Preferences under the Bankruptcy Act
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Introduction
Trustees of bankrupt estates sometimes seek to recover payments or transfers of assets made by the bankrupt to a creditor. This is done when the payment or transfer was made within the six months before the bankruptcy, and when that creditor received a preference or advantage over other creditors.
Creditors will naturally be reluctant to return any monies or assets received, particularly when the receipt was a result of vigorous collection or legal procedures. Nevertheless, the Bankruptcy Act requires the creditor to refund monies or assets in certain circumstances.
Usually a 'preference' or 'preferential payment' is a payment of monies, but almost any transfer of assets and some creations of property (mortgages etc.) may also fall under this section. For ease of explanation, the paper generally describes preferences as a payment of money.
Only trustees of bankrupt estates and Personal Insolvency Agreements (where the agreement includes that right) may seek the return of preferences. The procedure is not available in Part IX estates.
To be able to recover a preference, the trustee must show that:
1. a transaction was actually entered into;
2. the transaction was between the bankrupt and one of their creditors;
3. it was entered into at a time when the bankrupt was insolvent;
4. the transaction gave the creditor an advantage over other creditors (preferential treatment); and
5. it did not involve protected property.
This paper contains links to legislation. These will open in a separate window. Most of the legislation shown in this paper is only a summary or extract of the entire section. The links go to the entire section.
Reasons for recovering preferences
One of a trustee's roles is to ensure an orderly and equitable distribution of the bankrupt's assets between the bankrupt's creditors. Part of that role is to discover whether any creditor received a distribution before the bankruptcy that was not equitable when compared to the distribution to other creditors in the bankruptcy (i.e. that this creditor received preferential treatment).
These provisions are meant to deter creditors from scrambling to get their hands on any available asset at the expense of other creditors, and to give the trustee power to recover monies or assets in order to make a more equitable distribution to all creditors.
In order to give effect to these reasons, the Bankruptcy Act sets a wide definition of transactions that may be preferential. They not only include the basic payment of money or transfer of an asset, they also include transfers that involve jointly held assets and / or joint debts.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(1A) Subsection (1) applies in relation to a transfer of property by the debtor in favour of a creditor:
(a) whether or not the liability of the debtor to the creditor is his or her separate liability or is a liability with another person or other persons jointly; and
(b) whether or not the property transferred is the debtor's own property or is the property of the debtor and one or more other persons.
Recovering a preferential payment
Two major factors must be considered to determine whether a payment is preferential. They are:
1. Has preferential treatment been given to a particular creditor?
2. Was the bankrupt insolvent at the time of the payment?
Has preferential treatment been given?
The creditor must have received an advantage - been preferred - over other creditors. This concept is described in section 122 of the Act as "giving the creditor a preference, priority or advantage over other creditors". Similar provisions in the Corporations Act define preferential treatment as "the recipient receiving more than they would have if they refunded the monies and proved for that amount in the Winding Up of the company". The idea is the same in both Acts.
This matter is proven by a mathematical calculation based on the dividend rates to that creditor, taking into the account the return of the preference. Take a simple example:
A creditor receives a $25,000 payment before bankruptcy in satisfaction of their debt. A dividend paid with the remaining $20,000 available in the estate (without recovery of the preference) to $100,000 of creditors is at a rate of twenty cents in the dollar. But prior to the bankruptcy, the preferred creditor has his entire $25,000 debt paid or 100 cents in the dollar. That creditor has received more than the other creditors: compared to
If the $25,000 was returned to the estate, there would be $45,000 to disburse, but now over $125,000 of creditors after adding back the preferred creditor's debt. The dividend rate would now be 36 cents in the dollar to all creditors.
The creditor in this case received 16 cents in the dollar more than the other creditors by receiving the payment, and the other creditors would benefit by the return of the money. Subject to the other factors, this payment could be seen as preferential.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(1) A transfer of property by a person who is insolvent (the debtor) in favor of a creditor is void against the trustee in the debtor's bankruptcy if the transfer:
(a) had the effect of giving the creditor a preference, priority or advantage over other creditors;
If the creditor did not receive more from the payment than they would have received from a dividend in the bankruptcy, there is no preference. This would be unusual when some creditors are only paid cents in the dollar.
Two more factors must be considered.
Preferences not only occur when existing assets are passed to the creditor. Creating new assets (e.g. a mortgage over property) is also an asset that 'transferred' according to the Act. The debtor is giving something that they hold (the equity in the property) to the creditor.
