5. The Ministry's Proposal
5.1 An Effects-Based Test
5.1.1 Proof of Intention to Prefer under the Insolvency Act
While the 1993 amendments to company law introduced effects-based tests for determining whether a transaction can be set aside, some provisions in the Insolvency Act still focus on the debtor's intention. For example, section 56 of that Act, which provides for the setting aside of voidable preferences, requires proof that the debtor made the payment "with a view to giving that creditor...a preference over other creditors."
There are two key problems with using proof of a debtor's intention as the determining factor for whether a transaction should be set aside. First, proving a subjective element such as intention can be difficult. More significantly, such a test is inconsistent with the general objective of avoidance provisions. Each of these difficulties is addressed in more detail below.
Case law interpreting section 56 Insolvency Act has held that the intention to prefer must be the debtor's dominant intention.35 It is not enough that one of the debtor's intentions was to prefer that creditor. In practice, proving that a particular intention was the dominant intention is very difficult. It is relatively easy for a creditor to point to some other intention. For example, the courts have held that if the debtor intends to benefit himself or his family, or his dominant motive was to defeat other creditors rather than to benefit a particular one, the intention element is not met.36 The small number of cases taken under section 56 reflects the difficulty created by the interpretation of "intention" in this section.
More significantly, however, any test that uses the debtor's intention to prefer one creditor as the basis for setting aside transactions is at odds with the primary object of voidable preference law, which is to achieve equality between creditors. This is because under such a test a transaction that has the effect of preferring one creditor may be allowed to stand, depending on what can be proved to be the debtor's intention in entering into that transaction.
The 1993 amendments to company law moved to an effects-based avoidance regime. This was intended to remove the evidential difficulties associated with proving the state of mind of any party to the transaction and, more importantly, ensure that transactions are set aside on a basis that is consistent with the pari passu principle.
| Recommendation: Voidable transactions provisions in the Insolvency Act should, like those in the Companies Act, set aside transactions based on their effect, regardless of the intention, motive or knowledge of the debtor or the recipient of the transaction. |
5.1.2 The "Ordinary Course of Business" Exception under Section 292 of the Companies Act
The voidable preferences provision in the Companies Act is section 292. Changes made to section 292's predecessor in 1993 were intended to shift the focus away from the parties' knowledge or intentions, and focus instead on the transaction's effect.37 However, section 292 provides that an otherwise voidable preference will not be set aside if it is "in the ordinary course of business". The knowledge of the other party to the transaction is still a factor in establishing whether a payment was made in the ordinary course of business.38 This has re-introduced the evidential difficulties and cost associated with proving such an element.
As was discussed above, given the objective of voidable preferences law, the parties' knowledge or intention should not be the determining factor for whether should be avoided. Focusing strictly on the effect of the transaction will provide a more principled and consistent basis for determining which transactions should be set aside.
In the context of section 292, a number of interested parties have criticised the uncertainty surrounding the ordinary course of business exception. While it could be argued that judicial interpretation may in time clarify the exception, the significant number of cases in the six years since it was enacted, including decisions of the Court of Appeal and the Privy Council, have not done so to date.
There is always a trade-off to be made between simple rules and principles. Simple rules provide more certainty, but may not cover every situation that arises, with the result that wrong decisions may be reached in some cases. In contrast, using general principles allows the flexibility to adapt to any situation. However, that flexibility may be achieved at the expense of excessive uncertainty, enforcement and litigation costs.
The advantages of flexibility offered by the "ordinary course of business" exception are considered to be considerably outweighed by the disadvantages associated with it, particularly the unnecessary costs caused by the uncertainty surrounding what that phrase means in any given situation.
| Recommendation: The ordinary course of business exception should be removed and replaced with a simple rule that will achieve greater certainty. This should be coupled with a shorter time period so as to minimise the likelihood that any injustices will result from the application of a more rigid rule. |
5.2 Harmonisation of Corporate and Personal Avoidance Provisions
Section 56 of the Insolvency Act39 in its current form is almost identical to the voidable preferences section in the Companies Act 1955 (section 309). That section was repealed in the Companies Act 1993 so that an intention to prefer is no longer a crucial element in liquidations. However, section 56 was not amended at the same time. There is no justification for differentiating between transactions on the basis that the debtor is an individual or a company. The increasing number of sole traders incorporating since the enactment of the Companies Act 1993 shows that any distinction based on the form of the debtor is arbitrary and does not necessarily reflect any actual difference in the nature of the debtor.
