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In David Browne Contractors Ltd v Petterson [2017] NZSC 116, the Supreme Court laid down a new test for determining when a company is unable to pay its due debts under s 292 of the Companies Act 1993.
The solvency test under s 4 of the Companies Act has two parts: a company must be able to pay its debts as they become due in the normal course of business (the cash flow test) and the value of the company’s assets must be greater than the value of its liabilities, including its contingent liabilities (the balance sheet test). When assessing the value of a contingent liability, account must be taken of the likelihood of the contingency occurring and any claim the company has that can be reasonably be expected to reduce or extinguish that contingency.
Notwithstanding the two parts to the solvency test, the definition of an insolvent transaction in s 292 refers only to the cash flow test. An insolvent transaction is a transaction entered into by a company at a time where the company is unable to pay its due debts and which enables another person to receive more towards satisfaction of a debt owed by the company that the person would receive, or likely receive, in the company’s liquidation (s 292).
The issue in David Browne Contractors Ltd was whether a contingent liability (a damages claim) could be taken into account when determining whether or not a transaction was an insolvent transaction.
Facts
The claim involved three related companies controlled by Mr David Browne: Polyethylene Pipe Systems Ltd (in liquidation) (Polyethylene); David Browne Contractors Ltd (Contractors); and David Browne Mechanical Ltd (Mechanical). The liquidators of Polyethylene sought to claw back payments made by Polyethylene to Mr Browne, Contractors and Mechanical within two years of its liquidation.
In March 2007, Polyethylene subcontracted with McConnell Dowell to perform welding work on polyethylene pipes for a sewer outfall. There were successive failures of three welds. It was initially unclear whether the welds were faulty, or whether the failures were caused by stress placed on the pipes during installation. Various experts reviewed the failures and the evidence increasingly pointed to faulty welds.
In June 2008, McConnell Dowell notified Polyethylene that its investigations indicated that the welds were at fault. It said that it had suffered significant losses, which it would seek to recover under the subcontract (which included an indemnity). Polyethylene had already been told by a loss adjuster that the loss should fall within the contract works policy held by McConnell Dowell. The loss adjuster had not reviewed the policy wording and a claim had not been made on the policy by either McConnell Dowell or Polyethylene.
Ten days after McConnell Dowell’s notification, Polyethylene resolved to repay unsecured advances made by Mechanical, Contractors and David Browne. Polyethylene also decided to transfer shares it held in a related company to Mr Browne’s family trust for less than half of their value in Polyethylene’s 2008 accounts. The share price was advanced by Polyethylene to the trust, and did not have to be repaid for 20 years. Mr Browne agreed to advance $450,000 to Polyethylene as working capital, which would be secured by a GSA.
Polyethylene’s directors signed a certificate of solvency. In relation to McConnell Dowell’s claim, they stated that the claim was disputed, would be offset by extras and variation claims and would be covered by McConnell Dowell’s contract works insurance policy.
In the High Court, Associate Judge Matthews held that these transactions were part of a legitimate business restructure. The Court of Appeal and Supreme Court held that their purpose was to safeguard Mr Browne and his interests from McConnell Dowell’s claim.
Polyethylene repaid the unsecured advances by Mechanical, Contractors and Mr Browne in September 2008. By that time, McConnell Dowell had provided a breakdown of its losses in relation to two of the weld failures and had disputed the availability of insurance cover.
McConnell Dowell issued an adjudication claim in 2009, which was determined by Derek Firth on 20 July 2009. He assessed recoverable losses at c$3m. The determination was subject to an adjustment to account for the impact of insurance, as Mr Firth did not have sufficient information to determine whether cover was available and the level of the deductible.
Mr Browne then appointed a receiver for Polyethylene under the GSA. Polyethylene was put into liquidation on 5 October 2009, on the application of McConnell Dowell. In 2013, the liquidator served notices on Mechanical and Contractors under s 294 of the Companies Act to set aside the September 2008 payments. The accountants who received the notices did not pass them on, and the transactions were automatically set aside 20 working days after the notices were served. The liquidator then issued proceedings against Mechanical and Contractors to recover the payments.
The liquidator also served a notice on Mr Browne to set aside the payment made to him in September 2008 and the GSA. Mr Browne filed an objection within time, and the liquidator brought proceedings claiming that both the payment and GSA were voidable. The liquidator also applied to set the GSA aside under s 299 (which applies to charges in favour of directors, controlling shareholders and related companies).