Secondly the time for judging the value of the transaction, and hence whether mathematically there is a preference, is when the transfer is made - not when the debtor becomes bankrupt or when the trustee makes his or her demand.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(8) For the purposes of this section:
(a) transfer of property includes a payment of money; and
(b) a person who does something that results in another person becoming the owner of property that did not previously exist is taken to have transferred the property to the other person; and
(c) the market value of property transferred is its market value at the time of the transfer.
Was the bankrupt insolvent at the time of the payment?
There is no preference without insolvency at the time when the payment or transfer was made. The reasoning is that a solvent debtor has the capability of paying all of their debts as they fall due and, consequently cannot have preferred any creditor over others by making payments, albeit that some of these creditors may not have been paid at the time of the bankruptcy. The Bankruptcy Act defines solvency as:
BANKRUPTCY ACT - SECTION 5
Interpretation
(2) A person is "solvent" if, and only if, the person is able to pay all the person's debts, as and when they become due and payable.
(3) A person who is not solvent is "insolvent".
Proving insolvency is necessary from the words "a person who is insolvent" in section 122.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(1) A transfer of property by a person who is insolvent (the debtor) in favor of a creditor is void against the trustee in the debtor's bankruptcy if the transfer:
The onus of proving insolvency lies with the trustee. This is the factor that may take some time for the trustee to prove as they will have to gather information on available assets and due and payable debts. The process of determining solvency is the subject of another paper in this series.
Other elements of preferences
The trustee must also prove a number of other factors:
1. A debtor - creditor relationship
2. A transfer of property occurred
3. The timing of the transaction
4. The debt was unsecured
Debtor - creditor relationship
The transfer must be to one of the bankrupt's creditors, or involve a creditor if other parties are involved, otherwise the recipient cannot be 'preferred' or receive an advantage over other creditors and this section will not apply - though transfers to parties that are not creditors may be voided under other sections, particularly section 120 and section 121.
The creditor only needs to have been someone able to lodge a proof of debt for a provable debt if they had not received the payment. This has effect even if the debt is a joint debt with another solvent or insolvent person. The legislation gives the necessary debtor creditor requirement in the wording "in favor of a creditor" in section 122.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(1) A transfer of property by a person who is insolvent (the debtor) in favor of a creditor is void against the trustee in the debtor's bankruptcy if the transfer:
The transfer of property does not need to only involve the bankrupt and a creditor, it may also involve another party. Transfers to third parties at the direction of the creditor, that extinguishes a debt owed to the creditor, may also be preferences. Payments from one of the bankrupt's debtors directly to one of their creditors, bypassing the bankrupt, could also be preferential. These transactions may be caught if any 'right' of the bankrupt is compromised.
Has a transfer of property occurred?
There must have been a transfer of property (a transaction) between the bankrupt and the creditor (and any other party). The transaction is usually the payment of monies, but any asset passing from the bankrupt to the creditor, or to someone else on direction of the bankrupt, will be sufficient for these purposes. The asset may also be jointly owned with another party and still be a transfer that is caught by this section.
Further, the creation of some instruments is deemed to be transfers of property that may be void. The most common example is the creation of a mortgage over an asset that supports what was until the security an unsecured debt. This technique is used to give access to the assets solely to this particular creditor by way of granting the security.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(1) A transfer of property by a person who is insolvent (the debtor ) in favor of a creditor is void against the trustee in the debtor's bankruptcy if the transfer:
Without a transfer of the bankrupt's property, there can be no preference, as the section is designed to recover the bankrupt's former assets. If the asset transferred was not property divisible in the bankrupt estate, there will usually be no preference as the asset could not have been distributed to creditors if it had not been transferred, so the other creditors could not have been disadvantaged.
Timing of the transaction
Strict time periods apply. The transaction must have occurred within 6 months before the date specified as the commencement of the bankruptcy. The Act sets different dates for the commencement depending on how the bankruptcy commenced.