| Recommendation: Personal and corporate insolvency voidable transactions law should be harmonised into a single law based strictly on the effect of the transaction, regardless of the intention, motive or knowledge of the debtor or the recipient of the transaction. |
5.3 A Single Provision
Both the Insolvency Act and the Companies Act provisions distinguish between, and provide different rules and procedures for, different types of transactions. For example, some of the Companies Act provisions enable the liquidator to challenge transactions by filing a notice with the High Court, while other provisions require the liquidator to commence proceedings in the normal way.
Another anomaly caused by the existence of different provisions for different type of transactions is seen in the application of section 57 of the Insolvency Act. That section provides that where a charge is granted against the bankrupt's property within 12 months of bankruptcy it is voidable unless it was granted in return for adequate contemporaneous consideration. The provision therefore enables a security granted shortly before bankruptcy to an existing creditor to secure a pre-existing debt, can be set aside. Such a security is analogous to a voidable preference, in that it puts the particular creditor in a better position on the insolvency of the debtor.
The difficulty arises where such a security is acted on shortly before bankruptcy, for example, by the grantee of the security seizing and selling the property pursuant to the powers granted under the security. In this situation, the Assignee cannot set the security aside because it no longer exists.40 Legally this is the logical conclusion, based on the wording of the section. However, the results produced are inconsistent. If the security still exists, the law provides that the grantee should not enjoy its protection and the security is set aside. If, however, the grantee uses the powers under the security, and sells the property, the grantee is able to enjoy the proceeds of the sale. From a policy perspective, therefore, the provision is not consistently supporting the objective of achieving equality between creditors.
A section that focused instead on whether the ultimate effect of a transaction is to diminish the value of the debtor's assets would avoid anomalies resulting from sections targeting specific types of transactions. Arguably, the effect on creditors of granting a voidable security is no different to the effect of a voidable gift or a voidable preference. The Ministry therefore considers that there appear to be strong policy justifications for applying the same rules and procedures regardless of the nature of the transaction.
| Recommendation: The Ministry considers there are strong policy arguments in favour of replacing the existing voidable transaction provisions with one provision that would cover all types of voidable transactions. The Ministry seeks submissions on whether a single provision could be achieved, with careful definition of terms, to cover any depletion of the insolvent's assets, that enables another person to receive more than they would have in the liquidation. Could such a provision be effective regardless of whether the recipient is a creditor, the beneficiary of a gift, the grantee of a security, or a person acquiring an asset for less than the market value? |
5.3.1 Section 47 of the Matrimonial Property Act 1976
Section 47 of the Matrimonial Property Act provides that the Assignee may challenge any transaction between spouses which is intended to defeat, or has the effect of defeating, creditors. So any transaction which gives one spouse more than the protected matrimonial property they would otherwise have been able to retain on their partner's bankruptcy will be voidable. This potentially creates an exception to the general rule in section 20 of the Matrimonial Property Act that the Act does not affect creditors' rights to a debtor spouse's property.
A Court of Appeal decision41 has made it clear that, where section 47 Matrimonial Property Act applies, the provisions of the Insolvency Act and the Property Law Act are subordinate. Fisher on Matrimonial Property states, at page 46: "Section 47 may therefore be better described as replacing the relevant sections of the Insolvency Act, rather than merely `supplementing them'".
Clearly, given that the Ministry's preferred option is to move to a single transaction with a single process, there are strong arguments in favour of repealing section 47 to ensure consistency of rules and process. However, the Matrimonial Property Act was created to protect spouses" interest in matrimonial property. It is beyond the scope of this review to address the continued validity of that protection.
| Recommendation: The Ministry does not propose that any amendments be made to section 47 of the Matrimonial Property Act 1976 at this time. |
5.3.2 Section 60 of the Property Law Act 1952
This provision provides that every alienation of property with intent to defraud creditors is voidable. It has a different historical origin to the provisions in the Insolvency Act and applies outside of bankruptcy to any attempt to put property beyond creditors" reach.42 While it is not necessary to show fraud, it is necessary to show the debtor"s intention to put assets beyond creditors" reach, and thus dishonesty in relation to creditors.43
This provision has no time restriction on when a transaction must have occurred to be voidable and so can be used in cases of transactions outside the normal period provided in the Insolvency Act (although it is subject to time restrictions under the Limitation Act 1950). However, because this provision requires proof of the debtor"s intention to defraud creditors, it is easier to proceed under the Insolvency Act if a transaction is within a relevant time period and so does not require proof of intention under that Act.
