Resisting liquidators' claims for
recovery of unfair preferences
By PAUL RODIONOFF
If a supplier to a company receives a letter of demand from the liquidator to
that company, consideration should be given to challenging the liquidator' s
claim to recover an unfair preference.
Paul Rodionoff is a barrister at 7 Windeyer Chambers, email
[email protected].
Your client has been supplying goods or services to a company (let's call it
company D) for some time. Recently, company D went into liquidation and
your client received a letter of demand from the liquidator of company D. The
letter alleges company D had been trading while insolvent and demands that
your client pay to the liquidator all the money company D had paid to your
client for a period of several months. Your client is aghast and comes to you
for advice on whether or not the liquidator is entitled to claim the money or if
your client can keep the payments made. Your client emphasises to you that
this was money that was owed to it by company D for goods or services it
provided to company D about which there was no dispute.
What advice would you give your client?
A number of issues need to be considered in such a situation.
Basis of a liquidator's claim to recover an unfair
preference
When an insolvent company is wound up, a liquidator is appointed to realise
the assets of the company and to distribute the funds in accordance with
priorities set out in s.556 of the Corporations Act 2001. (In this article the
legislation referred to will be the Corporations Act unless otherwise specified.)
Usually (but not always), an insolvent company has been in an insolvent state
for some time prior to the appointment of a liquidator. Quite often, directors
continue trading an insolvent company because they feel that the company is
about to turn the corner and be able to pay off all its debts.
Companies in a precarious financial position tend to pay the creditors that are
pressing most for payment and fob off those creditors that are not so insistent.
This is not always the case. Sometimes companies in a precarious financial
position pay creditors who are important to their business without any
pressure being brought to bear and fail to pay other less important creditors.
Sometimes creditors know that a debtor company is in financial difficulty;
other times they do not. The legislation makes provision for a liquidator to
recover from a creditor money paid to it in certain circumstances including
when the creditor has received an unfair preference.
What is an unfair preference and how is it recovered?
An unfair preference is defined in s.588FA. Essentially, the section provides
that a company and the creditor must have been parties to a transaction
(which may have included other parties) and that transaction must have
resulted in the creditor receiving more from the company (in relation to an
unsecured debt) than if the transaction was set aside and the creditor had to
prove for the debt in the winding up. It doesn't matter if the payment was
made as a result of a court order.
An unfair preference will be an insolvent transaction if the conditions
mentioned in s.588FC are satisfied. The most often-used condition is that the
transaction was entered into when the company was insolvent.
If an insolvent transaction was entered into within six months of the 'relationback' day or after that time and before a liquidator was appointed, then it is a
voidable transaction (s.588FE(2).)
"Relation-back day" is defined in s.9. Generally speaking, if the company went
into liquidation as a result of: (a) an application to the court for its winding up,
then the relation-back day will be the date of filing the winding up application;
or of (b) a vote of creditors following the appointment of administrator(s), then
the relation-back day is the date of appointment of the administrator(s).
Where, on the application of a company's liquidator, a court is satisfied that a
transaction of the company is voidable because of s.588FE, it may make
orders under s.588FF. Generally, liquidators seek orders for repayment of
money, but other orders may be sought.
Typically, once a liquidator has made an investigation of the records of the
company and determined if there were any preferences paid within the six
months ending on the relation-back day, the liquidator will send a letter of
demand to a creditor demanding repayment of the alleged preference.
If the creditor refuses to pay, the liquidator needs to take court proceedings to
recover the preference. If the liquidator is successful in a court proceeding,
the court generally awards interest from the date of the demand.1
If the claim is against a trading creditor, the choice of court depends on the
size of the claim. If the claim is against the Commissioner of Taxation,
proceedings are often taken in the Supreme Court or Federal Court. The
reason for this is that if the Federal or Supreme Court makes an order against
the Commissioner under s.588FF, the Commissioner is entitled to make a
claim for indemnity against the directors of the company in relation to
remittance taxes he is ordered to disgorge (s.588FGA). Directors get a
defence under s.588FGB.
The creditor needs to consider whether to repay the alleged preference or to
resist the claim. Some creditors think that because the amount of the demand
is small, a liquidator will not incur costs in pursuing the preference claim.
Whether a liquidator will pursue a claim through the courts may depend not
only on the size of the claim but also on the perceived strength of the claim.
I have acted for a defendant in a Local Court claim by a liquidator where the
amount claimed was only $13,742. The liquidator was sure he would win.
Both interstate witnesses for the defence were required for cross-examination.
When the liquidator lost in the Local Court, he believed in the strength of his
case so much that he appealed to the Supreme Court, but lost the appeal.2
Defending preference recovery claims
Defending preference recovery claims may involve three avenues:
• checking to see that the preconditions for recovery exist;
• a running balance accounts argument; or
• a s.588FG defence (this article will focus on the s.588FG defence).
