Elements of Insolvent Trading – Corporations Act

Recovery of preferences under the Corporations Act (Cth) 2001 is similar to, but not the same as, in bankruptcy. The development of the recovery provisions in Corporate Law followed and relied on the Bankruptcy Act for many years and many of the legal precedents referred to thus far actually involve corporate matters.

The Corporations Act (Cth) 2001 now contains section 95A which states that a person (including a company) is insolvent is they are not solvent. A company is only solvent if it is able to pay all of its debts as and when they become due and payable. The emphasis is on the ability to discharge all of one’s debts, not one particular debt.

Insolvency is not determined by looking at the ratio of a surplus of assets over liabilities, but rather through the analysis of a continuous cash-flow.

While the term used is different, transactions are essentially what the Bankruptcy Act refers to as transfers. The Corporations Act defines a transaction to mean a transaction to which the company is a party, for example:
(a) a conveyance, transfer or other disposition by the body of property of the body; and
(b) a charge created by the body on property of the body; and
(c) a guarantee given by the body; and
(d) a payment made by the body; and
(e) an obligation incurred by the body; and
(f) a release or waiver by the body; and
(g) a loan to the body;
and includes such a transaction that has been completed or given effect to, or that has terminated.
It should be noted that the Corporations Act does not limit the definition to the types of transaction above.

Section 588FA, which defines unfair preferences specifically requires that the company and its creditor must be parties to the transaction, even if someone else is also a party.

While section 588FA requires that the debtor and creditor must be parties to the transaction, it does not require that they be parties to all of the transaction’s components.

We highlight here that if the transaction under section 588FA comprises a series of related transactions, to be caught under this section, the “creditor” has to have been a creditor at the commencement of the series of transactions. A person who becomes a creditor as a consequence of the transactions is not a creditor for the purpose of this section.
Benefit to creditor

While wording of the Bankruptcy Act requires that a creditor have received a preference, priority or advantage over other creditors, the Corporations Act does not require that element of proof. It only requires that the creditor have received more than it would have if the transaction were set aside and the creditor were to prove in the winding up.
We advise our clients here that for all intents and purposes, the intention from a corporate viewpoint is very similar to the intention of the Bankruptcy Act.

For a preference to be voidable, it must be an insolvent transaction. Section 588FC defines an insolvent transaction as, inter alia, an unfair preference:
occurring or given effect when the company is insolvent.
whose occurrence or effect causes the insolvency of the company

Basically, a company is insolvent if it is unable to pay all its debts as and when they fall due. This definition is consistent with that in the Bankruptcy Act, and reinforces the judgment in Sandell v Porter, and tries to place an objective test on the question of insolvency.

Corporations Act provides for further presumptions on insolvency. These presumptions, contained in section 588FE, are
If a company is insolvent within twelve months of the relation back day, in the absence of evidence to the contrary, it is presumed to be insolvent from that point.

We strongly urge our clients to take heed of continuous company book-keeping as a form of protection, as liquidators devote significant energy into establishing a date of insolvency through the examination of:

• lists of outstanding creditors
• obtaining copies of statements and invoices
• evidence of legal threats and demands
• analysis of aged creditor
• examining bank statements for evidence of dishonoured cheques
• balance sheet test
• examining management accounts
• reviewing director reports and minutes of meetings
• assessing quality of books and records

How far can the liquidator can go to recover preferences depends on the specific situation, in summary:

• from six months before the relation back day up to the day winding begins in the case of unrelated parties
• four years up to and including the relation back day in the case of related parties and
• Ten years up to and including the relation back day where purpose of the transactions was to defeat creditors.

s588FG(2) outlines the three main elements that encompass the defence provisions:

(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

(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

The Onus of proof rests with the creditor claiming the protections, and we should note from the wording of these sections that the creditor must prove all three elements of the defence.

It should also be noted that this is a substantial departure from the Bankruptcy Act requirement that the creditor also demonstrate that the transaction was in the “ordinary course of business”. This is no longer a requirement for the defence in the corporate scene.

A running account is a continuous account, the balance of which fluctuates from time to time, increasing as the creditor provides further goods and services, and decreasing as payments are made.

Defence under s 588FA(3) of the Corporations Law, in contending for a running account.

Section 588FA(3) codifies this defence in the following terms:

“Where:

(a)  a transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company (including such a relationship to which other persons are parties); and

(b)  in the course of the relationship, the level of the company’s net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship;

then:

(c)  subsection (1) applies in relation to all the transactions forming part of the relationship as if they together constituted a single transaction; and

(d)  the transaction referred to in paragraph (a) may only be taken to be an unfair preference given by the company to the creditor if, because of subsection (1) as applying because of paragraph (c) of this subsection, the single transaction referred to in the last-mentioned paragraph is taken to be such an unfair preference.”

For the defence to be maintained, there are some essential prerequisites:

1. There must be no cessation of that mutual assumption of payment and reciprocal supply throughout the relevant period.
2. Those payments must continue to have as at least one operative, a mutual purpose, namely inducing further supply. We stress to our clients here, in line with established common law, that such purpose should not come to subordinated to a predominant purpose of recovering past indebtedness.

The essence of a running account is a continuing relationship between the supplier and purchaser with value being exchanged between them.

