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

 

In recent times there has been quite a few interesting unfair preference cases coming before the Courts. It’s against this backdrop that we thought it an opportune time to prepare this article exploring the 4 ways that a creditor can defend a Liquidator’s unfair preference claim to recover pre liquidation payments made to the creditor including discussing the practical takeaways from recent unfair preference cases.

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 the unfair preference regime may seem pretty unfair given that the company didn’t pay a creditor when they should have and when they finally did, the creditor may end up losing those payments, it’s important to recognise 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:

  1. The creditor received the payment in good faith; and
  2. 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
  3. 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.

A couple important points to note:

  • The grounds for “suspecting” insolvency must be “more than mere idle wondering. It is an actual apprehension of fear or mistrust” (see Queensland Bacon Pty Ltd v Rees).
  • It must be a suspicion of actual insolvency, not possible insolvency.
  • When assessing suspicion, the Courts will look at the companies’ business dealings to the date of the alleged unfair preference payments. For instance, is it normal for the company to pay the creditor outside standard credit terms?
  • A “reasonable person” in the context of an unfair preference claim is a reasonable business

Good Faith Cases

The Court in ReAlsafe Security Products Pty Ltd atf the Alsafe Trust (In Liquidation) [2016] NSWSC 428 in finding for the Liquidator observed the following in respect of the company’s dealings with the creditor:

  • The creditor had placed the company on stopped supply for two years.
  • The creditor was pressing for a formal repayment plan.
  • There were various email chains where the company advised it was having difficulty paying the creditor’s debt in full.
  • Many of the alleged preferential payments had been paid in lump sum amounts.

Quigley (Liquidator) v Minesite Maintenance Pty Ltd [2018] FCA 316 involved a claim for $10,400 of alleged unfair preference payments. Ultimately in that case, in finding that a reasonable person would have suspected the company was insolvent the Court noted:

  1. When the creditor and the company had entered into a payment plan the company had not made any payments for four months towards a debt of $17,694.05.
  2. The company could only offer to pay its debt by way of instalments of $1,300 over 13 weeks.

In Heavy plant leasing pty ltd (in liq) [2018] NSWSC 707 the creditor was successful in arguing they could rely on the good faith defence. That case involved a Liquidator pursuing a creditor for unfair preference payments totalling around $150,000.

Essentially, the company had placed an order for certain goods it needed for a project and the creditor had then issued an invoice to the company for the supply of these goods. No payment was made by the company for some weeks, due apparently to a key executive being away from the office and unable to sign off on the payment.

Some weeks later, when the company still had not paid, the company advised a payment had been made on a Friday and the delay in receiving it was likely due to processing times over the weekend. This payment was in fact not made and after a few more days the creditor advised they would be registering a default against the company with a credit agency. In response to this the company paid the invoice in full.

Throughout this period there were various emails and calls from the creditor following up the company about the unpaid invoice. This all happened over a relatively short period of three to four months. In finding that the creditor could rely on the good faith defence the Court in particular noted:

  • Recalcitrance by a debtor does not of itself provide grounds to suspect insolvency, still less does mere late payment by a debtor provide of itself grounds to suspect insolvency.
  • The fact that it is necessary to resort to conventional debt collection procedures to recover a debt from a late or recalcitrant debtor does not necessarily provide grounds to suspect insolvency.
  • On one assessment the invoice was barely one month overdue.
  • The invoice was issued around the Christmas period and so the advice that an executive absent on holiday was unable to sign off on the payment was plausible.
  • As it was the building industry it was well known that subcontractors relied on progress payments from head contractors for cash flow to meet their own obligations.
  • The debt collection actions taken by the creditor were steps that are taken just as much by an unpaid creditor of a solvent debtor as they are by an unpaid creditor of an insolvent debtor. The fact that a creditor applies pressure of that order (incl. repeated requests for payment and withholding supply) to secure payment does not indicate the creditor fears the company is insolvent.
  • The creditor never actually engaged solicitors or debt collectors or issue a statutory demand.
  • There was nothing to indicate to the creditor that there was any general or systemic problem with creditors of the company being paid.
  • The fact the payment was made in full without proposals for a payment plan.

In Hosking v Extend N Build Pty Ltd [2018] NSWCA 149 the creditor in question was a sub-contractor on a building project. The creditor had received payments totalling around $93,000 over a period of two months after it had completed its work on the building site and in circumstances where it knew the company “couldn’t pay everyone”.

