In early 2023, we provided an update and noted that the number of insolvencies is increasing, but still below the level before the COVID-19 pandemic. We also noted two High Court decisions were expected on the issue of unfair preferences.
The High Court has handed down both decisions. In order to understand why these decisions are important, it is worth recapping what unfair preferences are.
An unfair preference (also called an ‘unfair preference payment’, or just a ‘preference payment’) is one type of the broader category of voidable transactions [Part 5.7B of the Corporations Act 2001 (C’th) (CA)].
Voidable transactions are transactions that a liquidator can apply to Court about, so as to have the transaction set aside, or be compensated for it, in order to recover property or compensation for the benefit of the creditors of the insolvent company which is now in liquidation.
Some other voidable transactions include uncommercial transactions, e.g. a company selling its assets off at an unreasonable undervalue, or unreasonable director related transactions. Those sorts of transactions are easy to understand in principle (although applying the law in particular cases might be difficult). Those voidable transactions accord with a generally held sense of fair play.
What is classified as an unfair preference, specifically?
In our experience, unfair preference claims can be different to those other voidable transactions mentioned above. It can be quite shocking when you, as a creditor, have had the company you are trading with go into liquidation, leaving you with unpaid debts, and the liquidator then comes to you and asks to be repaid money that the company had previously paid you.
Generally, a liquidator will make a claim for an unfair preference where:
a) the creditor has been paid in the six (6) month period (or four (4) years for related entities), prior to liquidation in circumstances where the creditor knew, or ought to have known, that the company was insolvent;
b) there are factual circumstances present at the time which show the company was insolvent at the time the transaction occurred; and
c) the payment results in the creditor receiving more than they would receive if the debt were set aside and they had to prove the debt in the winding up of the company.
In short, unfair preferences are claimed where the payment discriminates against other creditors in circumstances where there are obvious signs that the company might be insolvent. It can also cover other transactions, such as the receipt of an asset in lieu of payment.
The law aims to ensure all unsecured creditors of a company are treated equally by preventing one unsecured creditor getting an advantage over the other because they have been paid above all others in the relevant period prior to liquidation.
There are defences to an unfair preference claim, so you should immediately seek legal advice of you receive a claim from a liquidator.
The High Court cases
The two recent High Court decisions should make unfair preferences work in a clearer way which is easier for all parties – and indeed the community as a whole – to understand and accept.
Both of the recent High Court cases affirmed the respective earlier decisions of the Full Federal Court that were under review. In a sense this is a slightly surprising result.
Appeals to the High Court are not automatic (a party must obtain "special leave", and on average only roughly one in ten applications are granted). So, the High Court using its resources (twice) to confirm what the Full Federal Court had already done (twice) perhaps indicates that the High Court has wanted decisively to bring stability to this area of law.
The cases disussed.
This case dealt with a very specific issue: could a party who was the subject of an unfair preference claim offset that claim (under section 553C(1) of the Corporations Act 2001) against amounts that the company already owed it (i.e. the party facing the unfair preference claim) before the company went into liquidation (allowing the creditor to reduce or defeat the unfair preference claims)? The historical position had been that this was not possible, but this had begun to be doubted.
The High Court's answer (like the Full Federal Court's before it) was: No.
The reasoning behind that is that there is a lack of "mutuality".Section 553C(1) allows for set-offs against claims by the company, but the unfair preference claim is a right that did not belong to the company prior to its liquidation, only arising after the liquidation.
The High Court decision means that parties can still rely onset-offs when sued by liquidators for claims that pre-date the liquidation (such as a regular contractual claim) but not for unfair preferences (or other voidable transactions). That party can, of course, also still make a "proof of debt" claim as a creditor for any dividend from the liquidation in respect of amounts that were owed by the company before liquidation.
The effect of this decision is that it reduces the amount of funds claimable by liquidators in unfair preference claims.
This case related to a continuing business relationship (also known as running account) defence under section 588FA(3) of the CA.
Previously, under the "peak indebtedness rule" that had developed in the case law, but is not explicitly stated in the CA, liquidators could, “in effect”, choose what level of indebtedness would apply for the purpose of an unfair preference claim, when the debt level fluctuated over the course of that business relationship.
This is a very technical issue, but as liquidators would understandably choose the highest level ("peak indebtedness") it led to bigger unfair preference claims. This, however, did not fit well with the wording of the either the Corporations Act or the earlier High Court Compass Airlines case (1996) 185 CLR483.
The Court effectively removed the discretion from the liquidator on this point. So, we can expect that liquidators will need to determine if there was a preference payment.
We still have a lot more to see this year in terms of how "normal" the year will be for insolvency. However, the High Court has taken an early decisive move to try to make the law clearer in relation to unfair preference claims.
In this environment we expect more companies to be at risk of insolvency and at risk of being wound up by creditors. If you are concerned about the solvency of your clients or customers, or are experiencing payment defaults, we recommend seeking advice on how best to resolve the situation.
How can Sharrock Pitman Legal help?
If you have a specific issue about insolvency, whatever that may be (whether in relation to pursuing or resisting a claim), please do not hesitate to contact member of our Disputes & Litigation Team.
The information contained in this article is intended to be of a general nature only and should not be relied upon as legal advice. Any legal matters should be discussed specifically with one of our lawyers.
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Mitchell is the Managing Principal of our law practice.
He is an Accredited Specialist in Commercial Law (accredited by the Law Institute of Victoria). He also deals with areas of Employment Law, Wills & Estate Planning and Probate. For further information, contact Mitchell on his direct line (03) 8561 3318.