BANKRUPTCY ACT 1966 SECTION 122
Avoidance of preferences
| Description of petition leading to debtor's bankruptcy | Period during which the transfer was made |
|---|---|
| Creditor's petition | Period beginning 6 months before the presentation of the petition and ending immediately before the date of the bankruptcy of the debtor |
| Debtor's petition presented when at least one creditor's petition was pending against a petitioning debtor or a member of a partnership against which the debtor's petition was presented | Period beginning on the commencement of the debtor's bankruptcy and ending immediately before the date of the bankruptcy of the debtor |
| Debtor's petition presented in any other circumstances | Period beginning 6 months before the presentation of the petition and ending immediately before the date of the bankruptcy of the debtor |
In summary, the periods during which transfers of property may be void are:
(a) Bankruptcy by creditor's petition - period beginning 6 months before the filing of the petition and ending immediately before the date of the bankruptcy of the debtor;
(b) Bankruptcy by a debtor's petition presented when at least one creditor's petition had been filed - period beginning on the commencement of the debtor's bankruptcy and ending immediately before the date of the bankruptcy of the debtor;
(c) Bankruptcy by a debtor's petition presented in any other circumstances - period beginning 6 months before the presentation of the petition and ending immediately before the date of the bankruptcy of the debtor.
The date of the commencement of the bankruptcy used in option (b) is set out in section 115 and is also dependent upon a number of differing circumstances. In this case the commencement date will be the time of the commission of the earliest act of bankruptcy on which the creditor's petitions was based.
BANKRUPTCY ACT 1966 SECTION 115
Commencement of Bankruptcy
| Circumstances in which debtor's petition was presented or accepted | Time to which bankruptcy has relation back and time of commencement of bankruptcy |
|---|---|
| Petition accepted by the Official Receiver under a direction of the Court | Time specified by the Court as the commencement of the bankruptcy |
| Petition presented when at least one creditor's petition was pending against the petitioning debtor (whether alone, as a member of a partnership or as a joint debtor), and accepted by the Official Receiver without a direction from the Court | Time of the commission of the earliest act of bankruptcy on which any of the creditor's petitions was based |
| Petition presented when no creditor's petitions were pending but the debtor had committed at least one act of bankruptcy in the past 6 months, and accepted by the Official Receiver without a direction from the Court | Time of commission of the earliest act of bankruptcy within the 6 months before the petition was presented |
| Petition presented when no creditor's petitions were pending and the debtor had not committed any act of bankruptcy in the past 6 months, and accepted by the Official Receiver without a direction from the Court | Time of presentation of the petition |
An Unsecured Debt
The creditor receiving the payment or transfer of property must be an unsecured creditor, or at the very least part of their debt must be unsecured.
The reasoning is that a payment to a secured creditor in reduction or discharge of the secured debt reduces or extinguishes the security interest over the secured asset and does not change the debtor's net asset position. The payment is equal to the increase in the equity in the asset. The debtor is effectively trading cash for equity. This theory is fine if the value of the asset is more than the amount of the secured debt or the amount of the payment.
If the debt to the secured creditor is more than the value of the asset secured, the excess debt is not secured by the asset. This creditor is only a 'secured creditor' to the value of the secured asset. A payment to the creditor for more than the value of the asset will only reduce the security interest in the asset the amount of the value of the asset. The balance may be preferential to the extent that the payment exceeds the value of the security.
For example - if the creditor is owed $100 and is paid that $100, but the asset secured is only worth $60, the difference of $40 may be classified as 'unsecured' and may be preferential.
Statutory Defenses
The Bankruptcy Act sets out certain statutory defenses that may be available to defend against recoveries sought by trustees. For the defenses to be available, a creditor must have been acting:
1. in the "ordinary course of business";
2. "in good faith"; and
3. "gave market value" for an asset.
The creditor will need to prove all three parts of the defenses to be able to rely on it. The Act also specifically protects payments or transactions under Part IX of the Bankruptcy Act or under Maintenance Agreements or Orders. The legislation states:
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(2) Nothing in this section affects:
(a) the rights of a purchaser, payee or encumbrancer in the ordinary course of business who acted in good faith and who gave consideration at least as valuable as the market value of the property; or
(b) the rights of a person who is making title through or under a creditor of the debtor in good faith and who gave consideration at least as valuable as the market value of the property; or
(c) a conveyance, transfer, charge, payment or obligation of the debtor executed, made or incurred under or in pursuance of a maintenance agreement or maintenance order; or
(d) a transfer of property under a debt agreement.
The creditor must prove the defenses and the trustee has the right to challenge any defense proposed by the creditor.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
(3) The burden of proving the matters referred to in subsection (2) lies upon the person claiming to have the benefit of that subsection.
