CUTTING THE GORDIAN KNOT OF INTENTION IN UNFAIR PREFERENCES

Citation(2004) 16 SAcLJ 236
Date01 December 2004
Published date01 December 2004

The transaction avoidance provisions seek to regulate the permissible conduct of creditors in the run-up towards and post insolvency. In the case of the unfair preference provision, it requires that the company must have been influenced by the desire to prefer the creditor. This article seeks to argue that this requirement is inconsistent with the modern objectives encapsulated in the insolvency regime and that this provision should be reformed to eradicate the need for such a desire and all preferences should, regardless of intention, prima facie be deemed unfair.

In Gordium, by the Temple of the Zeus Basilica, was an ox cart, which had been put there by the King of Phrygia over 100 years before. The staves of the cart were tied together in a complex knot with the ends tucked away inside. Legend said that whoever was able to release the knot would be successful in conquering the East. Having arrived at Gordium it was inconceivable that Alexander the Great would not tackle the legendary “Gordian Knot”. His army leaders gathered round as he struggled with the Knot for a few minutes. Then he asked Aristander, his seer, “Does it matter how I do it?” Aristander couldn’t provide a definitive answer, so Alexander pulled out his sword and cut the knot through. He went on to become the conqueror of the known world.

Part I: Introduction

1 The basic building block of economic growth is the phenomenon of credit. The insolvency regime is a direct response to the casualties of credit, for it determines the extent of a debtor’s obligation to repay his creditors when his assets are insufficient to cover all his

outstanding debts.1 In this respect, insolvency law has been most misunderstood perhaps because of its close links to bankruptcy law. Insolvency law does not exist to protect the insolvent company from the clinging hands of its creditors. Instead, most of the insolvency process revolves around the resolution of creditor-distribution issues.

2 This article seeks to examine one particular facet of the creditor-distribution situation, that is, the avoidance of transactions which are deemed to be unfair preferences as encapsulated in s 99 of our Bankruptcy Act (Cap 20, 2000 Rev Ed) (“BA”). In particular, this article takes issue with s 99(4) BA, which defines a transaction as being unfair only if the individual who gave the preference was influenced by a desire to unfairly prefer the creditor. This article argues that such a definition of unfairness is inconsistent with the aims of our insolvency regime and that the time is ripe for legislative amendment.

3 This article will first examine the underlying philosophy of our insolvency law and the rationale behind the unfair preference provision. Second, it will set out how the provision works in practice and the problems it has caused. It will then conclude with suggestions on how the provision can be reformed such that it may better further the aims of our modern insolvency regime. At this juncture, before I proceed any further, I will just clarify that the use of the phrase “insolvency” in this article refers to the winding up regime (of companies) as opposed to its generic meaning which would include the bankruptcy regime (of individuals).2

Part II: Aims of insolvency law

4 Modern insolvency law is widely regarded as representing a distinct discipline bound together by a coherent set of principles distinct from other areas.3 Insolvency law, as a branch of commercial law, is moulded by the pressures of business conditions and shifts according to the changing economic and social values of our society. Indeed, the

roots of insolvency law developed from bankruptcy law which, in turn, developed from personal property law. In those early days, the law scrutinised the conduct of the person and looked to the person of the debtor for recourse when his assets were inadequate. Thus, the debtor was liable not only to have his property seized, but could himself be subject to imprisonment or even worse.4

5 Naturally, with such a backdrop, the traditional view of insolvency law focused on the allocation of the common pool of assets such that the benefits for the creditors are maximised as a whole.5 This view however, became subject to strong academic criticism. Critics6 contended that it would be overly simplistic to merely concentrate on maximising returns as the failure of a corporate enterprise affects a wide range of interests, with wide repercussions. These interests include the need for investigation into the conduct of directors so as to protect the public against future misconduct, looking after the interests of shareholders in the protection of their financial investment7 and the protection of the workforce especially where labour law or tort law is not sufficiently developed to protect them.8 Further, they argue that even if these interests were subordinate to those of the creditor, this alone is not a sufficient reason to deny them any role in the proceeding.

