The Income tax Act 2007 allows a company to make a tax free distribution of capital gains “on liquidation”.
The IRD issued publication QB20/03 on 11 December 2020. The publication discusses the first step legally necessary to achieve “liquidation” in both the short form (s318(1)(d) Companies Act 1993) and long-form liquidation (s241(2)(a) Companies Act 1993).
IRD have confirmed when “liquidation” occurs under each process. It reinforces BR Pub 14/09 that a short form liquidation commences (for tax purposes) when a valid resolution is passed, when the directors (and/or shareholders depending on the constitution) make the decision to wind up the business, pay all creditors, distribute surplus assets and request removal from the register of companies, and then carry out the short from liquidation process. It also confirms that the first step legally necessary to achieve a long form liquidation is not the same. A long form liquidation commences when the shareholders pass a resolution to appoint a named liquidator.
The commentary talks of the trigger for losing the “on liquidation” status under the short form method. Quite simply, if the company continues to trade after the winding up resolutions under the short form process or before the formal liquidation, there is a risk a capital distribution in that period is taxable. Also, if a company commences a short form process then there is a significant delay or does not complete the formal strike off, earlier capital distributions may be held taxable.
Directors need to be wary that when they decide to wind up their company and opt for the shortform method that they cannot be held to have traded in the winding up process and they cannot incur significant delay without reason. Refer IRD’s example 3 below. The short form liquidation process must lead to the company strike off.
Example 1 below shows it can take time to achieve a winding up, even years.
Changing processes from short to long form is less clear. The article suggests “unforeseen processes” as a legitimate reason. It does not specify the common position where companies resolve to wind up their businesses, start to carry out that process and then appoint a liquidator to complete the process down the track. Liquidation for tax purposes starts on the winding up resolution and then the formal long form liquidation starts from the shareholder resolution appointing the liquidators by name later. It seems so long as there is a clear intention and reason to change process that this is acceptable.
These are the key clauses relating to the change of process, from my perspective are at 12 and 13 of QB20/03 :
12. Changing Processes “Sometimes, a company that has embarked on a short-form liquidation may find it necessary due to unforeseen circumstances to appoint a liquidator. This could occur, for example, where a dispute arises in the course of winding-up the business that would be better to have a third-party liquidator resolve. The Commissioner considers that the period known as “on liquidation” began when a valid resolution was passed commencing the short-form liquidation process.”
13. Time Delays “In some cases, there may be an extended period between the first step legally necessary to achieve liquidation and the removal of the company from the register. The period may even span different tax years, so that a distribution is made in a period preceding the removal of the company from the register. The Commissioner will assume that any distributions are made pursuant to a genuine intention to liquidate. However, if the liquidation is not completed or, in the case of a short-form liquidation, the company does not cease to trade after a resolution to cease to trade is passed, then such a distribution will not have occurred “on liquidation” and the distributions will be taxable.”
This suggests that a company may change processes so long as there is a genuine intention to liquidate from the outset and “on liquidation” occurs from the initial resolution (so long as further trading does not disrupt that).
The key message is, so long as your client can clearly show there was no trading after the winding up resolution then there should be no issue with advancing a short form method. For certainty advancing a formal long form solvent liquidation is recommended – particularly for companies with large capital distributions. It removes the risk.
For advice on solvent or shortform liquidations contact our team.
Related Article: Ceasing to Trade a Company in New Zealand
It is important to keep proper books and records and ensure you meet your tax obligations. IRD say “declare it all or risk everything” in a recent announcement.
Late payments and bad debts are the main triggers of insolvency in construction companies. The payment of taxes however contributes to cash flow problems.
IRD’s recent release is heavily focussed on enforcement. Winding up applications by the Revenue are also on the rise generally.
For more information on the Revenue’s latest release relating to “cashies” read here.
We recommend communicating early and negotiating a time payment arrangement if your company falls into arrears but generally your business is viable. The IRD will likely require you to complete an IR591 (12 month cashflow forecast) to support any plan. The IRD provide the following advice for managing tax and for gaining financial relief for companies, partnerships and trusts <read here>
If the financial position of the company is dire then contact a Licensed Insolvency Practitioner to discuss the options. The IRD may consider financial relief or an instalment plan.
There is a high risk of financial penalties for failing to take action. By making a full voluntary disclosure, IRD say you may have your penalties reduced by up to 100%, you may avoid prosecution and you may retain your good business reputation. By communicating early on, your business has more chance of survival. By taking action early as a director you are less likely to be breaching your duties under the Companies Act 1993 and to be held personally liable.
Voluntary liquidation allows a company to terminate its operations and sell off assets and for any shortfall to be dealt with.
Some companies are liquidated because they serve no further purpose. Some are liquidated as they have unfeasible operations or poor operating conditions or technology has moved on. Others are liquidated because the founder has retired or passed and the business cannot operate without that expertise. Some have been affected by the failure of a large customer, the loss of a major contract or an extraordinary event, like Covid-19.
• The business cannot pay its debts as and when they fall due.
• Liabilities exceed total assets.
• The business is making losses and there are minimal prospects to turn it around.
• The directors are finding it hard to cope with the stress and pressure of trading.
• Trading is in decline and there is concern of personal liability for trading insolvently
• The directors would like someone else to deal with the creditors and all their claims.
