The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

A recent article discussed how companies on the verge of going bust are settling with trade and other creditors, then voluntarily winding up their businesses leaving the Inland Revenue Department out on a limb. This happens all too often. Also, there are as the title suggests too many "friendly liquidators".

Various solutions were offered. My view is that those solutions are not the only solutions.

Registration of Insolvency Practitioners
The one thing upon which many professionals agree is the need for the registration of insolvency professionals. As it stands, at the present time a liquidator needs no academic qualifications, no training and no experience. The only requirement is that the liquidator must not be less than 18 years old, must not be a creditor, must not be a director, must not be a bankrupt, and must not be committed under the Mental Health Act. No positive attributes whatsoever are required.

On the other hand, registration could demand the following:

•Membership of the Institute of Chartered Accountants of New Zealand or the New Zealand Law Society. Both of these bodies have a code of ethics under which professional independence is mandatory. Both bodies have a robust disciplinary system under which the acts of the members can be examined.
•The Institute of Chartered Accountants has a system under which the files of Insolvency Practioners are examined. Members of the Law Society would need to make arrangements for examination of their insolvency files.
•Registered practitioners would need to demonstrate they had appropriate
•experience and would need to show they had attended courses each year to enable them to keep up-to-date.
•They would have to show each year they had adequate Professional Indemnity Insurance.
•They would have to show they were respected by their peers as suitable persons to be registered.
Law changes required
To give creditors a say in the conduct of a liquidation the creditors need information. The principal duty of any liquidator is to take possession of, realise, and distribute the assets of the company to its creditors in accordance with the act. Another duty is to prepare and send to every creditor a report containing a statement of the company's affairs and proposals for conducting the liquidation. Progress reports are made every six months.

In theory this is fine. In practice there is one enormous loophole that enables the friendly liquidator and the cowboy liquidator to thrive and thumb their noses at the creditors.

None of the reporting including the statement of affairs needs to be done if the liquidator files a notice stating that he or she is satisfied that the value of assets available for distribution to unsecured creditors is not likely to exceed 20 cents in every dollar owed to such creditors. In practice, in order to properly hold that belief, a statement of affairs has to be prepared. Once prepared then it is not a large step to at least file at the company's office a first report and statement of affairs. Likewise progress in liquidations has to be reviewed and monitored by liquidators. Consequently, it is very little trouble to send six monthly reports to the company's office.

In practice the cowboy prepares neither a first report nor six monthly reports. The only report is a final report. Unfortunately once this has been filed, the liquidation is completed and the cowboy liquidator and his horse have disappeared into the sunset.

I believe that with the role of liquidation comes certain responsibilities. The section dealing with no reporting should be repeated and all liquidators should file a first report and six monthly reports. Without such reports there is no accountability to the creditors.

Friendly liquidators - who appoints them?
The original article suggested that it would be prudent to introduce legislation banning shareholders from appointing their own liquidator once a liquidation petition is before the Court.

The reasoning is that the shareholders would, at that stage, no longer have the opportunity to appoint a friendly liquidator. The idea has some merit but on the whole we do not agree with it. In the first place, the liquidator appointed by the shareholder might be a totally independent frontline liquidator. In the second place, the shareholders may have nothing to hide.

In practice, the shareholder of the failed company is often under immense stress. An immediate appointment is better than waiting six to eight weeks for a court hearing. The immediate appointment also places someone in charge who can seize the assets for the benefit of creditors. There is a real danger that in the six to eight week period assets will dissipate and creditors will do a raid on the company and take away assets to which they are not entitled.

If there is to be a change then it could be on the basis that if the shareholders appoint a liquidator in the five working day period prior to the application to the court, then that liquidator should be present in the court to answer any questions the judge might have.

Another law change? Meeting of creditors to change the liquidator

It is very difficult to change a liquidator for the simple reason that shareholders, in respect of the current account, and related parties have a vote on the same basis as unsecured creditors. This can lead to obvious unfairness.

•The shareholders are able to contact friendly creditors;
•The creditor wanting to change liquidators does not even have a list of creditors;
•In many cases the money owed to the shareholders has been inflated;
•In some cases the amount owed to shareholders could be regarded as part of their share capital.
It is arguable that the law should be changed so that at a creditors' meeting shareholders/directors do not get a vote in respect of any money the company might owe them.

The assumption that a court appointed liquidator would be independent
By friendly liquidator we mean a liquidator who is on the side of the directors rather than on the side of the shareholders. The assumption seems to be that shareholder appointments are bad, and court appointments are good. The argument is clearly fallacious. The front-row liquidators all do an excellent job regardless of whether they are appointed by either the shareholders or the court. The incompetent liquidators remain incompetent whether they are appointed by the shareholders or the court. What matters most is who is appointed rather than how they are appointed.

For example, in a recent case a creditor had a disputed debt. The liquidator was friendly to the creditor and was not in a position to independently examine the creditor's claim. Obviously, neither was the liquidator in a position to independently examine the issue of voidable preferences which had been received by the creditor. The point here is that this was a Court appointed liquidator. It underscores the point that Court appointed liquidators are nominated by the applicant creditor and on that basis they also are not always truly independent and impartial.

Conclusions
Friendly liquidators are a fact of life. Law changes to combat them are required urgently. Meantime, it remains a fact that regardless of how they are appointed, the front-line liquidators will demand of themselves and their staff a standard of excellence and independence on all appointments.

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.

The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

New Zealand is the home of small business. Each year thousands of businesses are started, and each year many businesses fail. Traditionally a person starting a business formed a company, put some assets or cash into the company, and borrowed money from a bank under the security of a debenture. The debenture was a charge over the whole undertaking of the business, and invariably the bank was covered.

