8. Options
8.1 Enforcement
Options to enhance the effectiveness of enforcing the current provisions include, at a broad level, making it easier to take court action and increasing penalties on directors for abusing the phoenix company approach.
8.2 Increase Access to Courts
Some options to reduce the cost of taking court action are outlined below:
8.2.1 Placing Onus of Proof on Receivers of Assets
Sections 297 and 298 of the Companies Act, which specify as voidable the transactions most likely to arise in phoenix company situations, could be amended to make it easier for liquidators to take action under those sections.
The amendment could provide for the same procedure as in section 294, which applies to applications made under sections 292 and 293 of the Act. Those provisions enable the liquidator, on application to the court, to set aside all transactions within a specified period. This would put the onus of proof on the receiver of the assets to demonstrate that the assets were not acquired at undervalue.
There are risks associated with this approach. For instance, it may be difficult for directors/managers and affected creditors to counter-prove, resulting in successful court challenges when the challenges should not be successful and increased costs incurred in defending those challenges (perhaps often by innocent parties). These costs are likely to be far more pronounced than arise in respect of the transactions captured by sections 292 and 293, that are relatively straightforward. Sections 297 and 298, in comparison, would entail the problematic task of determining the correct valuation, and the circumstances that led up to the transfer. It may also make third parties more reluctant to purchase the assets of a failing company (to avoid costly defences of court action), thereby compromising creditors' interests.
The Ministry does not support this option.
8.2.2 Extend Enforcement Action to Prior to Insolvency
In insolvencies, most enforcement action is undertaken by liquidators/receivers and during the insolvency. Another option is to allow creditors to also take certain enforcement action, and before the insolvency. Provision could be made, for example, for creditors to apply to the court before insolvency to challenge the consequences of a company transferring business or assets.
These measures would increase the burden on the court system. Perhaps more importantly, however, giving creditors wide powers to challenge company decisions (before insolvency) may unnecessarily delay prudent business decisions, adversely impacting on business confidence and heightening international concern and perception of the risk of investing in New Zealand.
The Ministry does not support this option.
8.2.3 Litigation Funding Arrangements
Allowing lawyers to operate on contingency fees where payment is conditional on court action being successful could further enhance the effectiveness of this approach. This would shift the risk of court action from creditors to lawyers, who may be better placed to judge the probability of court action being successful, and therefore the value of further enforcement effort. However, it is important to note that there is ongoing debate regarding the introduction litigation funding arrangements and this proposal cannot be considered in isolation. The Ministry welcomes submissions on this proposal.
8.3 Strengthen Penalties
A liquidator can reverse transactions involving business assets transferred from a company at undervalue before or after insolvency. However, it is questionable the courts can otherwise impose penalties on the parties to those transactions. This means directors seeking to defeat creditors' legitimate interests, in the event of the offending transaction being detected, would in most cases be no worse off than if they had not undertaken the transaction.
A penalty, for example, exemplary damages for directors who act in bad faith to defeat the legitimate interests of creditors, could be imposed to deter possible breaches in the legislation. However, a weakness with this approach, is that it does not get around the difficulty creditors have in accessing the court system, especially where the creditors have only a small interest in the company and are numerous. In these circumstances, the deterrence effect is likely to be minimal as there will be limited if any enforcement effort.
One option to reduce this problem is to provide for criminal rather than the current civil penalties. This would do two things. First, it would increase deterrence by making directors significantly worse off in the event they have initiated a transaction in a deliberate effort to defeat creditor's legitimate interests.
Secondly, it would mean the government, through the Registrar of Companies, would take primary responsibility for enforcement effort. This compares with the current situation which relies on private action. This would get around the free rider problem and the high transaction costs associated with numerous small creditors co-ordinating their actions.
However, a possible disadvantage with this approach, is that the Registrar may not have the best incentive or capability to undertake the appropriate amount of enforcement (up to the point where the extra benefit from enforcement equals the extra cost). This is due to, for example, budget constraints faced by the Registrar. This compares with the current situation where the creditors, by both incurring the cost and receiving the benefit of enforcement, have the best incentive to trade off enforcement effort against expected benefits.
Further, increasing penalties runs the risk of discouraging directors from taking sensible business risks, perhaps to the point where it disadvantages the company and its creditors. It is noted that creditors are currently encouraged to look after their own interests. A key judgement to make here is whether the legislative regime could be made "too tough" on directors leading to too conservative an approach to business risk and under-performing businesses, or not tough enough, contributing to too high a number of insolvencies. The Ministry is undertaking further work in this area and a further discussion document on directors' duties will be released next year.
On balance, the Ministry recommends that criminal penalties be available to the courts where directors are shown to have acted in bad faith to defeat creditors' legitimate interests. So that directors would not be discouraged from taking legitimate business risks, the court would need to be satisfied beyond reasonable doubt that the directors acted with intent to defraud. The higher burden of proof that must be satisfied before imposing criminal penalties compared with civil penalties means that only the more serious offenders would be at risk and harsher penalties would be available.
Back to Top