Struggling companies juggle the payment of debts, are often in receipt of formal demands or statutory demands and commonly are on instalment plans with Inland Revenue or certain suppliers that they are having difficulty honouring.
When a company is facing financial distress and having trouble paying its creditors including GST and PAYE, there is a high chance that the business is already insolvent. Company directors who operate an insolvent business must act in the best interests of creditors and cease trading immediately if there is no realistic prospect of recovering from the financial difficulties being experienced.
When a company is in too much in debt to recover from a turnaround strategy or restructuring procedures such as company compromises or voluntary administration, liquidation is often the only viable course of action.
Liquidating leads to dissolving the failed company structure and bringing all activity of that company to a close. It is a way for a company that has run out of funds to deal with the shortfall to creditors.
The role of the liquidator in an insolvent liquidation is essentially to realise the company's assets, and, where possible, to make a distribution to the creditors.
The liquidator also conducts investigations into the failure of the company, the conduct of its directors and, sometimes the conduct of third parties, like creditors.
An insolvent company is generally wound up voluntarily by the shareholders or on a Court application by a creditor. A licensed insolvency practitioner (IP) is appointed to oversee the liquidation process.
The liquidators take steps to realise the company assets and pay outstanding creditors according to a designated hierarchy set out in the Companies Act 1993. If there is a shortfall the creditors receive their entitlement and the balance is written off or possibly pursued under a personal guarantee if one has been granted.
If the company has sufficient funds to pay all creditors, it is solvent and surplus funds are distributed among shareholders according to their percentage shareholding.
If the company is solvent, the company can be wound up following a S218(1)(d) strike off process or by way of a solvent liquidation process. The latter can provide more certainty for companies with larger capital gains.
The process of voluntary liquidation is less stressful than facing a winding up proceeding following a creditors application to the Court. The voluntary appointment can be planned in advance to minimise disruption and the shareholders have the opportunity to select the licensed insolvency practitioner who will manage the entire process. The appointment process is fairly straightforward.
Liquidation may not necessarily mean the end of the business. It may be that the business assets are sold at market value as a going concern and a new company takes over. The IP decides on the best way to maximise value for the creditors and whether that involves closing or trading whilst the business is marketed for sale. With a voluntary process the plan can be discussed prior to the appointment including how staff are managed and assets realised. Often directors can have an involvement or a say in the process because it is in their interests to maximise the recovery and minimise the exposure to creditors who hold personal guarantees.
Although a company structure provides limited liability, this does not mean directors can ignore matters if financial problems arise. Directors have legal obligations to adhere to certain standards. Acting earlier reduces the risk of personal liability.
Continuing to trade with knowledge of insolvency is a risk, where you could find yourself as a director being held personally liable for trading.
Once a director or shareholder knows their company to be insolvent, they must not engage in any activity which could worsen the position of creditors or increase their losses any further. Directors should not increase debt, incur further credit, dispose of assets below market value, or increase their overdrawn current account.
If you do not have sufficient funds to pay everyone you owe, you place your creditors at risk of receiving a voidable transaction if they have knowledge of the demise of your company.
If your limited liability company is facing financial distress but the business is viable, gain advice from a professional. A licensed insolvency practitioner will be able to talk you through the options for rescuing the company (restructuring), giving you the best chance of a successful turnaround, while also ensuring you are adhering to your duties as a director.
There are options such as a hive down process (new company structure), creditor compromises (current company structure with a repayment plan for creditors), voluntary administration (current company with a Deed of Company Arrangement).
For advice, contact the MVP team.
Generally speaking, in the liquidation of a company, creditors of equal ranking in the liquidation are treated equally. So, if there are funds to distribute, they will all receive the same proportion of the amount that they have claimed. This is known as the Pari Passu Rule.
The exception to this rule is when there is a mutual set-off between the company in liquidation and another party that is both a creditor to whom the company owes money, and a debtor that owes the company money.
The requirement for the mutual set-off is set out in section 310 of the Companies Act 1993 as follows -
(1) Where there have been mutual credits, mutual debts, or other mutual dealings between a company and a person who seeks or, but for the operation of this section, would seek to have a claim admitted in the liquidation of the company,—
(a) an account must be taken of what is due from the one party to the other in respect of those credits, debts, or dealings; and
(b) an amount due from one party must be set off against an amount due from the other party; and
(c) only the balance of the account may be claimed in the liquidation, or is payable to the company, as the case may be.
Note that the wording of the section includes the use of “must”, meaning, in a liquidation, if the conditions for a mutual set-off are met, then it is mandatory and cannot be contracted out of.
There are further provisions in S 310 that place restrictions on the ability to claim the mutual set-off because of the timing of the relevant transactions, in relation to the date of the company’s liquidation, or the other party’s relationship to the company in liquidation.
The key legal requirements for set-off in liquidation are:
• The claims must exist at the start of the liquidation. At that time, there must be mutual dealings capable of being subject to an accounting between the parties.
• The claims must be measurable at the commencement of the liquidation. In effect, there must be money claims each way. The claims must be provable in liquidation but need not be for a liquidated amount or an amount due at the date of liquidation. This would include damages, whether liquidated or not, contingent claims, secured debts and future debts due to mature after the commencement of the liquidation.