There are now so many preferential creditors who rank ahead of the debenture that the security of a debenture holder has been watered down. Those standing in front of the bank are not only wage earners, but the Inland Revenue Department for GST and for PAYE. These latter amounts can be substantial. Because of this the banks, instead of a debenture, now commonly require as security personal guarantees from the shareholders and directors supported by a mortgage over the family home. The effect of this is that if the business fails the bank will call up its securities. The family home is therefore at risk and often has to be sold.

The attitude of the banks is perfectly understandable. In the early days of a company's life it has little in the way of assets and invariably the company from its own resources is not able to provide sufficient security for the banks purposes.

What is overlooked in this equation is the fact that by the time the company fails the assets of the company have built up and are greater than at the commencement. As well as physical assets there will be trade debtors which did not exist at commencement. This means that if from the outset there had been a debenture as well as a mortgage then the family home would not have been at risk. We have seen many cases where people have lost their home because of the mortgage held by the bank, whereas, if the bank had held a debenture as well as a mortgage the home would not have been at risk.

We strongly urge all advisors to companies that they should insist on their client's behalf that the banks as well as taking the personal guarantee and mortgage over the directors houses should also take a debenture over their companies. In most cases our experience has been that if this had happened the directors would be still living in their homes and their homes would not be sold from under them. In considering this, legal and accounting advisors should be aware that where the family home is lost then there is not only a loss of assets but invariably there is the emotional and personal cost of a broken relationship.

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.

The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

The intention of these articles was to give Chartered Accountants an appreciation of insolvency matters. If I have concentrated on the potential liability of the Chartered Accountant this is because the risks of the accountant being sued are very real and are not just theoretical or perceived.

THE CASE
In the recent case which I am about to discuss, the accountant was not on trial. He was merely a witness. He was however, severely criticised by the Judge.

The case has two aspects which are common to many companies in financial difficulties:-

•The directors were conscientious and put more money into the business when it ran short of funds
•The accountant was also conscientious and assisted the directors by preparing two-monthly accounts and discussing the position with them
Despite this the directors were found personally liable for the debts of the company, and the accountant was criticised. So what went wrong?

THE FACTS
The brief facts are as follows:-

In 1996 a company called B M & B B Jackson was incorporated. The two directors from date of incorporation were Brian Jackson and his wife Carole Jackson. Over the latter years the company was selling completed houses on a section and was also in the business of non-residential construction including rest homes and extensions to schools.

•The chief supplier to the company was Benchmark.
•After the company had traded profitably for some years it ran into financial difficulties.
•The Benchmark account ran out to 120 days where it stayed.
•Benchmark put of a stop credit on the company's account and on legal advice the shareholders placed the company in liquidation. This happened on 25 March 1997.
•Benchmark brought action against the officers of the company claiming that at the time the company incurred debts, the directors could not have believed on reasonable grounds that the company could repay those debts.
•Prior to liquidation the company had been making losses.
Loss for Year
1993          $218,000
1994          $   1,200
1995          $113,000
The position had deteriorated significantly in the latter part of 1996 and in the early part of 1997.
•The defendants through their Family Trusts had injected cash of $195,000 into the company in September 1995.
THE VERDICT - DIRECTORS FOUND GUILTY OF RECKLESS TRADING
The Judge found that the directors carried on business in a manner likely to create a substantial risk of serious loss to the Company's creditors. The directors had knowingly exposed creditors to a real risk of non-payment. He ordered that the directors pay the trade debts totalling $387,746 incurred by the company from June 1996 to liquidation. In effect the creditors got 100 cents in the $1.00.

So the directors were found liable but this does not explain why the Judge criticised the accountant. The following extracts from the Judgement reveal all:-

THE ACCOUNTANT IS CONSCIENTIOUS BUT FAILS TO ADVISE
Points arising from the evidence of the company's accountant are:-

[37]   [a]   He accepted the company was "technically insolvent" from the end of 1995, in that its liabilities exceeded its assets.
[b]   Particularly because of the bank's concerns, he met regularly (at least two monthly) with Mr Jackson throughout 1996 and provided him with timely (i.e. up-to-date) information as to the company's financial position. The discussions focused on the position to date as disclosed by the two monthly financial reports, and the company's outlook, in terms of work on hand or ahead and the company's ability to trade its was though its difficulties. He was satisfied that Mr Jackson appreciated the company's financial position.
[c]   From receipt (in March or April 1996) of the company's accounts for the year ended 31 December 1995, he recognised, and believed Mr Jackson also recognised, that there was a real risk that the debts the company continued to incur by trading on would not be paid. That risk remained right through until the company went into liquidation.
[d]   Early in 1996 both he and Mr Jackson recognised the risk of any one of the company's trade creditors losing patience with the level of overdue debt and putting the company in difficulties, and they discussed this risk with the Bank. Notwithstanding that risk, the company did not make any formal arrangements with trade creditors to remove or reduce that risk.

THE ACCOUNTANT IS DAMNED BY THE JUDGE

[52b]   I am unimpressed by the company's accountant. Having prepared the company's financial statements for the year ended 31 December 1996 he did not immediately contact the directors and suggest that the accounts disclosed a hopeless financial predicament, and required immediate cessation of trading. Instead, he actually penned the letter to Benchmark I have outlined in paragraph [21] above. To put it figuratively, he invited Benchmark to apply CPR to the corporate corpse. By contrast, the company's solicitor, upon seeing the 31 December1996 accounts, immediately advised that the directors had no alternative to immediate liquidation. I do not wish to be unduly harsh about the company's accountant. But, having assessed him in the witness box, I do not think he was capable of advising the directors to take the hard but irresistible decision to liquidate. It was a case of the blind leading the blind.

