In recent times, we have seen two key decisions heard in the High Court which further clarify the position about potential claims against creditors by a liquidator concerning unfair preferences. In this article we summarize the Court’s rulings and their implications for creditors, companies and their advisors.
Under Section 588FA of the Corporations Act (“the Act’’) in Australia, some payments made by a company when the company was insolvent are known as unfair preference payments. Once a company is placed into liquidation, a Liquidator may be able to overturn these transactions.
The purpose of an unfair preference payment is to even up the playing field between creditors, whereby payments to certain creditors that were paid in priority to other creditors are returned to the liquidation process. Those payments occur leading up to the liquidation and generally within six months before the commencement of an appointment.
There are varying schools of thought for and against unfair preferences. For instance, it seems unfair that a creditor that has strong collection procedures is penalised for better debt recovery compared to another creditor who has poor collection procedures.
However, under the Act, the law of Pari Passu (everyone is treated equally) is preferred to the strong recovery practices of businesses. There have been many cases heard in courts over the years about how liquidators should pursue creditors for unfair preferences, if at all, to recover money for the benefit of all creditors.
Here is a summary of the implications of the two most recent Court rulings.
The first decision related to the availability of mutual set-off concerning the ability of a creditor to offset a preference claim against an amount that had been accrued leading up to the appointment of a liquidator to a company. In essence, what that previously meant in practice was that if a creditor was being pursued for a preference claim of say $100,000 but had supplied services that were invoiced to a company for $50,000, a liquidator was only entitled to the net amount of a preference claim which in this example would be $50,000.
Creditors have historically argued that a liquidator is only entitled to the net amount when there were mutual debts. This is because claims or dealing between the company in liquidation and its creditors could be “set off’’ against one another.
Metal Manufactures Pty Limited v Morton  HCA 1 has now confirmed that set-off under section 553C does not apply as a defense to a liquidator's claim that a creditor has received an unfair preference. The court confirmed, in essence, the transactions leading up to the appointment of the liquidator could not be “set off’’.
Under section 553C of the Act, set off has two key elements:
Mutual dealings – claims to set-off must be between the same parties; and
The timing of the claim – the claims must have been available before the appointment of the liquidator.
The High Court noted the payments couldn’t be set off or offset were as follows:
The claim which the liquidator was pursuing did not exist before his/her appointment. The transactions that the creditor had received payment for were made prior to the liquidator’s appointment; and
The dealings were not mutual between the same parties. The payment relationship was between the company and the creditor prior to the liquidator’s appointment whereas the parties involved in the unfair preference claim made by the liquidator, post the appointment of the liquidator, were the creditor and the liquidator.
Peak Indebtedness rule
The second recent development in the case of law concerning unfair preferences was around a term known as the “peak indebtedness rule”.
The peak indebtedness rule allowed liquidators to select the company’s point of peak indebtedness to the creditor in circumstances where there was a running account (effectively a continuing business relationship) between the company and the creditor, as the starting point of the single transaction. This allowed a liquidator to pick the period that was most likely to support a claim and generally allowed for the largest claim to be made.
As a consequence of the High Court’s decisions in Bryant v Badenoch Integrated Logging Pty Ltd  HCA 2, a Liquidator is required to assess the whole relationship for the entire relation back-period to determine whether the creditor has received a preference or not. A liquidator can no longer nominate the peak indebtedness in that period for the purposes of maximising a potential preference claim.
If it can be established that there was a break in the continuing relationship, each payment received by the creditor is accessed individually to determine whether it was received in preference or not.
Creditors awareness of Insolvency and Strong Debt Collection Procedures
Usually, the evidence to prove that a creditor knew of the company’s insolvency, includes (but is not limited to) the issuing of a statutory demand, winding up applications, and various communications between the two parties. Whilst one may argue that creditors who have strong collection procedures are potentially being unfairly treated when pursued by liquidators for these payments, it is also acknowledged that there are many instances where strong collection procedures have resulted in much lower exposure to companies that ultimately end up in liquidation.
It can be argued that a creditor has strong collection procedures as part of their normal course of business to recover debts. We often see these kinds of businesses have detailed documented processes which outline the process to recover as a way to demonstrate that the process is their normal approach and that it is not a reflection that they are aware of such solvency concerns of the customer/client.
Creditors or clients of advisors should continue to invest in strong collection techniques and proper documenting of those processes for all their customers to avoid such risk when it comes to being pursued for an unfair preference payment. The engagement of solicitors to assist is recommended.
Cathro & Partners are experts in providing insolvency and restructuring services that help to create and preserve business value. Cathro & Partners is a boutique firm specialising in restructuring, turnaround, insolvency, safe harbour, secured enforcement services, and pre-lending services.