Usually the easiest part of the defence to prove is that the recipient gave market value or valuable consideration. Since the recipient must be a creditor, the initial supply of goods, services or loan of monies would provide the market value or valuable consideration. Nominal consideration is insufficient for this defense. As a majority of preference claims are made against trade creditors, there is generally little difficulty in the creditor proving this point.
The other two arms (Good Faith and Ordinary Course of Business) are more difficult to explain and prove, consequently they are the areas of most contention. In essence, the creditor must not have acted in any manner that would give the perception that they were not acting in good faith or outside normal business practice. Actions that may repute this are issuing collection proceedings or ceasing supply.
Ordinary course of business has been held to be in the ordinary course of the relevant industry, not the ordinary course of that particular creditor. These matters are open to interpretation and are too wide to discuss in this paper. Creditors should seek legal advice if they receive a demand from a trustee.
The Act provides that these defenses will not be available to creditors where the circumstances of the payment infer that the creditor knew or should have suspected that the bankrupt was insolvent at the time and that the transfer would prefer them.
BANKRUPTCY ACT 1966 - SECTION 122
Avoidance of preferences
4(c) a creditor shall be deemed not to be a purchaser, payee or encumbrancer in good faith if the transfer of property was made under such circumstances as to lead to the inference that the creditor knew, or had reason to suspect:
(i) that the debtor was unable to pay his or her debts as they became due from his or her own money; and
(ii) that the effect of the transfer would be to give him or her a preference, priority or advantage over other creditors.
Protection of some transactions
The Act provides some protection to people dealing with debtors before they become bankruptcy. The section says that people acting with the bankrupt with no knowledge of the impending bankruptcy and in normal business circumstances have some protection - unless the transaction can be voided through one of the recovery provisions, including preferential transfers.
That is, this protection provision will not save a creditor from a preferential recovery action commenced by a trustee.
BANKRUPTCY ACT 1966 - SECTION 123
Protection of certain transfers of property against relation back etc.
(1) Subject to sections 118 to 122 (inclusive), nothing in this Act invalidates, in any case where a debtor becomes a bankrupt:
(a) a payment by the debtor to any of his or her creditors;
(b) a conveyance, transfer or assignment by the debtor for market value;
(c) a contract, dealing or other transaction by or with the debtor for market value; or
(d) any transaction to the extent of a present advance made by an existing creditor;
if:
(e) the transaction took place before the day on which the debtor became a bankrupt;
(f) the person, other than the debtor, with whom it took place, did not, at the time of the transaction, have notice of the presentation of a petition against the debtor; and
(g) the transaction was in good faith and in the ordinary course of business.
(2) The burden of proving the matters referred to in paragraphs (1)(e), (f) and (g) in relation to a transaction lies upon the person who relies on the validity of the transaction.
This provision protects an innocent, unknowing party who entered in commercial transactions in ordinary dealings with the bankrupt as long as the following factors are met:
(a) the transaction happen before the bankruptcy (the bankrupt does not have the right to deal with their assets after bankruptcy);
(b) the other party was unaware of the impending bankruptcy; and
(c) the transaction was in good faith and in the ordinary course of business.
Good faith and ordinary course of business are more difficult to explain and prove, consequently they are the areas of most contention. The creditor must not have acted in any manner that would give the perception that they were not acting in good faith. Actions that may repute good faith are the issuing of proceedings or ceasing supply to the bankrupt etc.
Ordinary course of business has been held to be in the ordinary course of the relevant industry, not the ordinary course of that particular creditor.
The main factor is that the transaction must have been commercial. If value was not given or received by the debtor (before bankruptcy) the transaction is likely to be voided by the trustee under one of the relevant provisions - including the preferential payment provision - of the Act.
The burden of proof rests with the party attempting to gain the protection of the section.
BANKRUPTCY ACT 1966 - SECTION 123
Protection of certain transfers of property against relation back etc.
(2) The burden of proving the matters referred to in paragraphs (1)(e), (f) and (g) in relation to a transaction lies upon the person who relies on the validity of the transaction.
Time limit for making a claim
A trustee must commence a claim (or more correctly, must commence an action to void the transfer of property) within six years of their appointment otherwise the right to do so will be lost.
BANKRUPTCY ACT 1966 - SECTION 127
Limitation of time for making claims by trustee etc.
(5) An action under section 122 with respect to a transfer of property shall not be commenced by the trustee of the estate of a bankrupt after the expiration of 6 years from the date on which the bankrupt became a bankrupt.
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Last Updated: 9.6.2010