THE LESSONS
So what are the lessons -

•Why was the wife a director? Whose idea was it? Did the accountant advise on the issue? In any event the matter was clearly explained by the Judge. The bold type is my emphasis.
[65]   Reckless directors range from the crooked to the honest, but hopelessly and unreasonably optimistic. Mrs Jackson was much less involved in the running of the company than was her husband, and was probably not at all involved in the critical decisions as to whether to continue trading or liquidate. But I do not regard that as absolving her from full responsibility. Directorships of any company involves acceptance of all the directional duties imposed by the law. There is no halfway house.
•Directors can face action from creditors as well as liquidators.
•Why put good money after bad?
The directors and their Trusts lost at the very least -
Share Capital                            20,000
Advances                                 218,000
Payments to Creditors          387,746     Plus interest
Repay Bank Overdraft              10,000

$635,746
•If you are a Chartered Accountant and a client is in financial difficulties give clear advice and put it in writing. Where appropriate seek a further opinion from an insolvency specialist.

My next article will be on creditors compromises and I will try not to give accountants a hard time.

If anyone wants a copy of the case I have discussed, the reference is:-

Benchmark Building Supplies Limited v B M Jackson & C B Jackson (2001) unreported Palmerston North High Court Registry CP 26/99 Wild J 29 March 2001.

The Judgement is 29 pages long and can be obtained from Judgements Unlimited, telephone: 0-4-472 4953 or we will photocopy and send you a copy for $12.00 GST inclusive.

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.

The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

Graeme McDonald and John Vague attended a Business Law Reform seminar in Wellington on Thursday, 22 November 2001. At that seminar Laila Harre, the Associate Commerce Minister, announced changes to the laws dealing with preferential payments.

You may be aware, that both Graeme and John, other Insolvency Practitioners, the Law Commission and the Credit & Finance Institute have made submissions recommending that the amount of preferential payments should be reduced so that the amount which will be available to unsecured creditors can be maximised. In the circumstances we found it hard to come to grips with the announcements of the Minister.

Whereas it had been suggested that the Inland Revenue Department should rank as an unsecured creditor for GST and PAYE it was announced the department would retain its priority. Not only that, the existing priorities in respect of individuals would be increased. At present an employee has a priority of $6,000 in respect of wages going back for four months and for holiday pay. That priority has now been increased to $15,000 and also includes redundancy. Redundancy in the past has never been regarded as preferential.

We find the new legislation to be anti business. Certainly the rights of unsecured creditors have again been eroded. We believe that there will be less incentive for businesses to set up as they will find it even more difficult to obtain money from banks under the security of a debenture. At one stage the security of a debenture was valuable. This is no longer the case.

For a full copy of the Associate Commerce Minister Laila Harre's address, along with media releases:

1.Ministerial Announcement
2.November 22 2001 - Media Statement
3.Herald Article
4.Insolvency Law Reform

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.

The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

Insolvency Practitioners liaise with the law profession on a daily basis. As in all professions it is easy to communicate with some practitioners and difficult to communicate with others. In such circumstances time and effort is wasted. Increased costs reduce the amount which will be available to creditors and delay any payout. We are invariably happier when the solicitor on the other side has the skill to present his or her clients' case clearly, concisely and in a way we understand.

We have an ongoing case in our office which is an extreme example of what we encounter. The sum of money is comparatively low. The solicitor alleges we hold money in trust but seem to be unable to explain where the mysterious trust funds are held.

All quotes and dates are actual. Only the names have been changed.

DEFINITIONS
"liquidators" - McDonald Vague & Partners
"solicitor" - The legal firm concerned
"creditor" - Their client
"company" - The company in liquidation

A creditor wrote claiming that we as liquidators were holding money in trust. There was an exchange of letters with the creditor culminating as follows -

• 2 October 2001 - liquidators to creditor
"…there are no moneys held in trust… Your claim must rank as that of an unsecured creditor."

The solicitor then came into the act -

• 19 October 2001 - solicitor for creditor
"Please be advised … that we are investigating our client's legal remedies."

The liquidators write back -

• 23 October 2001 - liquidators to solicitor
"There is no money in Trust. You client therefore ranks in the liquidation as an unsecured creditor."

In hindsight, solicitor gets extravagantly optimistic -

• 24 October 2001 - solicitor to liquidators
"… it would be very much appreciated if resolution of this matter could be delayed until Monday or Tuesday of next week."

Monday and Tuesday come and go. Nothing is heard. There is a delay which I will later find out is par for the course -

• 13 November 2001 - liquidators to solicitor
"We have received no correspondence whatsoever from you, and therefore consider the matter closed."

At least we get a prompt response this time -

• 15 November 2001 - solicitor to liquidators
"The matter is not closed…"

We start to get frustrated -

• 15 November 2001 - liquidators to solicitor
"We would have thought that a legal firm should be backing up assertions by either giving us evidence of those assertions or legal opinion in some support of those assertions. Neither has happened."

Another frustrating delay. We write again -

• 28 November 2001 - liquidators to solicitor
"We have not heard from you… We have closed our file."

February the following year another letter. This man never gives up and loves delays -

• 7 February 2002 - solicitor to liquidators
"You will recall we act for [creditor.]"

We could hardly forget. The letter is supported by documentation and a legal analysis. We write back -

• 11 February 2002 - liquidators to solicitors
"Our current position remains that there is no trust in your client's favour and that the money that has been banked into [the company's] bank account cannot be traced to the funds claimed by your client. We … cannot agree that all the cases you mention are relevant."

