Barring a major disaster, a business doesn’t go from being perfectly fine to insolvent overnight. There is usually a whole list of precipitating events that go overlooked or aren’t managed correctly in order to get to the point of no return.

Sometimes, you can be so involved in the day-to-day running of the business that signs of financial trouble can pass you by. Usually, your accountant should pick up on these signs, as we discussed in a previous article, but sometimes these signs slip through the cracks.

In this article we look at three different risk stages for business owners. What are the signs you need to look out for to recognise financial trouble? What can you do right now to help avoid insolvency?

Stage 1: Your business could be heading for financial trouble if you’re:

  • - meeting your current tax obligations, but have tax arrears.
  • - struggling to pay your creditors within their normal terms.
  • - increasing your overdraft facility in order to pay your creditors or meet payroll.

What to do: Don’t ignore the problems and hope they go away. Start working toward solutions now before these problems become overwhelming. Speak with your accountant to get an accurate picture of your finances and plug the holes.

Stage 2: Your business could already be in trouble if you’re:

  • - struggling to fulfil current or new orders as you don’t have the available funds to purchase raw materials.
  • - being cut off by creditors for not paying within their terms.
  • - can’t accept new orders.
  • - being threatened with legal action.
  • - under risk review by the IRD.
  • - having a conversation with your accountant and he/she looks very grim.
  • - fighting with the bank, who are trying to rescind your overdraft facility.
  • - forced by your bank or creditors to undergo a review.

What to do: Negotiate creditors compromises, and work towards paying down/paying off business debt. Speak with a qualified professional – like the team at McDonald Vague – about your options to avoid insolvency and improve cash flow.

Stage 3: Your business is in serious danger of insolvency if you’re:

  • - unable to raise working capital and are on stop with key suppliers.
  • - consistently under break-even point with turnover.
  • - not able to meet your outgoings with revenue.
  • - being put under formal review by the IRD.
  • - unable to take a company loan secured over company assets without a personal guarantee too.

What to do: Your business is in emergency mode. You need to act fast to salvage your company. Contact the professional team at McDonald Vague to find out your options.

You can avoid insolvency by catching the warning signs early on, and solving problems before they grow too big.

If you think your business is in financial trouble or have a client who may be, you may benefit from our free Guide to Options for Companies in Financial Difficulty.

Being the Director of a company looks good, it's prestigious, and looks good on business cards. But it’s not all glamour and cocktail parties. By becoming a company director, you are exposed to the business’ risks and responsibilities that go with a directorship.

If business isn’t going so well, when is trading-on an option and when do you run the risk of breaching director duties?

First and foremost, look at the Companies Office director requirements.

If continuing to trade will end with you filing for bankruptcy, you’ll lose the ability to be a company director for three years. You can be discharged from bankruptcy after three years, but court orders can still prevent you from running a business.

How are you managing your insolvency risk? Will you find yourself lying to creditors about when they will be paid, shifting money from tax accounts to settle debts or perhaps working cash-jobs or paying employees under the table?

The New Zealand Companies Act (1993) requires directors to act in good faith in the best interests of the company. Essentially without malice, dishonesty and avoiding conflicts of interest by putting your own interests ahead of the company. When you apply that litmus test to most situations, you should have a clear idea whether or not you should continue trading or pause for thought.

If you are convicted of a crime involving dishonesty, this will prevent you from being a company director for 5 years, while a criminal record may stop you working in your industry altogether.

What’s happening in your industry? Prior to recent changes in New Zealand Health & Safety legislation, Sir Peter Jackson resigned as a director of Weta Workshop – the creative studio behind The Lord Of The Rings films. The law changes required him to be more involved on a daily basis, and Sir Peter didn’t feel he could deliver.

Health & Safety changes affect some businesses more than others, so it’s a good idea to keep up-to-date with issues in your field.

Each business is unique, and workplace codes of conduct may apply. Check your company’s Constitution, which should set out the rights, powers and duties of company directors. That important document may provide some framework around whether to continue trading or when you might be in breach of your directorial duties. It’s worth noting that if your company does not have a constitution, you’re governed by the New Zealand Companies Act (1993).