Of importance was the fact the creditor told the company’s director if he was not paid he would go to the union and that the director of the company had told the creditor that they were unable to pay everyone.

After reading the cases above 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

Set off arises under Section 553C of the Act and effectively provides for a creditor or Liquidator to set off a debt/credit against a credit/debt owed to the same party. The typical situation is that a creditor, ABC Pty Ltd owes $20,000 to a company in liquidation but is also owed $40,000 by the company. If the creditor had no notice the company was insolvent they could “set off” the $40,000 against the $20,000 they owe to the company so they wouldn’t have to pay the Liquidator anything and would only have a claim for $20,000.

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.

Set Off Case

In Stone v Melrose Cranes & Rigging Pty Ltd, in the matter of Cardinal Project Services Pty Ltd (In Liq) (No 2) [2018] FCA 530 the Court upheld a creditor’s right to use the setoff provisions under Section 553C of the Act to defend a Liquidator’s unfair preference claim.

The Liquidator in this case was pursuing $308,544 of alleged unfair preference payments. The creditor had supplied the company with cranes on two building sites. They had gone unpaid for some time on the first site but agreed to work on the second site as a third party had guaranteed payment of their invoices for that job.

The creditor argued that they should be able to set off $80,774 (being the debt they were owed at liquidation) against the unfair preference payments. While the Court agreed they could, the Liquidator in this case did not make any detailed submissions on why creditors cannot rely on set off to defend an unfair preference claim. We suspect it’s only a matter of time until such submissions are raised and accepted by a superior Court.

Despite this, the Court held that the creditor couldn’t rely on set off because they had the required notice of the company’s insolvency under Section 553C. The Court noted in particular:

  • At the date of appointment the company had a number of payment plans going and the payments in question were not reconcilable to specific invoices.
  • The company’s credit account with the creditor had been frozen and remained frozen until the company was placed into administration some time later. During cross-examination the director of the creditor said he froze the account because he was worried about the company’s ability to pay its debts.
  • The creditor had sent a formal letter of dispute under the relevant contract to the company’s solicitor and to head principal just nine days after the 30 day period for payment of the invoice (despite the company usually paying around the 45 day mark).
  • There was evident concern from the creditor’s director that they wouldn’t get paid, including extensive emails and calls to a director and manager of the company demanding payment over period of a couple months.
  • The creditor threatened issuing a statutory demand.
  • Payment was made far in excess of the 30 day payment terms and only after persistent follow up of those and other amounts owing.
  • The company had essentially imposed a payment plan on the creditor.
  • The creditor had practically ceased working with the company due to non-payment of its invoices and only undertook the second job because its invoices were guaranteed by an unrelated third party.
  • The creditor had engaged solicitors to draft a deed for an instalment arrangement for payment of the amount owing as well as providing for what would occur if the payments made were unfair preferences. The creditor’s director accepted that the deed’s purpose was to protect the creditor in the event that the company went into liquidation.
  • The creditor was being paid irregularly, in rounded amounts and not referable to any specific invoices.

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.

Retention of Title Case

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.

Originally the company had completed a credit application for the supply of goods which included a reference to the company acknowledging the credit application was subject to standard terms and conditions. It also contained an ROT clause.

A couple years later in 2013 the creditor updated its terms and conditions, provided these to the company and registered a PMSI (Purchase Money Security Interest) on the PPPSR in relation to these 2013 terms & conditions.

While not overly detrimental in this case the Court found that the original 2011 credit application did not constitute a contract between the company and the creditor. This meant that there had not been an ongoing agreement between the parties for the supply of credit on 30 day terms. The later 2013 PMSI registration was therefore invalid.

Pursuant to Section 267 of the Personal Properties Securities Act 2009 (Cth) the security interest vested in the company upon liquidation (i.e. the creditor couldn’t enforce their ROT terms). 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.

Ultimately the Court held that the creditor had received a preference totalling $473,291 as the terms of the relevant supply and credit agreement provided that any payment made by the company was to be applied firstly towards the unsecured portion of the debt and then to the secured portion.

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 will 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.

If you have received an unfair preference demand from a Liquidator and want to discuss whether you have a defence get in touch on 07 3221 0055 or send us an email at mail@pearceheers.com.

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