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Creditors: 4 ways to defend a liquidator’s unfair preference claim

What is an Unfair Preference?

Essentially, an unfair preference is when a creditor, within the six months before a company goes into administration or liquidation, receives payment(s) from that company that is more than they would receive if the payment(s) hadn’t occurred and they proved for their full debt in the liquidation.

The “unfair preference” part is that the creditor has been preferred by the company over other creditors, which is unfair to these other creditors.

Elements of an Unfair Preference

Specifically, for a payment made by a company to be an unfair preference payment, the following elements must be satisfied:

  • The company and a creditor must be parties to the transaction – Section 588FA(1)(a) of the Corporations Act 2001 (Cth) (“the Act”).
  • The transaction must be entered into during the 6 months ended on the relation back day (being either the date of an earlier administration, the date of liquidation or the date winding up proceedings were filed) – Section 588FE(4)(c) of the Act.
  • The transaction must result in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction was set aside and the creditor were to prove for the debt in a winding up of the company – Section 588FA(1)(b) of the Act.
  • The transaction must be an insolvent transaction, i.e. the transaction must be entered into at a time when the company is insolvent or the company must have become insolvent because it entered into the transaction – Section 588FC of the Act.

Defences to an Unfair Preference Claim

While this may seem pretty unfair, it’s important to note that there are four possible defences (they aren’t technically but essentially are used as one) that can be raised by creditors to a Liquidator’s unfair preference claim. These are:

  1. Good faith defence
  2. Running Account defence
  3. Set Off
  4. Retention of Title

Good Faith Defence

Under Section 588FG(2) of the Act a creditor can defend an unfair preference claim on the basis that:

  • The creditor received the payment in good faith; and
  • The creditor had no reasonable grounds for suspecting the company was insolvent and a reasonable person in the creditor’s circumstances would not have had grounds to suspect insolvency; and
  • The creditor provided consideration.

Usually a creditor can easily satisfy the good faith and consideration elements. However, it’s the question of whether the creditor had reasonable grounds for suspecting insolvency or a reasonable person in their circumstances would have had grounds for suspecting that is usually the contentious argument.

After reading some recent unfair preference cases some recurring themes come through as to what Courts pay close attention to when looking at the good faith defence in the context of unfair preference cases:

  1. Creditors that freeze a company’s credit account or places it on stopped supply.
  2. Whether a creditor has been continually following up a company for payment(s) over a prolonged period of time.
  3. How long has it been since the debts were due. The longer it has been since the company should’ve paid the more likely the Court will consider a creditor did know or should have known the company was insolvent.
  4. Whether a creditor has engaged debt collectors or solicitors to pursue a debt. Also whether a creditor has threatened to issue a statutory demand or wind up a company.
  5. A company having to pay its debt to a creditor by instalments rather than in full. The longer the payment plan the more obvious the company is in financial difficulty.
  6. Lump sum payments to a creditor that are not referable to any specific invoices.
  7. A creditor knowing that other creditors of the company are also going unpaid.

Running Account / Continuing Business Relationship

The “running account” refers to a situation where a payment (or payments) made during the relation back period (i.e. the six months prior to liquidation) is an integral part of a continuing business relationship between the company and the creditor. The effect of all transactions between the company and creditor therefore need to be considered as a whole.

This defence can only apply if the purpose of any payments made to a creditor are to induce further supply of goods and cannot pay out an existing debt in full, otherwise there will be no “continuing business relationship”.

In relation to a running account defence there is also the “peak indebtedness” rule to consider. What this means is that a Liquidator is entitled to pick a date within the six month relation back period as the date of the greatest indebtedness and to calculate the running account from that date (see Rees v Bank of New South Wales (1964) 111 CLR 210).

For example, if during the six month relation back period the debt owed by a company to a creditor reaches $100,000, then at the date of liquidation this amount is $50,000 (due to various payments having been made) then the liquidator may have an unfair preference claim of $50,000.

Set Off

While the set off defence is widely considered by insolvency practitioners and lawyers to be bad law, the fact of the matter is that at the current point in time it is the law. It’s therefore open to creditors to raise this defence to any unfair preference claims by a liquidator.