Similarly, the basis of a running account can also be defined in the continuing relationship between the debtor and creditor with an expectation that further debits and credits will be so incurred.

In this defence, the defendant must show the requisite mutual assumption as to the continuing operation of the account.
A basic principle of the running account is that further transactions, both payments and supply, may be anticipated. It is commonplace that running account balances generally do not come down to a zero balance, especially if purchases are made on a frequent basis and payments made monthly.

Running accounts have always produced difficulties in the area of preferences, primarily because of the difficulty of determining the advantage or preferential effect where there is a continuing business relationship. The fluctuating balances in the account provide a dilemma as to which transactions during the relation back period may be attacked, given that payments are made with the anticipation of future supplies.

PLEASE NOTE: If the normal course of trading continues, payments made on a running account will not be preferential.

However, if the creditor attempts to reduce the debt contrary to normal dealings, the advantage gained may appear to breach good faith, unless it can be demonstrated that reduction operates on a periodic basis.

We also warn clients of the complexity involved in determining which payments were made to reduce the balance, while others were made to ensure continuing credit.

The important aspect to take from this is that the court tends to look at the overall effect of the series rather than the effect of each transaction.

The dual purpose of inducing the creditor to provide further goods and to discharge an existing debt does not render the payments a preference. This is unless those payments exceed the value of the goods so supplied in the relevant period.

We emphasise here that the label “running account” is not relevant, but rather the understanding that the payments in the account were connected with future supply of goods or services, because it is precisely that connection which indicates a continuing relationship of debtor and creditor.

As per s588FA(3), where a running account has been established, the group of transactions within the period in question are to be treated as a “single transaction”, with each individual transaction only being a preference to the extent that the “single transaction” is deemed to be a preference.

We stress here, where a running account has been established, whether there is any preference depends on the ultimate effect on the balance of the account rather than on the immediate effect. The issue is whether there has been a permanent reduction in the account balance over the period of the running account.

The first element for a defence in successfully defending an action for an unfair preference, is that of Good Faith.

The courts have tended to adjudge good faith on the basis of propriety, honesty and awareness of other creditors. If a creditor accepts payment knowing or having reason to suspect that other creditors will be left unpaid while he receives payment, good faith cannot be present. Similarly, all that is required to show absence of good faith is knowledge of other creditors over whom the creditor might be receiving a preference.

The term “good faith” is to be given its natural meaning, namely to act with propriety or honesty. The requirement of good faith under s 588FG(2)(a) is a subjective test: Re Ermayne; Sims v Tech Holdings Pty Ltd (1998) 30 ACSR 330 at 336; Downey v Aira Pty Ltd (1996) 14 ACLC 1068 at 1075.

In order for a defence to be made out under s 588FG(2) of the Corporations Law it is necessary to establish two essential elements.

First, that the payments were made in good faith.

The defendant bears the onus in establishing this defence: Sims v Celcast Pty Ltd (1998) 71 SASR 142. These elements partially overlap. A payee who had actual suspicion on reasonable grounds that the payee was insolvent could hardly be said to be acting in good faith in receiving the payment

It is generally difficult for a bank, the company’s accountant, or a director to prove good faith than it would be for trade creditors, especially those who do not deal with the company or a regular or frequent basis.

Accordingly, good faith will be difficult to establish where payments are made to persons with control of the company and should have been aware of its insolvency.

This is the second element of defence, and is a far more objective test than that for ‘good faith’. The key issues here are not that the company was insolvent, but that the creditor had no reasonable grounds for suspecting insolvency or, in the alternative; a reasonable person in similar circumstances would have no grounds for suspecting insolvency.

As Santow J in Sydney Appliances case, we would consider that where a payee offers or allows an informal indulgence, solvency is to be tested by reference not just to the contractual due date, but also by reference to the effect of the indulgence.

The key focus is to observe whether or not there has been a systematic failure to maintain a payment regime in the overall commercial context. There also needs to be an in-depth consideration of other factors including the age of the debtors, which would in turn show evidence demonstrating a systematic failure to maintain the payment regime.

In this appraisal, it is helpful to ask:

– Were there substantial portions of indebtedness that were still being paid in excess of payment terms?

– Were a substantial number of invoices still outstanding after the days of trading terms?

– Was the practice of extending terms in the course of usual business?

In Sydney Appliances, there was sufficient reason to suspect insolvency as highlighted by: i) the debtor’s inability to meet 60 day terms; ii) the use of post-dated and undated cheques, iii) acknowledgement by the creditor that the debtor was having financial trouble and needed the support of its creditors to survive; iv) if the creditor were to analyse the figures provided, it would have showed that the company was in financial difficulty.

We should note that the industry norms should be taken into account, and have regard

The Corporations Act differs from the Bankruptcy Act in that whereas the Bankruptcy Act requires that consideration provided should be at least as valuable as the “market value” of the property transferred, the Corporations Act does not. A purchaser for valuable consideration must give consideration which has real and substantial value and not one which is trivial, nominal or colourable. Consideration can be valuable without being adequate, but it must have substance.

The existence of a debt is sufficient consideration for its discharge.
Where a creditor agreed to carry out work it was not obliged to do, not to enforce immediate payment of its debt and to withdraw caveats over land, it was held to have given valuable consideration.