Some sectors of the Australian economy continue to struggle with the consequences of the COVID-19 pandemic. Lockdowns without substantial government support make the future risk for current repayments different from what it was in 2020. Pretty quickly, a good customer can become a solvency risk. Creditors with substantial exposures to those situations, but which are aware of these ongoing legal developments, may be able take advantage of them to reduce some of their risk when supplying these businesses.
Creditors of companies that go into liquidation may be better positioned to resist unfair preference claims as a result of a series of decisions over the last 12 months. The Courts have considered and reshaped previous approaches which creditors have endeavoured to use to allow them to deal with companies in financial difficulties, and to defend preference actions if businesses ultimately fail. The cases appear to show a trend by the courts to reconsider previously accepted approaches to preference claims.
Key takeaways
A payment on behalf of an insolvent debtor by a solvent related company of the debtor may be a "transaction" involving the debtor, but is not necessarily an unfair preference. Such a payment may not be "from" the debtor. For creditors, this can potentially be a way to structure payment to minimise voidable transaction risk.
Creditors who supply more goods and services to encourage their customer to continue to pay will not be subject to a liquidator choosing the point in time that is least favourable to the creditor to calculate the amount of any preference. The courts have shown a greater willingness to assume a continuing relationship, providing some additional protection from preference claims for those who choose to continue to deal in difficult times.
Less helpfully for creditors, the trend of case law is that debts arising before a liquidation may not be able to set off against claims by liquidators for unfair preferences (with that issue approaching a more authoritative answer shortly).
In depth
Creditors can in some cases improve their defence against the risk of a liquidator's later attack by taking payment from a solvent company related to the insolvent debtor
The extent to which payment by a solvent third party can manage preference risks has been contentious for some time. The Victorian Court of Appeal decision in the Eliana case1 has shifted the dial back towards anxious creditors structuring payments in this way.
Debtor Company A owed money to a creditor (later, wound up). The debt was paid by Company B (a related entity of Company A), and authorised by the sole director of both companies. The liquidator of Company A sought to claw back the payment.
The Court of Appeal decided:
- the payment was a "transaction" involving Company A because of the common director;
- but, the payment was not an unfair preference because it was not a payment "from" Company A.
The Court of Appeal considered the payment did not diminish or affect the assets of Company A (as Company A did not owe money to Company B at the time the payment was made). By not contributing to the benefit, the payment was not "from" Company A. Further, the payment was not a redirection of a previously existing intra-group debt.
Traditionally this approach was known as the doctrine of "ultimate effect". Are creditors worse off by the result of the transaction as a whole? If so, the transaction could be an unfair preference. If not, it is unlikely to be a preference.
Liquidators will have less say in framing their preference claims where creditors have continued to trade to encourage future payments (the "running account defence" and "the peak indebtedness rule" have been redefined)
The law attempts to draw a distinction between payments made as part of a continuing business relationship (where the intention is to encourage future supply of goods and services) and payments made in conscious reduction of past ballooning debt. The first is to be encouraged. The latter may unfairly benefit the recipient creditor over other creditors.
Penalising suppliers, who continue to support a business, by treating all payments they received as unfair preferences would be bad policy. The "running account" defence to a preference claim seeks to protect future focused trading. Deciding whether that is the purpose of any given payment though can be difficult. Payments plainly can have more than one purpose.
A shorthand way to answer the question of purpose is for the Court to look at the "ultimate effect" of the overall sequence of payments. Are creditors worse off as a result of the total sales and payments over the 6 month look back period for preference claims? If so, the "running account" defence will not apply to net-off all sales and payments to determine whether the creditor received a preference.
Deciding whether creditors are worse off is then an exercise in comparing the amount owed at two different times. If the creditor's debt overall has increased, the payments along the way may not be treated as individual preferences. Rather, if the creditor's debt has been paid down, then the net difference in sales and payments over time is treated as the amount by which the creditor has been unfairly preferred.
Until this year's Badenoch decision2 of the Full Court of the Federal Court, it was thought that the liquidator could pick the starting point for this comparison. Allowing the liquidator to pick the point of "peak indebtedness" can make the preference claim larger. That is no longer the case. The starting point will be (assuming insolvency at that time) the later of the 6 month claw back period, or when the business relationship began. The end point will be when the business relationship stopped, or when the winding up began.
However the Full Court has also left open whether the start of the relevant period for this assessment is from the start of the relationship, from the start of the 6 month claw back period, or (if the company becomes insolvent after that period starts) from the time the company is first insolvent. 3
This may nevertheless give creditors greater protection depending on the facts. The court also showed a greater willingness to accept payments which actually reduce previous debt may nevertheless be characterised as a continuing business relationship.
An application seeking special leave to appeal to the High Court from the Badenoch decision has been lodged by the liquidators.
The ability of a creditor pursued under attack by a liquidator for an unfair preference to set off the creditor's remaining debt continues to be attacked
Section 553C of the Corporations Act 2001 (Cth) allows for the set off of debts and claims between an insolvent company and a creditor where "mutual" credits, debts or dealings have occurred between the insolvent company and creditor prior to the winding up. Across a sequence of cases a director's debts claimed against the company in liquidation have been set off against insolvent trading claims. Whether section 553C may be applied to reduce the amount payable under a successful unfair preference claim is more controversial.
The recent decisions of the Supreme Court of New South Wales in Force Corp4 and the Federal Court in Bryant5 point to reasons why section 553C is not available to reduce an otherwise successful unfair preference claim.
The Full Court of the Federal Court will consider the issue in the hearing of a case stated in Gavin Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd (in liquidation) and Anor v Metal Manufactures Pty Ltd on 26 August 2021, the first substantive consideration of the issue by an appeal court plainly and directly addressing the question.
Creditors and liquidators can expect the trend of significant outcomes in preference cases to continue into the near future.
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1 Cant (in his capacity as liquidator of Eliana Construction and Developing Group Pty Ltd) v Mad Brothers Earthmoving Pty Ltd [2020] VSCA 198, Beach, McLeish and Hargrave JJA
2 Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64, Middleton, Charlesworth and Jackson JJ
3 Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) (No 2) [2021] FCAFC 111, Middleton, Charlesworth and Jackson JJ
4 In the matter of Force Corp Pty Ltd (in liq) [2020] NSWSC 1842, Gleeson J
5 Bryant, in the matter of Gunns Limited (in liq) receivers and managers appointed) v Bluewood Industries Pty Ltd [2020] FCA 714, Davies J.