6 A further criticism attacked the theoretical underpinning of this approach to insolvency law: namely the creditor’s bargain.9 The creditor’s bargain postulates an approach that views insolvency as mirroring the system that the creditors would be expected to form among themselves were they able to negotiate such an agreement. However, critics contend that the operation of the concept of creditor’s bargain is fraught with difficulty since creditors do not, in practice, act collectively in taking credit decisions which means that it is impossible

to determine what are the factors that they would consider.10 In addition, the creditor’s bargain model postulates that each creditor acts with perfect information as to the actions of the other creditors, another fact clearly absent in reality.11 Hence, critics contend that the role of corporate insolvency laws cannot be constructed in the abstract and the extent to which the law of a country adheres or deviates from the principle of collective maximisation of returns are related to its preinsolvency social and economic policy.12

7 Given the above criticisms, it is perhaps no surprise that today, insolvency law has gone beyond viewing liquidation as just being a method of asset recovery for creditors. Indeed, there has been a gradual shift towards using the various methods of corporate restructuring as an alternative to liquidation.13 This has arisen from the recognition that the termination or liquidation of a business has wider social repercussions beyond just the insolvent company and its creditors. Other interests such as the company’s suppliers, employees, customers and society in general are also affected.14

8 Thus it can be said that insolvency law today primarily aims to:

… relieve and protect where necessary the insolvent … from any harassment and undue demands by his creditors whilst taking into consideration the rights which the insolvent … should legitimately continue to enjoy; [and] at the same time; to have regard to the rights of creditors whose own position may be at risk because of the insolvency”.15

Further, there are other subsidiary goals of insolvency law such as ensuring the division of the debtor’s assets rateably among all his

creditors in an honest and competent manner16 and to prevent conflicts between individual creditors.17

9 This does not then mean that insolvency law no longer considers the rights and interests of creditors. Instead, one of the key recurring dilemmas is that insolvency law still centers around maximising the returns of creditors. The point here is that a system based upon individual creditor remedies will invariably decrease the pool of assets for the creditors as a group when there are insufficient assets to go round.18

10 In other words, what this means is that in the absence of rules regulating the equitable division of assets among creditors, there would be a perverse incentive on the part of individual creditors to get in line immediately for if they failed to do so, they would run the risk of getting nothing. Such a cut-throat first come, first served environment would only do more harm than good for the business community when viewed as a whole and similarly for individual cases. In fact, it might actually hasten a company’s descent into insolvency since all creditors would be ready to recall their loans at the first sign of trouble. Further, the pursuit of individual remedies for creditors would only lead to increased costs for creditors as a group, benefiting no one. Simply put, it is a classic example of the game theorist’s “prisoner’s dilemma”.19 The central thesis of a prisoner’s dilemma is that rational individual behaviour, in the

absence of co-operation with other individuals, leads to a sub-optimal decision for the group as a whole. Here, unless each creditor attempts to “beat” the other creditors, they will individually fare worse. However, if everyone gets in line, it defeats the entire purpose of getting in line since everyone will have to incur costs to monitor the debtor for no additional benefit.20

11 Insolvency thus offers a way out of this unfruitful race by imposing a collective regime of debt collection on all the creditors.21 It further enhances the maintenance of commercial morality by ensuring the fulfilment of financial obligations.22 In this regard, insolvency law is often described as an economically efficient alternative to the piecemeal dismemberment of an insolvent debtor’s estate23 which eliminates the benefits that flow to the debtor, the creditor and the community from the existence of an ongoing business.24

12 I now turn to the doctrine of unfair preferences and the role that this doctrine plays in relation to insolvency law as a whole.

13 The cornerstone of this doctrine is the pari passu doctrine.25 This principle essentially encapsulates the ideal of equal treatment for all that are similarly placed.26 This can only be attained by taking...

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