured creditor appoint receivers in New Zealand.

Once receiver is appointed, the receiver will take control over the assets subject to the security, will run the business (if business is subject to the security), and will sell the assets to repay the secured creditor from the proceeds. In New Zealand, receiverships are conducted under the Receiverships Act 1993.

In this article, we address the Court’s power to intervene in the secured creditor’s exercise of power of appointment of the receiver through the issuance of an injunction. Injunctions in the context of a private receivership can be sought to:

  • Preclude appointment of a receiver. Such injunction being appropriate where no receiver has been appointed yet, but there is risk of appointment; or
  • Restrain the actions of the receiver in a receivership. Such injunction being appropriate where the receiver has already been appointed.

Court’s power to issue injunction

Injunctions can be permanent or interim. A permanent injunction is sought to permanently preclude actions, whereas the interim injunction is sought to preclude actions on an interim basis until the substantive proceeding (i.e. the main dispute) is resolved. Depending on the type and complexity of the proceeding, the substantive proceeding could take 12 months or more to be resolved. In such circumstances, it is necessary to seek an interim injunction to preserve status quo in the meantime.

In the context of receiverships, most commonly interim injunctions are sought. This is to preserve the assets over which a receiver has been appointed, or is about to be appointed, while the substantive dispute (e.g. determination whether there has been a default, whether the security agreement is defective, or a declaration be made that the receiver was appointed invalidly) is underway.

When the Court determines whether to issue an interim injunction, there are three stages to the consideration of the application, being:

  • The application must establish that there is a serious question to be tried in the substantive proceeding.
  • The balance of convenience must be considered by the Court, which requires consideration of the impact on the parties of the granting of, and the refusal to grant, an order.
  • An assessment of the overall justice is required as a check.

Further, prior to the issuance of the interim injunction, the Court will need to be satisfied that the applicant has provided a sufficient undertaking as to damages sustained through the injunction.

Injunction to preclude appointment of receiver

Application to Court can be made to stop the secured creditor from exercising its power of appointment in the following circumstances:

  • Where the security agreement does not provide for a power to appoint a receiver or there is a challenge as to validity/enforceability of the agreement, however, the secured creditor threatens to appoint a receiver.
  • Where the event of default which would have triggered the appointment of the receiver under the security agreement has not occurred or not all necessary pre-requisites for appointment under the agreement have been complied with (e.g. notice of default with the right to remedy the default has not been issued but required to be issued under the agreement), however, the secured creditor threatens to appoint a receiver.

One of the recent examples where an application was made to Court seeking an interim injunction to preclude the appointment of the receiver was subject to the proceeding in Greenfield Global Ltd v MKAH Ltd [2017] NZHC 1298 where we were successful in restraining the powers of a creditor who wished to appoint a receiver.

In Greenfield Global Ltd v MKAH Ltd, the secured party made a number of threats to appoint a receiver over all assets of various companies unless payment was made. There was a dispute between the parties as to the calculation of the debt. In the secured creditor’s view, funds were still outstanding. However, the companies’ position was that the debt had already been paid in full. The companies proposed informal resolutions, including appointment of an independent accountant to resolve the dispute with calculations (and in the interim, deposit funds equal to the disputed amount into a trust account), however, the secured creditor still demanded immediate payment or there would be a receivership.

At the time, the companies employed over 50 staff, whose jobs could be lost if the companies went into receivership, and a permanent harm to the companies’ reputation and goodwill would have been caused. As a result, the companies commenced proceedings in Court seeking a declaration that no debt was owed and as such, there was no default which would have entitled the secured creditor to appoint a receiver. A without notice application was also made seeking an interim injunction precluding the secured creditor’s right to appoint the receiver.

The Court agreed that it was appropriate to issue the interim injunction and made orders. The Court also awarded costs against the secured creditor on the basis of unreasonable conduct which resulted in the application being necessary.

Injunction to restrain actions of receiver

Application to Court can be made to restrain all or specific actions of the receiver in a receivership in the following circumstances:

  • Even though the receiver has already been appointed, the power of appointment or the occurrence of the default which could trigger the appointment is challenged in the substantive proceeding.
  • A particular step undertaken by the receiver within the receivership is considered to be outside of the scope authorised under the security agreement.

One of the recent examples where an application was made to Court seeking an injunction to restrain the actions of the receivers was subject to the proceeding in Alpine South Fishing Ltd (in Rec) v Kim [2018] NZHC 2579.

In Alpine South Fishing Ltd (in Rec) v Kim, the secured party, Mr Kim, appointed a received over the assets of Alpine South Fishing Ltd (in Rec) (“Alpine South”) due to non-payment of debt.

