Tips on defending a liquidator’s preference claim.

Preferences are payments or transfers of assets that give a creditor an advantage over other creditors.

Any payments or transfers made to a creditor within a certain period before a company is placed into liquidation, may in certain circumstances be recovered by a liquidator. Preferences are usually payments of money, although a variety of transactions could be deemed ‘preferential’ such as transfers of physical assets (e.g. stock, equipment, or motor vehicles).

In order for a liquidator to successfully prove a preference claim, they must establish the following (section 588FA):

  • The company (in Liquidation) and the creditor were parties to the transaction.
  • The creditor receiving the payment is an unsecured creditor.
  • 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 company made the payment when it was insolvent, or the company became insolvent as a result of the transaction.
  • The payment resulted in the creditor receiving more than they would in a liquidation scenario.

Assuming a liquidator can establish these points, they have a fair chance of convincing a court that the monies should be repaid (section 588FF)—however, creditors have certain defences available against such a claim. It should also be noted that the onus of proving a defence is on the creditor—not the liquidator (Levi v Guerlini (1997) 24 ACSR 159).

This article briefly explores some of these defences—obviously if you or one of your clients receive a demand from a liquidator, then you should obtain appropriate legal advice before seeking to defend any such claim yourself.

So, what are some of these defences?

The ‘Running Account’ – Continuing Business Relationship

Subsection 588FA(2) of the Corporations Act 2001 provides that where a transaction is, for a commercial purpose, an integral part of a continuing business relationship such as shutterstock_158522279a running account between a creditor and the company (including such a relationship to which other persons are parties). It should not be attacked as a preference, but rather the effect of all the transactions which form the relationship between that creditor and the company, as though they constituted a single transaction (EM to the CLR at [1042]).

The continuing business relationship provision is similar to what was previously known as a ‘running account’.

The business relationship provision is used to determine the amount of any preference received by a particular creditor; it takes into account all transactions between relevant dates. It shows whether the owed debt increased or decreased to the creditor during that period.

If the balance owing decreased, this amount is the potential preference amount, with all other factors being considered. If the balance owing increased, there is no preference as the creditor is actually disadvantaged by the transactions.

The running account is not a complete defence to a preference—but it may help reduce the claim’s total amount. Obviously, if the transactions do not form a continuing business relationship, the defence is not available.

Statutory Defences

Section 588FG provides certain statutory defences for creditors to a liquidator’s preference claim.

(1) A court is not to make under section 588FF an order materially prejudicing a right or interest of a person other than a party to the transaction if it is proved that:

(a) the person received no benefit because of the transaction; or

(b) in relation to each benefit that the person received because of the transaction:

(i) the person received the benefit in good faith; and

(ii) at the time when the person received the benefit:

(A) the person had no reasonable grounds for suspecting that the company was insolvent at that time or would become insolvent as mentioned in paragraph 588FC(b); and

(B) a reasonable person in the person’s circumstances would have had no such grounds for so suspecting.

588FA(1)(a) “the person received no benefit because of the transaction”—is reasonably self explanatory—if you did not receive a benefit because of the transaction there is no preference.

Section 588FG(1)(b) is not so straight forward and has resulted in numerous legal cases.

The defence requires a creditor to prove the following:

  1. The creditor gave valuable consideration for the payment.
  2. The creditor received the payment in good faith.
  3. The creditor had no reason to suspect the company’s insolvency.

A creditor must establish each limb of section 588FG(1)(b) or the defence will fail.

  1. What is valuable consideration?

Usually, the easiest condition to prove is the creditor gave valuable consideration.

For trade creditors, the initial supply of goods or services provides the valuable consideration. In regards to a loan, the creditor can rely on the initial loan to the company.

The creditor only has to show that they have given something of value in consideration for receiving the payment.

2. What is good faith?

In Queensland Bacon Pty Ltd v Rees (1966) the Court discussed the test for good faith:

“The existence of knowledge or suspicion of insolvency negatives good faith and the knowledge of circumstances from which ordinary men of business would conclude that the debtor is unable to meet his liabilities is knowledge of insolvency”.

Taking the above into consideration such actions as issuing statutory demand or commencing litigation to recover monies owed might be seen as ‘knowledge of insolvency’, and therefore negate a good faith defence to be raised.

Obviously every industry is different—so what might be considered as common practice to recover a debt in one—isn’t in another. For this very reason “good faith” can be a difficult issue to resolve.

3. What is no reason to suspect the company’s insolvency?

In Dean-Willcocks v Commissioner of Taxation (2004) the courts have indicated this suspicion must be one of actual and existing insolvency, as distinct from impending or potential insolvency.

The creditor must not have received or have known of any information or circumstance that would lead them (or a reasonable person in their position) to suspect the companyshutterstock_691351762 was insolvent.

Actions such as receiving post-dated cheques, dishonouring cheques, entering into repayment agreements, knowing of other unpaid creditors, and pressing for payment can reasonably lead to this suspicion.

Whether or not a person should have suspected insolvency is often difficult to determine, particularly as the courts recognise a distinction between a short-term cash-flow problem and insolvency.

Subject to satisfying all the above factors the statutory defence may be available.

Doctrine of Ultimate Effect

The Doctrine of Ultimate Effect may be used in certain circumstances to defend a preference payment by a liquidator.

The Doctrine was explained in Airservices Australia v Ferrier—that for a payment to be preferential “it must ultimately result in a decrease in the net value of the assets to meet the competing demands of other creditors”.

So, in essence, if you can show the payment resulted in the value of the company’s assets increased or preserved, you can potentially argue the payments are not preferential.

The doctrine was considered in the matter of McKern v Minister administering the Mining Act 1978 (WA).

The liquidator in this case sought to recover certain payments in respect of rent (for various leased mining tenements) and royalties as preferential payments (section 588FA). The company in liquidation was Centaur Mining and Exploration Ltd.

The Court considered that the doctrine extended to the rental payments as those enabled Centaur to retain certain tenements and preserved/increased the value of assets available to creditors. Therefore the Minister received no unfair preference within the meaning of section 588FA in respect of the rental payments.

The Minster was unsuccessful in respect of the royalties, as they were deemed to relate to debts already incurred and the payments did not increase the value of the company’s assets. They simply extinguished a past debt.

Whether the Doctrine of Ultimate Effect can be used must be assessed on a case by case basis.