• The parties must be the same and the claim must be in the same right. No set-off can be asserted against a person in different capacities, for example, debts due from a person in their capacity as a trustee or partner cannot be set-off against a claim against that person in a personal capacity.
The requirement to use the mutual set-off provisions in a liquidation is an exception to the pari-passu rule. It is there to avoid the injustice that could occur if a liquidator could require a person, who is both a debtor and a creditor of the company, to make payment in full of the amount they owe to the company in liquidation, when the same person, as a creditor of the insolvent company, may potentially receive nothing at all.
If you would like more information about mutual set-offs, or any other matters relating to insolvency procedures, please contact one of the McDonald Vague team.
On 24 September 2020, the Supreme Court delivered its judgment on a case taken by the liquidators of Debut Homes Limited (In Liquidation) (Debut) against its director, Leonard Wayne Cooper.
In this case, the liquidators alleged that the director had been in breach of duties as director under the Companies Act 1993 (the Act) and were seeking orders against the director.
The liquidators were successful in the High Court, but that decision was overturned by the Court of Appeal. The liquidators were then granted leave to appeal to the Supreme Court, where they were successful, and the orders made in the High Court were restored.
The background to the case was that Debut was a property developer and Mr Cooper was its sole director. At the end of 2012 Mr Cooper decided to wind down Debut’s operations. It would complete existing projects but would not take on any new ones. At the time the decision was made, it was predicted there would be a deficit of over $300,000 in GST once the wind-down was completed.
Section 135 of the Act relates to reckless trading and contains duties of particular relevance to insolvency situations. Section 135 states –
135 Reckless Trading
A director of a company must not-
(a) Agree to the business of the company being carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors; or
(b) Cause or allow the business of the company to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors.
Mr Cooper submitted that continuing to trade in circumstances of insolvency can be a legitimate business risk, not a breach of duty, if there is a probability of improving the position of most of the creditors, as was the case in this matter. He submitted that the reasonableness of such actions must be assessed in terms of the benefit to the company as a whole and not by reference to any detriment to individual creditors.
The Supreme Court found that there was a breach of section 135. It was known by Mr Cooper that there would be a GST shortfall of at least $300,000, which is a serious loss. It also said that it was not possible to compartmentalise creditors and held that it was a breach whether or not some creditors were better off and whether or not any overall deficit was projected to be reduced.
Section 136 of the Act also relates to insolvency situations and provides as follows-
136 Duty in relation to obligations
A director of a company must not agree to the company incurring an obligation unless the director believes at that time on reasonable grounds that the company will be able to perform the obligation when it is required to do so.
The liquidators accepted that by continuing to trade, Mr Cooper may have reduced the company’s obligations to secured creditors. However, continuing to trade caused the company to incur new debt to the IRD and 10 new unsecured creditors who had supplied goods and services to complete the properties.
They submit that Mr Cooper knew, when signing the sale and purchase agreements, that the GST obligation at least would not be met and that therefore he had breached the duty under section 136.
The Supreme Court decided that it is clear from the existence of section 136 that it is not legitimate to enter into a course of action to ensure some creditors receive a higher return where this is at the expense of incurring new liabilities which will not be paid.
Section 131 of the Act requires the directors to act in good faith and in the best interests of the company and provides –
131 Duty of directors to act in good faith and in best interests of company
(1) Subject to this section, a director of a company, when exercising powers or performing duties, must act in good faith and in what the director believes to be the best interests of the company.
The High Court held that Mr Cooper breached this duty in two respects. First, when he applied the funds realised from the sale of properties to fund further work and to satisfy secured debts which he had personally guaranteed. In doing so, the High Court said, he was not acting in good faith as he was not considering the obligations Debut owed to all its creditors. Secondly, Mr Cooper was acting in his own interests above those of Debut as, by failing to pay GST to the IRD, Mr Cooper was creating a new debt for Debut which would be subject to penalties and interest, while limiting his own liability for debts guaranteed by himself.
The Supreme Court held that Mr Cooper had breached his duties under section 131 because he failed to consider the interests of all creditors and acted in his own interests in direct conflict with Debut’s best interests.
The Judgment also includes decisions in relation to a possible defence for Mr Cooper under section 138 of the Act, whether or not a security in favour of a related trust should be set aside in part or in full, and the level of compensation to be ordered under section 301 of the Act, which we have not summarised.
As can be seen from the Judgment of the Supreme Court, which resulted in the restoration of the High Court orders against Mr Cooper to pay $280,000, there is a strong requirement on the directors of insolvent companies to consider the interests of the company, and all of its creditors, ahead of their own best interests.
It is also clear, when considering the interests of creditors, that a director has to consider them individually – not lump them together and say that while some creditors have lost more than they would have if trading hadn’t continued, overall the creditors are better off.
The practice of “robbing Peter to pay Paul” is not legitimate and can lead to directors facing allegations of breach of duty and, potentially, substantial orders to compensate the company and its creditors.
If you would like more information on the duties of directors, please contact one of the team at McDonald Vague.
Link to the Judgment Of The Court
One of the obligations on the liquidators of insolvent companies, whether appointed by the shareholders or the Court, is to review the books, records and affairs of the company to identify any potential causes of action that could lead to a benefit for creditors.