Even under an effects-based regime, there may still be instances where the section may be used to challenge transactions that occur outside the period of the insolvency legislation. This inconsistency could be argued to justify the repeal of this provision. However, the section originated outside the scope of insolvency law and applies more widely than just where a debtor is bankrupt. As a result, while again the goal of consistency would suggest that this section should be removed, the ramifications of that removal would be wider than the scope of this review.
| Recommendation: Section 60 Property Law Act should be retained. |
5.4 Form of the Provision
There are two effects-based voidable transaction regimes to which reference is commonly made. These are found in Australia and the United States. Each is explained in more detail below.
5.4.1 The Australian "Running Account" Principle
The running account principle existed at common law under Australia's voidable preference provision before1993 when its company law was reformed.44 It is based on an explicit or implicit mutual assumption by the parties that payments would be made from time to time to ensure a continuing supply of goods or services, rather than merely to close an account in respect of a pre-existing debt.45 Where there was a running account, the ultimate effect of a series of dealings was considered, rather than looking at an isolated transaction. This meant that even though the amount of a transaction exactly matched a pre-existing debt, if it were paid to ensure the continued supply of goods, then the transaction is viewed as part of a series of dealings. Sometimes, the debtor company may have been better off in that it received more value than the amount by which its assets were depleted, and so the transactions, viewed as a whole, would have been allowed to stand.
Australia has expressly recognised its "running account" principle in section 588FA of the Corporations Law. That provision defines an "unfair preference" as a transaction that results in a creditor receiving more from the company than they would have received if the transaction were set aside and the creditor were to prove for the debt in a liquidation at that time (a fictitious liquidation). The "running account" principle is included as an example of a "continuous business relationship" which, if proved, enables a series of transactions to be treated as a single transaction. The combined effect of those transactions is then considered to determine whether there was an unfair preference.
The key difficulty with the Australian running account principle is that it still requires proof that the parties considered the transaction to be part of a continuing business relationship. That approach focuses on the parties' state of mind with all the evidential difficulties associated with proving motive or knowledge.
5.4.2 The United States "Net Effect" Principle
The United States has an effects-based preference test in section 547 of the Bankruptcy Code and an ordinary course of business exception. However, the Code also contains a provision that states that the trustee cannot avoid an otherwise preferential transaction to the extent that after such transfer the creditor gave new value to, or for the benefit of, the debtor which value was unsecured and for which the debtor made no other unavoidable transfer. The effect of this is to codify a "net result" rule which means that in the usual 90-day period before bankruptcy during which voidable preferences may occur, the trustee "nets out" the payments made by the debtor against new value given by the creditor.
5.4.3 Conclusion
Both the United States and Australian regimes have problems associated with them that have resulted in an undesirable amount of litigation. However, in both countries the problems appear to relate more to the defences, such as the ordinary course of business exception in the United States, and their interaction with the voidable transaction provisions than to the provisions themselves.
Though the United States provision has less cumbersome wording than Australia's, the purpose is the same, and the provision is not limited to showing a running account or a continuing business relationship. This avoids factual examination of how far the creditor expected to be supplying future services and the details of the trading relationship between the parties. Given that the time period in the United States is only 90 days, there is less risk of unfairness or arbitrariness.
| Recommendation: New Zealand should enact a provision that is in line with the United States "net effect" provision. The provision should not, however, include the defence of "ordinary course of business" exception or the requirement of insolvency contained in that provision. Further, the New Zealand provision should be phrased more widely than the American provision so that it encapsulates all types of depletion of assets rather than just payment of a pre-existing debt. |
5.5 Time Periods
Many of the provisions in the Companies Act contain different time periods. For example, section 292, which deals with voidable preferences granted by a company, contains two different time periods. Transactions occurring within two years of formal insolvency can be challenged, but unless the transaction is in the ordinary course of business, the liquidator must prove that the transaction:
- Took place within two years of liquidation;
- At a time when the company was unable to pay its debts; and
- Enabled the recipient to receive more than they would have received on liquidation.
