Introduction
In August 2011, the High Court issued an important decision in Burns v Commissioner of Inland Revenue on the widely argued question of "what is an account receivable?". This followed an earlier decision (re Northshore Taverns, 2008) in which the High Court decided that "accounts receivable" amounted to "book debts" only. This may sound like an academic point, but it is very important in determining which creditors receive distributions from the various sources of funds realised in a receivership or liquidation. The decision has positive implications for employees and the IRD as preferential creditors, and negative implications for General Security Agreement ("GSA") holders and guarantors.
The legal issue
The Seventh Schedule to the Companies Act 1993 sets out the order in which receivers and liquidators must pay preferential claims. This relies on definitions in the Personal Property Securities Act 1999 ("the PPSA"). The current wording took effect from 2002 but the meaning of some of the definitions is still being debated in insolvency circles.
The Seventh Schedule provides that, where a creditor holds a GSA over a company's assets, they rank ahead of most other creditors in the distribution of funds from the insolvent estate, except where the assets comprise "accounts receivable" or "inventory", in which case the proceeds must first be used to pay preferential claims, ahead of the GSA holder.
These preferential claims mainly comprise employee debts for wages, holiday pay and redundancy pay, and amounts owing to IRD for GST and PAYE.
While inventory is relatively easy to assess, there are many assets that could potentially be considered accounts receivable. Whether these assets are categorised as accounts receivable or not can have a major impact on the returns to secured and preferential creditors. In many cases, these items are the only assets and therefore the interests of preferential and secured creditors are directly in competition, with one or other of these groups potentially standing to recover nothing.
The PPSA defines an account receivable as "a monetary obligation...whether or not that obligation has been earned by performance". In most cases it is easy to determine whether an asset is an "account receivable" within that definition. There is no question that routine trade debtors, properly invoiced and appearing in the company's accounts as a trade debt, fit the definition. This had already been confirmed in the earlier High Court decision. Where problems arise is in situations where money is due to a company for some other reason.
The Burns v IRD decision considered this definition in the context of such items as:-
- Council bond refunds
- Amounts refundable following overpayments
- Amounts held for the company in a lawyer's trust account
These, and similar items, have in the past proved difficult to categorise for distribution purposes and therefore entitlement to the proceeds of these assets has been potentially contestable.
The decision in Burns v CIR
The Burns decision stated that a broad interpretation should be applied to the phrase "account receivable". It held that bond refunds, refunds of overpayments and amounts held for the company in a lawyer's trust account all fitted the definition of accounts receivable and were therefore available to preferential creditors. The decision thus clarifies the position regarding a range of assets which were previously seen by practitioners and their lawyers as a "grey area". The decision also resolved the question of at what point a debt is classed as an "account receivable". Is it at the date of liquidation, or could it also refer to amounts which only become due after liquidation or receivership? The Court confirmed that the wording only refers to amounts due at the date of liquidation, and therefore only these amounts will be payable to preferential creditors. This is unsurprising, as otherwise many anomalies would arise.
For instance, if a liquidator trades on for a short period and sells inventory purchased after liquidation on credit, or sells a company's plant and gives the buyer 30 days to pay, should the amounts due suddenly become payable to the preferential creditors? The High Court has said no; the asset type is tested and determined as it exists at the date of appointment.
Implications for preferential and secured creditors
This decision will clearly not be welcomed by banks, finance companies and other parties who have lent against GSA securities (for instance, private individuals including investors, directors, and their spouses, friends and family members). It will, however, be welcomed by employees and the IRD, who will see themselves pushed to the front of the queue in cases where they might otherwise have ranked behind a GSA holder. For our part, there remains the question of which other assets the definition could capture. We are concerned that the two decisions have not provided total clarity as to what assets may constitute an account receivable. Instead, there is the potential for the definition to capture even more assets.
We understand that the case may be subject to an appeal in mid 2012, but for now it is the precedent and we must follow it. There may well be other cases on this issue, as there unfortunately remain some unanswered questions.
This decision should be brought to the attention of GSA holders, and also to guarantors under those GSAs. It means that there are likely to be less proceeds available to secured creditors and consequently there is a greater likelihood that secured creditors will be pursuing other repayment rights and remedies. The decision, and consequent expectations of loan collectability, will also impact on the holding values of loans in the financial accounts of secured lenders.
Update - December 2012
The Burns v IRD case is the subject of an appeal to the Court of Appeal. We understand that this is likely to be heard in mid 2013.
Note: This article was written by Jonathan Barrett who has subsequently left the firm.
DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.