When a company enters liquidation, it is understandable that creditors often feel aggrieved.
Firstly they are owed a debt, which will usually become a bad debt. But secondly, they may be asked to refund some of the money they have worked hard to collect – when a Liquidator claims they have received an "unfair preference".
In this 3 part series, I will provide a practical summary of the law concerning unfair preference transactions.
The topics to be covered are:
• what is a preference payment?
• what are the defences?
• how can you reduce the chances of a preference claim?
Part 1 - What is a Preference Payment?
The rationale for unfair preferences is that when a company is insolvent, by definition, the company will not be able to pay the full amount of its debts when due for payment.
The governing law, which is the Corporations Act, encourages insolvent companies to pay all their creditors proportionally. It does this by penalising those creditors who have received a disproportionate share (an unfair preference). The creditor who has received the disproportionate share is required, subject to certain defences, to repay the amount they have received.
It is the duty of the Liquidator to collect these preference payments and then distribute the monies proportionately to all the company's creditors.
"Unfair preferences" are defined under Section 588FA(1) of the Corporations Act as follows:
[What is unfair preference] A transaction is an unfair preference given by a company to a creditor of the company, if, and only if:
(a) the company and the creditor are parties to the transaction (even if someone else is also a party); and
(b) the transaction results 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 were set aside and the creditor were to prove for the debt in a winding up of the company;
even if the transaction is entered into, or is given effect to, or is required to be given effect to, because of an Order of an Australian court or a direction by an agency.
There are several aspects of preferences which ought to be noted:
a) Timeframe. The timeframe within which payments can be deemed to be preferences is within six (6) months before "commencement" of a liquidation. This period of time is referred to as the "relation-back period".
"Commencement" of a liquidation is defined in the Corporation Act and is not necessarily the day that a company enters liquidation.
Where a company is in Voluntary Administration (or trading under a Deed of Company Arrangement) and later enters liquidation, the "commencement" of liquidation is deemed to be the date that the company first entered Voluntary Administration (s. 513B).
In the case of a liquidation ordered by the Court, it is six months before the filing of the application to Court to wind up the company (s. 9 definition of "relation-back day").
The time period for transactions with related parties is four (4) years.
Sometimes, there is an issue as to whether or not a payment falls inside the relation-back period - if there was a delay between a cheque being drawn and presented.
In the case Re: Transconsult Australia Pty Ltd (In liq) (1991) 9 ACLC 1052 – it was held that the date of a payment by cheque is the date on which the cheque was given to the creditor, not the date that the proceeds of the cheque were made available to the creditor through the bank transfer system.
b) Liquidation. The company must be in liquidation for a payment to be caught by the preference provisions. In other words, payments are not liable to be deemed preferences where a company enters Receivership (unless it enters liquidation at the same time) or enters Voluntary Administration and then enters a Deed of Company Arrangement that does not end in a liquidation.
This is relevant if a debtor company enters Voluntary Administration and you as a creditor are given an option to vote for liquidation or for a Deed of Company Arrangement proposal. If you consider that you may have received a preference within the previous six months, this may influence your vote as you may be liable to repay the preference in the event of liquidation.
c) Insolvency. A payment can only be deemed to be a preference if the company was insolvent at the time of the payment.
It is important to note that even though there is a six (6) month timeframe for recovery of preferences, a company may not be insolvent throughout the entire six months.
The Liquidator usually seeks to prove insolvency by preparing a report on the company's financial position during the relation-back period.
If defending a preference claim, it may be worthwhile scrutinising the Liquidator's report and seeking an opinion on the company's solvency from another Insolvency Practitioner.
There have been several cases where a Liquidator has lost a preference claim on the basis that they have failed to prove that the company was insolvent at the time of the preference payment.
d) Interest and costs. A Liquidator can claim interest on a preference payment and legal costs if the matter proceeds to trial and the Liquidator is successful.
Conversely, if the Liquidator is unsuccessful, the creditor can claim some of their legal costs against the Liquidator.
In the case Star v O'Brien  22 ACSR 434, it was held that interest on a preference claim runs from the date of the Liquidator's letter of demand for payment.
It should also be noted that legal costs awarded by a court to the successful party is usually on a "party/party" basis rather than "solicitor/client" basis.
