An insolvent company can pose several risks to businesses and their owners. Protecting yourself when dealing with financially distressed companies is increasingly important, particularly given the rising number of liquidations in New Zealand in recent years – see Insolvency Statistics.
It is important to highlight three major risks associated with dealing with a company that later becomes insolvent:
Securities granted may be voided by the liquidators
This is a relatively rarely used provision; however, if a company is insolvent, any security interests it grants may be set aside by a liquidator. This applies to General Security Agreements (GSA) and to security interests granted over existing assets. It does not apply to lenders who provide funds specifically to acquire a particular asset, such as under a Purchase Money Security Interest (PMSI).
The purpose of this rule is to prevent a distressed company from granting security to certain creditors shortly before insolvency, which could unfairly disadvantage other creditors. If a security interest is set aside, the secured creditor may lose its priority status and instead rank alongside unsecured creditors in the liquidation.
Money paid may be clawed back (voidable transactions)
Under New Zealand insolvency law, certain transactions that occurred before the commencement of a formal insolvency appointment may be subject to investigation. If certain requirements are met, these transactions can be set aside and any benefit received by the recipient may be required to be repaid to the insolvent estate for the benefit of all creditors.
In simple terms, if an insolvent company pays money to one creditor, thereby giving that creditor an advantage over others, the payment may be considered preferential. In such circumstances, the liquidators may seek to recover those funds.
The ‘Six Month No-Net-Off’ Rule
According to the section 310 of the Companies Act 1993 (the Act), where a company is trading with another company that later goes into liquidation, and there are mutual debts between the parties, only debts that arose more than six months before liquidation can generally be netted off against the debt owed to the liquidated company.
For example, assume Company A is trading with a company that later enters liquidation:
The insolvent company owes Company A $10,000
$3,000 was incurred one week before liquidation
$7,000 was incurred one year before liquidation
Company A owes the insolvent company $20,000
In this case, Company A can only nett off the $7,000 that arose more than six months before liquidation. The $3,000 incurred within the six-month period cannot be netted off. As a result, the liquidator may claim $13,000 from Company A.
If the liquidation follows a court application, the six-month period is calculated from the date the legal proceedings to place the company into liquidation were commenced, rather than from the formal liquidation date.
There is one key defence available. A creditor may rely on set-off if they can demonstrate that they did not know, and had no reasonable grounds to suspect, that the company was insolvent at the time the credit was given. Importantly, the burden of proof rests with the creditor, not the liquidator.
Here are some steps you can take to protect yourself when dealing with an insolvent company
Get a security
To reduce this risk, creditors should conduct proper due diligence on the financial position of the company and ensure that any security interest is properly documented and registered in accordance with the Personal Property Securities Act 1999 (PPSR).
Having a registered security interest may allow you to recover goods that have not been paid for if the company later becomes insolvent. While a security interest over goods already supplied may have limited value if those goods have already been sold or used, a security interest over goods yet to be supplied can provide stronger protection, particularly if the company still has possession of the goods at the time of enforcement.
Personal Guarantee
Consider including a personal guarantee clause in your contract(s). However, it is important to ensure that the guarantee contains the necessary key elements to be enforceable.
Get the money from a third party
If a director personally pays a company’s debt, the insolvent estate or its liquidators generally cannot claw that payment back from you. However, if the director later becomes bankrupt, the Official Assignee (OA) may still have the ability to recover those funds. While not a complete safeguard, this approach therefore provides an additional layer of protection.
A work around
If you are dealing with a potentially insolvent company, consider contracting directly with its customer where possible. For example, in the construction sector, you may be able to contract directly with the homeowner rather than the builder, with the builder receiving a commission for facilitating the arrangement.
Proof of solvency
If you suspect that a company may be insolvent, consider asking the director to sign a written statement declaring that the company is solvent. If the director refuses to do so, it may be prudent to reconsider entering into the transaction or seek alternative customer. If the director does provide such confirmation, it may assist as a defence in the event of a later claim by a liquidator.
If you have any questions or enquiries, please do not hesitate to contact the team at Waterstone.
To get in touch with our team, please contact us at reception@waterstone.co.nz or call 0800 256 733.