However, if the transaction took place within six months of formal insolvency, there is a presumption that it took place when the company was technically insolvent (or unable to pay its debts) and that it was not in the ordinary course of business.46 The other party may attempt to rebut the presumption by leading evidence to the contrary. Therefore the presumption's main effect is to shift the onus of proof from the liquidator to the recipient if the transaction took place within six months of formal insolvency.
The six-month and two-year periods are sometimes criticised as being arbitrary and lengthy. It is said that the two-year period in particular inhibits creditors from encouraging a company to trade out of its difficulty. Others argue that in some situations it would be preferable if creditors did "pull the plug" earlier because, by allowing or encouraging a company to continue to trade, the dire financial situation is exacerbated and the indebtedness to creditors is increased.
Invariably any time-frame is likely to be somewhat arbitrary. The alternative, however, is to use the actual date of technical insolvency in each case for determining the relevant time period. The benefits of establishing an arbitrary timeline is that it increases certainty and reduces the costs involved in proving the date of technical insolvency in every case. The potential disadvantage is that an arbitrary rule will result in some transactions being set aside where the company was not in fact insolvent. However, the adoption of a shorter time period should minimise the likelihood of any such injustice occurring.
While there is no statistical evidence, it is also generally accepted that debtors are almost invariably insolvent for some time before formal insolvency. A shorter time period, such as six months, is more likely to coincide with that period of technical insolvency than a longer period, such as the current two-year period under the Companies Act. The six-month period also has the advantage that it matches the current "restricted period" during which presumptions as to solvency apply in many of the Companies Act provisions. The existence of those presumptions mean that the bulk of the transactions currently challenged occur within 6 months of formal insolvency.
| Recommendation: There should be one period in which transactions may be set aside unless there is a strong justification for a different time period. The Ministry recommends that the period in which payments may be recovered be six months from the date of filing the application commencing formal insolvency procedures. |
5.6 Procedure
Different procedures apply to different provisions within the Companies Act. For example, section 297 of the Companies Act is aimed at transactions that effect a net diminution in the value of the debtor company's assets because either inadequate consideration has been paid to the company or the company has paid excessive consideration. However, unlike section 292, no presumptions apply, and the liquidator cannot take advantage of the notice procedure under section 294 to challenge a transaction, but instead must commence proceedings in the normal way. The liquidator must prove the debtor company was insolvent when it entered the transaction, or became insolvent as a result of the transaction, or incurred obligations for which it had inadequate assets. The liquidator must also prove the other party to the transaction knew of the company's state of insolvency and show there was a disparity in consideration.
This large burden of proof for the liquidator has meant few transactions have been set aside on this ground. Thus, it is only in cases of clear disparity between consideration given and benefits received that a liquidator would be inclined to bring a case. A liquidator will generally pursue the transactions under section 292 if it is also a preference or under section 293 if it is a voidable security.
The procedural difficulties associated with pursuing voidable transactions have largely been addressed by the changes made this year to the High Court Rules,47 which stipulate the procedure for issuing a notice setting aside a transaction (rules 700ZJ and 700ZK).
Masters have jurisdiction over sections 290, 291, 294 to 296 and 299 of the Companies Act 1993.48 However, they do not have jurisdiction in relation to section 292 (voidable preferences), section 293 (voidable securities), or section 298 (transactions with directors or other insiders), or over the voidable transaction provisions in the Insolvency Act. The issues to be considered under these provisions are no more complex than those the Masters currently deal with. The Masters have considerable experience in voidable transactions law and it would seem appropriate that they be given jurisdiction over all matters relating to voidable transactions.
| Recommendation: The Masters should have jurisdiction over all matters relating to voidable transactions. |
The Ministry has recommended that there be one provision that covers all types of voidable transactions. This naturally leads to the conclusion that there should be only one procedure for all types of recovery.
| Recommendations: The notice system contained in s 294 Companies Act and rules 700ZJ and 700ZK of the High Court Rules should be retained and used as the single process for challenging voidable transactions. Voidable transaction matters should remain within the jurisdiction of the High Court The High Court has a general overview of the administration of insolvency. It is not considered appropriate that the High Court's overview should be piecemeal. |
5.7 Voidable Transactions with Directors and Other Insiders
Currently the Companies Act provides additional provisions relating to transactions with insiders. Under section 298, transactions between the company and certain insiders for inadequate or excessive consideration may be challenged. The liquidator may make recoveries from insiders for property, services, or businesses acquired, or disposed of by, the company during a 3-year period immediately before the liquidation. There is no defence to a section 298 claim and the liquidator is not required to prove that the company was insolvent at the time. Nevertheless, the onus is on the liquidator to establish the claim for inadequate consideration.
