Update for Creditors regarding Unfair Preference Claims: High Court of Australia confirms no Set-Off and rejects Peak Indebtedness Rule

1. What do you (or your company) do when a liquidator comes knocking and demands to claw back money you’ve received from the company in liquidation?
2. One of the most common issues our clients face are claims for Unfair Preferences and other types of Voidable Transactions, that is, transactions that liquidators have the power to claw back, pursuant to the Corporations Act 2001.

What is an Unfair Preference Payment?

3. Unfair preferences are governed by section 588FA of the Act.
4. In short, an unfair preference is a transaction that is entered into by an insolvent company (or a company that is about to become insolvent, i.e. by entering into the transaction) which allows the creditor of the company to receive a benefit from the transaction as a priority over other creditors.
5. These are transactions that liquidators will try to recover because the benefit of those transactions should become part of the assets to be distributed to the company’s unsecured creditors in the winding up of the company.
6. The first element the liquidator needs to establish to prove an unfair preference, is that a “transaction” existed, within the definition of that term in section 9 of the Act.
7. The most common forms of unfair preference transactions are payments of money or transfers of assets where the company and the creditor are both parties, however, occasionally they also involve other parties to the transaction.
8. For a transaction or payment to be voidable and recoverable as an unfair preference it must:
   • Be an insolvent transaction, pursuant to section 588FC of the Act, in that the company must be insolvent or become insolvent because the transaction; and
   • Be made by the company to a creditor during the relation back period, that is the 6 month period prior to the relation back day (or 4 years prior to the relation back day if the creditor is a related entity); and
   • Result in the creditor receiving more from the company than it would have received in winding up of the company, i.e. if the creditor proved for its debt in the company’s liquidation.
9. This applies even if the transactions are entered into because of a Court order, i.e. the payment of a judgment debt owed by the company in liquidation.
10. It is in those circumstances that liquidators will often seek to set aside the transaction and require the creditor to prove for its debt in the company’s winding up.

Relation Back Day

11. Incorrectly determining the relation back day is a pitfall to which many of our clients fall victim when attempting to oppose an unfair preference claim without first seeking professional advice. This is particularly so after the amendments to section 91 of the Insolvency Law Reform Act 2016.
12. The relation back day is, in the case of a:
    • Creditors voluntary liquidation (CVL), generally the date a liquidator is appointed;
    • Court-appointed liquidation, the date the winding up application was filed with the Court; and
    • Company in administration prior to liquidation, the date its administrator was appointed.

Defending an Unfair Preference Claim

13. The liquidator has the burden of proof in proving the elements of the unfair preference claim, including proving the company was insolvent at the time of the transaction.
14. As a creditor, there are a number of potential defences available to you if you or your company are on the receiving end of an unfair preference claim, in defending the claim and otherwise trying to negotiate a commercial outcome.

Secured Debt

15. The first thing you should do is check if the unfair preference transaction being alleged by the liquidator was for a secured debt (such as debts secured by mortgage or security interest over the company’s property). In that case, a transaction will not be an unfair preference.

Good Faith Defence

16. As we mentioned above, a liquidator needs to prove that the company was insolvent at the time of the transaction. That being said, if you are able to show that you had no reasonable grounds to suspect that the company was insolvent at the time of the transaction, and that you entered into the transaction in good faith, you may be entitled to retain the benefit of the transaction.
17. In deciding whether you knew that the company was insolvent at the time of the transaction (or would become insolvent because of the transaction), a Court will consider whether a reasonable person in your circumstances would have suspected that the company was insolvent.
18. This means that a Court will likely examine your commercial history with the company, including whether that company had a prior tendency to making payments later than credit terms allowed, or making sporadic payments in lump sums, which cannot be attributed to specific invoices.

Running Account Balance

19. If payments you received by the company in liquidation were transactions for a commercial purpose which are an integrated part of a continuing business relationship, such as a running account, the effect of all of the transactions which form the relationship between that creditor and the company in the relation back period, or in the period from insolvency to the end of the relation back period, should be taken into account[1]
20. This Running Account Principle is also referred to as the doctrine of ultimate effect.
21. A liquidator’s initial demand against a creditor for repayment of an unfair preference may fail to take into account the doctrine of ultimate effect, generally because on first glance they do not identify the circumstance of a running balance account with the creditor.
22. Invoking the Running Account Principle, requires detailed and careful analysis of the historical payment circumstances and your business relationship with the company in liquidation, preferably with professional assistance.

Peak Indebtedness Rule – No Longer

23. We note that since first publishing this article, the ‘peak indebtedness rule’ which was previously applied in practice and by lower courts to calculations of unfair preference claim amounts where there was a running balance account, has been rejected by the High Court of Australia in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2. This rule allowed a liquidator to take the peak indebtedness of the company to the creditor during the relation back period, and subtract from it the indebtedness of the Company to the creditor at the end of the relation back period, to calculate the amount of the unfair preference claim. It often resulted in a higher claim for liquidators.

Set-Off – No Longer

24. Prior to 2021 you might have been able to set off mutual credits, debts and transactions between you and the insolvent company against an unfair preference claim, pursuant to section 553C of the Act, if you could demonstrate that you did not have notice of the company’s insolvency at the time of giving credit to the company. This would have had the effect of reducing the amount of the unfair preference.
25. However, as a result of the decision of the Federal Court of Australia in Gavin Morton As Liquidator Of MJ Woodman Electrical Contractors Pty Ltd (In Liquidation) & Anor v Metal Manufacturers Pty Limited (MJ Woodman) [2021] FCAFC 228, creditors who receive an unfair preference can no longer rely on the set off defence to reduce the amount it must pay to the liquidator in respect of the preference.
26. This decision has now been affirmed by the High Court of Australia in Metal Manufacturers Pty Limited v Gavin Morton as liquidator of MJ Woodman Electrical Contractors Pty Ltd (in liquidation) & Anor [2023] HCA 1. We will address the potential significance of this decision for other voidable transaction claims that a liquidator can bring in our next publication.
27. If you or your company are a creditor, and find yourself facing a claim for unfair preferences by a liquidator, feel free to contact PGC Legal and we would be happy to provide you with some advice about the options that are open to you in either defending an unfair preference claim, or trying to negotiate a more favourable outcome with the liquidator.
28. PGC Legal has a number of insolvency experts, with experience in dealing with unfair preferences and we are always happy to help in any way that benefits our clients.
29. We also have specialisation and experience working for liquidators in asset recovery claims and litigation.
30. Whether you need some initial advice on how to tackle your situation, or if you need experienced legal representatives to act for you in Court proceedings against a liquidator, our solicitors have decades of combined experience and proven favourable outcomes for our clients.

Please contact Peter Charatsis, Brenton Priestley, Jennifer Hills or Jonathan Khoury for more information.

[1]   Explanatory Memorandum to Corporate Law Reform Bill 1992

Published 12 May 2022

The above is general in nature and is not intended to, and does not, constitute professional advice.