Checking preconditions
It's necessary to check if the preconditions for recovery exist. These include
basic questions such as: Did your client receive the payment? Were your
client and Company D both parties to the transaction that included the
payment?3 Was there a creditor/debtor relationship between your client and
Company D?4 What is the relation-back day? Was the transaction/payment
within the relation-back period? Has the limitation time expired?
Often the most difficult matter to determine is whether the company was
insolvent (or became insolvent as a result of the transaction) on the dates of
the payment(s). In most instances creditors have very limited information
about the financial position of companies to which they supply goods or
services.
Solvency and insolvency are defined in s.95A.
The test of solvency is a cash-flow test,5 although a balance-sheet test retains
a subsidiary relevance.
The concept of temporary cash-flow problems (sometimes called temporary
illiquidity) can be very important in determining the solvency of a company.6
Useful summaries of solvency principles have been given in a number of
cases. Sutherland v Hanson (2009) 254 ALR 650 is an example of a recent
case in which the principles have been set out at paras [7] to [13]. At para [10]
Barrett J points out that s.95A requires a decision on whether the company is
suffering from a temporary lack of liquidity or an endemic shortage of working
capital.
As said earlier, most creditors have limited information about the solvency of a
debtor company at any given time. A creditor would not want to concede a
debtor company was insolvent unless that concession was appropriate.
However, putting a liquidator to proof that the debtor company was in fact
insolvent at the time(s) of payment can be a costly exercise, even with the
liquidator having the benefit of s.588E. Depending on the complexity of the
company's accounts, it may cost hundreds of thousands of dollars. As a
practical measure it is often best to reserve options until after discovery of the
liquidator's documents has been obtained and someone who understands
insolvency has inspected the documents.
Running balance account argument
A running balance account argument is provided for under s.588FA(3) as a
partial defence to a liquidator's claim. This topic requires greater consideration
than is possible in the scope of this article.
At the risk of oversimplifying the position, if successful, the defence limits the
liquidator's recovery to the difference between the peak indebtedness during
the relation-back period, and the final indebtedness.
The leading case is Airservices Australia v Ferrier &Ors (1996) 185 CLR 483.
If you were to be involved in a case where a running balance account defence
may be appropriate and you are unfamiliar with the defence, it would be
advisable to get advice tailored to the specific situation.
Section 588FG defence
A s.588FG(2) defence (see box) is most relevant to defences for creditors.
This defence requires the proof of a negative. It has been said at times to be a
hard defence to prove.
In my experience, good faith and valuable consideration are not often in issue.
It seems to me that good faith is often not in issue because the test for it is
probably easier for the creditor to satisfy than the s.588FG(2)(b)
requirements.
Under well-established principles based on s.122 Bankruptcy Act provisions,
the courts have found that good faith is determined on whether the creditor
knew or had reason to suspect that the debtor company was in fact insolvent,
so that accepting money from the debtor would amount to a preference.7
However, there is some uncertainty about whether the test has now been
simplified to be merely that the person acted with propriety and honesty.8
Usually, it is easy to determine whether or not valuable consideration was
given for a payment. Note that the Act defines the discharge of a tax as
valuable consideration.
Most often, the issue in contested litigation on a s.588FG defence is whether
the creditor or a reasonable person in the creditor's circumstances had no
reasonable grounds for suspecting the company was insolvent at the time(s)
of payment.
No reasonable grounds for suspecting insolvency
The principles of solvency are obviously relevant to keep in mind in
considering whether a creditor had no reasonable grounds for suspecting that
the debtor was insolvent at particular points in time.
Some of the cases try to find differences between what has sometimes been
called a "subjective/objective" and purely "objective" tests. Barrett J in DeanWillcocks v Commissioner of Taxation [2008] NSWSC 1113 endorsed what
Bryson J had said (in Mann v Sangria Pty Ltd [2001] NSWSC 172; 38 ACSR
307) that "it would be seldom that the two tests would produce different
results, although it is conceivable that a person might be afflicted by some
personal difficulty in forming a suspicion".
As said earlier, proving a negative can be difficult. The Court of Appeal in
Cook's Construction Pty Ltd v Brown (2004) 49 ACSR 62 made it clear that
the creditor seeking to rely on s.588FG in discharging its onus of proof would
need to call all evidence available to it on the point. In practical terms this
would mean calling evidence from everyone in the organisation that had
anything to do with company D in the relation-back period and, depending on
circumstances, maybe for some period of time earlier, regardless of how
insignificant this contact may have been. Their name may be mentioned in file
notes, correspondence or emails and if you don't supply any evidence from
them the liquidator will likely make submissions on the failure to call them.
The relevant principles have been summarised in many cases, including
Sutherland v Eurolinx (2001) 37 ACSR 477. The principles in relation to a
s.588FG(2) defence are summarised there in paras 38 to 47, and include:
• The term "good faith" is to be given its natural meaning of acting with
propriety or honesty.