Under section 299, every charge or security between a company and an insider is open to challenge, whether at a time of solvency or insolvency, with only the court, rather than any statutory requirements or defences, as the filter for deciding which ones should or should not be reversed (or creditors otherwise compensated). There is no time period before liquidation during which the transaction must be shown to have occurred.
Insiders are generally considered to be in a position to observe a company's or a person's financial precariousness at a far earlier time than independent creditors. Insiders therefore have far more time and scope to protect their position or remove assets than other people. The pari passu rule is based on the proposition that all creditors in a like position should be treated equally, but clearly there will be occasions where insiders will not be in the same position as other unsecured creditors. The Ministry therefore considers that insiders' intimate knowledge of the financial position of the company or person is sufficient justification in terms of the pari passu principle to justify a different rule.
| Recommendation: Insiders should be treated more severely with regard to voidable transactions by extending the length of time within which insider transactions may be challenged to two years rather than the six months generally. |
5.8 Defences to Voidable Transactions
5.8.1 Defences under the Companies Act
Section 296(3) of the Companies Act provides a general defence to recovery by the liquidator if:
- The person from whom recovery is sought received the property in good faith and has altered their position in the reasonably held belief that the transfer to that person was validly made and would not be set aside; and
- In the Court's opinion, it is inequitable to order recovery or recovery in full.
This section is almost exactly the same as section 311A(7) of the Companies Act 1955. The problem is that section 309 of the 1955 Act, for example, was based on the debtor company's intent, whereas s 292 of the current Companies Act is effects-based. The predecessor to section 296(3) was therefore created as a defence to an intention-based voidable transactions law. It has been argued that the relief section made more sense when it related to a provision based on an intention to prefer.
It is somewhat difficult to reconcile the defence in section 296(3) with the ordinary course of business exception in the section 292 voidable preferences provision, because it is usual to consider knowledge of the debtor's insolvency when deciding whether a payment is in the ordinary course of business. If a court has already found that a creditor knew of the insolvency in the context of "ordinary course of business" relief is unlikely to be able to be granted under the defence in section 296(3). If the creditor is held not to have the requisite knowledge under the ordinary course of business exception, the transaction will not be set aside and no defence is necessary.
If the ordinary course of business exemption were replaced with either a "running account" or similar principle (as discussed in 5.4.1 to 5.4.3), the defence in section 296(3) would again be relevant.
The wider issue of whether there ought to be any defences to, or relief from, the voidable transaction regime at all must also be considered. One could argue that there should be no defences to the voidable transactions regime, as any defence would inherently undermine an effects-based test designed to enhance the pari passu principle. The counter-argument is that a move to a strictly effects-based test removes any protection afforded by the ordinary course of business to recipients of transactions in situations where it might be unjust to require repayment. If that is correct, some form of defence provision is necessary to prevent those injustices occurring in the individual situations.49
5.8.2 Conclusion
The Ministry is recommending that both the corporate and personal voidable transactions provisions be replaced with one effects-based voidable transaction provision. It considers that the adoption of a simple rule, and a short time period will increase clarity and certainty regarding voidable transactions law. However, it is possible that a simple rule will not produce the correct result in every case and that a strictly effects based-test removes any protection afforded currently to recipients of transactions in situations where it might be inequitable to require repayment.
The concepts of good faith and alteration of position in the existing Companies Act defence are now well established and the retention of that defence should not reintroduce too much uncertainty into the new voidable transactions provision.
| Recommendation: The existing defence should remain available to recipients who, acting in good faith, have altered their position in reliance on the receipt of the transaction and would suffer such hardship as a result of having to repay it that it is inequitable to require repayment. The court would be given the power to order either partial or no return of the transaction in such a situation. |
Back to Top