How to spot a zombie company

This article was current at the time of publication.

In September, company liquidations reached their highest level since March 2015.

Companies Office data shows 285 companies went into liquidation in September 2024, nine went into receivership and six into voluntary administration.

Tony Maginness, Head of Corporate Advisory at Baker Tilly Staples Rodway in Auckland, says those numbers are just the beginning – bleak times have led to a sharp rise in trading while insolvent.

His practice alone has seen twice the usual number of insolvencies.

While recent Official Cash Rate (OCR) cuts might show light at the end of the tunnel, Maginness says any celebration might be premature.

The harsh reality for businesses is that inflation is down because consumer spending is down.

And Maginness says that in recent times businesses are becoming terminal more quickly. 

Before the Reserve Bank started lifting the OCR in October 2021, funding was cheap and liquidity was plentiful. Interest rates then rose at a historically record rate.

“It took 12 to 18 months for [OCR] rises to bring inflation under control. It will take just as long for the flow-on effects of cuts to create improved trading conditions,” he notes.

Even once the economy recovers, businesses that have used up all their working capital could still become “zombie companies”.

“During the COVID lockdowns, many businesses couldn’t trade and ran out of working capital. A business can appear strong, but suddenly they’re not paying IRD or creditors. When you lift the hood it’s apparent it’s terminal,” notes Maginness.

As a result “many NZ directors have been engaged in practices such as avoiding tax payments, juggling which creditors they pay in any given month, or trading on when it’s clear the business is terminal.”

Many business owners, particularly those who self-manage, will be unaware of all the legalities involved in reckless trading.

“Fraud often starts small, but owners who get into trouble tend to double down on the risks to earn their losses back, until the debt is impossible to repay,” says Maginness.

Sharper teeth for liquidators

Among changes proposed to the Companies Act is an amendment to the insolvency provisions doubling the clawback period for voidable transactions to four years.

Voidable transactions are payments the liquidator of a business could seek to reverse if the business were insolvent at the time the payment was made.

Maginness recommends that these could include payments to related-party creditors such as directors.

As many small business directors have their homes as collateral for business loans, up to four years’ worth of mortgage payments could potentially need to be paid to creditors.

Maginness notes that directors risk penalties for engaging in reckless trading even if the company isn’t technically insolvent.

“Reckless trading occurs when a director of a company allows the business to continue trading in a manner that is likely to result in substantial risk of serious loss to the company's creditors.”

This doesn’t necessarily mean the company is insolvent, but rather that the way the business is being run creates a significant risk to creditors. The key test is whether the company is trading in a way that is irresponsible or carries a high probability of loss to those who have lent money to, or are owed money, by the company.

Insolvent trading focuses on whether the company can meet its current and future debt obligations at the time a debt is incurred.

It happens when a director agrees to incur a debt on behalf of the company when they know, or should know, that the company is insolvent (unable to pay its debts as they fall due) or will likely become insolvent because of incurring the debt.

Maginness says directors and business owners need to get advice fast if their company is showing danger signs.

“You don’t have to shut down completely if you’re technically insolvent, but you do have to see your lawyer or an insolvency practitioner. And you can’t run up accounts you can’t settle monthly in cash.”

How to spot a zombie company

So how do practitioners spot situations where they might need to step in with advice?

Maginness says that it can be tricky. By the time a business goes into receivership or liquidation it’s likely to have been trading while insolvent for some time.

“You can certainly pick up a business that’s trading while insolvent in the annual accounts, and the directors must sign off on solvency once a year.

“But their accountant might not be aware they haven’t, for some time, been paying their monthly obligations when they fall due.”

Where there’s a regular flow of information, the two tests — balance sheet solvency, where assets exceed liabilities, and sufficient cash flow to pay monthly obligations as they fall due, suffice.

Where there’s only a once-a-year flow of information, practitioners need to “watch the trends,” says Maginness.

“Several industries in New Zealand, such as construction, hospitality, retail and import/export—particularly with countries experiencing shipping disruptions like China— are widely recognised as facing significant challenges."