Alpine South, and its director, Mr Choi, commenced proceedings seeking a declaration that the security agreement was a nullity and the appointment of the receivers was invalid. Mr Choi argued that due to limited English he did not understand the meaning of the security agreement at the time of execution and also maintained that Mr Kim represented the meaning of the agreement to him differently. Mr Kim denied that Mr Choi’s level of English was inadequate to understand the agreement, and in any case, Mr Choi was advised in native language by Mr Kim’s solicitors, and provided with opportunity, to seek legal advice prior to execution. Mr Kim also denied that he misrepresented the meaning of the agreement to Mr Choi.

An application was also made by Alpine South and Mr Choi seeking an interim injunction restraining the receivers from taking further steps pending the determination of the substantive proceeding. Mr Kim opposed the application on the basis that no serious question to be tried had been established, the balance of convenience lied in favor of Mr Kim, and it was inappropriate to restrain the receivers from taking further steps without adequate security (secured funds pending resolution or adequate undertakings).

The Court agreed that based on the evidence presented to Court, the prospects of Alpine South and Mr Choi succeeding in the substantive proceeding were low, however, the Court was not prepared to make a finding that there was no serious question to be tried (as further evidence could be introduced at the trial). However, the Court found that the balance of convenience lied with Mr Kim and that the interim injunction would not be appropriate. Accordingly, we were successful in defending the application for injunction and the application was dismissed.

Conclusion

Appointment of receivers is a draconian remedy and it can destroy the company’s business, reputation, credit rating and goodwill. Unsurprisingly, receiverships often result in the companies going into liquidation.

It is important for the secured creditors to verify, before appointing a receiver (or before making threats to do so), that the security agreement provides:

  • for a right to appoint the receiver and that the agreement is valid;
  • that there is a default or event that triggers the right to appoint a receiver;
  • that default or event has occurred and that appropriate procedure has been undertaken prior to the appointment (if the agreement prescribes a compulsory procedure, for example, the issuance of the notice of default).

It is also prudent to explore options and alternatives to ensure receivership is the most appropriate course of action.

Otherwise, an application for an injunction stopping the appointment of receiver, or the continuance of the receivership, could be made, and a cost award could be ordered against the secured creditor.

Remuneration of Directors

Remuneration of Directors

Directors of companies are entitled to receive money from their company, such as salary or wages, bonuses, fridge benefits and loans.

There are strict statutory requirements relating to the process the directors can be paid money from the company. These requirements have been imposed to recognise the directors’ position of power within a company, the position of potential conflict when the director authorises payments to him/herself, and to impose on the director additional checks to reduce the chances of unfair payments.

Nevertheless, it is still common in New Zealand, especially amongst small to medium size companies, that directors take drawings (be it for service of running the company in lieu of salary or in addition to the salary), or receive a salary, without complying with the mandatory statutory processes.

In such circumstances, any monies paid to a director could be treated as a loan repayable on demand.

While there are some directors who still manage to avoid liability for not following the proper processes, with the third parties becoming more aware of such practices, more directors start facing consequences. For example, if the company becomes insolvent and is placed into liquidation, the liquidator in almost all cases investigates and demands repayment of the funds, or if there is a shareholder dispute, often the other shareholder causes the company to demand immediate repayment of funds, or the Inland Revenue Department demands repayment of unpaid tax on the drawings taken from the company.

Interestingly, 63% of companies in New Zealand fail. On that basis, the risk is more than marginal.

Current account

Directors commonly misunderstand the concept of drawings.

Drawings are funds taken by directors (who are also shareholders) from the company for personal use and benefit. When directors take drawings from the company, and/or introduce funds into the company, this is treated as a running loan account between the company and the director.

Unfortunately, a large number of directors still believe that since they are in charge of and run the company, they are entitled to receive payments by way of taking drawings. In certain cases, this practice is engaged into due to the director’s ignorance of the legal requirements, in other cases, intentionally to avoid payment of the income tax.

However, if the director’s current account with the company is overdrawn (i.e. the amount of funds taken exceeds the amount of funds introduced), then the difference is treated in common law as a loan that is repayable on demand. From tax perspective, it is treated as an interest free loan that attracts a fridge benefit tax.

If the directors engage into the practice of taking drawings throughout the year, it is important that when the annual accounts are completed, a salary is declared in order to offset the drawings. However, the statutory requirements for authorisation of salary (outlined below) still need to be followed to avoid personal liability. Further, once a salary is declared, the directors become liable for personal income tax on that amount.

If the drawings are not offset with the salary, there is risk that a liquidator, in case of an insolvent company, or a business partner, in case of a business prone to shareholder disputes, might later demand repayment of these funds from the director. Further, the Inland Revenue Department reviewing the company’s accounts might demand payment of the fridge benefit tax. Such demands could go back to years of drawings made by the company and could result in financial hardship for the director.

Salary, wages and other monetary benefits

Section 161 of the Companies Act 1993 (“the Act”) creates strict processes for authorisation of payments to directors. These processes have to be followed by all companies registered in New Zealand, including companies having only one director and/or shareholder (as is commonly misunderstood amongst directors).