In any scenario, the best course of action for managing insolvency risk is to seek advice from the experienced team at McDonald Vague. Our business advisors can guide you, helping you avoid paths that might lead to bankruptcy, insolvency, or criminal activity. If you’re unsure, seeking help now can save you time, money, and a lot of stress in the long run.

Did you know that not using the Personal Property Securities Register (PPSR) could expose your business to unnecessary risk? 

Despite the fact that the online register celebrated its 10th anniversary in May this year, a surprising number of small business owners are not aware of the reduced financial risk that comes with registering security interests on the PPSR. 

Registering your security interest on the PPSR may give you a better chance of recovering a debt if your debtor defaults. (Note:  Suppliers of stock need to register before delivery and suppliers of equipment need to register within 10 working days of delivery)

What a lot of people don't realise is registering on the PPSR is a valid defence against Insolvent Transaction (voidable preference) claims. 

To date, you or one of your clients has probably never had to pay money back to a liquidator on a debt you have already collected.  If you do it's going to hurt as it feels like you are being penalised for doing your job properly! 

Insolvency Practitioners are increasingly using Insolvent Transactions as their only means of recovering funds for creditors. 

 

What is an Insolvent Transaction? 

Insolvent Transactions can only arise when the debtor goes into liquidation and are covered in Section 292-296 of the Companies Act 1993. 

A transaction is voidable on the application of the liquidator if: 

  • At the time the payment was made the company was unable to pay its due debts; and
  • The payment was made within the specified period (up to two years prior to commence of the liquidation); and
  • The creditor received more than they would have been likely to receive in liquidation.

 

We are suggesting that if the company was unable to pay its debts within terms of trade, and if the payment was made in the specified period, it may be pursued as an Insolvent Transaction but if you have registered a specific security to cover your supplies (a purchase money security interest "PMSI") then you will have a valid defence. 

The reason for this is that the payment was simply settlement of a PMSI with a "super priority" and that consequently the secured creditor received no more than they would have been likely to receive in liquidation. There were no creditors with a higher priority.   

Please be aware that this has not been tested in Court.  There are ways in which a liquidator may seek to challenge this. 

As insolvency practitioners, McDonald Vague constantly sees what happens when people do not register on the PPSR correctly, or don't use the PPSR at all.  We can assist in mitigating the risk of Insolvent Transactions for you or your client losing priority to another creditor by implementing a PPSR policy.  We can also review terms of trade to ensure there is a right to register a PMSI or a General Security Agreement before goods are supplied. 

Call Tony Maginness for a free consultation about registering on the PPSR and terms of trade.

Are you likely to be forced to repay to a liquidator money previously received from a customer?

It has become relatively common for suppliers and others to be challenged by liquidators to repay funds that they have previously been paid.

Prior to the change of rules in late 2007, the contentious issue was determining what "the ordinary course of business" meant. The decisions surrounding liquidators' challenges did not discourage conventional or usual debt collection measures.

Since the McEntee Hire decision in August 2010 we have observed an increase in liquidators sending out letters seeking to challenge transactions.

It is disappointing that some liquidators seem to take an approach of challenging all payments made, rather than first considering whether there has been an actual preference to the creditor, any continuing business relationship (ie whether the contract was ongoing at the time of payment), industry practice (which may tolerate delays of payments), evidence and knowledge of credit concern, the nature of payments and trading history.

Consequently, we are sometimes asked to assist in reviewing Insolvent Transaction challenges taken by other liquidators.

As a result of such challenges, the Insolvent Transactions regime can be seen by suppliers in particular, to be at odds with prudent credit management. This is a conclusion that could be reached in light of the McEntee decision, but is that conclusion right?

We have also observed that suppliers are belatedly endeavouring to patch up holes in their procedures, in particular by late PPSR registrations of additional security rights to secure past indebtedness.

