Unfair preferences to be fairer?
In and amongst the one-off cost of living payments and investments in defence, infrastructure and innovation: there were a few insolvency reforms announced in the recent Federal budget.
One of the announcements was the government’s proposal to amend the rules governing unfair preference claims by liquidators. The reforms’ intent, as the government stated, is to simplify and make fairer preference claims so that creditors who act honestly and at arm’s length shouldn’t be pursued for small payments where a company they dealt with enters liquidation.
What is an unfair preference?
In certain circumstances, payments or transfers made by a company to a creditor before a liquidation may be recovered by a liquidator.
Unfair preferences 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 (generally within six months of the commencement date). 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).
The purpose of “clawing back” unfair preference payments is to enforce equal treatment among creditors. This enables a liquidator to distribute the proceeds of the company's assets—not from what is left at the date of liquidation—but instead from the company’s resources at the date the company became insolvent.
What are the proposed changes?
Under the proposed reforms, transactions that either amount to less than $30,000 or are made more than three months prior to the company entering external administration will no longer be able to be clawed back, provided those transactions involve unrelated creditors and are within the ordinary course of business.
While these changes were announced as being consistent with the unfair preference rules that apply under the simplified liquidation process the government implemented from 1 January 2021, there is no specific “ordinary course of business” carveout in the simplified liquidation regulation.
What isn’t changing
While there are proposed changes to the dollar amount of unfair preferences that may be claimed and a reduced timeframe that such transactions can be claimed, the other elements required to be established to recover a transaction as an unfair preference payment from an unrelated creditor will remain the same. These are:
- There was a transaction (usually the payment of funds or the transfer of an asset) between the company and an (unsecured) creditor of the company.
- The company was insolvent at the time when it entered into the transaction.
- The creditor received more as a result of the transaction than they would have received in the liquidation of the company.
In addition, the defences that unsecured creditors may rely on when faced with a liquidator’s unfair preference claim under section 588FG of the Corporations Act 2001 remain unchanged.
On the assumption that the creditor was a party to the transactions (see section 588FG(1) of the Corporations Act if it was not), three elements must be satisfied:
- The creditor became a party to the transaction in good faith.
- At the time when the creditor became such a party:
- The creditor had no reasonable grounds for suspecting that the company was insolvent at that time or would become insolvent
- A reasonable creditor in the creditor’s circumstances would have had no such grounds for so suspecting.
- The creditor provided valuable consideration under the transaction or has changed their or its position in reliance on the transaction.
Consideration should also be given to the “running account” principle as found in section 588FA(3) of the Corporations Act. Note that this does not provide a complete defence to a claim. In essence, where parties have an ongoing business relationship rather than considering each transaction to determine whether a creditor received a preference, the court looks at the transactions’ net position that formed part of the relationship as if they were one transaction.
Until recently, liquidators could calculate the preference amount under the running balance principle by capturing the highest point of debt owing (“peak indebtedness rule”) to a creditor during the relation-back period as a shorthand way of calculating the net effect of the running account. However, the decision in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (In liq) (receivers and managers appointed)  FCAFC 64 found that the peak indebtedness of a running account does not apply in calculating the value of a liquidator’s preference claim. Read more about this decision and its implications here: Peak indebtedness rule squashed for preference claims
For more information on preference payments or any other insolvency matter, please don’t hesitate to reach out. The teams at Worrells are here to help.