Seven tips for advisors to consider when providing services to an insolvent entity.
We often hear business advisors concerned about payments of their fees clawed back by a liquidator as a “preference payment”. And just as often we’re asked how advisors can protect themselves from becoming embroiled in such a claim in the first place.
Here is a brief background to the preference payment provisions and some useful tips to help advisors not fall in the realms of having received a preference claim.
A preference payment or “preferences” as they are known in the industry, are payments (or transfers of assets) that give one creditor an advantage over other creditors. Put simply, it is where one creditor is paid more than another creditor in the lead up to a liquidation. Payments that are seen to have preferred a particular creditor within a certain period before a company is placed into liquidation, may, be recovered by a liquidator (i.e. clawed back).
For a liquidator to successfully prove a preference payment was made to a creditor, they must first establish the following points prescribed in section 588FA of the Corporations Act 2001:
- The company, and the creditor are parties to the transaction (even if someone else is also a party).
- The creditor that received the payment was an unsecured creditor.
- The transaction occurred within six months before the liquidation “commenced” (i.e. six months before the relation-back day).
- The company made the payment when it was insolvent, or the company became insolvent as a result of the payment/transaction.
- The payment resulted in the creditor receiving more than they would have in a liquidation scenario. That is, they received more “cents per dollar” on their debt than other creditors did or will receive.
Assuming a liquidator can establish these points, they have a fair chance of convincing a court that the monies should be repaid to the liquidator (noting that the vast majority of preference claims are in fact settled outside court).
However, there are ways for advisors to protect themselves and reduce the risk of being involved in a transaction that could be pursued as a preference claim by a liquidator. The options explored below are designed to give some guidance and help advisors from being caught in the crossfire when their client becomes insolvent.
Some things for advisors to consider include:
1. Get your fees pre-paid wherever possible—especially if you’re dealing with a potentially insolvent client
Because to be preferential a payment must be a transaction between the company and a creditor, payments in advance may be beneficial. If you’re never a ‘creditor’ of the company, you will not be subject to the preference payment provisions. Getting pre-paid (either upfront or by monthly fee instalment arrangements) for your services is a great way to ensure a preference claim will never be a consideration.
2. Get paid by a third party outside of the company
Clearly to be a preference the company and the creditor must be parties to the transaction. However, while a payment from a third party may arguably not fall into that category, a transaction involving the company, the creditor and a third party can still be regarded as preferential (i.e. essentially the third party must be a volunteer).
3. Work the running account
If there is a ‘continuing business relationship’ between you and the client that gives rise to a running balance account (i.e. a fluctuating debt balance), then it is the net position of all the transactions over the relevant period that is important—this is known as the “net effect” of the transactions.
The relevant period is six months prior to the start of the liquidation if the appointment type is a voluntary liquidation (it is a longer period for a court liquidation and is dictated by the date the winding up application was filed).
Work the running account in your favour to limit or extinguish any potential preference claim. The key for a liquidator is to show whether the debt owed to you increased or decreased during the relevant period. If the balance owed to you decreased, this amount is the potential preference amount (with all other factors being considered). If the balance owing increased, there is no preference as you were actually disadvantaged by continuing to transact with the client over the relevant period.
Also give consideration to the implication of the peak indebtedness rule that denotes the point (or peak) of when the debt decreased and to what value. Call us to discuss how this works and how it can impact preference claims.
4. Take security where you can
Secured creditors are not subject to the preference payment provisions. Where possible and appropriate, and before services are incurred: seek security and register a security interest over the company on the PPSR. Ensure your engagement terms contain a charging clause (including over the business assets if possible). Obtain personal guarantees from directors and ensure they take the form of an equitable charge over their real property.
If you are going to take security, make sure you act quickly as the granting of the security itself may be deemed a preferential act.
5. Stay on top of your debtor’s ledger and talk to Worrells early
It’s only a preference if there were reasonable grounds for you to suspect the impending or actual insolvency. If you have a client that’s tinkering on the edge, the best thing to do is contact your local Worrells office and get the client informed about their financial issues. Minimise having insolvent clients that drag their financial issues out.
And while there is no minimum amount defined to pursue a preference claim, as a rule of thumb payments to a creditor during the relevant period for less than a few thousand dollars are generally not commercial for a liquidator to pursue. Therefore, by being on top of your debtor’s ledger and proactively getting clients to address any financial issues they have, the more likely it is that you will not be caught up in a preference payment claim.
6. Doctrine of Ultimate Effect
When all else fails and you find yourself on the receiving end of a preference claim from a liquidator, the legal principle known as the Doctrine of Ultimate Effect may serve to assist you in defending the liquidators claim. Where it is applied, the Doctrine creates a higher threshold for establishing an unfair preference than would otherwise result from a literal interpretation of section 588FA.
The Doctrine was explained in Airservices Australia v Ferrier—that for a payment to be preferential “it must ultimately result in a decrease in the net value of the assets to meet the competing demands of other creditors”. So, in essence, if you can show the payment resulted in an increase or preservation of the value of the company’s assets (such as through the provision of professional services that would not otherwise have been provided and directly benefited the company), you can potentially argue the payments are not preferential.
It has been held however that the Doctrine will not extend to certain transactions (including where the payment is made in respect of a past debt and is not made to secure the continuing provision of goods or services).
Whether the Doctrine of Ultimate Effect can be used must be assessed on a case by case basis. Call us to discuss how this works and how it can impact preference claims.
7. Talk to the liquidator, negotiate, and if required seek legal advice
As insolvency practitioners we are commercially-minded people. If you are the subject of a preference claim, it is best to deal with matters head-on. Talk it through—obviously if you or your clients receive a demand from a liquidator, then you should obtain appropriate legal advice before seeking to defend any such claim yourself.
While these considerations are relevant to advisors and their fees, some of these tips might apply to business clients with the same concerns.
For further guidance in this area, contact your local Worrells Partner.