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• 7.1 The Right to Priority
• 7.2 The Extent of Priority
• 7.2.1 Directors as Employees
• 7.2.2 Contractors
• 7.2.3 Redundancy Payments
• 7.2.4 Wage Earner Protection Funds
• 7.2.5 Phoenix Companies
• 7.2.6 Award for Lost Wages
• 7.2.7 Apprentices
• 7.2.8 Volunteers Employment Protection Act 1973

7.1 The Right to Priority

Currently, employees are entitled to priority on any arrears of salary and wages and related earnings (excluding redundancy payments) accrued over the previous four months, up to a maximum of $6,000.

The Commission supported the retention of this priority on the grounds that:

• The government has demonstrated in other areas a clear intention to protect employees;
• New Zealand is a member of the International Labour Organisation that has produced a convention that provides for workers' claims to be protected either by a privilege or by a guaranteed institution such as a wage earner protection fund;
• An employee is at arm's length from the employer, and is, consequently, not in a good position to evaluate an employer's financial position.
• There is a community expectation that employees should be protected to a degree on the insolvency of their employer.

The Commission also proposed that the priority should be expressed as being limited to employees who have the right to bring a personal grievance under the Employment Contracts Act 1991. The Commission's paper was written before the introduction of the Employment Relations Act 2000 ("ERA") and, while the Ministry considers that this recommendation is consistent with the objectives and principles underpinning the ERA, it invites further submissions on this point.

The market failure identified by the Commission (which the priority seeks to address) is the information asymmetry between employees and the company. It is argued that the asymmetry is greater for employees than for other creditors. This is because creditors such as banks are better placed to impose conditions on the debtor and withdraw their security if the company is considered to be getting into financial difficulty. However, one of the key objectives of this paper is to promote a robust debate regarding the retention of this priority. This is because, from an economic perspective, the employee preference creates potential risks and market distortions. For example:

• Many other creditors (such as contractors, trade creditors and customers) are in no better position, and perhaps in an even worse position, than employees to judge company performance.
• The preference may reduce availability, or increase the cost, of credit to certain firms, particularly in labour-intensive organisations. This may reduce the growth of some companies and also reduce job opportunities. In this case, the cost would be borne, principally, by the unemployed.
• As a group, employees are not necessarily more disadvantaged than other creditor groups, such as trade creditors. In fact, it can be argued that by increasing the cost on trade creditors in preference to employees, there is an increased risk that, to the extent trade creditors fail as a result, employment opportunities will be reduced, at least in the short term.
• Employees have the opportunity to take out income protection insurance to cover the risk of redundancy. The priority could therefore create inequality between those employees who have taken out income protection insurance and those who have not.
• It is not an efficient means of targeting need. For example in some insolvencies few if any assets will be available.
• Social Welfare is there to address instances of financial hardship.

These factors obviously need to be weighed against the benefit to creditors of retaining the priority. The submissions that were received in response to the Commission's paper tended to focus on the extent (i.e. the amount) of the priority and not whether there were legitimate policy grounds for retaining it. For this reason, the Ministry welcomes further submissions on this issue.

7.2 The Extent of Priority

7.2.1 Directors as Employees

The Commission recommended that directors, as defined by section 126 of the Companies Act, should be excluded from the employee preference. This definition includes employees acting in a management role.

Currently, directors of a company can enter into employment contracts with their companies to ensure that, in the event of insolvency, they are elevated from being a shareholder (who is paid only after all creditors have been paid) to a preferred creditor. This is in spite of their being privy to information about the company's financial status not available to other parties (and thereby in a better position to control their risk) and participating in decision-making that affects the company's future prospects. This reduces, if only marginally, the incentive directors have to ensure the company retains solvency and is inconsistent with the purpose behind the employment priority of protecting an otherwise vulnerable group.

7.2.2 Contractors

The Commission considered and rejected the proposition that independent contractors should be entitled to the same preference as employees (as mentioned in section 7.1 above, this recommendation needs to take account of the new definition of "independent contractor" contained in the ERA).

It could be argued that independent contractors, and sole traders who are completely dependent on an insolvent company, have no better information than employees and will suffer at least as much as employees. However, to treat some contractors (i.e. those with similar exposure to employees) but not others in this way would be extremely difficult in practice.

7.2.3 Redundancy Payments

The priority of redundancy payments in insolvency has become a topical issue, arising, for example, in:

• A Private Members Bill (arising from the collapse of Weddel freezing works) which provided for redundancy payments to be added to the list of employee benefits entitled to preferential treatment on insolvency. Consideration of the Bill was deferred pending consideration of the issue in the insolvency review.
• More recently, the New Zealand Stevedoring Limited insolvency in 1998 which renewed calls for greater protection of employee entitlements. In this case employees, as unsecured creditors, lost redundancy, holiday and long service entitlements to the approximate value of $14 million. At the time, it was widely argued that the insolvency of New Zealand Stevedoring Limited and the resultant continuation of a number of its businesses was a cynical attempt to defeat the legitimate interests of creditors (mainly employees) though a phoenix arrangement.

The Ministry acknowledges that without a priority for redundancy payments some employees will, in certain circumstances, be worse off than with such a priority. However, this benefit needs to be weighed carefully against the costs it could impose on other creditors and the likely impact on the cost and availability of credit, particularly for small companies.

In many liquidations, there is no secured creditor. A priority for redundancy payments could significantly reduce money available to trade and other unsecured creditors. This in turn could lead to a further round of company failures, and loss of employment opportunities. Further, such a priority could lead to trade credit being withheld or its cost increased in certain circumstances, thereby reducing opportunities for some companies to expand and decreasing income and employment opportunities.

