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Preferences in Liquidations

What are preferences?

Preferential payments, or preferences, are payments or transfers of assets that may be recovered by liquidators of companies under provisions of the Corporations Act. Liquidators may seek to void transfers of assets made to a creditor prior to the liquidation, where that creditor has received a preference or advantage over other creditors. Preferences are usually a payment of money, though a variety of transactions could be preferential.

Who may recover preferences?

Only liquidators may claim the return of preferential payments under the Corporations Act. The option is not available to provisional liquidators, voluntary or deed administrators or receivers and managers. Similar provisions exist in the Bankruptcy Act for transfers made by individuals.

Why do liquidators recover preferences?

One of the liquidator's roles is to distribute of the company's assets between its 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 liquidation that was not equitable when compared to the distribution to other creditors in the liquidation. Liquidators void transfers to 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 void a transfer, it must be satisfied that:

(a) a transaction was entered into (usually a payment of monies);
(b) it was between the company and a creditor of the company;
(c) it occurred at a time when the company was insolvent;
(d) it occurred within a certain statutory period;
(e) the transaction gave the creditor an advantage over other creditors; and
(f) the creditor suspected or should have suspected that the company was insolvent.

When is a company insolvent?

Section 95A of the Corporations Act defines insolvency as not being able to pay ones debts as and when they fall due. The company must have either been insolvent at the time of the payment, or became insolvent because of making the payment. The reasoning is that a solvent company has the capability of paying all of its debts (whether they actually did or not) and could not have preferred any creditor over the others.

Who has to prove insolvency?

The onus of proving insolvency lies with the liquidator.

The main elements of a preference

1. There must be a debtor creditor relationship

The transfer must be made to, or done at the direction of, a creditor of the company to satisfy what would have been a provable debt if the transfer had not been received.

2. There must be a transfer of an asset

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

3. The time period

The transaction must have occurred during a particular time period before the 'relation back day'. The time period depends on whether the recipient is related to the company and the intention of the directors of the company. These are:

The relation back day is the day on which the liquidation is deemed to have commenced. For a liquidation which follows a voluntary administration, it is the day that the Administrators were first appointed, even if a Deed of Company Arrangement intervenes. For other voluntary liquidations, it is the date of the members meeting. For an official liquidation (a court appointment) it is the day that the application was filed in the court.

4. The debt must be unsecured

A preference cannot be given to a creditor holding a valid security over company assets, because that creditor is entitled to the monies or assets under the security or the transfer creates equity in the secured assets. If the security is not properly created or registered, it is likely to be void and the debt deemed unsecured. Other provisions also apply to securities created within 6 months of the appointment to related parties. The creation of a security itself within the 6 months can also be a preference.

5. Continuing business relationships

The continuing business relationship provision is similar to what was known as a 'running account'. It is used to determine the amount of any preference received. The liquidator looks at all of the transactions with that creditor between the relevant dates and calculates the net effect to see whether the debt owed to the creditor increased or decreased . If the balance owing to the creditor decreased, the net decrease is the potential preference (all other things considered). If the balance owing increased over the period, there is no preference as the creditor has actually been disadvantaged.

6. 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 winding up. This is a mathematical calculation. For example, if the dividend rate is thirty cents in the dollar, but the creditor had half his debt paid before the liquidation, 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 liquidation, there is no advantage or preferential treatment.

What defenses are available to the creditor?

A creditor that is a party to a suspect transfer must be able to prove all three arms of the statutory defense under section 588FG of the Corporations Act. If they cannot prove even one of these arms, the entire defense fails. It is up to the recipient to prove these matters, not the liquidator to disprove them. These three arms are:

1. They gave valuable consideration for the payment;
2. They received the payment in good faith; and
3. They had no reason to suspect the insolvency of the company.

What is valuable consideration?

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

What is good faith?

The creditor must not have acted in any manner that would indicate 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 company, ceasing supply to the company, changing to a COD basis etc. They must not have forced the payment to be made by threat or action.

What is needed to suspect insolvency?

The creditor must not have received or have known of any information or circumstance that would lead them (or a reasonable person in their position) to suspect that the company was insolvent. It is not necessary that the creditor knew, or believed, or even expected that the company was insolvent to loose the benefit of this defense. The mere suspicion of a reasonable man is enough.

Actions such as receiving post dated cheques, having cheques dishonored, knowing of other creditors that are unpaid and pressing for payment can lead to this suspicion. Whether or not a person should have suspected insolvency is often difficult to assess particularly as the courts recognize a distinction between a short term cash flow problem on one hand and insolvency on the other.

What should creditors do if a liquidator claim a preference?

They should ensure that:

(i) the transfer was done within the relevant time period;

(ii) they are not a secured creditor;

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

(iv) the liquidator shows an advantage over other creditors.

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

1. whether you gave extra credit to the company after the payment or transfer was received. It is possible that the claim may be reduced or eliminated by the amount of extra credit granted. That is, determine whether you had a continuing business relationship;

2. that the liquidator can show the insolvency of the company at the time of, or before the payment was received;

3. 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 liquidator?

Creditors refunding preferences may lodge a proof of debt with the liquidator 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 liquidator have to make a claim?

Claims have to be commenced within 3 years after the relation back day. It is not sufficient for the liquidator 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: Corporations 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: 26.2.2008