Recently espoused in Morton v Rexel Electrical Supplies Pty Ltd [2015] QDC 49, the gist of the defence is that creditors are entitled to set off the debt they’re owed at liquidation against the alleged unfair preference amounts being pursued by a liquidator.

A creditor can only rely on set off in respect of debts that were incurred before the creditor receives notice the company is insolvent. In Morton v Rexel the Court held that the notice of insolvency required under Section 553C(2) of the Act to deny a set off constituted actual notice and not constructive notice.

Retention of Title

It’s been held that creditors that trade under Retention of Title (ROT) terms are a “secured creditor” for unfair preference purposes. This is the case even if the creditor hasn’t registered its ROT terms on the PPSR, meaning their security interest would be unperfected and therefore vest in the company upon liquidation. Remember, only unsecured creditors are caught by unfair preference claims.

The second aspect of this defence is valuing the security at the time the payments are made.

The recent case of Trenfield v HAG Import Corporation (Australia) Pty Ltd [2018] QDC 107 involved a Liquidator pursuing unfair preference payments totalling $600,000. Effectively the creditor’s debt had been paid out in full by the company prior to liquidation. The creditor in this case had been supplying goods on credit to the company from 2011.

In holding that, despite not having a valid security interest at liquidation the creditor was secured at the time it received the alleged preferential payments, the Court noted the PPSA does not make an unperfected and invalid security interest void.

In assessing how and when to value a creditor’s security, the Court held that the value of the security is to be assessed at the time the payments are received and not at liquidation. In this case that value was the wholesale value of the stock and not retail as “the value of the security must be the value to the creditor”. The creditor’s market for its goods was a wholesale market and valuing the goods at retail would therefore have reflected what the insolvent company might receive for them and not their value to the creditor.

Practical Takeaways for Creditors

If you’re dealing with a company that owes you a debt and you’re having trouble getting paid or you think the company may be in some financial difficulty you need to be careful how you go about trying to collect your debt. If you do get paid after this point you also need to recognise the risk that you may later receive a demand from a Liquidator.

With this in mind below are some practical tips for creditors to try and mitigate the risk of an unfair preference claim:

  1. Recognise that if you’re in the building industry you are at a heightened risk of debtors going into liquidation and of later receiving unfair preference demands from a liquidator.
  2. If you are supplying goods to a company, make sure you trade under ROT terms. Also ensure that you register your security interest correctly on the PPSR and if possible collect your goods before the debtor company goes into liquidation.
  3. If you are repeatedly following up a debtor company you should look very closely at the responses you are getting/discussions you are having. If they start using words like “financial difficulties”, “cash flow problems” and “we can’t pay other debts” you need to recognise the risk that any payments you receive after this will likely be unfair preferences.
  4. If you have a credit application from a customer, make sure you follow it up with an actual contract/agreement which includes your ROT terms, personal guarantee and/or charging clauses (if possible).
  5. Stay on top of your accounts receivable. If certain debtors are a couple days outside ordinary trading terms contact them and get confirmation of why they haven’t paid and when they will. When the date for payment comes around call them and confirm they’ll be paying that day. Remember – the longer it goes without payment, the more likely a Court will be to consider you did or should have known the company was insolvent.
  6. Try and get your debtors to pay specific invoices and not lump sum payments. Likewise, if a payment instalment is necessary try and ensure they are making significant instalment payments so the plan can be completed in a short period of time.

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About the Author

Elan
Nick Love is a Supervisor in Pearce & Heers Insolvency Accountants’ Brisbane office after completing a Bachelor of Laws in November 2015. Nick has significant experience in all types of personal and corporate insolvency appointments as well as informal debt settlements and general debt advice to individuals and businesses. Servicing the SME business community, Pearce & Heers focuses on achieving commercial outcomes for individuals and businesses that are suffering financial distress. Nick regularly posts articles on LinkedIn on various insolvency related topics and general business advice for Pearce & Heers and Cactus Consulting.