News and Insights

Considerations upon a demand for unfair preferences

When a client receives a letter from a Liquidator demanding repayment of amounts received by it as “unfair preferences”, there are questions raised:

We are entitled to the money, why do I have to pay it back?

Why do we have to pay money back when the company still owes us money?

Surely our security held over the company can be raised as an argument?

What if we received cash on delivery of the goods?

As the term “unfair preference payment” suggests, it certainly seems unfair that a creditor of a liquidated company should receive a demand seeking repayment of monies it received prior to the company going into liquidation.

Years ago, I received a call from a company. They had received a letter of demand from a Liquidator seeking payment of $1million. Their accountant told them that they would just have to pay it. Not content with this answer, they consulted an insolvency practitioner who referred them to me. Upon review of the circumstances and the relationship between the parties, the company had numerous defences but we had to respond quickly as the Liquidator only had a few weeks to issue legal proceedings.  A lengthy letter was sent to the Liquidator setting out all of the defences the company was entitled to rely upon to refute the unfair preference claim.  The overall outcome was that the company was not required to pay anything to the Liquidator, no proceedings were issued and the matter was concluded. I had a very happy “new” client who had avoided payment of $1million and was not required to pay a cent.

It is important to understand the claims seeking recovery of unfair preference payments and the elements to bear in mind:

• Section 588FA of the Corporations Act 2001 (Cth) defines an unfair preference as a ”transaction” between the company and a unsecured creditor, which results in the creditor receiving more in respect of an unsecured debt than the creditor would receive on the winding up of the company. Therefore, if the creditor holds some form of security in respect of the company, it can rely on that security to argue that the payments were not made in respect of an unsecured debt.

• There are four elements which must be established by the Liquidator in proving the transaction aspect of an unfair preference. They are as follows:
  1. Debtor/Creditor relationship – the payments were made by the company as debtor to the creditor. If there was cash paid on delivery, there is no debtor/creditor relationship between the parties as those payments are excluded.
  2. Payments within relation-back period – the payments were made by the company to the creditor within the relation-back period and this is usually six months before the winding up application was filed. The relation-back day is defined in sections 9, 513A, 513B, and 513C.  In a court-ordered winding up, the relation-back day is generally the day on which the court application was filed.  In a voluntary winding up, the relation-back day is the day on which the resolution was passed.
  3. Insolvency – the insolvency of the company at the time the payments were made by the company.
  4. Effect of the preference – in order to show that there was a preferential effect upon the creditor by receiving the payments during the relation-back period, the Liquidator needs to show that there were other creditors of the company at the times that each of the payments were made, which remained creditors of the company at the date of the liquidation.

• The defences to these claims are set out in section 588G(2) (and section 588FG(1)) and the defence comprises several elements which are cumulative:
• • the creditor received the payment in good faith;
  • at the time when the payment was made, the company was insolvent or would become insolvent because of the payment;
  • a reasonable person in the position of a creditor would have had no grounds for suspecting insolvency; and
  • valuable consideration has been provided under the transaction.

• The critical part of the defence is the grounds for suspicion.  The first part of the test is subjective – that is, a Court looks at the state of mind of the creditor in light of what they knew or were aware of at the time.  The second part of the test is objective – even if the creditor did not suspect, would a reasonable person given the same information have reasonable grounds for suspicion?

• Section 588FA(3) of the Act entitles a creditor to rely on their continuing business relationship with the creditor to demonstrate the existence of a “running account”.

• Essentially, a running account is as follows:
  • there must be a continuing business relationship between the creditor and the company;
  • as part of this relationship, there are supplies made on the one hand and payments made on the other to reduce the ongoing indebtedness (and not to discharge past indebtedness);
  • one of the reasons for making the payments must be to induce the creditor to continue supply to the company;
  • The commencement date for the “single transaction” is likely to be the latter of either the relation-back day or the commencement date of the continuing business relationship. The determination of the closing balance in a running balance defence will remain as either the end date of the continuing business relationship or the date of liquidation (whichever is earliest).

If any of your clients receive a letter of demand in respect of unfair preference payments, please ensure they obtain the necessary advice as to how they should respond. If necessary, we can act on your client’s behalf to address all relevant issues and clearly demonstrate the evidence and facts that can refute the claim.  Alternatively, we can negotiate a lesser amount to be paid to the Liquidator if very few or no defences can be relied upon at all.

The key issue is to determine what information or documents the client may need to gather so a carefully drafted response can be promptly put to the Liquidator.