Navigating Credit Risk: A legal perspective on dealing with liquidator unfair preference claims

Christopher Hadley MICM Partner

Andrew Tanna MICM Special Counsel

AICM

NSW Legal Representative of the Year 2022

Holman Webb

For the unacquainted, unfair preference claims can be brought by a liquidator against an unsecured creditor in circumstances where that creditor has received payment from the company in preference to other unsecured creditors. It is often the case that when a company is in financial distress, it makes payments to certain creditors in preference to others, leading to an arguably unfair distribution of payments to preferred creditors.

The Corporations Act 2001 includes provisions that allow liquidators to “claw back” such payments, to the intent that the liquidator may ultimately distribute assets of the company equally amongst creditors by way of a dividend.

Most credit managers loathe (to put it mildly) the thought of having to deal with a demand from a liquidator to make payment of an alleged unfair preference. In Holman Webb’s experience, this is particularly the case when credit managers have acted diligently in the recovery of outstanding amounts by customers, only to have a liquidator seek to claw back those hardfought monies.

The past three years have been marked by significant economic disruption and uncertainty. The COVID-19 pandemic has led to financial distress for businesses across many industries, resulting in new challenges for credit professionals.

The most recent insolvency statistics published by ASIC1 have confirmed an increase in insolvencies in Australia. A significant number of those insolvencies (circa 30%) are in the building and construction industry.

In an article published in AICM’s 2022 Risk Report, Holman Webb highlighted concerns over the emergence of unfair preference claims off the back of ‘zombie companies’. Some of those concerns have certainly been confirmed (at least anecdotally), as we have seen an uptick in instances of insolvency which have led to liquidators being appointed, particularly within the construction industry.

As credit professionals, navigating the risk landscape in this uncertain economic environment can be a real challenge. In order to make informed credit decisions, and minimise risk exposure from trading with customers on credit terms, it is critical to have a clear understanding of the legal framework underpinning the unfair preference payment regime.

As lawyers who have worked extensively in the field of credit and insolvency law, we have seen first-hand the impact that litigation commenced by a liquidator seeking to recover an allegedly unfair preference payment can have on a business.

It is critical for credit professionals to be aware of the unfair preference payment regime set out in the Corporations Act, and the various strategies and defences available to defeat such claims.

In this article, we will provide practical insights and observations relevant to credit professionals looking to navigate the current risk environment concerning unfair preference claims. We will set out the legal tools available to help creditors manage risk and protect their interests in the event of an insolvent customer and a claim brought by a liquidator.

Additionally, we will explore the impact of recent High Court decisions that have clarified the law concerning two common defences deployed by creditors in response to unfair preference claims.

Through a better understanding the legal framework, credit professionals can make informed decisions and take steps to minimise risk.

Regrettably for credit managers, preference claims are an inevitable part of the credit function.

It is often the case that the available defences do not act as “silver bullets” in completely defeating preference claims. However, there are measures that credit professionals can adopt to mitigate the risk of a liquidator being successful in an unfair preference claim.

We set out recent developments in the law concerning available defences to creditors facing an unfair preference claim below.

Availability of set-off under Section 533C of the Corporations Act?

S. 533C of the Corporations Act provides that where there have been mutual credits, mutual debts or other mutual dealings between an insolvent company that is being wound up and a person who wants to have a debt or claim admitted against the company: z an account is to be taken of what is due from the one party to the other in respect of those mutual dealings; z the sum due from the one party is to be set off against any sum due from the other party; and z only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be.

The main exception to the above provision in that a creditor is not entitled under this section to claim the benefit of a set-off if, at the time of giving credit to the company, or at the time of receiving credit from the company, the creditor had notice of the fact that the company was insolvent.

For a number of years, some creditors have sought to defend, or otherwise limit the quantum of unfair preference claims brought by liquidators on the basis of s 533C.

By way of example: at the time of a liquidator being appointed to a customer company, let us assume that the creditor had received payments of $80,000 from the company during the 6 months preceding the relevant relation back period and was separately owed $100,000 by the company as at the date of liquidation. Within the relevant limitation period, the liquidator then brings an unfair preference claim against the creditor seeking to recover the payments of $80,000.

