Preference Claims – Payments that may come back to bite you

24 January 2012

In difficult times, it is very common for struggling companies to request entering into payment arrangements with their creditors in order to sustain cash flow. Creditors accepting these payment arrangements must be careful of the implications in accepting the part payments if the payee company is placed in Liquidation within the six months of receiving part payments.

Pursuant to the Corporations Act 20001, a liquidator has the ability to recover, for the benefit of all creditors, certain payments (known as unfair preferences) made by the company to creditors in the six months before the start of the liquidation.

In essence, a creditor receives an unfair preference if, during the six months prior to liquidation, the company is insolvent, the creditor suspects the company is insolvent, and receives payment of their debt (or part of it) ahead of other creditors. To be an unfair preference, the payment must place the creditor receiving it in a more favourable position than other unsecured creditors. A Liquidator does not have an automatic right to claw back the payments if a creditor refuses to repay these monies and the Liquidator in this instance would need to obtain a Court Order requiring payment from the creditor. However it is common for preference claims being commercially settled out of court.

The elements required for a Liquidator to prove preference claims

In order for a Liquidator to successfully prove a preference claim, the following must be established;

- The company (in Liquidation) and the creditor were parties to the transaction;

- The transaction took place within six months before the commencement of the winding up (this is extended to four years for payments to related parties)

- The payment is made by the company when it was insolvent or the company became insolvent as a result of the transaction; and

- The payment resulted in the creditor receiving more than they would have received in a Liquidation scenario

Defences available for creditors

The Corporations Act provides creditors with defences to unfair preference claims. In order for a creditor to properly defend a preference claim, they must establish;

- It became party to the transaction in good faith;

- At the time it became party to the transaction, it had no reasonable grounds for suspecting the company was insolvent or would become insolvent as a result of the transaction; and

- It provided valuable consideration as part of the transaction

Continuing Business Relationship

A common defence available to creditors is whether the transaction in question could be considered a part of a continuing business relationship – such as a running account. The running account defence is that during the course of the relationship, if the level of the company’s indebtedness to its creditor increases and decreases from time to time as a result of a series of transaction, then all the transactions are considered as one single transaction. For example, during the period payments are made by the company, a creditor continues to provide goods or services. In this case, an unfair preference is only in existence if the value of payments during the relevant period is greater that the value of goods or services provided to the company during the relevant period.

Recent case law on preference claims

The courts have been quite busy in recent times dealing with preference claims by Liquidators. The following are two notable cases.

In Clifton (as liquidator of Adelaide Fibrous Plasterboard Linings Pty Ltd (in liq)) &Anor v CSR Building Products Pty Ltd [2011] SASC 103 , the Supreme Court of South Australia had to consider the ‘good faith’ and ‘running account’ defences contained in the Corporations Act.

In this case, the court held that the defendant had failed to establish the ‘good faith’ defence however was successful in establishing the ‘running account’ defence in respect of two of the five payments that the liquidator had sought to recover as unfair preferences.

The reason the ‘good faith’ defence was not successfully proven was due to the existence of strong insolvency indicators. However, knowledge or even actual suspicion of insolvency in this case did not stop the creditor relying upon the ‘running account’ defence for a payment received.

The other recent decision was in the Federal Court of Australia in the case R oufeil v Gliderol International Pty Limited [2011] FCA 847 , where it was made clear that to successfully maintain a defence to an unfair preference claim the creditor must prove on both a subjective and objective basis that the creditor had no grounds for suspecting the insolvency of the company.

In this case the creditor tried to establish a defence by arguing that at the time it received the payments, it had no reasonable grounds to suspect of the payee’s insolvency.

The court held that the basis of the creditor’s defence was insufficient given that:

(a) subjectively, the basis of the credit manager’s conclusions about lack of reasonable grounds to suspect insolvency was insufficient; and

(b) objectively, the history of the creditor’s dealings with the insolvent presented grounds which would have led a reasonable person in the creditor’ position to suspect insolvency such as the creditor ceasing its commercial relationship due to failure of the insolvent to pay any of its invoices after a specified date coupled with a statutory demand issued to the insolvent not being satisfied.

Common signs of a preference payment

A Liquidator’s duty when investigating the affairs of the company is to identify potential preference claims. The following are strong indicators which Liquidators look out for when trying to identify preferential payments they may be able to claw back;

- Payments made after supply has stopped or threats are made to stop supply;

- Payments made outside normal trading terms;

- Payments made after legal recovery action has commenced;

- Payments are made in lump or rounded sums

Conclusion

It is very rare for creditors to refuse payments from struggling companies with the possibility the payments they receive may be clawed back in the future– however creditors must accept the risk that in the event the payee becomes insolvent, they may have a Liquidator knocking on their door attempting to recover the payments.