We then bend over backwards -

"…we could make books and records available to you."

We receive a response remarkably quickly -

• … February 2002 - solicitor to liquidators
"We take it from your letter that you would be prepared to send books and records down to us by post… Who is to pay the cost of transfer from Auckland to South Island return?"

This solicitor is incredible. There are no proceedings on foot. Liquidators do not easily give up records which are under their care and control. The solicitor even suggests that we should pay the cost of transfer. We write back -

• 18 February 2002 - liquidators to solicitor
"… the matter should have been resolved long ago. You have still given us no details as to where these trust moneys are held.. If you would like to look at the books and records it will be necessary for you to either appoint an agent in Auckland or attend Auckland yourself. We will make a room available for you. A member of our staff will be present in the room… We will charge you $50.00 plus GST for each hour spent by that staff member… We will also want 25 cents a copy for any documents you wish photocopied."

The solicitor writes back. His letter is a classic and brightens the day of our staff working on the file. Emphasis is mine -

• 20 February 2002 - solicitor to liquidators
"3. Our client will attend your offices in Auckland to inspect the books and records. We undertake to pay your reasonable costs so as to facilitate that inspection. However our client is not prepared to pay the proposed photocopying charge and will bring its own photocopy.[sic.] It is prepared to pay a reasonable fee for the use of an electrical outlet.

6. …any proposed distribution (without notice) will be opposed."

For heaven's sake. How much wear is there on an electrical outlet every time a plug is pushed in and pulled out. Twenty copies at the most at 25 cents a copy totals only $5.00. I have a mental image of the client coming off the plane from the South Island with a photocopier under his arm. I write back -

• 25 February 2002 - liquidators to solicitor
"3. The proposal as regards the photocopier we find to be somewhat Gilbertian. If the cost of photocopying is really a problem we will reduce the charge to 10 cents a copy."

6. We cannot understand how you can oppose a distribution which is made without notice. The statement seems to confound logic. Perhaps you could explain further."

We try again for informal discovery -

• 26 February 2002 - liquidators to solicitor
"We have two filing boxes full of records. We also have a computer disk which holds most of the company's financial records. Provided you are prepared to sign the usual confidentiality agreement then we would be prepared to let you have a copy of the computer disk."

The solicitor writes back -

• 27 February 2002 - solicitor to liquidators
"… we would appreciate your agreeing to Ms Cardinal of our Auckland office visiting your offices tomorrow morning to make inspection… Ms Cardinal will be better placed after a physical inspection to estimate the size and likely time of the inspection… and also the possible photocopying costs."

Good grief. We have reduced photocopying costs to 10 cents a copy and he is still going on about them. We also now find the solicitor has an Auckland office - Why would his client come from the South Island uninvited. Why can't Ms Cardinal simply inspect the records rather than seeing what records there are to inspect? -

• 28 February 2002 - liquidators to solicitor
"We have made arrangements for your Ms Cardinal to attend our offices… We require your undertaking that [your firm] will pay $50.00 plus GST for each hour spent by our staff member. We advised you of this in our letter of 18 February 2002 and 25 February 2002."

Ms Cardinal visits our offices and is efficient and professional. We seem at long last to be getting on track. However, things are too good to last. I quote in full a long extract from the next letter -

• 18 March 2002 - solicitor to liquidators
"2. Following our Ms Cardinal's visit to your office on 28 February 2002 we have provided our client with detailed instructions on the documents in your possession. Our client proposes that (creditors son) together with Maisie Doaks attend your offices this Wednesday to copy documents. Our client will arrange for a rental photocopier to be delivered to your offices for creditor's son's visit. Rather then being "gilbertian" the suggestion that our client bring its own photocopier to the inspection is quite practical and is borne partly out of our client's desire not to tie up your firm's photocopying resources on 20 March 2002. If creditor's son can have access to an electrical outlet for the photocopier he can copy documents quickly and without interrupting your staff."

He is now suggesting the client's son comes to our office. If the client is not welcome what on earth makes him think the client's son will be welcome. Who is Maisie Doaks? She certainly doesn't appear in the list of barristers and solicitors. I write back and get the following answer -

• 19 March 2002 - solicitor to liquidator
"Our client is disappointed with your … negative response. We …agree to signing ….confidentiality agreement provided agreement extends to our client's accounting advertiser [sic]…"

Our reply is quoted in full -

• 20 March 2002 - liquidators to solicitor
"I have received your facsimile of 29 March 2002. I respond as follows:

1. I would ask that in future you read and take note of what I say in my letters to you. I wrote to you on 7 February 2002 and offered to make the books and records available to you. I wrote to you again on 18 February 2002 and stated in that letter, that the records were still available to you or you could appoint an agent in Auckland. I wrote to you yet again on 25 February 2002 and stated clearly that as follows:-

"We did not offer to make the files available to your client."

How you could then suggest that your client's son attend our offices is beyond us. In the circumstances it is not proper of you to talk about a "negative response."

2. We will prepare a confidentiality agreement. It will not be in draft. If the confidentiality agreement is unacceptable to you, then we would suggest you file proceedings or go away.

3. You have still not told us who Maisie Doaks is and why you believe it is appropriate for her to attend our offices. Before we send the confidentiality agreement, we want a reply. We want to know more about Maisie Doaks.

4. Please explain what an "accounting advertiser" is."

• 25 March 2002 - solicitor to liquidators
"Maisie Doaks is [our client's] son's partner."

Now we know -

• 3 April 2002 - liquidators to solicitor
"Please find attached a Confidentiality Agreement requested by yourselves regarding the above named company and your client.