A 2015 decision of the District Court of Queensland 2 and a 2018 decision of the Federal Court 3 were often relied upon by creditors to argue that s 533C of the Corporations Act ought to be applied in dealing with an unfair preference claim.

Using the example referred to above, if such a defence was available the claim brought by the liquidator would be defeated (that is the sum of $100,000 against the alleged preferential payments of $80,000).

The application of the set-off under s 533C in the above circumstances resulted in objections from liquidators who did not accept that a set-off of this type was available at all, including because of a lack of mutuality of dealings between the parties involved.

The uncertainty ultimately came to a head in 2021 where, in a decision of the Federal Court, the primary judge reserved the following question for consideration by the Full Court of the Federal Court:

“Is statutory set-off, under section 553C(1) of the [Act], available to the [appellant] in this proceeding against the [first respondent’s] claim as liquidator for the recovery of an unfair preference under section 588FA of the Act?”

The Full Court said that the question posed should be answered “No”. In response, the creditor appealed to the High Court.

Availability of ‘Peak Indebtedness’ and the Doctrine of Ultimate Effect

Where there has been ongoing (uninterrupted) trade with a customer company during the relevant period, a creditor may use the running account calculation to argue a reduced exposure to an unfair preference claim.

Until recently, many liquidators had adopted the calculation based on the difference between the so-called ‘peak indebtedness’ during the relevant period, and the amount owed to the creditor at the time that the liquidator was appointed.

By way of example, let us assume that in the 6-month period immediately prior to the liquidation there was ongoing trade between the company and the creditor such that the balance outstanding fluctuated from time to time, and that at the end of the period an amount of $100,000 was outstanding to the creditor. Let us further assume that at the beginning of the 6-month period, the amount outstanding was $150,000 and the peak indebtedness during the 6-month period was $500,000.

In Metal Manufactures Pty Limited v Morton [2023] HCA 1, the High Court dismissed the appeal and held that any liability of a creditor to a liquidator’s unfair preference claim was not eligible to be set off against the debt owed to the creditor by the company in liquidation under s 533C.

In the finding, the High Court considered that the lack of mutuality of dealings and the lack of a liability to claw back the preference payment prior to the liquidation were fatal to the creditor’s argument.

The decision has been endorsed by liquidators and has no doubt disappointed many credit managers. In all events, the decision of the High Court has provided much-needed clarity with respect to the availability of set-off in the circumstances of an unfair preference claim brought by a liquidator and the argument is now resolved on a final basis.

The application of the “peak indebtedness rule” would permit the liquidator to select the $500,000 peak as the starting point for the analysis of the account, such that in the above example, the unfair preference claim would be $400,000.

Many in the credit industry were critical of the approach taken by liquidators in effectively “cherry-picking” an artificial peak point in the relevant period, and not having regard for all transactions forming part of the relationship.

In 2021, the Full Court of the Federal Court delivered judgment in the matter of Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64.

The appeal considered whether the primary judge had erred in finding that the peak indebtedness rule applied to claims made in respect of section 588FA of the Corporations Act.

The Full Court considered the history of the rule and competing decisions and ultimately found that the language in section 588FA(3) (c) points against the application of the peak indebtedness rule.

The Full Court of the Federal Court of Australia held that:

1. The ultimate effect doctrine requires the Court to look to all payments (both impugned and non-impugned) and all supply (both past and future) forming part of the continuing business relationship, and otherwise falling within the relevant statutory period.

If value provided to the company, and a subsequent payment against accrued debt are viewed as part of an arrangement which has the effect of giving the company valuable goods and services, there is no depletion of assets (and no preference).

It is impossible to reconcile the peak indebtedness rule with the ultimate effect doctrine (at [117]-[118]).

2. The peak indebtedness rule does not apply in the context of section 588FA(3) being the running account defence.

Section 588FA(3) requires the running account to be taken as a single transaction encompassing within it all payments and all supplies forming a part of the continuing business relationship. The Court considered that single transaction so as to determine whether or not the single transaction constitutes a preference.

