Undue Preferences, Insolvency and Legal Defences
When a company begins to experience financial hardship, it often faces conflicting interests. On the one hand, it must continue with commercial transactions to preserve, maintain and hopefully restore the company; on the other, it must respect the integrity of its creditors’ rights by not making such payments which may be seen as showing preference over other creditors.
As a result, the Law has explored the balance between the rights of creditors, on the one hand, and the legitimate attempts by directors to resuscitate a company in financial difficulties on the other. In those circumstances where directors have acted in good faith, and made authentic efforts to preserve and revitalise the company, the Court is more likely to reject the argument of payment preference. However, where related parties have indeed benefitted from priority payments, the Law would treat such transactions with scepticism, particularly when the interests of unrelated creditors are simultaneously ignored.
Here at Stephen Wawn & Associates, we often have creditors approach our firm for advice when they have received a letter from a Liquidator or Trustee demanding payment of an alleged preference and threatening legal action.
We still find it astonishing how many firms, prior to sending out these letters of demand, have not bothered to ensure that all the elements for voiding a transaction have been met. Even more concerning, is that many liquidators choose to ignore any possibility of a successful defence.
When our clients have received any demanding letters, they are strongly advised to request from the author of the letter an outline establishing that the necessary elements exist. We would then work with our client to examine and draft the relevant defence provisions that may be available to them. We have found this process to considerably save time and cost for both parties.
Thus, we always strive to ensure that all letters of demand that are either sent out or received, detail the elements of preference and if, known, point to the specific reasons as to why they would consider that the defence would not be available to the creditor.
We also warn our clients of the unacceptable practice by some practitioners and liquidators of simply sending out letters of demand to every creditor who has received payment within the relation back period, often called “fishing”. This process is fairly common and at times successful, unfortunately enabled by the creditors’ ignorance of their rights.
Here at Stephen Wawn & Associates, we consider that some of these letters are simply forms of intimidation and bullying, and many of the funds received from such letters are not voidable preferences. Furthermore, we believe it is unethical for a practitioner to accept the funds under such circumstances, as prescribed in the long-held rule in Ex parte James.
So what is an unfair preference?
An unfair preference is defined in s588FA Corporations Act (Cth) 2001 (“the Act”) as having two components:
(i) that the company and creditor be parties to the transaction; and
(ii) that the transactions result in the creditor receiving more than it would if it were to prove for the debt in the winding up of the company.
Pursuant to s588FA of the Act, upon the application of a liquidator the court may order that an unfair preference is to be repaid to the company if it occurred within six months of the relation-back day (usually six months before an order for winding up, or the passing of a resolution for voluntary winding up.).
Relevantly, s588FG(2) of the Act provides a defence to a claim by liquidator under s588FA, to the extent that the creditor can establish the following:
1) the transactions were entered into in good faith;
2) the creditor had no reasonable grounds for suspecting the company was insolvent, and any reasonable person in the creditor’s circumstances would have had no such suspicion; and
3) a reasonable person would have no reason to suspect the debtor company was or would become insolvent as a result of the transaction; and
4) the creditor provided valuable consideration or has changed its position in reliance on the transaction.
These statutory defences place the onus on the creditor to:
- a) not only show that it acted genuinely but that it acted as a reasonable creditor would have acted in the circumstances; and
- b) show that there was no reason for the creditor to suspect that the debtor company was insolvent at the time that it received the payments.
For a transaction to be void, it needs to satisfy the following criteria:
- property must be transferred;
- there must be a debtor/creditor relationship;
- the recipient must have received a preference, priority or advantage over other creditors;
- transaction took place in the qualifying period; and
- at the time of the transfer, the debtor was insolvent.
How To Prove Insolvency?
For a transaction to be voidable, it must be one that is made by an insolvent debtor. The onus is on the creditor to prove the insolvency of the debtor at the date of the transaction.