Court of Appeal on when a third party payment is voidable

​Creditors concerned about the solvency of a debtor will often ask that payment be made by a third party. But payments from a third party can be treated as being made by the debtor, and therefore voidable. The Court of Appeal has considered when that will be the case, in overturning the High Court's decision in the context of a "direct deed" entered into as part of the finance arrangements for a construction contract.

A developer entered into a tripartite direct deed with its bank and its builder (Ebert). Banks usually seek such agreements to get the right to step into the construction contract should the developer fail. In some cases, the direct deed contains a mechanism for the bank to pay the builder directly. In Ebert's case, that happened. The bank paid significant sums to the builder, which it recorded as advances to the developer.

The High Court said the payments were to be treated as having been made by the developer. The Court of Appeal disagreed, saying the direct deed in this instance created payment obligations for the bank.1 Accordingly, the payment was by the bank, not by the developer.

The Court of Appeal decision

Had the direct deed not created an obligation on the bank, the payment would have been voidable by the liquidator. In that case it would have been a payment by the developer, regardless of the fact that the cash came from the bank.

The key question in such cases is whether the third party had paid under "a direct liability" owed by the third party. The evidence was that direct deeds are in different forms, and that this one was "not as heavily bank-weighted" as others.

The form of a direct deed or other similar arrangement may therefore be very important in any voidable transaction case. Interestingly, the Court's discussion of the question of whether there was a direct liability included a number of comments about the "commercial reality" of the arrangement. The Court called expert witnesses, including Chapman Tripp's Brian Clayton, to give evidence on the development and place of direct agreements in the construction industry.

The Court then went further, introducing an analysis that has not often featured in New Zealand voidable transaction decisions. It said an essential feature in a voidable payment is whether the funds were from resources which would otherwise have been available to pay the company's general creditors. So if payment was made by a third party from funds which would not have been made available to pay other creditors, the Court of Appeal's decision suggests that payment cannot be avoided by a liquidator.

This reasoning appears to be similar to the "earmarking" doctrine applied in the US Courts. Where a debtor satisfies a pre-existing debt owed to a creditor, using the funds of a third party who has specifically designated (or 'earmarked') the funds for that purpose, the payment will not be voidable.

It will be interesting to see if New Zealand cases further develop this idea.

Click here for the Court of Appeal decision, and here for the High Court decision.

Our thanks to Natasha Kusel for writing this Brief Counsel.

1 Ebert Construction Limited v Sanson & Anor [2017] NZCA 239 [8 June 2017]

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Related topics: Restructuring & insolvency; Voidable transactions; Construction and major projects; Debt recovery

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