Legal Unfair preferences and how to avoid them

By Nick Cooper* Part 1 – What is a Preference Payment? The rationale for unfair preferences is that when a company When a company enters , it is is insolvent, by definition, the company will not be able to pay the full amount of its debts when due for payment. understandable that often feel The governing law, which is the Corporations aggrieved. Act, encourages insolvent companies to pay all their creditors proportionally. It does this by penalising those Firstly they are owed a debt which will creditors who have received a disproportionate share usually become a bad debt. Secondly, they (an unfair preference). The who has received may be asked to refund some of the money the disproportionate share is required, subject to certain they have worked hard to collect – when defences, to repay the amount they have received. It is the duty of the to collect these a Liquidator claims they have received an preference payments and then distribute the monies “unfair preference”. proportionately to all the company’s creditors. “Unfair preferences” are defined under Section 588FA(1) In this 3 part series, I will provide a practical of the Corporations Act as follows: summary of the law concerning unfair preference transactions. What is unfair preference? A transaction is an unfair preference given by a company to a creditor of the company, if, and only if: The topics to be covered are: (a) the company and the creditor are parties to the • what is a preference payment? transaction (even if someone else is also a party); and • what are the defences? (b) the transaction results in the creditor receiving from • how can you reduce the chances of a the company, in respect of an unsecured debt that preference claim? the company owes to the creditor, more than the creditor would receive from the company 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; even if the transaction is entered into, or is given effect to, or is required to be given effect to, because of an Order of an Australian court or a direction by an agency. There are several aspects of preferences which ought to be noted:

a) Timeframe. The timeframe within which payments can be deemed to be preferences is within six (6) months before “commencement” of a liquidation. This period of time is referred to as the “relation-back period”. “Commencement” of a liquidation is defined in the Corporation Act and is not necessarily the day that a company enters liquidation. Where a company is in Voluntary Nick Cooper (or trading under a Deed of Company Arrangement)

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and later enters liquidation, the “commencement” of liquidation is deemed to be the date that the company In the case of a liquidation first entered Voluntary Administration (s. 513B). ordered by the Court, it is In the case of a liquidation ordered by the Court, it is six months before the filing of the application to Court six months before the filing to wind up the company (s. 9 definition of “relation- back day”). of the application to Court The time period for transactions with related parties is four (4) years. to wind up the company Sometimes there is an issue as to whether or not a payment falls inside the relation-back period – if d) Interest and costs. A Liquidator can claim interest on there was a delay between a cheque being drawn and a preference payment and legal costs if the matter presented. proceeds to trial and the Liquidator is successful. In the case Re: Transconsult Australia Pty Ltd (In Conversely, if the Liquidator is unsuccessful, the liq) (1991) 9 ACLC 1052 – it was held that the date of a creditor can claim some of their legal costs against the payment by cheque is the date on which the cheque Liquidator. was given to the creditor not the date that the proceeds In the case Star v O’Brien [1996] 22 ACSR 434, it was of the cheque were made available to the creditor held that interest on a preference claim runs from the through the bank transfer system. date of the Liquidator’s letter of demand for payment. It should also be noted that legal costs awarded by b) Liquidation. The company must be in liquidation for a court to the successful party is usually on a “party/ a payment to be caught by the preference provisions. party” basis rather than “solicitor/client” basis. In other words, payments are not liable to be deemed This means that some costs cannot be claimed such preferences where a company enters as the cost of providing legal advice as opposed to (unless it enters liquidation at the same time) or enters preparation for a trial. Voluntary Administration and then enters a Deed The costs awarded are also calculated on a set of Company Arrangement that does not end in a scale of rates, which might be less than your solicitors’ liquidation. standard charge out rates. This is relevant if a company enters Voluntary Administration and you as a creditor are given an What the Liquidator must prove option to vote for liquidation or for a Deed of Company To successfully establish at trial that a payment is an Arrangement proposal. If you consider that you may unfair preference, a Liquidator must prove to the court the have received a preference within the previous six following matters: months, this may influence your vote as you may be liable to repay the preference in the event of liquidation. a) . The Liquidator must prove that the company was insolvent at the time of the preference c) Insolvency. A payment can only be deemed to be a payment. This is usually done by the Liquidator preference if the company was insolvent at the time of preparing a report on the company’s financial position the payment. which demonstrates that the company was insolvent. It is important to note that even though there is a “Insolvency” is explained in section 95A of the six (6) month timeframe for recovery of preferences, a Corporations Act, as follows: company may not be insolvent throughout the entire six (1) A person is solvent if, and only if, the person is months. able to pay all the person’s debts as and when The Liquidator usually seeks to prove insolvency by they become due and payable. preparing a report on the company’s financial position (2) A person who is not solvent is insolvent. during the relation-back period. Insolvency is a “cash flow test” rather than a If defending a preference claim, it may be “balance sheet test”. In other words, insolvency is worthwhile scrutinising the Liquidator’s report and not determined by examining a Balance Sheet but by seeking an opinion on the company’s solvency from examining a company’s cash inflows and cash outflows. another . A company is insolvent when the cash outflows will There have been several cases where a Liquidator exceed both the: has lost a preference claim on the basis that they have zz cash inflows; and failed to prove that the company was insolvent at the zz the available cash funds and credit available on time of the preference payment. bank overdraft accounts, etc.