Please sign the Confidentiality Agreement and facsimile/post back to McDonald Vague & Partners in order that we may send you the computer disk by return post."

We are now in the month of June 2002. Further correspondence has taken place. For example, I sent a copy of a draft report to all creditors down to the solicitor. On 3 May 2002 he stated he would provide me with a substantive comment about what I said. I am of course since awaiting that substantive comment. Meantime, I have reported to creditors as follows -

"As previously reported, one creditor had advised that the company held approximately $25,000 in trust and had demanded repayment. The liquidator maintains that no such funds were held in trust, and therefore considers the creditor to be unsecured in their claim in the liquidation.

The solicitors for the creditor are currently still in correspondence with the liquidators. In February 2002 they were given the opportunity to make discovery of the books and records of the company, but they have not yet availed themselves in respect of this opportunity. The liquidators comment that because of these actions costs have been incurred and a distribution to all unsecured creditors has been delayed."

Also there has been a further development. The case is now being handled by a solicitor from the Auckland office of the firm. I am sure that anyone who reads this story will agree that the new solicitor must do better. What I don't understand is why a reputable firm puts itself in a position where its reputation could be at risk.

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.

The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

Some years ago some meat processing companies failed. Workers lost their jobs and whereas wages and holiday pay were preferential, redundancy due ranked as unsecured.
 

Recently the Government determined that redundancy should be preferential and the Status of Redundancy Payments Bill was passed into law in the form of the Insolvency Amendment Act 2004 and the Companies Amendment Act 2004. These Acts come into force 60 days after the 30 March 2004, which is the date they received the Royal Assent. I calculate the effected dated as being 29 May 2004.

Both Acts make redundancy preferential and increase the maximum preferential claim from $6,000 to $15,000. On the surface of it workers would appear to be better off. This, however, is not necessarily the case.

Statistics New Zealand confirms that there are approximately 295,000 businesses in New Zealand. Most of these, between 240,000 and 250,000, employ ten people or less. It is with this typical business that the discrepancy in the new insolvency law reveals itself.

Imagine a typical small business which has one director, one executive and four wage earning employees. The executive is paid on the 15th of the month for the whole month. The other employees fill out timesheets and are paid weekly. Cash gets tight and the executive leaves. Being the executive she had a redundancy package. She is owed $20,000. The wage earners have no redundancy packages.

The company is placed into liquidation. The executive officer is owed $20,000 for redundancy and each of the workers are owed $800 for wages and $500 for holiday pay. The debts have been factored and there is a debenture in place. The liquidator sells the little stock of value and has $8,000 to spread around the employees.

They are paid as follows:-

As can be seen under the new legislation, the workers do not get paid in full for the hours they have actually worked while the executive who has received all her salary gets the bulk of the available money. This seems grossly inequitable. We would all hope that the workers who had done the hours would get paid for those hours.

A much fairer result would come through if the maximum preferential claim of $15,000 were to be retained but redundancy were to rank immediately after wages and holiday pay.

If the new law were to be amended in that way then under the above scenario each of the workers would receive their full claim - that is $1,300 each. The executive would receive $2,800 - twice as much as the workers. Nevertheless, the result would be fair and equitable.

Any person reading this article might wonder why in the example given there was no preferential claim made by the director. After all, directors at the very least are invariably owed holiday pay. A day off a week - 50 days a year - does not in the mind of most directors qualify as holidays.

The answer is that for the purpose of the new law the director is no longer regarded as an employee. This is a wonderful piece of news for liquidators who in the past have not been able to disprove imaginative preferential claims from directors in respect of wages and holiday pay.

The new Act states that an employee

"…does not include a person who is, or was at any time during the 12 months before the commencement of the liquidation, a director of the company in liquidation, or a nominee or relative of, or a trustee for, a director of the company:"

Another good piece of news in the new legislation is that every three years the maximum preferential claim is adjusted - increase only - to reflect any overall percentage increase in average weekly earnings. This means that the amount of $15,000 will be updated regularly and will not become irrelevant.

Overall the new legislation is relevant and is needed. The unintended side result given in the example is capable of amendment. Also the director, the architect of the failure of the company, no longer gets to share the little money there is to go around.

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.

The content of this article may be out of date - please refer to our more recent articles for up-to-date information.

Introduction - Definition
Traditionally the following entities have been used to conduct business -

• Sole Traders
• Partnerships
• Companies
Over past recent years it has become more common for the trading entity to be a Trading Trust. A Trading Trust is a trust which is formed for the purpose of carrying on a business.

The obvious advantages of trading through such a trust are -

• The ability to distribute profits and assets to beneficiaries
• The ability to organise the tax affairs of the trust so that beneficiary income is distributed to beneficiaries at lower tax rates and thus reduce the total tax payable
• The flexibility of a Trading Trust
Trading is conducted by a trustee who carries on the business under the authority of a trust instrument.

Because the concept of Trading Trusts in New Zealand is comparatively recent there is very little literature and there appears to be no books relating to the insolvency of Trading Trusts in New Zealand. This paper discusses the insolvency of a Trading Trust from the view of an insolvency specialist. Because of the very nature of a Trading Trust it is clear that there are special considerations.

