When a company is struggling to pay its bills, ‘insolvency’ and ‘reckless trading’ are frightening words that may be thrown around the table. On 3 April 2020, as the first wave of Covid lockdowns hit, the government introduced a brief ‘safe harbour’ regime. Its purpose was to protect directors of New Zealand companies from being held liable for trying to stay afloat and it permitted a company to trade whilst technically insolvent. This protection was removed on 30 September 2020. In this article we discuss an alternative to liquidation or receivership. Using the ‘creditor compromise’ regime can return better outcomes for both the company and its creditors.
When is a company ’insolvent’?
A company is considered insolvent when it cannot pay all debts as they fall due or the total debts of the company are greater than its total assets. The company could be recklessly trading if the directors allow the business to be carried on in a manner likely to create a substantial risk of serious loss to the company’s creditors. Allowing a company to trade when it is insolvent can put the directors at risk of being held personally liable for reckless trading. The directors could also be personally liable if they allow the company to incur an obligation unless they reasonably believe the company will be able to perform that obligation when required. The consequences of reckless trading or breaching those director obligations can be significant. In the well-publicised and ongoing Mainzeal case, directors were found personally liable for $36 million after allowing the company to trade recklessly.[1]
Options for an insolvent company
When directors of a company establish that it is no longer solvent, few choices are available. The two most common options are liquidation and receivership. Either option can be voluntary (the company elects to go through the process to ensure compliance with the Companies Act 1993) or involuntary (a creditor or group of creditors may force the company into the process).
Receiverships and liquidations have very detailed processes and procedures, and need skilled independent advisors, including lawyers, accountants and insolvency professionals, to guide the company through the process and liaise with creditors.
There is, however, another choice that may be appropriate for a company facing insolvency.
What is a creditor compromise?
Creditor compromise is a lesser-known option that is available when a company cannot meet its debts. The company proposes an alternative (the ‘compromise’) to all creditors, such as forgiveness of part of the debt or extended timeframes for repayment, and then calls for all creditors to vote on the compromise. If passed, all the creditors are bound to that compromise, and cannot put the company into liquidation or receivership.
It is important when entering into a creditor compromise that the directors are confident the company can commit to the terms of the compromise; failing to meet the terms could lead to significant consequences for the company and its directors, including personal liability for reckless trading.
A creditor compromise can be preferable for a company and its directors for many reasons. No public notice is required, and the terms of the compromise are often kept private therefore reducing reputational damage to the company.
Aside from those obvious advantages, a creditor compromise also allows the directors to retain control over the company and its assets, the compromise is binding on all creditors, and it can provide a means for the company to slowly return to solvent trading. For the creditor, the compromise often allows them to receive more in the long run than they would have received under a liquidation.
The process
A creditor compromise follows this process:
Directors drive the process: A creditor compromise plan is usually driven by the directors. They identify that the company is insolvent, or at risk of being deemed insolvent, and look for a ‘compromise’ that will allow the company to manage its debts.
Appoint independent manager: The directors appoint a professional to manage the process and develop the creditor compromise plan. It can be an accountant, lawyer, or insolvency professional (or often, a combination) who are experienced in navigating solvency issues.
Identify classes of creditors: A critical, and most often litigated, step, is the classification of all creditors into appropriate classes by the independent manager. This usually starts with secured creditors, followed by unsecured creditors. The grouping of creditors into ‘classes’ is not a straightforward process, and it is crucial to get this right to ensure the creditor compromise is binding.
The manager must understand features of each creditor such as their dependency on the debt, size of the debt, size of the creditor, the financial strength of each creditor and more.
As this step can lead to court action, incorrectly classifying the company’s creditors can lead to the entire compromise arrangement being overturned by the court and the company being placed into liquidation.[2]
Present the creditor compromise plan for key creditor agreement: Whilst not a legislative step, once a preferred plan has been outlined most companies find it prudent to engage with their key creditors at this stage to ensure there is agreement to the plan. If key creditors aren’t satisfied the plan will give them a better result than liquidation or receivership, the creditor compromise is unlikely to succeed and there is no point progressing further. Sometimes key points of the agreement are negotiated at this point before a final version is circulated to all creditors.
Formally notify all creditors: Once the creditor compromise plan is finalised, the key information is circulated to all the company’s creditors. It must include specific information including naming the acting parties, events that have led to the compromise situation, the compromise proposal itself, an assessment of what the creditors would receive in a liquidation (to allow them to compare their options), and a full list of all creditors and the estimated amounts owing. This key information also includes the method by which the creditors can vote. A minimum of five days’ notice must be provided to creditors to review the creditor plan and submit their votes.
Vote: If the creditors vote to approve the plan, it will be binding on all creditors regardless of which way they voted. In order to ‘pass’, at least 50% of the number of creditors and 75% of the value of the creditors in each class must approve the compromise. If the compromise is not approved, a liquidation or receivership may result.
Regardless of whether you are a director of a company facing insolvency, or a creditor who has discovered a company which is indebted to you has, or may, become insolvent, seeking experienced legal advice on insolvency is key.
Directors will need a good legal or insolvency advisor to discuss all available options to get the best result for the company and its creditors, as well as ensuring there is protection from the risk of an accusation of reckless trading.
As a creditor, an advisor will ensure you are fully informed of all options that could lessen your total losses.
If you would like to know more about how a creditor compromise works, or if your company is heading towards insolvency, please don’t hesitate to contact us. +
[1] Mainzeal Property and Construction Ltd (in liq) v Yan and Others [2019] NZHC 255 [2] Trends Publishing International Ltd v Advicewise People Ltd [2017] NZCA 365