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There are a number of factors which will indicate receive in the winding up of the company conducted by insolvency, such as: the Liquidator. ¾¾ high proportion of trade creditor aged 90 days Preferential effect is important for one class of or more; creditors, being landlords, who are in a privileged ¾¾ late lodgement or non-payment of amounts due position with respect to preferences. It has been held in on Business Activity Statements; the case Re: Discovery Books Pty Ltd (1972) 20 FLR 470 ¾¾ late or non-payment of WorkCover levies; that landlords do not necessarily receive a preference ¾¾ demands from suppliers for payment; when a tenant pays rent – as the ultimate effect is ¾¾ legal action commenced by suppliers; that the company is allowed to continue trading from ¾¾ negotiating repayment arrangements with the rented premises. This is known as the “doctrine of suppliers; ultimate effect”. ¾¾ a deficiency in “working capital” generally calculated by deducting current liabilities from e) Transaction. The Liquidator must prove that there current assets as disclosed in the Balance Sheet. was a “transaction”. Clearly when a creditor receives a payment, the payment itself is the transaction. b) Debtor/Creditor Relationship. The Liquidator must There have been several cases in which the meaning prove that there was a debtor/creditor relationship at of a “transaction” was important, including: the time of the preference payment. zz Re Emanuel (No. 14) Pty Ltd (In liq) (1997) 24 In other words, the recipient of the payment must ACSR 292 – it was held that the definition of have been owed monies at the time of payment. This “transaction” was sufficiently broad to catch an will usually be the case. arrangement whereby a payment from a third However, there will not be a debtor/creditor party, rather than from the company which relationship where payments are made on a cash- entered liquidation, to the creditor was liable on-delivery (“COD”) basis. Such COD payments can to be repaid as a preference – given that the therefore never be preferences. payment was authorised by the company. zz Bartercard Ltd v Wily (2001) 19 ACLC 1461 c) . The Liquidator must prove that the – it was held that a transaction existing in creditor who received the preference payment was an circumstances where a creditor terminated a “unsecured” creditor. In other words, there cannot be franchise agreement and obtained the business a preference payment against a bank or other creditor (including goodwill and plant & equipment) of who has valuable security over the company’s assets. a franchisee. It was a transaction as the creditor Similarly, with the introduction of the Personal set-off the value of the business against the Property Securities Register (“PPSR”), suppliers of debt owing to it. goods who have a valid PPSR registration are secured creditors and immune from preferences – but the In the next article, I will discuss the defences and remedies value of their security against the value of the alleged that are available to creditors. n preference payment must be considered.

If a receives a payment which *Nick Cooper is a Partner of the Adelaide office of Worrells Solvency exceeds the value of its security, then the portion of the & Forensic Accountants. He is qualified as a Chartered Account and hold a Bachelor of Laws. He is an Official Liquidator and a Registered creditor’s debt that is effectively unsecured is liable to Trustee in . Nick has worked in the insolvency practice for be repaid as an unfair preference (section 588FA(2)). 20 years. He has acted as an Administrator, Liquidator and Receiver of companies in a diverse range of industries. He has acted on behalf of major banks and in respect of clients of many accounting firms. d) Preferential Effect. The wording of section 588FA(1)(b) In his role as a Liquidator and as a , Nick is often suggests that a payment can only be a preference if the involved in litigation to recover assets for the benefit of creditors. creditor was effectively preferred over other creditors of the company. The test is whether the transaction results in the creditor receiving from the company more than it would The Liquidator must prove have received in respect of the debt if the transaction was set aside and the creditor were to prove for the that the creditor who debt in a winding up of the company. In the case Walsh v Natra (2000) 1 VR 523, it received the preference was held that preferential effect is demonstrated by payment was an comparing the return that the creditor received from the payment against the return the creditor would “unsecured” creditor.

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