This is the second part of a three part series on a practical summary of the law concerning unfair preference claims.
By Nick Cooper*
In this part, I discuss the defences and responses that may be claimed in answer to a Liquidator's claim for an unfair preference.
The defences and responses I deal with are:
-running account defence
-defence of ultimate effect
-no grounds to suspect insolvency
a) Secured creditor. As noted in my previous article, there cannot be a preference claim against a secured creditor.
The introduction of the Personal Property Security Register (“PPSR”) provides assistance in identifying secured creditors. Sections 51E and 51A of the Corporations Act gives the holder of a PPSR registration status as a secured party.
But there remains uncertainty as to when to assess value of the security. That is, at the date of the alleged preference payment or at the date of the liquidation. The latter date was preferred in Matthews v Tap Inn Pty Ltd  SADC 108, but that decision is subject to an appeal.
Since my previous article, there have been two conflicting decisions in which the Courts have considered a creditor’s security in the context of preference claims.
In Hussain v CSR Building Products Limited  FCA 392, CSR supplied products under retention of title (“ROT”) terms. It asserted in a preference claim that it was a secured creditor and not liable to repay payments claimed by a Liquidator as preferences.
It was held that the ROT clause was a secured debt, even though it was a transitional security interest, which fell outside the s. 51E/51A definition of a ‘security interest’. The Liquidator then argued that the payments could still be preferences to the extent the payments exceeded the value of ROT stock at the date of liquidation. This argument failed for several reasons including because of a lack of records available to assess the value of ROT stock at the relevant times.
However, only 3 days later, Blakeley v Yamaha Music Australia Pty Ltd  VSC 231 was decided. In that case, the defendant to a preference claim brought an application for summary judgment on the basis that its debt was clearly secured. It had supplied stock under ROT terms both before and after the introduction of the PPSR. In dismissing the claim for summary judgment, the Court held that the pre-PPSR supplies were unsecured debts. The post-PPSR supplies were secured debts but the status of the security depended on when the stock was supplied and when the debts arose.
Further clarity is needed from the Courts on these issues.
b) Running account defence. This defence may act as either a partial or a complete defence to a preference claim and is set out in section 588FA(3).
Essentially, these provisions apply where there has been continuous trading between the creditor and the debtor company throughout the relation back period.
In other words, there have been supplies of goods or services and payments for those supplies throughout the period – as opposed to merely payments without the supply of goods and services.
For example, there could not a running account whilst an account was on stop credit, as there would be no further supply of goods or services to the debtor company on credit.
However in Julzar Pty Ltd v Rogers  NSWSC 199, it was held that a temporary suspension of credit, to allow the account to be brought back within trading terms, does not destroy the "continuing business relationship" needed for the running account defence.
In the case Air Services Australia v Ferrier (1996) 21 ACSR 1 – the High Court held that a running account defence would apply if the purpose of the payments was to induce the creditor to continue providing services, but the defence would not apply if the purpose was to merely repay an existing debt. In other words, whether the parties were looking into the future to continue the business relationship or whether the creditor was merely trading with the company in order to extinguish the debt.
The effect of a running account defence is best illustrated by example.
The amount of a Liquidator's claim for a preference, after a running account defence, represents the difference between the peak indebtedness on an account and the closing balance (or balance of the account at the end of the business relationship).
Consider the following examples, where a Liquidator claims payments totalling $200,000 over the six month period. The following charts plot the balance of the debtor's account over that period:
In the above chart there was a net increase in the balance of the debtor company's account. The peak indebtedness occurred at the end of the period.
In such circumstances, the running account is a complete defence to the Liquidator's preference claim.
Also consider the following example:
In this example, there was a net decrease in the debtor company's account.
However, the running account is still a partial defence to the Liquidator's claim – as the Liquidator's claim is not the value of all payments within the six month period ($200,000) but is the difference between the peak indebtedness ($120,000) to the closing balance ($20,000).
In other words, in this example, the defence reduces the Liquidator's claim from $200,000 to $100,000.
c) Doctrine of ultimate effect. This is a common law defence which effectively provides that there cannot be a preference from a payment made in circumstances whether there was ultimately a benefit to the company in making the payment.
The defence has been successful where payments are made in the context of a series of transactions benefitting the insolvent company, such as:
-payments to a landlord to secure the ongoing rental of a premises: Re Discovery Books Pty Ltd (1972) 20 FLR 470.
-payments to a consultant for insolvency advice: Beveridge v Whitton  NSWCA 6.
d) Set-off. In the recent case of Morton v Rexel Electrical Supplies Pty Ltd  QDC 49, it was held that a pre-appointment debt could be set-off against a Liquidator's preference claim.
In other words, if one of your customers enters liquidation and you are owed a debt, any later preference claim brought by a Liquidator can be reduced by the amount of your debt still owing by the company.
If your debt exceeds the amount of the preference claim, the Liquidator's entire preference claim may be defeated.
However, it was held that the set-off is not allowed when the creditor has knowledge of the company's insolvency. "Knowledge" of insolvency is more difficult for a Liquidator to prove than "suspicion" of insolvency.
It should also be noted that many academics believe that the Morton case was wrongly-decided. The decision issued out of the District Court of Queensland. It will have to be seen whether the finding is reversed when next considered by a Court or superior jurisdiction.
e) Good faith and no reasonable grounds to suspect insolvency. A common defence to preference claims is that there were no grounds for suspecting that the debtor company was insolvent. This defence is provided at section 588FG(2).
The creditor defendant has the onus of establishing this defence.