This could include identifying potentially voidable transactions, where an individual creditor has received a payment, giving it preference ahead of the body of creditors, or the transfer of assets or property to other parties for no, or insufficient, consideration.
It could also include identifying breaches of duties by the directors which has caused creditors of the company to suffer increased losses.
While many such causes of action are identified and settled by agreement between the liquidators and the parties concerned there are also cases where there is no agreement and the liquidator is left with the options of either initiating legal proceedings or dropping the matter.
In making that decision, the liquidator will consider the strength of the case, the likely costs to be incurred in proceeding and how these could be funded, and the level of return to creditors that could eventuate from such action.
The funding of the proceedings is the major obstacle the liquidators need to overcome and many good cases are not actioned because of the inability to raise the funds.
Broadly speaking, a liquidator has 5 potential avenues of funding available –
If the liquidators have realised sufficient funds from the liquidation of the company’s unencumbered assets, they are entitled to use those funds to cover the costs of their investigation and any legal proceedings.
In those circumstances, the liquidators have to give careful consideration to the likelihood of success in the legal proceedings and, if those proceedings are successful, the likelihood that any amounts ordered are collectable and will result in a distribution to creditors.
It could leave a liquidator open to criticism if they use up funds, that could have been distributed to creditors, on a risky action against a director and ended up with no recovery or only sufficient recovery to cover the costs of the liquidator’s investigations and the legal costs incurred in running the case.
The Liquidators can decide to fund the proceedings from their own resources. This will be done by allowing their time to accumulate as unpaid Work in Progress (WIP) and by paying any legal costs from their own funds and recording those payments as a disbursement to be recovered when, or if, funds are available.
This is a reasonably common practice amongst insolvency practitioners, but the same things will be considered when making the decision. The bottom line is, will the actions lead to a return to creditors?
It is not the liquidator’s job to take proceedings that will lead to a penalty being imposed on the defendant that only pays the liquidators costs. If legal actions are not likely to lead to a benefit for the creditors, but the director’s actions warrant it, the Liquidators can, and should, report the breaches committed by the director to the Registrar of Companies, with a view to having them banned.
Creditors of a company in liquidation can be approached by the liquidators to see if they are prepared to provide funding to allow legal action to be undertaken. Those creditors that do agree to provide funding receive a priority ahead of other unsecured creditors pursuant to clause 1 (1) (e) of the Schedule 7 of the Companies Act 1993.
This allows payment of the unsecured debt of that creditor, and the amount of the costs incurred by that creditor in helping to recover the funds, ahead of some other preferential creditors and the rest of the unsecured creditors.
The use of 3rd party litigation funders is increasing in New Zealand but is generally limited to the larger cases, such as the Mainzeal Property & Construction Limited (in Liquidation) claim against its directors.
There have been questions raised about the ethics of this form of funding but, whilst there is no specific legislation about the use of 3rd party funding, it has been approved in various proceedings. The Law Commission is currently undertaking a review of class actions and litigation funding
The 3rd party funders provide the funding for proceedings, which would otherwise be unaffordable, in exchange for a percentage of any recoveries. If there are no recoveries, the 3rd party funder carries the cost, so there is no downside for the creditors.
Section 316 of the Companies Act 1993 establishes, and regulates the use of, the Liquidation Surplus Account (“the account”).
Funds that represent unclaimed assets from a liquidation must be paid to the Public Trust and will, if they remain unclaimed for a period of 12 months, become part of the account.
Liquidators can apply to the Official Assignee for New Zealand for a payment from these funds to cover the cost of proceedings, advice, or expert witnesses.
To be eligible for the funds, the liquidator must prove that it is fair and reasonable for the costs to be met out of the account. There should be a public interest element in the proceedings and the application must relate to the claims of the creditors in the liquidation.
It is understandable that the creditors of a failed company want to see errant directors held to account and forced to cover the losses they have incurred because of that director’s actions and they expect liquidators to do that.
The options outlined above all include one party or another taking on the often substantial risks and costs involved in taking legal proceedings, so, while the main objective is always to recover funds for the benefit of the creditors, any actions taken have to be carefully considered and reviewed objectively.
Throwing good money after bad, or spending money, that could have provided some return to creditors, without any recovery, is not in the best interests of either the creditors or the liquidators.
The country is in the process of working its way back from the economic standstill that most industries experienced as a result of the Level 4 lockdown. For those that traded at Level 3 and Level 2, they had to shift their business models to meet the COVID-19 trading requirements. Many of those requirements squeezed margins.
In the coming months, many business owners will need to look at their businesses and decide whether to continue to trade going forward. While the Government has provided some support, recovering from lockdown is just one more hurdle for businesses that have been experiencing year on year increases in operating expenses and the minimum wage, both of which have made tight margins even tighter.
How lockdown and decreases to many people’s take home pay has affected consumer spending is not yet known.
As business owners look to the future, what can they do if they find themselves in a spot of financial hardship and what options do they have available to continue to operate while the economy recovers?
If a business addresses the stumbling blocks that it is facing at an early stage, many are able to work through those obstacles though decision making and implementing change.
A business restructuring or turnaround can be done by the business owners, usually with the assistance of third parties. The fact that a business is going through a restructuring or turnaround is usually only known to the company’s directors, its lenders, and its key stakeholders.
