Dialogue: Credit where credit's due

When a firm goes broke, a compromise may offer creditors more hope than liquidation, says GARETH HOOLE*.

New Zealand law makes no provision for voluntary administration or bankruptcy protection, and offers few effective avenues through which corporate recovery practitioners can seek a temporary moratorium to reorganise the affairs of an ailing business.

But although at first glance this might appear to leave little alternative to the appointment of a liquidator for a business which can't meet its financial obligations as they fall due, there is another way.

The Companies Act of 1993 makes provision for compromises to be reached with creditors on an informal or a formal basis, allowing the under-performing business to be restructured and, hopefully, returned to profitability.

A compromise is an arrangement with a company's creditors under which they alter or suspend their legal rights against the defaulting company in expectation of a greater return than they would achieve through liquidation.

In a liquidation, unsecured creditors generally have little chance of being paid anything at all. Indeed, even secured creditors often find their security is not realised fully under the fire-sale scenario, leaving them out of pocket, too.

Shortfalls in the payment to creditors have a ripple effect and the injured creditors are often unable to meet their own trading obligations.

This puts them in danger of having somebody taking winding-up action against them, so the domino effect becomes a very real threat.

Increasingly though, creditors are realising that hasty action against a non-performing debtor may not be the wisest course of action. Instead, they are recognising that forbearance and a solid rescue plan could be the way to go.

But for this to be achieved, there has to be a core sustainable business which, were it not for some uncontrollable or extraneous factors which caused its downturn, would be capable of meeting its obligations.

Another essential element in a successful workout is to avoid action being taken by one creditor. That frequently leads to an avalanche of statutory demands and applications to the court for the appointment of a liquidator.

Without a legislative moratorium framework, this is often easier said than done, but creditor compromises are achievable. They require that a proposal - by a party who is known as a proponent - be made for a workout as an alternative to liquidation.

The next step is to call a meeting of the creditors, giving advance notice in accordance with Companies Act requirements.

The proponent must issue a statement which includes the terms of the proposal, the reasons the compromise is being offered and the reasonably foreseeable outcomes.

At the meeting, the creditors can vote on what the proponent has put forward. If a majority vote for it, as stipulated in the Companies Act, the plan can then be put into action.

The process, outlined simplistically here, must follow several legislative provisions to constitute a properly constructed compromise.

There are also other variations, depending on the type of proposal being made and the other surrounding circumstances, such as statutory schemes of arrangement and company amalgamations.

Creditor compromises have been criticised as expensive and unwieldy mechanisms which seldom achieve their objective, but this is not necessarily the case. They can offer an alternative to liquidation.

An offer of compromise will usually involve suspension or variation of claims against the company, giving it breathing space to implement a remedial plan to restore its financial health. ,

Clearly, this will work only if the business can be rescued. And it will appeal to creditors only if they stand to gain more from the scheme than they would if the company's existence were terminated.

What are the effects of a creditor compromise on the creditors? Must all creditors abide by the majority decision?

Assuming the debt is undisputed, a creditor has certain legal rights against the debtor. The creditor will have supplied goods or services in expectation of being paid and the debtor will have defaulted, resulting in a breach of contract.

Under the common law rules of contract, that creditor's rights are automatically varied where an offer of compromise has been reached.

The offer becomes the new contract and, unless the debtor company breaches those terms, it would be difficult for the creditor to enforce the original contractual terms.

The Companies Act stipulates what constitutes a majority acceptance of an offer of compromise and, where such a majority is achieved, all the creditors are affected.

In some cases the court might order a compromise to be binding.

A minority creditor who feels that the compromise process has been flawed or carried out without due regard to their rights can apply to the court to have the scheme set aside, but this would require an application to the court and potential litigation.

The provisions relating to a compromise can be difficult and costly to implement and they might not always be a feasible alternative to liquidation.

But they do offer creditors another avenue to pursue collection of what is rightfully theirs and also can protect rescuable companies from being closed down.

* Gareth Hoole is a senior manager in the client advisory services division of Staples Rodway. The views expressed in this article are his own and not necessarily those of Staples Rodway.