Obvious questions cover such matters as -

• In the event of insolvency is it the trust which is in liquidation or the trustee?
• What assets come under the control of the liquidator or receiver?
• Who could be made liable in respect of the insolvency of a Trading Trust?
• What is the position of a debentureholder?
• How is a Trading Trust placed in liquidation?
Liquidations and Receiverships
In all liquidations and receiverships the role of the insolvency practitioner is similar -

• The insolvency practitioner must ascertain what assets are under his/her control
• The insolvency practitioner must take those assets into his/her custody and preserve those assets
• The insolvency practitioner must realise those assets to the best advantage
• The insolvency practitioner must examine creditors and their claims and work out who those creditors are and rank them in order of priority
• The insolvency practitioner must distribute what cash he has in order of the various priorities. In the event of receivership the insolvency practitioner has no authority to pay any creditor with a lower priority than that of the debenture under which the insolvency practitioner is appointed
In the case of a Trading Trust the role of the insolvency practitioner is exactly the same. There are however, problems addressing such issues as -

• What are the assets of a Trading Trust?
• Who are the creditors of a Trading Trust?
• Who may be held liable in the event of the failure of a Trading Trust?
The purpose of this paper is to address such issues.

What is meant by the Insolvency of a Trading Trust
It is not proper for an insolvent entity to continue to trade and incur credit. Indeed any such trading might well invoke personal liability on those parties who induce the entity to continue to trade whilst it was insolvent. Because of this it is important to be able to recognise the insolvency of a Trading Trust. In the case of a Trading Trust even though trading is conducted through a trustee, the trustee will be deemed to be insolvent if the trust through the trustee cannot meet its debts as they fall due, or the liabilities of the trust exceed the assets of the trust.

The Nature of the Trustee
Trading Trusts are invariably conducted by a trustee which is a company. The reason for the trustee to be a company is that a personal trustee would have unlimited liability - a corporate trustee has limited liability.

The Nature of the Trading
All trading is conducted in the name of the trustee. In law the trust fund is not an entity. Courts will take no regard to the existence of a trust. Debts are incurred in the name of the trustee, assets are purchased in the name of the trustee, debts are discharged in the name of the trustee. The assets might belong in law to the company trustee but they are not its property in equity.

The Liability of the Trustee
The trustee is personally liable for all the trading debts incurred by him. Because the trade debts are the trustees own debts, the creditors remedy is against the trustee personally and no one else. A creditor has no direct remedy against the trust assets and these cannot be reached by process of execution. Creditors have no right of action against the beneficiaries, neither do they have any right of action against the settlor. It is the trustee who is liable to the creditors and no one else.

Liquidation of the Trustee
The corporate trustee can be placed in liquidation in the same manner as any other company and on the same grounds. The trustee can be placed in liquidation by either the shareholders or the Court. In certain circumstances the directors may place the trustee company in liquidation. The most likely reason for the company being placed in liquidation is of course the inability of the trustee company to pay its debts as they fall due.

The rules conducting the liquidation are the same as any other liquidation and the liquidator has -

• The same rights of examination of people having knowledge of the company
• The right to take action against officers of the company to make them personally liable for the debts of the company

Assets Available to the Liquidator
Assets available to the liquidator are divided into two groups -

• Those assets, if any, owned by the trustee
• Rights of indemnity
In most circumstances the trustee will own no assets and will be relying upon its indemnity from the trust.

Under the liquidation the trustee is entitled to retain trust assets for the purpose of satisfying trust liabilities. In essence, the liquidator through the trustee company has a lien over the assets of the trust. The lien has with it a right of sale.

Trustees Right of Action Against the Beneficiaries
There is a right which imposes on a beneficiary a personal obligation enforceable in equity to indemnify a trustee against liabilities incurred by the trustee for expenses properly incurred. The obligation of the beneficiary is founded on the principle that the person who gets the benefit of a trust should share its burden.

The right of action against the beneficiaries belongs to the trustee and would be available to any liquidator of that trustee. The person who has the indemnity (the trustee) is entitled to an order to indemnity as soon as his/her liability has crystallised as an actual present and enforceable debt.

It is not necessary that the trustee should have actually paid or discharged that liability before exercising the right. What exists is a true right of indemnity rather than a mere right of recovery.

The right of a trustee to be indemnified by the beneficiary exists only if the beneficiary is absolutely entitled. The right of the trustee cannot be enforced and is not available where the trust is in favour of discretionary beneficiaries. Discretionary beneficiaries cannot be made liable. If however, a beneficiary is entitled as of right and there is no discretion involved then it is clear that the beneficiary can be made liable to the trustee or to the liquidator of that trustee.

There is an exception to the general rule. If the beneficiary is an infant or a life tenant then there is no right against the beneficiary personally. For a beneficiary to be liable that beneficiary must be a beneficiary sur juris.

If there are multiple beneficiaries who are absolutely entitled then in the words of the Privy Council -

"absolute beneficial owners of property must in equity bear the burdens incidental to its ownership…"

Other cases have determined that the burden must be met in proportion to the interest.

The general rules are -

• A sole beneficiary is always bound to indemnify the trustee
• Beneficiaries who are entitled to the trust as of right are always bound to indemnify the trustees
• Discretionary beneficiaries are not bound to indemnify the trustees
• Where there are beneficiaries who are entitled to proceed to the trust as of right and also discretionary beneficiaries then only those beneficiaries who are entitled to the proceeds of the trust as of right have to indemnify the trustee
• The right of indemnity where there are several beneficiaries as of absolute right is for the beneficiaries to pay in proportion to their shares in the interest. If any beneficiary is in partnership with an insolvent beneficiary who is unable to pay, the partner is liable to meet it
• There is a general rule that if a beneficiary assigns his interest, the assignee takes the interest subject to the risk of insolvency. The assignor remains liable even after the assignment for all debts falling due after the assignment. There is a parallel to this in general insolvency law whereby it shares are transferred and there is unpaid capital in respect of those shares, then the liquidator may look not only to the present holder of these shares but to any past holder of these shares
It is possible of course to expressly exclude the liability of beneficiaries. There are circumstances, however, where such exclusion may not be binding -

• The beneficiaries might incur liability by an independent request to the trustee thus overriding the availability of the exclusion.
• The beneficiary might be stopped from relying upon the exclusion if the beneficiary has encouraged the trustee to act on the basis that the excluding provision will not be relied upon.
The question then arises as to the liability of the beneficiaries in the event of insolvency -
Young J. in McLeans v. Burns Philp Trustee Company Pty. Ltd. stated that the Courts could not allow such clauses to be "used as a cloak for fraud". His honour said:

"…where there is a discretionary trust which is so geared to enable a person to avoid his creditors by hiding behind the vehicle of the trust, equity would not allow that to happen".