The process includes:
- assessing/reviewing the business
- identifying areas of strength and weakness within the business
- determining what areas of the business need to be changed
- assessing what changes are best suited to the business and its stakeholders
- making an action plan and implementing the decided upon changes
By undertaking a financial and strategic analysis of the company, you have the tools you need to create an action plan that maximises the return on investment in the business and improves the business’ performance.
It is important to have stakeholder buy in around the timeframes for the turnaround, the KPIs being measured, and the responsibilities of those involved in the turnaround. It is also important that the key stakeholders monitor the plan to ensure that the objectives and milestones are met and that corrective action is taken to get back on track, if targets are not met.
If a business was doing well before COVID-19 hit and now needs some breathing space to get itself back on track, entering into a BDH scheme may be the right option. While BDH does not compromise any of the business’ debts, it gives the business extra time to pay those debts off.
If a business needs the support of its creditors as well as its lenders and key stakeholders to continue and it is not in a position to pay its creditors in full, the business’ creditors may agree to a creditor compromise. The key ingredient to a successful compromise is for the business to have a credible and achievable plan that, when implemented, is likely to result in a better return to creditors than they would receive if the company was put into liquidation.
Compromises can propose that specified unencumbered assets be sold and the net proceeds of sale be paid to creditors and/or for a third party to inject funds into the business so that creditors can receive an agreed payment in satisfaction of their debts.
The aim of entering into a VA is for the business to enlist outside assistance to provide the business with an opportunity to restructure its debt and ultimately trade out of difficulty. VA gives a business a way to maximise the chances of the business recovering or, if that is not possible, for it to be administered for a time so that creditors receive a better return than they would from immediately liquidating the company.
A voluntary administrator may be appointed to a company by the directors, a liquidator or interim liquidator, a creditor holding security over the whole or substantially the whole of the company's property, or the Court.
Receivers can be appointed by a creditor that holds security over the whole or substantially the whole of the company's property, which means that receivers are usually appointed by banks or private lenders. The aim of the receivers is always the same - to protect the interests of the secured creditor and ensure that the secured creditor’s debt is repaid as quickly as possible.
Both solvent and insolvent companies can be put into liquidation.
A company can be placed into liquidation by its shareholders (by shareholders’ resolution) or by the High Court (usually at the request of a creditor but can also be at the request of a shareholder or director of the company).
A solvent company might be placed into liquidation by its shareholders after the business has been sold, closed down, and/or reorganised for tax and/or management purposes.
An insolvent company can be put into liquidation by its shareholders by resolution, usually after the directors and/or shareholders have identified that the company is insolvent and that it is in all stakeholders’ best interests for there to be an orderly winding-down of the business’ affairs.
If a company owes an undisputed debt, the creditor can issue a statutory demand for that debt. If the debt is not paid within 15 workings days, the creditor can apply to the High Court for the company’s liquidation. If the High Court puts the company into liquidation, the liquidators nominated by the applicant are usually appointed.
If a company is facing liquidation by a creditor, the shareholders can put the company into liquidation themselves as long as they do so within 10 working days of being served with the liquidation proceedings. Some shareholders choose this option because they consider that liquidation is inevitable and liquidation by shareholder resolution allows them to appoint liquidators of their choosing.
Early Intervention: The earlier issues are acknowledged and addressed, the more options a business has to tackle those issues and the easier they are to deal with. If you need outside assistance, seek it. In our experience, issues left unaddressed for too long can become insurmountable.
Personal Guarantees: While directors are not automatically liable to pay company debts, most directors will have some exposure to a company’s creditors because they have given personal guarantees. As a director, it is important to know what your personal exposure could be, if the company fails.
Have Up to Date Business Records: If your company’s financial information is not up to date, it is harder for you to make accurate financial decisions. If the information is up to date, you will be able to see where your money is going and where you might be able to make savings.
Review Your Business Model: Now is a good time to look at where your revenue comes from, who your ideal customer is, and whether you are catering to that customer’s wants/needs. If there is a mismatch, what changes can you implement to reach that market?
Landlords and Leases: For many businesses, rent is a large portion of their fixed outgoings. In response to COVID-19, the Government has made some amendments to the Property Law Act that affects landlords and tenants’ rights, including in relation to timeframes for terminating leases for non-payment of rent and introducing a fair reduction in rent term for some small businesses (this amendment has not yet been enacted). If you are concerned about steps being taken by your landlord, seek professional advice.
There has been a lot of commentary around what the COVID-19 global pandemic is doing to countries’ economies. Some economists are predicting a global economic downturn to be the worst recession since the Great Depression and most are expecting this downturn to be worse than the GFC.
Today, 14 May 2020, New Zealand is moving from Level 3 to Level 2 and a lot of businesses are re-opening for the first time since the Level 4 lockdown came into effect seven weeks ago. In the weeks and months ahead, we will find out what effect the lockdown has had, so now would be a good time to look at the NZ insolvency figures to April 2020 and how those figures compare to the last couple of years.
Today is also budget day and Jacinda Ardern has signalled that the government will be spending to support businesses and keep people connected to their jobs.
Between 1 January 2020 and 31 March 2020, there were 421 formal insolvency appointments. Appointments were down over this period when compared to the same periods in 2019 (454 appointments) and 2018 (559 appointments).