In brief, s 161 provides that:

  1. The board must authorise remuneration or provision of benefits to a director.
  2. The board must forthwith enter the authorisation into the interests register.
  3. Directors who vote in favour of authorisation, must sign a certificate stating that in their opinion the making of the payment or the provision of the benefit, is fair to the company, and the grounds for that opinion.

Section 161 further establishes that where the three elements of authorisation and certification were not complied with, or where no reasonable grounds existed for the opinion to make the payment, the director is personally liable to the company for the amount of the payment, or the monetary value of the benefit.

Personal liability may be avoided in circumstances where the director demonstrates that the payments of benefits were fair to the company at the time they were made, however, the onus of proof in that instance is on the director wanting to avoid liability.

Unfortunately, in New Zealand, non-compliance with s 161 is common.

If liquidators are appointed, and the requirements under s 161 were not met, they will likely take the view that such a salary/monetary benefit is repayable on demand. Below are examples of proceedings brought by liquidators of companies under s 161 against directors.

National Trade Manuals Ltd (in Liq) v Watson

National Trade Manuals Limited was placed into liquidation by the Inland Revenue Department. The liquidators sought to recover sums paid to the director by the company. The director received a salary from the company, and the following resolution was purportedly made:

By credit to his current account shareholders remuneration for the 2005 year of sufficient monies to clear any debit balance in his current account at 31/3/05 or, $10,000.00 whichever is the greater figure.

The resolution was held by the Court to be defective as it did not satisfy the requirements of s 161. Specifically, there was no certificate stating that the payments were fair, or the grounds for that opinion. The legal effect of non-compliance is that the director to whom the payments were made was found to be personally liable to repay the payments or the monetary value of the benefits, except to the extent that the director could prove the payments or benefits were fair to the company at the time they were made.

The issue of ‘fairness’ was dealt with by the liquidators by allocating a salary of $1,000 per week to the director and deducting that from the amount being sought. Consequently, all other funds transferred to the director by the company were ordered by the Court to be returned to the company in liquidation.

Madsen-Ries v Petera

This was an appeal against a decision of the High Court that salaries paid to Mr and Mrs Petera by Petranz Limited (in Liquidation) (“Petranz”) were fair to Petranz when paid. The issue on this appeal was whether the Judge of the High Court, in reaching that conclusion, gave appropriate consideration to the very poor financial situation of Petranz at the time the remuneration was paid.

Petranz was a road transport business. It operated three trucks and specialised in moving containers. Mr Petera drove one of the trucks. Mrs Petera looked after its administrative needs.

The appellants, the liquidators of Petranz and Petranz itself, sued Mr and Mrs Petera as Petranz’ directors and shareholders. They claimed various breaches of duties and a debt due from Mr and Mrs Petera under the overdrawn current account (as shareholders) and for unfair remuneration (as directors).

The High Court Judge first found that the Peteras owed Petranz a total of $140,134.70 on their overdrawn current accounts. The Judge, however, declined the appellants’ application for the repayment of directors’ remuneration. The Judge went on to find the Peteras had, as alleged, breached duties they owed under the Act, including s 135 duty not to trade recklessly. The Judge also found that they had failed to keep proper accounting records as required under s 194 the Act.

The Court of Appeal rejected the liquidators’ approach as they were effectively claiming that the Peteras were liable for all creditors and liquidation costs as a result of breaches of director duties, and on top of this, for the amounts they were paid under the current account and as a salary. In the Court of Appeal’s view, this involved double counting.

The Court of Appeal held that the Peteras were able to retain amounts they were paid as a salary (and paid PAYE on) regardless of non-compliance with s 161 of the CA because the amounts were considered to be fair to the company. This is because:

  1. PAYE was paid, meaning the debt to the Inland Revenue Department did not become larger.
  2. Mr Petera worked 60 – 70 hours per week overseeing the operations and driving a truck.
  3. Mrs Petera worked circa 20 hours per week attending to the administrative requirements of the company.
  4. The company gained full value from the work carried out by the Peteras.
  5. In the circumstances, the salaries were fair to Petranz.

The Court of Appeal held that ‘fairness’ needs to be assessed from the prospect of the company, and not creditors. However, if directors take money while trading recklessly (or breaching another duty), they may be liable pursuant to a breach of duty cause of action.

Conclusion

Some directors still believe that since they manage a company, they are able to determine the way they receive salary or other monetary benefits from the company.

With the creditors, insolvency practitioners, business partners and the Inland Revenue Department becoming more aware of this practice, more and more directors face severe consequences for failing to follow the proper processes for authorisation of payments.

It is important that business advisors, accountants and lawyers working together with the directors of small to medium size companies emphasise the importance of following the proper processes for authorisation of payments to directors.

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