To apply a peak indebtedness rule is to impermissibly sever the single transaction into two parts, and there is no room for the implication of a rule that is inconsistent with the express language of the statute. The peak indebtedness rule is abolished (at [112] and [119]).

In short, the Full Court disagreed with the Primary Judge’s conclusion that the liquidators had been entitled to apply the peak indebtedness rule for the purpose of determining whether there was an unfair preference under section 588FA(1), and upheld the creditor’s appeal on this ground. Following the Full Court’s decision, the liquidator brought a High Court appeal.

In February 2023, the High Court undertook a thorough review of the history of the “peak indebtedness rule” and found that:

“cases which concluded that the ‘peak indebtedness rule’ is to be read into s 588FA(3) of the Corporations Act wrongly assumed that the ‘running account principle’ included the ‘peak indebtedness rule’, did not involve full argument on or reasoning about the issue, or must now be considered to be wrong in that respect 4.”

The High Court findings effectively mean an end to the “peak indebtedness rule” in the context of an unfair preference claim alleged by a liquidator.

Using the example above, the abolition of the “peak indebtedness rule” would require the liquidator to consider all of the transactions in the relevant period. As a practical matter, a liquidator/ creditor should undertake a reconciliation to consider the total of all payments received in the relation-back period against all invoices/goods supplied in the same period.

The relevant question concerns whether the effect of the payments was to give the creditor a preference over other creditors because their objective purpose was merely to discharge existing debts; or, whether their purpose was to facilitate the company buying further goods, as well as to discharge its existing indebtedness5

All is not lost

Although the recent High Court decisions will put an end to arguments involving set-off and the application of the “peak indebtedness rule”,

How To Manage Risk

there is no change to the various other defences available to creditors, which include:

1. Good faith – a creditor is entitled to assert that it had no reasonable grounds (and did not suspect) that the customer company was insolvent during the relevant period. If a creditor is successful in proving this defence, it can be a complete defence to a preference claim.

2. Secured creditor – liquidators may only claw back unfair preference payments for debts that were “unsecured” during the relevant period. Noting that this can be a complete defence to a preference claim, as a creditor may assert that the debt owed to it (the subject of the payments) was secured by virtue of:

(a) a retention of title clause in the credit agreement; and

(b) a security interest/PPS Registration with respect to the goods supplied to the customer company.

3. Ultimate effect – the relevant question is whether the effect of the payments was to give a creditor a preference over other creditors because their objective purpose was merely to discharge existing debts; or, whether their purpose was to facilitate the company buying further goods as well as to discharge its existing indebtedness.

If this dual purpose is established by a creditor, there is a strong argument against there being an unfair preference.

Conclusion

Holman Webb’s Commercial Recovery and Insolvency Team has dealt with scores of claims brought by liquidators, and we know that successfully opposing unfair preference claims can turn on a number of overlapping matters

– including timing, availability of defences, negotiation, and strategy.

Having an effective credit function is critical to maintaining successful business and cashflow. However, it is an area fraught with risk – as credit professionals must balance the needs of the business to generate sales against the risk of non-payment and default.

While it is not possible to completely eliminate risk within the context of a possible preference claim brought by liquidators, it is imperative that credit professionals: z continue to be vigilant; z implement appropriate preventative strategies and technologies; and z promptly collaborate with lawyers to mitigate that risk.

Christopher

Hadley

MICM, Partner

Andrew Tanna MICM,

Special Counsel

Holman Webb Lawyers www.holmanwebb.com.au

FOOTNOTES:

1 ASIC: Insolvency statistics (current)

2 Morton & Anor v Rexel Electrical Supplies Pty Ltd

3 Stone (in their capacities as joint and several liquidators of Cardinal Projects Services Pty Ltd v Melrose Cranes & Rigging Pty Ltd [2018] FCA 530

4 Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (8 February 2023)

5 Beveridge v Whitton [2001] NSWCA 6