In April 2020, there were 94 appointments, which was just over half the number of appointments in April 2019 (159) and April 2018 (160).
When the April 2020 figures are added to the previous months, insolvency appointments in the year to date are down by roughly 16%+ when compared to April 2019 and April 2018.
As at 30 April 2020, there were 652,033 companies registered on the Companies Register.
Many people will be feeling the financial impact of COVID-19. Many have lost their businesses and/or their jobs. The number of people on a benefit has increased, as has the number of people receiving food parcels.
The number of bankruptcies between January 2020 and March 2020 are similar to the same period in 2019 (268 and 281 respectively). The number of bankruptcies in 2018 was roughly 33% higher over this period.
The number of bankruptcies in April 2020 dropped to 50, of which 80% were debtor applications, which is a significant decrease in the number of bankruptcies when compared to March 2020 as well as April 2019 and April 2018. The decrease in creditor applications was probably because the Courts were operating at reduced capacity so creditor's applications were held off. In April 2019 and 2018, roughly 73% of the 109 bankruptcies were debtor applications.
We expect to see both company and personal insolvency numbers start to increase, especially in the second half of 2020.
The Government’s 12 week Wage Subsidy scheme is approaching its end, and many are now looking at whether they can access the next stage of support via the Small Business Cashflow (Loan) Scheme (SBCS) available from 12 May 2020 Link Here
The announcements made in today’s budget are likely to provide further targeted stimulus probably for infrastructure and tourism, as the country's balance sheet is not limitless. We will need to wait and see what those announcements and the timing of further spending are...
We hope that for the many business owners and employees returning to work today their day is productive and safe. Day by day we will all need to deal with the effects the lockdown has had on our businesses and the ability to restart, especially those who have not been trading at all, and will now need to look at how to deal with seven weeks of expenses and no income over that period.
As a firm we have been working through these situations with a range of clients for the last few weeks. There are many ways to address those issues.
Businesses in New Zealand are facing challenging times. Directors of companies are pulled in all directions - employees to care for, bills to pay and creditors chasing them for payments. Directors are not alone in feeling the extreme levels of stress, fear and anxiety.
Directors however should not now be prolonging the inevitable where they had no viable business pre Covid-19 and if post Covid-19 there is no reasonable prospect of the company recovering from the current circumstances. If circumstances are dire, the shareholders should be looking to appoint a liquidator to avoid debt increasing and further harming creditors. Liquidation does not necessarily mean the end of trading altogether. Often the business is sold and sometimes there is an opportunity to be involved in the successor company.
Viable companies at December 2019 that fail as a consequence of Covid-19 have relief measures available to them. The government has eased the rules around trading in insolvent circumstances to increase the survival prospects for businesses that were profitable at the start of COVID-19. This is to encourage directors of businesses that were viable pre Covid to not place their company into liquidation prematurely with the fear they be may held personally liable under 135 and 136 of the Companies Act.
The same relief is not afforded to businesses that have traded recklessly leading into lockdown and then carried on causing further demise to their creditors. Directors of companies that were trading insolvently pre Covid-19 could be held to have breached directors duties or found to have breached Section 380 of the Companies Act 1993 “Carrying on business fraudulently or dishonestly incurring debt”. Directors should be aware of their obligations and be taking proactive steps. The government’s message to show kindness also includes caring about the impact on creditors.
If the sudden and rapid economic effects of the COVID-19 pandemic, to be followed by the anticipated global recession and an expected long period of recovery, mean it is now unrealistic to continue trading, then liquidation is an option for both solvent and insolvent companies.
An insolvent liquidation is where there is a shortfall to creditors. A solvent liquidation is advanced to enable capital profits to be distributed tax free.
Some company failures are for reasons out of the control of the director. Many liquidations that are likely to commence in June/July 2020 will be attributable to the impacts of Covid-19.
Liquidation is not always the best answer and can be the last resort after exhausting all other options. Company compromises or the new Debt hibernation scheme are certainly options to review first as well as the loan schemes available. To some, liquidation is inevitable, there is insufficient light at the end of the tunnel, lack of funding or too much uncertainty or personal risk. Liquidation can be an opportunity to restructure, review, revise and build again and reduce personal liability.
Liquidators on appointment take control of the business and the process going forward. The liquidator acts for the creditors. They recover available assets, investigate the company’s affairs and distribute any available funds to creditors in the order of priority specified by the Companies Act 1993.
Liquidating a failed company does not necessarily mean the end of trading a business again or the inability to be involved in the liquidation process. Each liquidation is different.
Many directors have started again, learned from their failures and gone on to run highly profitable businesses. Many have relied on the exceptions in the Phoenix company rules to buy back the business and trade with the same/similar name.
With the agreement of the liquidator, there can be an opportunity to buy the business assets and Intellectual property (including brand/tradename) and trade again with the same/similar company/ trade name. An “exception” under the Companies Act is the ability to purchase from the liquidator and to then issue a successor company notice within a specific time period.
Directors of failed companies who do not comply with the exceptions at Section 386D are prohibited from being, directly or indirectly, a director, manager or promoter in a phoenix company or business.
Those that comply with the exceptions can go on to trade again with the support of their suppliers and customers.
