Nick Russell: Court decision on insolvency victory for the little guy

Clawbacks have been a particular issue in construction because a single development can have contractors who are at risk if the developer becomes insolvent.

Opinion

Small business owners, particularly in the construction industry, should be breathing a sigh of relief this week. The Supreme Court has delivered a decision which upholds their rights to keep payments made by companies which subsequently go into liquidation, against demands from liquidators to "claw back" the money so that it can be used to satisfy the claims of other creditors of the insolvent company. This is complicated, but it's also important, so bear with me.

The law's approach to insolvency is (relatively) straightforward: when a company goes into liquidation, its assets, including any debts owed to the company, get consolidated and then shared out among the creditors by the liquidator on a pro rata basis, after any secured or preferred creditors have been paid.

This is known as the "pari passu" principle. As part of this process, liquidators can try to claw back any payments made by the company up to two years before it became insolvent. Until 2006, the Companies Act provided that such payments could be clawed back by liquidators unless the company had made the payments in the "ordinary course of business". That phrase became something of a legal battleground between creditors who had been paid for supplying goods and services to the insolvent companies and the liquidators trying to claw those payments back.

Claw-backs are a terrifying prospect for a lot of small businesses, who can ill-afford to repay money received months ago for a barely-remembered job, or to pay a lawyer to argue the point with a liquidator. It has been a particular issue in construction because a single development can have dozens or even hundreds of contractors, all of whom are at risk if the developer becomes insolvent.

Accordingly in 2006 the Government changed the law to clarify the position, so that a creditor could avoid a claw-back by showing the payment was received in good faith, without knowledge of the company's insolvency, and that it had provided value in return for that payment. In theory this made life easier and more certain for businesses which receive payments for work done because in most cases there would only be a claw-back if the recipient knew the company was insolvent at the time they were paid.

It has taken nine years for that clarification to take hold. A series of Court of Appeal decisions in three different cases found in effect that the liquidator could claw back payments unless the recipient could show that he or she had provided additional value over and above the cost of the work for which he was originally paid. It wasn't enough to show that you had, say, delivered concrete and been paid for it. You had to show you had provided extra value in addition to the concrete before you could keep the payment.

The Supreme Court recognised that this is a situation of picking winners: where there is not enough money to go around, someone is going to lose out. The question is, who? The contractor's position was that if they have received a payment for goods or services rendered in good faith and had no reason to believe that the company was insolvent at the time (or becomes insolvent) then they should keep the payment. After 187 paragraphs of closely argued deliberations, the Supreme Court agreed.

The good news for business is greater certainty. The decision makes it much less likely that they will be on the end of liquidators' claw-back demands simply because a company they worked for in the past has gone bust. The most likely losers are the IRD and secured lenders such as banks, which are usually front of the queue when companies are insolvent, and therefore benefit most when payments are clawed back.

But as the Supreme Court recognised, when there isn't enough money to go around, someone has to lose. This time it isn't the little guy.

Nick Russell is a partner at Chen Palmer, New Zealand public and employment law specialists.