What are unfair preferences?
An unfair preference is defined in section 588FA of the Corporations Act 2001 (Cth) as a transaction between a company and a creditor which results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in a winding up of the company.
Section 122 of the Bankruptcy Act 1966 (Cth) contains an equivalent provision for unfair preferences where the debtor is an individual.
The basic elements of an unfair preference are that:
- there is a debtor/creditor relationship between the company and the creditor;
- the creditor receives a payment from the company;
- the payment is in respect of an unsecured debt. Note that a secured debt is considered to be unsecured to the extent of its value that is not reflected in the value of the security; and
- as a result of the transaction the creditor receives from the company in respect of an unsecured debt more than the creditor would have received if the creditor had proved the debt in the winding up.
Why should you be wary of unfair preferences?
An unfair preference may be an insolvent transaction under s 588FC if:
- the company was insolvent at the time the transaction was entered into; or
- the company became insolvent as a result of entering into the transaction.
The Court has the power to order a creditor to repay an unfair preference received under an insolvent transaction if the transaction is voidable: s 588FF. However, the first notice you will usually receive about an unfair preference is from a liquidator appointed to one of your former customers.
An insolvent transaction is voidable if the transaction took place:
- during the 6 months ending on the relation-back day; or
- after the relation back day but before the day when winding up began; or
- during the 4 years ending on the relation-back day if a related entity was a party to the transaction.
Defences to unfair preference claims
The following defences may be available in defending an unfair preference claim:
- the “running account” defence;
- the “good faith” defence – that the party acted in good faith and had no reasonable grounds to suspect the company was insolvent: s 588FG(2);
- the doctrine of ultimate effect; and
- set off provisions: s 553C.
Running account defence
This defence is only available where there have been multiple transactions as part of an ongoing business relationship between the company and creditor, i.e. under a running account. Under section 588FA(3), these transactions are treated as constituting a single transaction and the Court assesses the value of the preference as the difference between the maximum amount of the debt in the relevant period and the amount owed on the relation-back day. Whilst not a complete defence, the running account defence can potentially significantly reduce the amount of unfair preference claimed.
Good faith defence
The second option is the defence available under section 588FG(2). To establish this defence, the person must prove that:
- they became a party to the transaction in good faith; and
- at the time when they became a party:
- the person had no reasonable grounds for suspecting that the company was insolvent at that time or would become insolvent; and
- a reasonable person in the person’s circumstances would have had no such grounds for suspecting; and
- they provided valuable consideration under the transaction or changed their position in reliance on the transaction.
For the purposes of s 588FG(2)(b), “suspicion” involves a feeling of apprehension or mistrust without sufficient evidence of actual and existing insolvency and must have been felt at the time at which the payment was made: Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266.
Factors that may be reasonable grounds for suspecting insolvency include:
- a history of late or unpaid sales and deliveries;
- dishonoured payments;
- the absence of transactions or orders over selective periods;
- the negotiation of an instalment arrangement;
- a request for extended credit terms (or requiring COD);
- provision of post-dated cheques; and
- if the creditor had to issue a statutory demand to enforce payment.
The Court will take all the circumstances of the case into consideration, including industry practice, when determining whether a reasonable person would suspect insolvency.
The doctrine of ultimate effect
Otherwise known as the “landlord’s defence”, this doctrine requires the Court to consider the net or ultimate effect of the transaction, i.e. whether the transaction has ultimately decreased the net value of assets available to meet the competing demands of other creditors: Air Services Australia v Ferrier (1996) 185 CLR 483.
In cases where liquidators of tenants have sued landlords claiming that the landlord’s receipt of rent was an unfair preference, courts have held that the purpose of a payment by the tenant of rent in advance is to secure a continuing right of occupation, without which the tenant’s business could not survive. Accordingly, when the “ultimate effect” of the transaction is considered, the tenant has secured a right of equal or greater value than the payment of rent, and it is not a preference.
Set off provisions
It may be possible to “set-off” an unfair preference claim under Section 553C. This provision applies where there have been mutual credits, mutual debits or other mutual dealings between the parties and may allow the creditor to have payment received from the insolvent company set-off against money owed to it by the debtor company. This is not technically a defence to an unfair preference claim but rather an argument that the unsecured creditor received less from the creditor than they would have received if they proved the debt on winding up.
A set-off cannot be claimed if the creditor had notice of the fact that the company was insolvent at the time of giving or receiving the credit from the company.
Section 86 of the Bankruptcy Act 1966 contains an equivalent provision for creditors who have had dealings with insolvent individuals.
Managing exposure to unfair preference claims
The simplest (but sometimes not the most practical) way to avoid unfair preference claims is to avoid being a creditor, which means getting paid up front or cash-on-delivery.
If you are a creditor, then obtaining security from the debtor will help you to avoid unfair preference claims, but only to the extent that the value of the security is more than the debt.
Having appropriately drafted indemnities from directors of corporate debtors will not assist you in resisting an unfair preference claim, but it will assist you to recoup money you have to pay to a liquidator to settle an unfair preference claim.
For more information contact Daniel Fleming on d.fleming@pigott.com.au
This article is intended to provide general information in summary form on a legal topic, current at the time of publication. The contents do not constitute legal advice and should not be relied on as such. Formal legal advice should be sought in specific circumstances.