• Suspicion of insolvency has both a subjective and an objective component.
Suspicion is more than an idle wondering; it is a positive feeling of
actual apprehension or mistrust but without sufficient evidence
(Queensland Bacon v Rees (1966) 115 CLR 266 at 303).
• There is no single factor whose presence invariably establishes the relevant
suspicion.
• Cash-flow problems are no more than a factor, as even solvent companies
have cash-flow problems from time to time.
• One needs to apply commercial reality.
• One needs to look through the contemporary eyes of the parties.
• Hindsight is impermissible.
The reasonable person in the "objective" test is a reasonable business
person.9
Care needs to be taken to identify every factor that may have been relevant to
forming a suspicion of insolvency and seeing if there is an explanation why
that factor did not lead to a suspicion of insolvency. If there is an explanation,
evidence needs to be prepared that sets out that explanation.10 For example,
it may be that payments were constantly being made a month after the date
required under the terms of trade. If that had been the consistent pattern of
trading with that company, evidence of this needs to be prepared.
Another example is that there may have been a dishonoured cheque. After
the dishonour, the debtor may have given an explanation for the dishonour
that was plausible and would not lead to a suspicion of insolvency. Evidence
needs to be prepared about any conversation that took place between the
credit department and the debtor regarding an innocent reason given for the
cheque's dishonouring.
However, keep in mind that even if no single factor could be said to have
been reasonable grounds for suspecting a company was insolvent, when a
number of factors are present at the same time the accumulation of factors
may be such that a court finds that there were reasonable grounds to suspect
that the debtor company was insolvent.
It is also important to remember that the defence needs to be made out at
each and every payment date. It is possible that the defence can be made out
for some dates and not for others.11
Final comments
As always, the conduct of litigation is uncertain. You can never predict how a
witness will react in the witness box. We have all seen witnesses who were
confident of their position in conference wilt under cross-examination.
The s.588FG defence depends on proving facts. Minds may differ on the
importance of any particular fact in suspecting insolvency.
Ultimately, whether to fight a claim or to settle it in a compromise will end up
being a value judgment. Your client will need to weigh up a number of factors
such as the prospects of making out the defence, the cost of litigation and the
desire not to be seen as too soft a target for liquidators.
Corporations Act 2001: Transaction not voidable as
against certain persons
Subsection 588FG(2)
(2) A court is not to make under section 588FF an order materially prejudicing
a right or interest of a person if the transaction is not an unfair loan to the
company, or an unreasonable director-related transaction of the company,
and it is proved that:
a the person became a party to the transaction in good faith; and
b at the time when the person became such a party:
i
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
ii
a reasonable person in the person's circumstances would have had
no such grounds for so suspecting; and
c the person has provided valuable consideration under the transaction or
has changed his, her or its position in reliance on the transaction.
ENDNOTES
1 Star v O'Brien (1996) 40 NSWLR 695.
2 Hamilton v DCT [2005] NSWSC 229; 58 ATR 559.
3 See Re Emanuel (No 14) Pty Ltd; Macks v Blacklaw & Shadforth Pty Ltd
(1997) 147 ALR 281; Re Burness [2009] FCA 893.
4 See Woodgate v Network Associates International BV [2007] NSWSC
1260. In that case the liquidator was liquidator of two related insolvent
companies. Creditors of both insolvent companies were paid out of the
bank account of either company (presumably depending on which
company had funds available at the time). The liquidator failed to
recover money paid by one insolvent company to the creditor of its
related company on the basis that there was no debtor/creditor
relationship between the payer and payee. Note, however, that a
liquidator can (if he is within time) seek recovery of an uncommercial
transaction (see s.588FB).
5 See Keith Smith Transport v ATO (2002) 42 ACSR 501; Sutherland v
Hanson (2009) 254 ALR 650 at para [8].
6 See, for example, Cussen v Commissioner of Taxation (2003) 47 ACSR
107 at paras 65, 74; on appeal Cussen v Commissioner of Taxation
(2004) 51 ACSR 530 at paras 40, 53; Downey v Hartsteel Pty Ltd
(1996) 14 ACLC 1083.
7 See, for example, Sheahan v Hertz Australia Pty Ltd (1995) 16 ACSR 765.
8 See, for example, Sutherland v Eurolinx (2001) 37 ACSR 477 at para 39.
9 See Cussen v Commissioner of Taxation (2004) 51 ACSR 530 at para 31.
10
See, for example, Dean-Willcocks v Commissioner of Taxation [2008]
NSWSC 1113 at para [38]
See, for example, Spectrum Joinery Pty Ltd (in liq) v Turners Building
Supplies Pty Ltd [2005] ACTSC 70. This case also at paras [22] to [26]
usefully summarises a number of cases on the issue of "no reason to
suspect".