Having to write off bad debt is one thing – having to pay in even more money for the privilege is just adding insult to injury.
Yet that is exactly the danger you face if one of your debtors is sequestrated or liquidated (we start off by explaining the different terminology) and you prove your claim without considering the “danger of contribution”.
What is that? How does it arise? What if you are a petitioning creditor or hold security for your claim? How can you protect yourself from having to contribute? Read on for the answers…
“A small debt produces a debtor; a large one, an enemy” (Publilius Syrus, Roman writer)
You are owed money by a debtor, whose “insolvent estate” is “sequestrated” (in the case of an individual or trust) or “liquidated” (in the case of a company or other corporate).
The Master of the High Court appoints a “trustee” (in the case of a sequestration), or a “liquidator” (in the case of a liquidation) to sell all the debtor’s assets and to distribute the sale proceeds between proved creditors.
When you learn of your debtor’s sequestration/liquidation, ensure firstly that the trustee/liquidator knows that you are a creditor so that you receive reports on the financial position of the estate and on progress towards its finalisation.
You will have an opportunity to lodge and prove your claim in the sequestration/liquidation, which you do by completing a formal “claim form” for proof at a meeting of creditors.
The question is – should you prove your claim or shouldn’t you?
Adding insult to injury – contributing to costs
Note: For simplicity we’ll refer below only to “insolvent estate”, “sequestration” and “trustee”, but the principles apply equally to corporate liquidations.
If you don’t prove your claim as above, you won’t receive any dividend and will effectively have to write off your debt entirely.
But the other side of the coin is that by proving your claim you may be exposing yourself to an even worse fate –
When the costs of sequestration of an insolvent estate exceed the funds in the estate available to pay them, the trustee of the estate recovers a “contribution” from proved creditors to cover those costs.
In that case you as a proved creditor risk adding insult (having to pay a contribution into the estate) to injury (having to write off your original debt). That’s why, as a creditor, you should be very wary of formally proving your claim against an estate until you are satisfied that no danger of contribution exists.
The special case of the “petitioning creditor”
Now the rub here for the “petitioning creditor” (the creditor who applied for the debtor’s sequestration in the first place) is this – whether or not you formally prove your claim in the estate, you must still contribute to the shortfall.
That’s why, although applying for sequestration can be an excellent way of recovering debt from a recalcitrant debtor, it is essential to consider the danger of contribution before making any such application.
What if you hold security for your claim?
Note that we are only talking here about holding security over a debtor’s asset/s. If you hold outside security – a surety from a company director for example – you can recover that separately, entirely outside the sequestration/liquidation process.
If you hold some form of security for your claim, like a mortgage bond over the debtor’s property for example, you are a “secured creditor”.
You need to prove your secured claim to be awarded the net proceeds of the property. In practice the trustee sells the “encumbered” property, pays out of the proceeds all costs directly related to that property – maintaining it, selling it, paying rates and taxes to pass transfer, the trustee’s fees and so on – and then pays out the balance to you as secured creditor in an “encumbered asset account”.
On the other hand the proceeds of all unencumbered assets fall into the “free residue” account, and if after being paid your secured dividend as above there is still a shortfall on your claim, that shortfall ranks in the free residue as a “concurrent” claim.
And that’s where your danger comes in – you are now in line to pay a contribution based on the concurrent portion of your claim.
The good news is that you can largely protect yourself from having to contribute by “relying on the proceeds of your security” in satisfaction of your claim. That means you waive your concurrent claim for any shortfall, but equally by removing your shortfall claim from the free residue account you no longer contribute together with other proved (or petitioning) creditors.
In some very restricted circumstances even relying on your security won’t protect you from a contribution (for example when no one else has proved claims or other contributors are unable to pay their share), but relying on your security is the best protection you have.
Note that there are grey areas in some of these provisions, so there is no substitute to asking your lawyer for advice on your specific circumstances.