An independent liquidator can consider a sale back to the director or management team or related party. The purchasing entity is termed a "phoenix" company, if the same (or a similar) company or trade name is used and the previous director or management team remain in a management position.
Since Insolvency practitioners hold and manage company assets in a fiduciary capacity and make decisions that can materially affect the total amount available for distribution to creditors, they typically gain independent valuations to support a sale back and prefer to test the market. In some cases the only market is the persons who were involved in the failed company.
The business assets of a struggling company in liquidation are sold usually following a robust sale process and at market valuation and after considering the specific circumstances leading to liquidation. The proceeds of realisation flow back to the company in liquidation to be distributed to creditors. The purchaser of the assets (related party or third party) needs to acquire the assets following a fair process and to fairly pay for those assets. A hive down restructure requires careful planning to protect the brand, company reputation, and supplier/customer relationships. Restructuring where creditors in the failed company are not paid fully has its challenges for the new company to gain continued supply and support.
A hive down structure needs to consider:
• Restraints of trade
• Transferability of contracts
• Staff retention
• Customer / supplier support
• License renewal
• Retention of tax losses
The new “phoenix” company has an obligation to issue a successor company notice within 20 working days of the purchase - when this occurs, it gives the director of the new company (successor company) protection from personal liability. It also informs suppliers they are dealing with a new entity and need new trade terms. A similar system can also apply to a management buyout, where the purchaser wishes to buy assets rather than shares.
A phoenix company can also arise for the wrong reasons, or can go very wrong, typically where a director of a failed company transfers assets to a new company at undervalue or alternatively transfers the assets for value but fails to take the required steps defined at Section 386A of the Companies Act 1993.
A sale of assets pre liquidation by the directors to another company prior to the liquidation of the failed company at undervalue, or even no value will be investigated by the liquidator. This is commonly referred to as ‘phoenixing’ and is contrary to insolvency law because fair value should be obtained from the sale of assets. The expectation is that the liquidator will seek to recover assets that were disposed of at undervalue or no value and add them to the pool of assets available for distribution to creditors.
Liquidators will also investigate the affairs of the company and decisions taken by the directors in the lead up to the liquidation. Directors can be held responsible to compensate the company for matters such as breaches of directors’ duties, insolvent trading or unreasonable director related transactions.
For those directors that sell at a market value and continue in a governance or a management role or as named directors in a new company structure before liquidating the failed company, they need to be aware of the phoenix company provisions in the Companies Act 1993 and apply to the court as a matter of urgency for Court approval to use the same/similar company/trade name.
Section 53 of the Insolvency Practitioners Regulation Amendments Act introduces sections 296A to 296D of the Companies Act in relation voidable dispositions of company property during the specified period. The specified period begins on the date on which an application is made to appoint a liquidator under 241(2)(c) and ending at the time the liquidator is appointed.
Disposition is not voidable if made in the ordinary course of business , or by an administrator of receiver or under a Court order.
The amendments will void the transfer of a company’s assets once a liquidation application has been filed, other than in the ordinary course of business, where the court has given leave, or where the liquidator has ratified the transfer, save for transfers by an administrator or receiver;
Creditors of a business that failed leaving them exposed will often see it as wrong that the business can be transferred to a new corporate vehicle, leaving the creditors of the failed company with no recourse to the business for payment of the old debts. This is a valid concern but only when proper value has not been paid or where the director has sought to defraud creditors.
There are many existing remedies in the Companies Act and other legislation to address the harms caused by the misuse of the voluntary liquidation process. Examples of existing provisions that help the creditors of the old company are enforcement of directors duties and fraud and dishonesty offences, repayment orders, the setting aside of prejudicial and voidable transactions and banning people from being directors.
While the phoenix provisions in the Companies Act are sometimes criticised for being too narrow, they do provide important protections for the creditors of the new company. Creditors of the new company should not be led into believing (wrongly) that the business has been longer established than it has been. The provisions themselves do not focus on the creditors of the old company.
In Commissioner of Inland Revenue v Clooney Restaurant Ltd  NZHC 451 the High Court granted relief to the Inland Revenue against a phoenix company and its sole director for the disposition of property intending to prejudice creditors; the breach of director duties; and the breach of s 386A of the Companies Act 1993 (phoenix company director liability).
Upon receiving winding up proceedings from Inland Revenue seeking to recover tax liabilities, the company director transferred the Clooney restaurant business to a new company Clooney Restaurant Ltd before the proceedings to place the failed company into liquidation.
The High Court found that the transfer was prejudicial as there was no right to recourse against the transferred property. The court also found that the director breached his duties to the vendor companies and said “Relieving the companies of their only significant asset, while leaving them without means to meet substantial liabilities, is not in their best interests”: at .
The High Court also found that the unmet tax liabilities were exclusively caused by the directors actions and that as a director of the new company and a director of the phoenix company, the director had breached s 386A(1)(a) of the Companies Act rendering him personally liable for the phoenix company’s debts.
Under s 348 of the Property Law Act 2007, the phoenix company was ordered to pay compensation to the vendor companies in the sum of $383,959.40. The director was ordered to pay the CIR $383,959.40 under s 301 of the Companies Act.
The decision can be found here.
A struggling company can consider liquidation and starting up again but the right processes need to be taken to protect the creditors, the director and the liquidator.
