By Kate Davey (Senior Associate) and Paul Welling (Principal Solicitor)
If one of your organisation’s customers or clients goes into liquidation, there is a risk that the liquidator may seek to recover (or “claw back”) payments made by that company to you as an unfair preference under Section 588FA of the Corporations Act 2001 (“the Act”).
What is an unfair preference?
A transaction will be an “unfair preference” given by a company to a creditor if the transaction results in the creditor receiving from the company (in respect of an unsecured debt that the company owes to it) more than the creditor would receive 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.
Put more simply, you are at risk if the company in liquidation made a payment to you which results in you receiving a greater proportion of the amount owed to you than other creditors will receive.
The transaction must have been entered into in the six month period prior to the relation back day (the legal term for the day on which the liquidation is recognised to have commenced).
A finding that a payment was an unfair preference may result in an order that the creditor pay to the liquidated company an amount equal to the amount originally paid to the creditor under the transaction.
Whilst it can seem deeply unfair for a creditor to have to hand back money which it received for work done or goods sold, the rationale is to prevent some creditors (who may have more leverage than others because of, for example, their importance to the insolvent business) pushing their way into a better position than other creditors.
Obviously, this can have serious ramifications for creditors who, due to the delay between liquidators being appointed and the pursuit of unfair preference claims (liquidators have three years within which to issue proceedings), may eventually find themselves ordered to repay amounts paid to them several years prior.
What defences are available?
The main defences to an unfair preference claim are:
- the running account balance defence;
- the creditor is a secured creditor; and/or
- the good faith defence.
The “running account balance” defence found in sub section 588FA (3) of the Act is not actually a complete defence but may help to reduce the quantum of an unfair preference claim.
Where there are multiple transactions between the company and a creditor over the relevant six month period, the court will assess the amount of the unfair preference not as the total amount of all payments made over relevant six month the period, but rather as the difference between the “peak” (maximum) amount of the debt owing during the period, and the amount owed at the “relation-back” date.
Sub section 588FFA (1) (b) of the Act only applies to transactions in respect of an unsecured debt that the company owes to the creditor, although a secured debt will be taken to be unsecured to the extent (if any) that it is not reflected in the value of the security. As such, if a creditor holds security over the company that is greater than the sum of the purported preference payment, then the creditor will likely be safe from an unfair preference claim.
The main defence to an unfair preference claim, found in sub section 588FG of the Act, is for the defendant creditor to prove that it did not know, and not ought reasonably have known that the company was insolvent at the time it received the alleged unfair preference payment.
Factors which will make it difficult to rely on this defence (as they may indicate that a creditor was, in fact, aware that the company was insolvent) include:
- documents evidencing constant and repeated attempts by the creditor to recover outstanding debts;
- documents evidencing internal discussions as to, or concerns about, the company’s solvency;
- payments being made to the creditor in round amounts, or in amounts which are irreconcilable to invoices;
- the creditor and the company entering into repayment arrangements, which are then defaulted on by the company; and/or
- dealings between the company and creditor which are inconsistent with the industry norm in which the creditor operates.
How can your organisation avoid such claims?
Your organisation can reduce its risk of unfair preference claims by taking the following steps:
- insist on payment upfront or on a “cash on delivery” basis – thus avoiding the establishment of a creditor/debtor relationship;
- take security – payments to a secured creditor (to the value of the creditor’s security) will not be deemed to be preferences; and
- encourage the debtor to pay its creditors proportionately – this may involve entering into Voluntary Administration or a Deed of Company Arrangement.
If your organisation has received a letter of demand from a liquidator or has been served with an unfair preference claim, you should obtain legal advice to maximise your chances of successfully defending the claim. Contact us for an obligation free discussion.