Associate Judge Matthews held that Polyethylene was able to pay its due debts and was solvent at the time of the September 2008 payments and entry into the GSA. The claims against Mr Browne accordingly failed. As Mechanical and Contractors had not filed an objection to the liquidator’s notice, their transactions had been automatically set aside. The Associate Judge held that the Court had a discretion under s 295 to decline recovery to a liquidator in circumstances where it was just to do so. There was no basis for the liquidator’s notices, and recovery was therefore declined.
The liquidator appealed and was successful. The Court of Appeal set the GSA aside, and ordered Mechanical, Contractors and Mr Browne to repay Polyethylene.
Due debts
The Supreme Court held the term “debt” encompasses both present and contingent debts. “Due debts” includes debts that will be become due in the future if there is “reasonably temporal proximity”. What constitutes reasonably temporal proximity will depend on the facts of the case.
A damages claim, once determined, will become a judgment debt. The Court noted that a damages claim under a construction contract can be determined by adjudication within a short timeframe. If the outcome of the determination has reasonably temporal proximity to the transaction under scrutiny, the damages claim may be a debt due.
The Supreme Court accordingly outlined the following test: a damages claim may be debt due for the purpose of s 292 if a reasonable and prudent business person would be satisfied that there is sufficient certainty that a claim will crystallise into a judgment debt in “the relevant period”. The relevant period is a period of reasonably temporal proximity to the transaction, and is determined on the facts of each case.
The Court emphasised that solvency in a cash flow sense must be assessed objectively from a practical business perspective: a company may be insolvent even if it is able to pay its debts “for the next few days, weeks, or even months before an inevitable failure.”[1]
When the September 2008 payments were made, it would have been clear to the directors of Polyethylene (who were also the directors of Mechanical and Contractors) that the company would be unable to discharge its liability to McConnell Dowell for losses flowing from the faulty welds. Although adjudication proceedings had not yet issued, McConnell Dowell’s claim was a due debt, and the transactions were insolvent.
Mechanical and Contractors submitted that this interpretation of s 292(2)(a) would require companies to cease trading when faced with a specious claim. The Supreme Court was unconvinced. In its view, the test is not unduly wide: if a reasonable and prudent business person would not be satisfied that there is sufficient certainty that the claim will crystallise in the “relevant period”, the claim will not be a due debt.
Implications
The Supreme Court’s test for a due debt introduces significant uncertainty for directors when assessing the solvency of a company. Reasonable and prudent persons frequently disagree on the likely outcome of litigation. Associate Judge Matthews, for example, took the view that at the time of the transactions in issue, there was significant doubt as to the cause of the weld failures and the availability of insurance.
The Supreme Court placed considerable emphasis on the adjudicator’s finding that there was no defence to McConnell Dowell’s claim. Mr Firth is a very experienced adjudicator and his ruling may well have been right. However, adjudication is a summary process that is undertaken without an oral hearing or the opportunity for cross-examination. It is dangerous to assume that the same conclusion would necessarily have been reached had the matter proceeded to arbitration.[2] The rough and ready nature of adjudication arguably means that there is significant litigation risk in all but the most hopeless of claims.
The flexibility allowed by the concept of “reasonably temporal proximity” adds to the uncertainty. Does the availability of adjudication mean that all robust construction claims must be considered due debts? The adjudication proceedings in David Browne Contractors were initiated months after impugned transactions occurred.
The Supreme Court noted that while a company that is unable to meet its due debts is not permitted to make preferential transactions, it may still continue trading. However any decision to continue trading must take provisions under the Companies Act for reckless trading into account (s 135). Directors who dishonestly allow a company to incur debt while knowing it is insolvent may also commit an offence under s 380(4) and be liable for a term of imprisonment of up to 5 years, or a fine of up to $200,000.
It will be interesting to see how the new test works in practice. As noted, the Supreme Court’s view is that the test is not unduly wide. The lower Courts may take this as a signal that account should only be taken of very strong claims, for which judgment is imminent. For parties to construction contracts, there may be advantages in initiating adjudication proceedings in some circumstances, to remove the uncertainty of contingent claims for business operations.
[1] At [90], citing Re Cheyne Finance Plc (No 2) [2007] EWHC 2402, [2008] 2 All ER 987 (Ch) at [51].
[2] Accepting that additional information may have been before the Court than is reflected in the judgment.
