Preferences in Bankruptcy

What are preferential payments?

Preferential payments, or preferences, are payments or transfers of assets that may be recovered by trustees of bankruptcy estates under the provisions of the Bankruptcy Act. Trustees may seek to void transactions with creditors, where that creditor has received a preference or advantage over other creditors. Preferences are usually payments of money, though a variety of transactions could be preferential.

Who may recover preferences?

In personal insolvency matters, only trustees of bankrupt estates and trustees of Personal Insolvency Agreements (where the Agreement includes recovery of these preferential transactions) may claim the return of preferential payments. Similar provisions also exist in the Corporations Act for payments made by companies.

Why do trustees void preferences?

One of the trustee's roles is to distribute the bankrupt's assets between their creditors on an equitable basis. To do so they must discover whether any creditor has received treatment that would have given them a distribution - before the bankruptcy - that was not equitable when compared to the distribution to other creditors in the bankruptcy. Trustees void transactions with one creditor so that they can make a more equitable distribution to all creditors.

What are the elements of a preference?

Before the court will avoid a preference, it must be satisfied that:

(a) a transfer of property was made (usually a payment of monies);
(b) it was between the bankrupt and a creditor of the bankrupt;
(c) it occurred at a time when the bankrupt was insolvent;
(d) it occurred within the relevant time period;
(e) the transaction gave the creditor an advantage over other creditors; and
(f) the creditor suspected or should have suspected that the bankrupt was insolvent.

When is someone insolvent?

The Bankruptcy Act defines insolvent as not being able to pay all the your debts as and when they become due and payable. The bankrupt must have been insolvent at the time of the transfer or payment. The reasoning is that a solvent person has the capability of paying all of their debts (whether they actually did or not) and could not intentionally have preferred any creditor over the others.

Who has to prove insolvency?

The onus of proving insolvency lies with the trustee.

The main elements of a preference

1. There must be a debtor creditor relationship

The transaction must have involved, or been done at the direction of, a creditor of the bankrupt, to satisfy a debt was provable in the estate if the transaction had not been done.

2. There must be a transfer of an asset

There must be a transfer of property between the parties. It is common for that transaction is a payment of monies, although any asset passing from the bankrupt to the creditor will be sufficient to be a transfer of property.

3. The time period

The transfer must happen in a specific period before the bankruptcy. The period differs depending on how the bankruptcy commenced. For a bankruptcy started by a:

1. Creditor's Petition - 6 months before the filing of the creditor's petition
2. Debtor's Petition (where a Creditor's Petition is pending) - the period starts of the commencement of the bankruptcy; defined as the time of the earliest act of bankruptcy within the 6 months before the creditor's petition was filed
3. Debtor's Petition - 6 months before the presentation of the Debtor's Petition

4. The debt must be unsecured

A preference cannot be given to a creditor holding a valid security over assets that are transferred to them, because that creditor is entitled to those assets or monies under the security and could not have been preferred other unsecured creditors. If the security was not properly created, the transfer is likely to be preferential. The creation of the security in the first instance may also be a preference.

5. Has a preference been obtained?

The creditor must have received more than they would have received if they had refunded the monies and proved for that amount in the bankruptcy. This is a purely mathematical calculation. For example, if the dividend rate is thirty cents in the dollar, but the creditor had half his debt paid before the bankruptcy, he has received a 100% return on one half and the 30% return on the other, as opposed to a 30% return on the whole debt given to other creditors. If the creditor did not receive more by way of the payment than they would have received from a dividend in the bankruptcy, there is no advantage or preferential treatment.

What defenses are available to creditors?

A creditor that is a party to a suspect transaction must be able to prove all of the arms of the statutory defense under section 122(2) of the Bankruptcy Act. If they cannot prove even one of the arms, the entire defense fails. The recipient must prove these matters, the trustee does not need to disprove them. The three arms are:

1. The transfer was in the ordinary course of business
2. The recipient acted in good faith
3. The recipient gave market value consideration or at least market value

The transfer is also not void if it was made pursuant to a Maintenance Agreement under the Family Law Act, or was made under a Part IX Debt Agreement.

What is good faith and the ordinary course of business?

The creditor must not have acted in any manner that would give the perception that they were not acting in good faith or under normal trading conditions. Actions that may repute good faith are the issuing of proceedings or statutory notices to the debtor, ceasing supply etc. They must not have forced the payment to be made by threat or action.

What is market value consideration?

The easiest arm to prove is usually that the recipient gave market value consideration. If the recipient is a trade creditor, the initial supply of goods or services would provide the market value consideration. A loan creditor can rely upon the initial loan to the bankrupt. The creditor will only have to show that they have given something of value in consideration for receiving the payment.

When will the defenses not be available?

The creditor can not rely on the defenses when they knew or had reason to suspect that the bankrupt was insolvent, and that the transaction would give them a preference over other creditors.

What should creditors do if a trustee claims a preference?

They should make sure that:

(a) the transaction was done within the relevant time period;
(b) they are not a secured creditor;

(c) they are (or were) a creditor when the payment was made and that the payment was not a C.O.D. type transaction.

(d) the trustee shows that they received an advantage over other creditors.

These are the basic points and are easy to show. The following points are more detailed to determine:

(a) whether the creditor gave extra credit to the debtor after the payment was received. It is possible that the claim may be reduced or eliminated by the amount of extra credit granted. This is commonly known as the running account defence.
(b) that the trustee can show insolvency at the time of or before the payment was received.

(c) whether the creditor has a realistic chance of convincing a Judge that all three of the statutory defenses are available.

What can creditors do if they have to refund money to a trustee?

Creditors refunding preferences may lodge a proof of debt for the amount refunded. They may also have some rights under any guarantees given by other parties that support that debt.

How long does the trustee have to make a claim?

Claims have to be commenced within 6 years after the commencement of the bankruptcy. It is not sufficient for the trustee to only have made a formal demand within that period, they must issue proceedings within that time period.

For more detailed information:

Insolvency Resource Page: Preferential Payments: Bankruptcy Act

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

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Last Updated: 25.2.2008