Suppliers beware!

Suppliers beware!

You can now be made to repay many times more than you’ve ever earned from customers who go broke.

Your money will go into the liquidators’ pool for the benefit of the IRD, the banks and other secured creditors, and then the unsecured creditors, often including the people who’ve taken the company into insolvency. You will get no entitlement to recover what you’ve supplied.

Our Court of Appeal confirmed this position late last month. More details appear later, but the decision means that the claw-back for payments while insolvent can apply to payments throughout the two years before insolvency of the customer company, even where:

a) there is no argument about the fair market value supplied,
b) you had nothing to do with the company’s difficulties, and no knowledge or reason to know about them;
c) you’ve naturally passed on most of what you were paid, to your suppliers, subbies and employees; and
d) you are not an insider or in any position to direct the company’s decisions, there is no question of any improper attempt to get unfair priority, or anything else out of the ordinary course of business.

How could the law be so stupid? Is this intentional, or an accident? Is this because we are copying other countries?

Answer – because we now routinely legislate by slogan, it's intentional and it is a foolishness all of our own.

All the countries with which we usually compare ourselves have stayed with the soundly principled approach to voidable preferences, inherited from the great English commercial law pioneers.

Sadly this is just one of many examples of the takeover of New Zealand lawmaking by well-meaning people who think that the merit of law depends on the claimed virtue of its intentions. They temperamentally cannot accept that the results depend on the incentives created by its detail, not the nobility of the slogan thinking they write into it.

Lawyer/priests now infest the ranks of policy ‘analysts’ who guide and feed legislators, the courts, the law society (see Attorney General Chris Finlayson’s recent exchanges on the Society’s approach to the GCSB issues) and to a surprisingly lower extent, our Parliament.

It is only lower because we have a low proportion of lawyers in Parliament. On the other hand, astonishingly few have the education in reality of coal face law practice, let alone any business law experience.

Unfortunately even practical experience does not convert people who are genetically predestined to sacrifice others in the cause of noble slogans. In this case the slogan is “pari passu” or equal sharing.

The small coterie of insolvency lawyers who serve liquidators contain too many who share the liquidators’ satisfaction at gouging penance payments out of former creditors. Perhaps they see only foolish bad luck in those who’ve failed to recognise that they were dealing with a company heading toward liquidation.

In the past perhaps these worthy people would have satisfied their clerical urges safely in the churches, or in other professions that rewarded ability to express ‘feelings’ and did not demand much mathematics or economics or other objectivity. For the past few decades they’ve been pouring into legal training.

Is there any way to protect yourself against such clericalism?
For most purposes the only practical protection against the claw-back exposure is to demand payment in advance. Third party guarantees could help, but even they have some technical fishhooks.
Payments in advance may be a full protection but in many industries such a change would not only be unlikely, it would be uncompensated cost for all concerned. For example there are powerful reasons for the near universal progress payment pattern in the construction industry.

Before the Court of Appeal decision in Farrell v Fences & Kerbs Limited several lower court decisions had minimised the problem, by holding that the relevant words should be interpreted to achieve a practical position close to what prevailed before the 2007 changes, and close to what prevails in Australia. The key distinction is whether the payment is in relation to a credit transaction, or instead for value to be delivered after the payment. The lower courts held that a payment could be protected when it was to discharge a debt incurred for goods or services or other value already delivered. Our Court of Appeal says that is wrong and the exception from claw-back applies only to payments in advance of delivery of the value (good, services etc).

The Court of Appeal’s approach is a legitimate and orthodox interpretation of the words introduced in 2007. But it would have been less worrying if the decision had shown some sign of recognition of the costs of the decision. Instead the Court appears to have felt it was doing God’s work.

The 2007 law change finally abandoned the sound rationale for voidable preference law. Voidable preference provisions were first designed to reinforce the base structure of company law. It allows directors and management full control or so long as there is an equity shock absorber for the consequences of their good faith decisions in the interests of shareholders. When that shock absorber has gone, control must pass to representatives of the next tier stakeholders – the creditors.

Voidable preference law is to discourage those who are about to lose their management powers from abusing them to protect favoured creditors from the haircut they are all about to take. So most countries focus voidable preference provisions on transactions with insiders. The early terminology was direct. “Fraudulent preference” morphed into voidable preference, and now in NZ down to “insolvent transaction”.

Worldwide, the orthodox approach to “unfair preference” is to allow a relatively short period, 3 or 6 months, in respect of which all transactions are potentially reversible, and a longer period, typically several years, during which transactions with “insiders” can be reversed. For example, the Australian Corporations Law “relation back” period is normally 6 months, but extends to 4 years if it was to a related party, or up to 10 years if the purpose was to defraud or delay the rights of creditors.

In New Zealand, the Court of Appeal has now held that the words used in our statute are not consistent with indications that Parliament thought it was broadly assimilating our law with Australian law.

The Court of Appeal intend to make the rule simple and predictable, without the need for future litigation. With a few statutory exceptions most payments for goods or services supplied on credit can be clawed back if an insolvent customer goes into liquidation within two years.

The Court appears to have regarded the increased certainty of the law as self-evidently valuable, without appearing to have weighed it against the consequential increased uncertainty over suppliers' income for at least two years after receipt of payments, or the uncertainties unavoidable as business scrambles to change contracts to nullify the dire effects of the law. Perhaps auditors will have to take an interest in this. Should there be a claw-back contingency for businesses, as a part of their revenue for each preceding two year period if they work in sectors with high insolvency risks?

This is not a trivial problem. For example a contractor with a long running building contract that consumes most of his capacity for two years might take all reasonable precautions to limit credit exposure. Despite, for example stopping work past payment deadlines until paid, he could face a claim for up to two years' total revenue (not just profit), notified long after the job is finished.

Lawyers too are exposed. Not many clients would want payment in advance to become standard practice. I would not respond well. I find it more satisfying to work in expectation of being paid by a satisfied client after the outcome is known. There are rumours that the legal profession might help fund the certain appeal of the Court of Appeal decision to the Supreme Court.

In our opinion the Supreme Court could find it easy to reverse completely the Court of Appeal's approach to the issues but that is unlikely. It may need a substantially different "theory of the case", and the legislative history is of decidedly mixed usefulness.

Business should be gearing up to ensure that government (as well as the Supreme Court) is led to understand the differences between dynamic and allocational economic efficiency when looking at the sermons that too often pass for law reform ‘analysis’. A legislative solution could be very simple, and much cheaper for New Zealand than extended years of legal piety.

Stephen Franks is principal of Wellington commercial and public law firm Franks and Ogilvie.