It would seem that it would be prudent for the beneficiaries of Trading Trusts to be discretionary beneficiaries rather than beneficiaries who are absolutely entitled.

Right of Action Against the Trust Assets
A trustee has a right to be indemnified out of trust assets in respect of those liabilities incurred by him in the course of his authorised activities as trustee. The right of indemnity covers all costs and expenses properly incurred. Under trust laws the assets are the property of the beneficiaries. The right of indemnification is a right to resort to the assets in order to discharge the liabilities. Trust assets include both the income and the capital of the trust. The trustee through the indemnity has been shown to have a right in equity in his favour over the trust assets.

I understand that some trusts deeds state that the trustee has no right of indemnity out of trust assets. This may be effective in some jurisdictions but is not the case in New Zealand. In New Zealand there is a statutory right to trustees indemnification.

Section 38(2) of the Trustee Act 1956 states as follows:-

"A trustee may reimburse himself or pay or discharge out of trust property all expenses reasonably incurred in or about the execution of the trust or powers; but, except as provided in this Act or any other Act or as agreed by the persons beneficially interested under the trust, no trustee shall be allowed the costs of any professional services performed by him in the execution of the trusts or powers unless the contrary is expressly declared by the instruments creating the trusts:
Provided that the Court may on the application of the trustee allow such costs as in the circumstances seem just."

The wording of "properly incurred" has been suggested to mean "not improperly incurred". The trustee can lose its right of indemnity if it acts in excess of the trust powers or if it is in breech of its duty of reasonable care and diligence. This is not unlike the case of a receiver acting. Whenever a receiver accepts a position, that receiver obtains an indemnity from the debentureholder. The indemnity does not extend to cover negligence on behalf of the receiver or a breech of duty of reasonable care and diligence.

It would follow from this that in the event of a liquidation of a company trustee then the liquidator will have immediate access to the trust assets. In saying this it is acknowledged that section (2)(5) of the Trustee Act 1956 could be said to apply. This appears on the surface of it to allow parties to modify rights of indemnity. Section (2)(5) of the Trustee Act 1956 is somewhat ambiguous. The right to indemnity is not only a statutory right but a right in equity. It seems probable that despite any clause in the trust deed that the Courts would uphold the trustees right to be indemnified out of the assets of the trust. In any event the subsection talks about the powers conferred on or under the Act by a trustee. It is hard to argue that a right to indemnity is a power.

The Hon. Mr Justice McPherson has suggested that although there might be an express provision excluding the trustees right of indemnity against trust assets it is difficult to conceive of a trustee who, while bound to incur liabilities in the course of trading, is nevertheless precluded from applying trust property to discharge those liabilities. In the view of the Hon. Mr Justice McPherson and other commentators, the right of indemnity from the assets is an incident of the office of trustee and inseparable from it.

Alienation of Trust Assets
It might well be of course that at the time a liquidator is appointed all assets have been distributed to beneficiaries. This position is covered by section 60 of the Property Law Act. This makes every alienation made with the intention of defrauding creditors voidable. For the Section to apply there must be actual intent. The section does not extend to any property received in good faith. Such a disposition could also be in breech of the trustee's duties.

Other Rights of Indemnity - Right of Indemnity Against the Settlor
In certain circumstances the trustee may be able to look towards the settlor for payment of the debts of the trust. There are two circumstances in which this can happen -

• It is possible that the settlor may have promised to indemnify the trustee in consideration of the trustee accepting the role of trustee
• There may be circumstances where the trustee has looked to payment towards the settlor in the past, and the settlor has in essence put more money into the company so debts can be paid
In such circumstances then it could be held that by his behaviour the settlor had agreed to indemnify the trustee.

The most likely circumstance in which a settlor could be made liable for the debts of the company is where the settlor has retained wide powers over the trustee. All liquidators are familiar with the circumstance whereby certain persons can be made liable without limitation of liability for the debts of a company. Included amongst the people who can be made personally liable are the officers of the company. Included under the definition of officers of a company is a person under whose instructions the directors are accustomed to act. If it can be shown that the trustee company was accustomed to act under the directions of the settlor then in my view there is no doubt that the settlor could be made personally liable for the debts of the company.

There is case law to support this, and the case law suggests that even though the trust deed may contain an express exclusion of the settlors' indemnity that clause may not be sufficient to exclude the settlor from personal liability. It was determined in Balsh v. Hyham (1728) to P. Wms 453

"that if the settlor is also a beneficiary under the trust then the settlor is bound in equity and at law to indemnify the trustee."

There is further case law to suggest that even if the settlor was not an original beneficiary, then he may be liable to indemnify at a later date if he obtains an interest by assignment.