7.2.4 Wage Earner Protection Funds

The Commission suggested that the problems associated with redundancy entitlements could be overcome through the establishment of a wage earner protection fund, with the costs to be met by a levy on employers. The Ministry does not support the establishment of such a fund, on the grounds that:

• It would penalise, and hamper the performance of successful firms;
• It would create a moral hazard;
• Only some employees would benefit; and
• Collection costs would be excessive.

Further, the Ministry notes that firms (as part of their remuneration policy) and employees are free to insure against the risk of redundancy, should they so chose. In this way, the cost and the resulting benefits of the "redundancy provision" are borne explicitly by the beneficiary (the employee). This is more likely than a priority or a dedicated fund to meet employee preferences regarding the value of the trade-off between the risk of redundancy (from whatever source) and the cost of that protection. it is also likely to provide more certainty in the event of company failure than a priority or a dedicated fund would achieve.

7.2.5 Phoenix Companies

In commenting on the problems raised by the New Zealand Stevedoring case, the Commission has suggested that employee liabilities should be transferred to the purchaser on a sale of a business as a going concern. This proposal is based on the European Union Acquired Rights Directiveunder which an employee's contract of employment is automatically transferred (on existing terms and conditions) to the purchaser.

Initial research has revealed that the Acquired Rights Directive has been the subject of extensive litigation in each of the European Union's member states. There is also little evidence to suggest that it safeguards employment opportunities. For instance, in the United Kingdom the Transfer of Undertakings (Protection of Employment) Regulations (which enacted the Directive) are the subject of regular litigation as parties grapple with technical legal issues regarding the date of the transfer, whether the transfer constitutes the transfer of an economic entity, and whether the new purchasers can make out a "economic, technical or organisational" ground that will enable them to renegotiate the transferred employees' contracts of the transferred employees. The Directive also allows member states to exclude collective insolvency proceedings such as liquidation from its ambit (although it does apply to receiverships).

The Ministry welcomes submissions on whether the Acquired Rights Directive may provide an effective solution to the complex issues that surround sales of going concerns. In particular, will such an approach encourage such sales and thereby stimulate the development of a corporate rescue culture?

The Ministry also notes that the Minister of Labour has established an advisory group to review minimum employment standards. The advisory group will examine the adequacy of existing arrangements for protecting wages and conditions of work when a business is sold or transferred or work is contracted out. It will also consider international practice in this area and consider options for change. The Ministry will have to revisit this issue once the advisory group's recommendations are known.

7.2.6 Award for Lost Wages

Section 123 of the Employment Relations Act 2000 provides that where the Employment Authority or the Employment Court finds that an employee has a personal grievance, it may settle the grievance through any of a range of remedies including:

• Reimbursing to the employee the whole or any part of the amount of wages or other money he or she lost as a result of the grievance; and
• The employee's employer paying compensation for, among other things, (a) humiliation, loss of dignity and injury to feelings of the employee and (b) loss of any benefit, whether or not of a monetary kind, which the employee might reasonably have been expected to obtain if the personal grievance had not arisen.

Section 128 also expressly provides provision for reimbursement of lost remuneration as a result of a personal grievance.

The Commission's provisional view when dealing with the priority for lost wages was that this liability was no different in nature to the current employee priority and should be treated the same. In relation to awards relating to, for example, humiliation and loss of dignity, the Commission concluded that a case had not been made for giving them priority. It also noted that no other forms of distress damages are given priority. The Ministry is inclined to support the Commission's recommendations, but it welcomes further submissions on this in view of the recent introduction of the ERA.

7.2.7 Apprentices

Apprentices are given priority under:

• Clause 2(g) of the Seventh Schedule to the Companies Act 1993, which provides that any amount under section 23 of the Apprenticeship Act 1983 (which section 16 of the Industry Training Act 1992 deems part of an apprenticeship contract) that the Employment Court orders to be paid to an apprentice by the Employment Tribunal is a preferential debt; and
• Section 104(1)(d)(ii) of the Insolvency Act 1967,which provides that sums the Court orders to be paid to an apprentice under section 83 of the Insolvency Act 1967 are preferential debts.

In its report the Commission charts the historical origins of both provisions. It concludes that "as the reasons for the apprentice provisions are now largely spent, it is unnecessary to retain the preference". The Ministry of Economic Development and the Department of Labour support this conclusion.

7.2.8 Volunteers Employment Protection Act 1973

Section 15 of the Volunteers Employment Protection Act ("VEPA") 1973 provides that any sum ordered or adjudged to be paid as compensation under section 6 VEPA shall be a preferential debt both in bankruptcy and liquidations. The priority is limited to $200.

Section 6 VEPA provides that every employer commits an offence if an employee's employment is terminated because the employee volunteered for, or underwent, any protected voluntary service or training. Where an employer contravenes section 6, the Court may order the employer to pay the worker a maximum amount equivalent to 16 weeks pay. The compensation under section 6 therefore relates to dismissal. Other awards made for compensation for dismissal do not have priority. The priority afforded to VEPA claims is an anomaly and the Commission identified objections which justified its abolition:

• Assessment being on a different basis to that which applies to other employees;
• The link between the employer's criminal behaviour and the preferential status of wages. The link is not a basis for priority in respect of other employees.

The Ministry endorses the Commission's views. However, it also notes that a private member's Bill proposing amendments to VEPA is currently before Select Committee. One of the proposed changes is to increase the list of currently protected issues. This matter will therefore have to be revisited once the Select Committee's report is available.