It should be noted that this defence requires the creditor to prove three elements being:
-good faith – in most cases, payments will have been made in good faith. A lack of good faith would be where there has been a serious threat or other misconduct which prompted the payment, or collusion with the company; and
-the creditor had no reasonable grounds for suspecting insolvency; and
-a reasonable person in the circumstances would have had no grounds for suspecting insolvency.
The statement that "I did not know that the company was insolvent" is not sufficient to meet this defence. The creditor must demonstrate that a reasonable person in the circumstances would have no grounds for suspecting (as opposed to actual knowledge of) the debtor's insolvency.
There is no general rule as to what constitutes grounds for suspecting insolvency and so this defence is best considered by looking at some cases:
-Mann v Sangria Pty Ltd  NSWSC 172 – The plaintiffs were Liquidators of a business trading as a wholesale butcher and meat supplier. Sangria Pty Ltd was owed $186,000 and issued legal proceedings against the company. In response, the parties agreed to a repayment proposal. The payments were made late, but not significantly late. Sangria Pty Ltd asked for security and a copy of the company's balance sheet. Sangria Pty Ltd supplied further stock to the company but only on the basis that it received post-dated cheques on delivery of the stock. It was held that the repayment arrangement was a demonstration of the company's insolvency and the payments were held to be preferences.
-Sellers v Offset Alpine Printing Pty Ltd  CA(Vic) – The plaintiffs were Liquidators of Eric Clarke & Associates, which traded an advertising business producing catalogues and brochures. The company was traditionally a slow payer. During the relation-back period, the company entered into a repayment arrangement with Offset Alpine. All payments, except the last instalment, were made by the agree due dates. Further credit was also advanced to the company. It was held that the payments were not preferences.
-KEL Builders (Qld) Pty Ltd (In Liq) v Brett Nash Electrics Pty Ltd  QSC 178 – A builder (KEL) issued a circular to its creditors, stating that it could not pay all its creditors when due and that it sought further time to pay. KEL's builder's licence was then cancelled and this was publicised in a newspaper. The creditor Brett Nash Electrics issued a Creditor's Statutory Demand, claiming approx. $70,000. After the demand was issued, Brett Nash received payments by cheque. KEL provided the cheques on the understanding that they would not be presented until advised by KEL. These payments were held to be preferences.
-Sims v Celcast Pty Ltd (1998) 71 SASR 142 – The Liquidator of Ermayne Pty Ltd (formerly Leal Boss Computer and Office Supplies Pty Ltd) brought a preference claim against Celcast, claiming $54,000. Several of the cheque payments to Celcast were initially dishonoured. A repayment arrangement was entered into, but Ermayne was unable to meet the installments. Ermayne sold its business and issued a circular to its creditors in late January 1995 stating that creditors would be paid as Ermayne collected its debtors and that this process should be completed by the end of March. Celcast appointed solicitors to collect the debt. Legal action was threatened, followed by the issue of proceedings and a Creditor's Statutory Demand for payment. The payments were held to be preferences.
-Sims v Technical Holdings Pty Ltd (1998) 30 ACSR 330 – In the same liquidation of Ermayne Pty Ltd, the Liquidator issued a preference claim against Technical Holdings, which traded as Westline Furniture. One cheque payment to Westline was initially dishonoured, although this occurred some six months before the alleged preference payments. Westline issued monthly statements to Ermayne with comments such as "Overdue!" and "Cheque Please – account is now long overdue". These were held to show nothing more than tardiness in payment of accounts. Westline received the same circular to creditors that Celcast had received, stating in late January 1995 that creditors would be paid as Ermayne collected its debtors and that this process should be completed by the end of March. Westline issued a letter to Ermayne in February threatening legal action if the debt was not repaid by 24 March. The payments is received were held not to be preferences.
When is a debt due for payment?
-Hamilton v BHP Steel (JLA) Pty Ltd (1995) 13 ACLC 1548 – The Liquidator of Hi Deck Roofing Pty Ltd sought repayment of $131,000. Hi Deck was a metal roofing contractor. Hi Deck was traditionally a slow payer. Although the preference payments were "round" amounts, there was little evidence of pressure being placed on the company to make the payments. It was held that irregular or spasmodic payments in reduction of the company's debts may be an acceptable practice within certain industries, such as the building industry. On this basis, the payments were not preferences.
Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation  39 ACSR 305 – The court held that payments to the ATO of $208,000 were preferences. No defence under s 588FG(2) was claimed. However, this case is important as the court set circumstances when a debt was "due for payment" other than within stipulated trading terms. The court held that that laxity of creditors in requesting prompt payment is not taken into account, but "in assessing solvency, the Court acts upon the basis that a contract debt is payable at the time stipulated for payment in the contract unless there is evidence, proving to the Court's satisfaction, that:
-there has been an express or implied agreement between the company and the creditor for an extension of the time stipulated for payment; or
-there is a course of conduct between the company and the creditor sufficient to give rise to an estoppel preventing the creditor from relying upon the stipulated time for payment; or
-there has been a well established and recognised course of conduct in the industry in which the company operates, or as between the company and its creditors as a body, whereby debts are payable at a time other than that stipulated in the creditors' terms of trade or are payable only on demand."
In the next article, I will discuss how you can reduce the chances of receiving a preference claim.
*Nick Cooper is a Partner of the Adelaide office of Worrells Solvency & Forensic Accountants. He is qualified as a Chartered Account and hold a Bachelor of Laws. He is an Official Liquidator and a Registered Trustee in Bankruptcy. Nick has worked in the insolvency practice for 20years. He has acted as an Administrator, Liquidator and Receiver of companies in a diverse range of industries.
He has acted on behalf of major banks and in respect of clients of many accounting firms. In his role as a Liquidator and as a Trustee in Bankruptcy, Nick is often involved in litigation to recover assets for the benefit of creditors.