The changing landscape of unfair preferences

What should creditors be aware of in 2022?

The Full Court of the Federal Court has determined that the set off defence under s 553C of the Corporations Act will not be available to creditors with respect to unfair preference claims.

By Anna Taylor MICM*

Anna Taylor MICM

Introduction

In the recent decision of Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited [2021] FCAFC 228 (MJ Woodman), the Full Court of the Federal Court reviewed a conflicting line of case authority to confirm that the set off provision under s 553 of the Corporations Act 2000 (Cth) (the Act) is not available to creditors as a defence to an unfair preference claim.

This decision removes a major strategy from the defensive arsenal of creditors subject to unfair preference claims and should prompt creditors to review their current understanding of their rights and obligations in relation to unfair preference claims moving into 2022.

Section 553C set off

Section 553C of the Act generally operates as an automatic set off provision whereby any mutual credits, debts or dealings between a creditor and an insolvent company will be set off, in order to simplify the liquidation process.

Prior to the recent decision in MJ Woodman, creditors facing unfair preference claims would raise the set off provision contained in s 553C of the Act as a defence, effectively allowing the creditor to set off the amount claimed as an unfair preference payment with any debts still owed to it by the company in liquidation.

While this defence was extremely controversial, unpopular with insolvency practitioners, and widely considered to be bad law, the case law was sufficiently unsettled to allow a creditor to use this strategy, and often succeed in negotiating a better outcome (without a trial on the issue).

MJ Woodman

In MJ Woodman, the Federal Court was tasked with determining whether a creditor could rely on s 553C of the Act to set off against a

liquidator’s claim for the recovery of an unfair preference payment under s 588FA of the Act.

The facts of the MJ Woodman were as follows: 1. The company obtained goods from the creditor on credit on two separate occasions, resulting in two separate debts of $190,000 and $194,000. 2. Before the company’s liquidation, but after it became insolvent, it paid $190,000 to the creditor, with $194,000 remaining outstanding. 3. The liquidator of the company sought to recover the $190,000 paid to the creditor as an unfair preference payment. 4. The creditor argued that as it was still owed $194,000 by the company, it should be allowed to rely on s 553C of the Act to set off the debts. In a unanimous decision, the Court held that the s 553 set off was not available to the creditor as the requirement of ‘mutuality’ was not met. ’Mutuality’ requires that the claims which are sought to be setoff against one another must be between the same parties, and those parties must hold those claims for their own benefit and interest.

The Court held that in the case of an unfair preference claim, the right of action pursued by the liquidator is not a right exercised for the benefit of the insolvent company but rather the unsecured creditors and the administration of the estate. While in contrast, the right of action available to the creditor in relation to the debt was solely against insolvent company. Therefore, the requirement of ‘mutuality’ was not met, and s 553C could not be activated.

The Court also held that there was a lack of mutuality as there is an absence of any obligation on the creditor to repay an unfair preference until the liquidator succeeds in obtaining an order to void the unfair preference payments.

Conclusion

While the decision in MJ Woodman has reduced the number of strategies available to creditors hoping to navigate the insolvency landscape, there are still a number of extremely effective strategies and defences available to creditors subject to unfair preference claims, including: 1. Good faith defence; 2. Running account; 3. Security; and 4. Proactive credit management practices. Whilst the insolvency landscape is still unpredictable and the foreshadowed tsunami of insolvency not yet apparent, it is likely that as we enter into the third year of the pandemic we will see an increase in business failure which will result in an increase in preference activity.

Until we see significant changes to legislation, unfair preference activity is a constant reality faced by creditors and insolvency practitioners. Moving into 2022, creditors need to consider what actions they can take to mitigate their risk and over all exposure.

*Anna Taylor MICM Principal Results Legal T: 07 3234 3205 E: ataylor@resultslegal.com.au

“The Court held that in the case of an unfair preference claim, the right of action pursued by the liquidator is not a right exercised for the benefit of the insolvent company but rather the unsecured creditors and the administration of the estate.”