Restriction of the Trustees Right to Indemnity
Although Section 38(2) of the Trustee Act 1956 gives the trustees the right to indemnification against trust property there is another clause, Section 2(5) which allows parties to modify any such right. It would appear that in certain circumstance the settlor might have an opportunity to challenge the liquidators right to the assets. In such circumstances the Courts would need to balance the conflicting requirements of the creditors and of the settlor. It would appear that for the Courts to favour the settlor in whole or in part, then the settlor in most circumstances would have to show that the trustee did not act with due care and should thus lose his right to indemnity. This of course would lead to the almost automatic situation where there would be a clear case for the liquidator to take against the directors of the company to make them personally liable. Section 13 of the Trustee Act 1956 states as follows -

• A trustee must invest prudently
• Where trustee have special skills by reason of his or her profession, employment or business, the standard of care is extended to what a prudent person engaged in that business, profession or employment would exercise in the managing the affairs of others (s13C)
• The test of prudence can be excluded in the trust deed (s13D)
• In exercising his power of investment, the items set out in Section 13E should be considered and the trust document complied with (s13G)
If it could be shown that the trustee did not do the things as provided for in Section 13E of the Trustee Act 1956 then it would seem that the Court might favour the settlor.

How would a Trust be Placed in Liquidation
As stated earlier in this paper it is not the trust which is placed in liquidation but the trustee. The trustee is invariably a company. The trustee can be placed in liquidation in the same way as any other company. Modern insolvency law provides that a company is placed in liquidation by the appointment of a named person or persons as liquidators of that company. Consistent with all insolvency law the trustee company can only be placed in liquidation by two parties -

• By the shareholders on the passing of a special resolution which must be signed by 75% in value and 75% in number of shareholders
• By the High Court on the application of a creditor or shareholder or director or some other person having an interest in the company
Priority of Creditors in the Event of a Liquidation or Receivership
In general the priorities in the event of a liquidation or a receivership come in the following order -

1. Liquidators or receivers fees
2. Wages, Holiday Pay and Deductions
3. GST and PAYE
4. Unsecured Creditors
It seems reasonably clear however, that in the case of a Trading Trust the priorities are not necessarily the same. This is because the assets in equity belong to the Trust.

Section 312(1) of the Companies Act 1993 states as follows -

"[Order of priority] The liquidator must pay out of the assets of the company the expenses, fees, and claims set out in the Seventh Schedule to this Act to the extent and in the order of priority specified in that Schedule and that Schedule applies to the payment of those expenses, fees and claims according to its tenor."

It is clear that the provisions of Section 312 of the Companies Act 1993 apply only to "assets" that are beneficially owned by a company and that are available in a winding up for division amongst the creditors generally. Such assets cannot include assets held in trust. It would therefore appear that the normal priorities may not apply and that things such as wages and GST and PAYE rank equally between themselves and equally with unsecured creditors. The position is uncertain.

It would appear that in Australia the liquidators follow the priorities even though there is a body of legal opinion in Australia which suggests that they do not apply. I have not found any New Zealand cases on the issue. I am pleased to advise that the situation of a liquidator of a trustee is quite different from that of the other preferential creditors. A liquidator of a trustee company is entitled to claim remuneration costs and expenses from the trust assets (Re Francis James Nominees Limited (In Liquidation) (1988) for NZ CLC 64,279 and Re Landbase Nominee Company Limited (In Liquidation); Re Landbase Securities Limited (In Liquidation) (1989) for NZ CLC 65,043.)

Change of Trustee on Insolvency
It has been suggested to me that there can be a clause in a trust deed which would provide for the automatic removal and replacement of a trustee if a trustee were to be placed into liquidation. In effect the trustee would be removed from the trust before the trustee was able to exercise his rights of indemnity. The question then arises as to whether that the removed trustee will still be able to be indemnified out of the assets of the trust. The point was clearly covered in a paper presented at the 20th Australian Legal Convention by R. P. Meagher Q.C, New South Wales. R. P. Meagher stated as follows -

It would seem that no such removal from office would prejudice his rights of indemnity, for two reasons:
a. Removal from office clearly could not destroy the trustee lien, and
b. Most of the cases dealing with the creditors - rights to subrogation to the trustee - rights of indemnity treat the rights as subsisting after the trustee has been removed from office.

Receiver Appointed Over a Trustee Company
Assets of a company within the context of the Companies Act means assets to which the company is beneficially entitled. It is for this reason that assets held by the company in trust are not assets of the company. The question arises then as to whether there can be a debenture over a trust. If the trustee company were to borrow money for its own purposes unconnected with the trust then even though the trustee company had purported to charge the trusts assets the charge would not be binding upon those assets and any attempt to appoint a receiver in relation to those assets would be ineffective. In effect the debenture would only be effective in so far as the trust company had assets of its own which did not belong to the trust.

If however, borrowing is authorised by the trust and undertaken for the purposes of the trust and there is a power in the trust to create a charge over trust assets to secure the borrowing then the debenture is effective.

The debenture will effectively be a charge against the trust assets and any receiver will have access to those assets as a matter of right and not as a matter of indemnity. The usual rule applies. Although the assets coming into the hands of the receiver belong in law to the company they are not the company's property in equity. Creditors have no direct access to those assets and cannot levy any execution against them. This again raises the problem of what priorities apply. It would seem that the position in respect of a receivership is more certain than that of a liquidation. In the case of a receivership it seems more likely than not, that in a receivership they do apply. This is certainly the view taken by Blanchard who states that the question was touched on by Needham J in

"Re Byrne Australia Pty Ltd who seemed to lean in favour of such a solution."

CONCLUSION
The Insolvency of Trading Trusts in New Zealand is in a state of infancy. Whilst there have been some notable cases many of the issues have yet to be tested.

There is a wealth of information which has come from Australia and whilst it is probable that New Zealand will follow Australia, it is by no means certain.

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.