This means that some costs cannot be claimed, such as the cost of providing legal advice as opposed to preparation for a trial.
The costs awarded are also calculated on a set scale of rates, which might be less than your solicitors' standard charge out rates.
What the Liquidator must prove
To successfully establish at trial that a payment is an unfair preference, a Liquidator must prove to the court the following matters:
a) Insolvency. The Liquidator must prove that the company was insolvent at the time of the preference payment. This is usually done by the Liquidator preparing a report on the company's financial position which demonstrates that the company was insolvent.
"Insolvency" is explained in section 95A of the Corporations Act, as follows:
(1) A person is solvent if, and only if, the person is able to pay all the person's debts, as and when they become due and payable.
(2) A person who is not solvent is insolvent.
Insolvency is a "cash flow test" rather than a "balance sheet test". In other words, insolvency is not determined by examining a Balance Sheet, but by examining a company's cash inflows and cash outflows.
A company is insolvent when the cash outflows will exceed both the:
• cash inflows; and
• the available cash funds and credit available on bank overdraft accounts, etc.
There are a number of factors which will indicate insolvency, such as:
high proportion of trade creditor aged 90 days or more;
late lodgement or non-payment of amounts due on Business Activity Statements;
late or non-payment of WorkCover levies;
demands from suppliers for payment;
legal action commenced by suppliers;
negotiating repayment arrangements with suppliers;
a deficiency in "working capital" - generally calculated by deducting current liabilities from current assets as disclosed in the Balance Sheet.
b) Debtor/Creditor Relationship. The Liquidator must prove that there was a debtor/creditor relationship at the time of the preference payment.
In other words, the recipient of the payment must have been owed monies at the time of payment. This will usually be the case.
However, there will not be a debtor/creditor relationship where payments are made on a cash-on-delivery ("COD") basis. Such COD payments can therefore never be preferences.
c) Unsecured Creditor. The Liquidator must prove that the creditor who received the preference payment was an "unsecured" creditor. In other words, there cannot be a preference payment against a bank or other creditor who has valuable security over the company's assets.
Similarly, with the introduction of the Personal Property Securities Register ("PPSR"), suppliers of goods who have a valid PPSR registration are secured creditors and immune from preferences – but the value of their security against the value of the alleged preference payment must be considered.
If a secured creditor receives a payment which exceeds the value of its security, then the portion of the creditor's debt that is effectively unsecured is liable to be repaid as an unfair preference (section 588FA(2)).
d) Preferential Effect. The wording of section 588FA(1)(b) suggests that a payment can only be a preference if the creditor was effectively preferred over other creditors of the company.
The test is whether the transaction results in the creditor receiving from the company more than it would have received 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.
In the case Walsh v Natra (2000) 1 VR 523, it was held that preferential effect is demonstrated by comparing the return that the creditor received from the payment against the return the creditor would receive in the winding up of the company conducted by the Liquidator.
Preferential effect is important for one class of creditors, being landlords, who are in a privileged position with respect to preferences. It has been held in the case Re: Discovery Books Pty Ltd (1972) 20 FLR 470 that landlords do not necessarily receive a preference when a tenant pays rent - as the ultimate effect is that the company is allowed to continue trading from the rented premises. This is known as the "doctrine of ultimate effect".
e) Transaction. The Liquidator must prove that there was an "transaction". Clearly when a creditor receives a payment, the payment itself is the transaction.
There have been several cases in which the meaning of a "transaction" was important, including:
• Re Emanuel (No. 14) Pty Ltd (In liq) (1997) 24 ACSR 292 – it was held that the definition of "transaction" was sufficiently broad to catch an arrangement whereby a payment from a third party, rather than from the company which entered liquidation, to the creditor was liable to be repaid as a preference - given that the payment was authorised by the company.
• Bartercard Ltd v Wily (2001) 19 ACLC 1461 – it was held that a transaction existing in circumstances where a creditor terminated a franchise agreement and obtained the business (including goodwill and plant & equipment) of a franchisee. It was a transaction as the creditor set-off the value of the business against the debt owing to it.
In the next article, I will discuss the defences and remedies that are available to creditors.
By Nick Cooper