Background
As consumer activities take a plunge, the ripple effects of the COVID-19 pandemic include, among others, drastic disruption to commercial activities, affecting the ability of businesses to remain as a going concern. Over the past year, it is not uncommon to hear winding up proceedings being initiated, whether voluntary or not, against bodies corporate and conglomerates of all sizes.
That said, the legal processes involved from the point when a company is deemed insolvent, to having winding up proceedings commenced against it and subsequently be ordered by the court to be wound up under the Malaysian Companies Act, 2016 (“CA 2016”) do not occur overnight and will, often, take time. This is proverbially known as the “twilight” zone where though the said company is no doubt financially distressed, it is not yet legally required to cease operations altogether (the “Twilight Zone”).
However, a notoriously tricky part about being in the Twilight Zone is that insolvent companies may sometimes innocently repay debts due to certain creditors in preference over others. However, regardless of the genuineness of the reason behind such a repayment, preferential treatment is prohibited under the CA 2016 because, all things being equal, it is trite that no one creditor should be treated as being more important or special over another.
The law
The law of undue preference aims to protect creditors by ensuring that, should a company be liquidated, whatever available assets left of the company are to be shared fairly among its general creditors. Such a concept has its origins from the pari passu principle based on the maxim that equality is equity and is a fundamental precept of corporate insolvency law. In Malaysian jurisprudence, this is encapsulated under Section 528(1) of the CA 2016, providing:-
“Any transfer, mortgage, delivery of goods, payment, execution or other act relating to property made or done by or against a company which is unable to pay its debts, as the debts become due, from its own money in favour of any creditor or any person in trust for any creditor shall be deemed to have given such creditor a preference over other creditors in the event of the company being wound up on a winding up petition presented within six months from the date of making or doing the same and every such act shall be deemed fraudulent and void” (emphasis added).
According to the Federal Court in Diamond Leasing (M) Sdn. Bhd. v JB Precision Mould Industries Sdn. Bhd. (In Liquidation) [1998] 4 MLJ 569 (the often-cited Malaysian landmark case on the interpretation of the pari materia predecessor provision of Section 528(1) of the CA 2016), a transaction could be set aside for undue preference if the transaction:-
took place within 6 months before the presentation of the winding up proceedings;
fulfills one of the types of transactions described in Section 528(1) of the CA 2016;
took place when the company was insolvent, i.e., when the company is “unable to pay its debts, as the debts become due”;
benefits a person who was a creditor of the company; and
has the effect of conferring that creditor a preference, priority or advantage over other creditors in the winding up of the company.
In reality
Disputes often arise when, despite being in the Twilight Zone, the insolvent company continues to make payments to, say, suppliers of raw materials.
On the one hand, the insolvent company would argue that such payments are genuinely required so that it can continue operations, in hopes that, regardless of how slim the chances are, the company would be able to rehabilitate itself and transpire out of the financially distressed state altogether.
On the other hand, the liquidator appointed to deal with the assets of the company to oversee a fair distribution of assets would argue that such transactions are void for fraudulent preference so that, if successfully argued in court, the money paid would be returned to the insolvent company for distribution to other creditors.
The final outcome is ultimately a factual decision on a case-to-case basis. What is clear is that the court would interpret the provision purposively, and undertake a balancing exercise between (i) the interests of the company in making genuine attempts to be a going concern; against (ii) the interests of general creditors being unfairly and deliberately neglected by a company that knows it has little to no hopes of financial recovery.
Takeaways
Despite the deeming language of Section 528(1) of the CA 2016, not every disposition made is necessarily fraudulently preferential, if it was made reasonably and not dishonestly or recklessly.
Living in times when the global economy is undergoing commercial rehabilitation, it is expected that businesses and companies would do all within their means to make ends meet - be it innovating new ideas, obtaining new financing or negotiating for longer credit periods.
What is important is that creditors on the receiving end from a company that is seemingly financially distressed are aware of the risks involved when entering into transactions during the Twilight Zone. To reduce the risk of needing to return money received in future, prudent creditors would conduct proper due diligence on the financial health of the company they are dealing with and study the nature of the contemplated transaction before diving into it. This is so that in the unfortunate event that the transaction is put to a test of good faith in court, the recipient creditor would stand a chance at arguing that the transaction was genuinely entered into to keep the company alive and should therefore be upheld.
Footnotes
1. It is generally settled that the commercial test of insolvency is to be distinguished from a mere liquidity problem. The High Court in Arab Malaysian Merchant Bank Berhad v Orient Apparel Berhad & Ors [2002] 1 MLJ 89 said it is only when a debtor company is unable to meet his debts when they fall due, even after utilising available cash resources, that insolvency is indicated. In other words, as phrased by the High Court in Hotel Royal Ltd Bhd. v Tina Travel & Agencies Sdn. Bhd. [1990] 1 MLJ 21, the commercial test of insolvency is such that a company will be presumed to be insolvent when it is unable to pay its debts as they fall due. While the presumption is rebuttable, account books showing that the company own more assets than the liabilities owed are insufficient in rebutting the presumption because what matters is what the company presently have, and not financial potentials or receivables.
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