In our opinion, in some circumstances knowledge of a debtor's insolvency may be hard to avoid. It follows that the longer a debt goes unpaid the more likely it is that the supplier will be considered to be aware of the customer's inability to convert non-cash assets into cash, ie insolvency.

We consider that the consistent use of proper terms of trade, normal timely debt collection procedures, and asset protection mechanisms may protect a supplier from successful Insolvent Transaction challenges.

The regime therefore can be seen to encourage stricter credit terms and management, well defined trading terms and better security management. The mere fact of applying pressure to get payment does not in itself compel the conclusion that the payment is an Insolvent Transaction.

Insolvent Transactions regime

In an insolvent liquidation, unsecured creditors are treated equally and the company's assets are shared on a pro rata (or 'pari passu') basis. The term that is often used is to stop a creditor from 'stealing a march' on others. Where payments give individual creditors a preference, the regime enables a liquidator to set aside and claw back payments made within the two years before liquidation.

One feature of the current regime is the running account concept. This allows for the net effect of a series of invoices and payments in a "continuing business relationship" to be considered as one transaction. This is designed to stop liquidators challenging a series of payments to the same supplier, instead putting the focus on what the overall effect of the transactions was.

A continuing business relationship is established through a background of trading between the supplier and the customer. Factors such as the basis for the relationship, the business purpose and the character of the relationship, length of the relationship and frequency of transactions will usually be taken into account.

In McEntee Hire, it was agreed that a continuing business relationship existed, as McEntee had traded with its customer for over three years, with many sales and payments regularly in that period. However, the Court found that the continuing business relationship ended when McEntee issued a stop credit notice and referred the debt to a collection agency. It was noted that this was done four months after the last invoice for supply had been issued, and in circumstances where its policy in cases of suspected insolvency was to refer the debt to a collection agency.

McEntee argued that the stop credit notice was not the end of the continuing business relationship but more to "rebalance" and "preserve" the trading relationship, and did not reflect any concerns about the company's solvency. The liquidators successfully argued that payments were not being made to induce further supplies, and the relationship had shifted to one of pure debt collection.

We speculate that had the right to stop credit been with regard to a credit limit or other credit terms, and the referral to a debt collection agency been earlier and as a routine referral, the continuing business relationship may have endured.

Running account

An Insolvent Transaction claim is calculated in a number of ways; firstly where there is no running account, as a sum of payments, secondly when there is a running account, the net difference between the opening and closing balances and lastly, at the point of peak indebtedness - being the difference between the peak and the closing balance. This is illustrated as follows:-

Month Supply $ Payment $ Net Balance $
Nov-11 30,000   30,000
Dec-11   20,000 10,000
Jan-12 20,000   30,000
Feb-12   20,000 10,000
Mar-12 60,000   70,000
Apr-12   60,000 10,000
May-12 30,000   40,000
Jun-12   20,000 20,000

Possible scenarios:-

  1. No running account - sum of all payments $120,000
  2. Simple running account (opening - closing) $10,000
  3. Peak indebtedness (point of peak indebtedness - closing balance) $50,000

In this example, a supplier commenced trading with a customer in 2010. By November 2011, the customer owed the supplier $30,000. Six months later the customer owed $40,000. In June 2012, the company is placed into liquidation owing the supplier $20,000. Using this example, a liquidator could argue peak indebtedness and say the supplier was preferred by $50,000. The liquidator cannot cherry- pick a transaction (eg the April 2012 $60,000 payment) when there is a running account, and ignore that the creditor continued to trade with the company as a result of the payments made. Australian authorities have said, however, that liquidators ought to cherry-pick a date of peak indebtedness that best suits the general body of creditors. Section 292(4B) of the Companies Act 1993 does not limit a liquidator's ability to do so.

Summary

Insolvent Transactions will be a contentious but necessary feature of insolvency law for the foreseeable future. Creditors should review trade terms, and ensure that they have policies and debt collection processes and procedures that minimise the ability for liquidators to claw back valuable funds.

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.