With the upheaval being caused to many SMEs by the Covid-19 lockdown and the potential for many of those SMEs to fail, the risk to people who have provided personal guarantees (PG’s) for company debts increases.
The support packages for companies being provided by the Government and the major trading banks is good news for the employees, because of the 12-week wage subsidy package, and for those businesses that can meet bank lending requirements to access the business finance guarantee scheme or possibly can use the debt hibernation and tax packages.
But the position for those companies that have other significant overheads and possibly were loss making startups or were already struggling, and for the individuals involved with those companies that have personally guaranteed some of the company obligations, the picture is not so bright.
It is expected that some creditors will make demand on individuals for payment of those company debts, pursuant to their PG’s, and, in the event the debt is not paid, proceed to bankrupt the individual concerned.
If the holders of PG’s or sole (unincorporated) traders end up being bankrupted, or declaring bankruptcy, due to the financial impact of the lockdowns largely through circumstances and decisions outside of their control, the current repercussions are, in our opinion, too harsh.
We would support a new personal insolvency regime that allows those bankrupted (say a Covid class) that can reasonably show the bankruptcy arose from Covid 19’s impact, be given a clean slate alongside an agreed reasonable repayment plan for the personal debts over time (potentially managed by responsible third parties) so that those people are:
- Not impacted further;
- Not consigned to the unemployment lines or pushed into the “black economy”;
- Able to access credit
- Able to open bank accounts
- Able to restart in business
Reducing the prospect of bankruptcy the below packages have been and remain available.
There are some companies who have applied for and received the 12-week wage subsidy for their staff that will not survive through the 12 week period and will be placed into liquidation.
The subsidy was provided so that staff could be retained to enable businesses to continue post lockdown. So, what happens if that doesn’t occur?
We understand that individual employees who received the wage subsidy payments will not be asked to pay any of those funds back, but what about the company and the directors involved who signed the declaration confirming employment for 12 weeks and best endeavours to provide ongoing employment? Will the directors be personally liable under the scheme for those funds?
MSD have advised that on liquidation, if the Liquidators cannot retain the staff, then they can use the subsidy to pay out employee entitlements (i.e. notice period) and any surplus funds should be returned to MSD. The wage subsidy cannot be used to pay out any redundancy obligations in an employee’s employment contract.
The wage subsidy, although providing some relief, doesn’t cover the other on-going expenses of the company that may be continuing whilst in lockdown such as rent, insurance, ACC payments, hire purchase payments and finance payments and interest.
Those amounts will continue to accrue, some with penalties being incurred for non-payment and many, such as rent, hire purchase and finance payments will in all likelihood, be covered by personal guarantees.
This provides for extra finance to be provided by the trading banks to eligible companies with the Government carrying 80% of the risk and the bank 20%. The bank will still be in the position of deciding whether or not a company is worth lending to but, with the bank carrying 20% of the risk it is to be expected that their lending criteria will continue to be enforced.
The loans have to be repaid in the normal manner, according to the terms agreed to and will, in all likelihood, be covered by a General Security over the company’s assets and either a pre-existing or new personal guarantee. So, what happens if the company fails before the loan is repaid?
Does the bank have to try and recover the full amount owing under the loan in the usual fashion – firstly from the company concerned and, if necessary, from the guarantors before it can call on the Government for its 80%? That appears to be the case.
An article published by Simon Thompson on Linkedin on 21 April 20 “How Does the NZ SME Loan Guarantee Scheme Measure Up To Others?” read here he comments “The simplistic property based focus will not be enough and their [the banks] blanket catch-all personal guarantees discourage applications.”
The article further suggests “An alternative model is to have a limited personal guarantee whereby the SME owners are only liable for the debt if there has been fraud or theft of funds from the business. The SMEs must pledge that the finance will be used exclusively for business purposes and that personal drawings will be no higher than in previous periods or as per a business plan.” And “The personal guarantee, if it is applied, should also be capped at 20% of the loss, as the UK model allows. The NZ Government already guarantees 80% of the risk under this scheme, while the bank takes 100% of the profit from the loans and has just 20% risk. Surely under that environment special conditions should apply.”
The following table developed by Mr Thompson compares the loan schemes in NZ, Australia and UK:
There are a wide range of proposed tax changes including;
• Depreciation on assets for some classes of assets
• Not charging UOMI on new debt
• Temporary loss carry back scheme
• Possible Permanent Removal of loss continuity provisions for the 20/21 period – discussion later in 2020, could be enacted before March 2021.
Tax payments arrangements can be modified by agreement if the taxpayer can show they have been significantly adversely affected and “income or revenue has reduced as a consequence of Covid-19 and as a result is unable to pay taxes in full on time. The key is to interact with IR as soon as practicable to agree to an arrangement to pay at the earliest opportunity.
The support packages provide somewhat of a life line for businesses that were viable before the Covid-19 lockdown and will be able to recover once “normal” (what ever that is like) trading resumes, but for those companies that were already struggling and cease operating, Covids impact and the support packages could become a millstone around the neck of the directors, and others, who have provided personal guarantees.
It is important that individuals who have provided personal guarantees and may be exposed to claims against their personal assets, seek independent advice from their professional advisors before taking any actions that might increase that risk and the level of exposure.