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unfair preferences

Unfair Preferences are the most common type of voidable transaction and occurs where a creditor has received an advantage over other creditors, by receiving payment (or other type of transaction) for their outstanding liabilities and does so in circumstances where they knew, or ought to have known, that the company was insolvent. The elements of unfair preferences include:

A transaction was entered into between the company and an unsecured creditor of the company during the relation-back period

Key terms

  • Transaction – a transaction is defined to include payments of money, transfer of property (which can include personal property, equipment, boats, cars and real property) or the entering into agreements
  • Unsecured – a liquidator cannot pursue a creditor for unfair preferences if they are a secured creditor, but only in proportion to the value of that security. This means that if a creditor validly registers on the Personal Property Securities Register (PPSR) and holds security over the company’s assets that is greater than the sum of the purported preference payment, then the creditor would likely be safe from a liquidators claim
  • Between the company and the unsecured creditor – the transaction must be between the company and the unsecured creditor. It will not be an unfair preference if the creditor receives money from a third party in satisfaction of the liability owed by the company. 

However, this is not always the case. The below diagram and paragraphs explain:

In this example,

  • The company owes the creditor $10,000
  • The third party (let’s say the third party is a debtor of the company) owes the company $10,000
  • The company directs the third party to pay the creditor $10,000, representing the sum that is owed by the third party to the company
  • The $10,000 payment made to the creditor removes any liability owed by the company to the creditor and any liability owed by the third party to the company

The courts have said that the payment of funds from the third party to the creditor may still be deemed a transaction between the company and the creditor, and therefore, potentially susceptible to being clawed back as an unfair preference.

Relation-back period

The relation-back period is the 6 month (for unrelated parties) or 4 year (for related parties) statutory time period during which a transaction must have occurred, in order for the liquidator to be able to recover the transaction as an unfair preference. The relation-back period is calculated as the period from the earliest of (known as the relation-back day): 

  • The date that the company is deemed to have been wound-up (eg the date of the creditor’s voluntary winding-up or the date a winding-up order is filed in court); or
  • The date voluntary administrators are appointed.  

Of interest is that if the court orders that the company be wound-up (in what is called an Official Liquidation (OL)), then the relation-back period extends not only 6 months (or 4 years, if related parties are involved) from the date of the filing of the winding-up orders in court, but also between the date of the filing and the actual winding-up order being handed down by the judge. 

 

The ultimate effect of the series of dealings (eg the supply of goods by the creditor and the subsequent payment for those goods by the company) during the relation-back period must be that the total outstanding balance owed to the creditor must have decreased

By way of example:

  • Say we present the following fictitious supplier ledger showing the dealings during the relation-back period for a creditor that is owed $100,000 by a company that went into liquidation on 31 December 2014:
Date Transaction type Amount ($) Running balance
1 July 2014 Balance carried from prior period   $500,000
15 July 2014 Supply of goods $20,000 $520,000
31 July 2014 Payment ($100,000) $420,000
1 August 2014 Payment ($100,000) $320,000
15 August 2014 Supply of goods $20,000 $340,000
31 August 2014 Payment ($240,000) $100,000
31 December 2014 Company in Liquidation   $100,000

 

As you can see from the above table:

  • On 1 July 2014, the company owed the creditor $500,000
  • During the relation-back period (being 1 July 2014 to 31 December 2014), the creditor supplied further goods worth $40,000, but received payments totalling $440,000

Although payments totalled $440,000, the liquidator could only pursue the creditor as an unfair preference (if all other elements are met) for the difference between:

  • The peak debt owed by the company during the relation-back period and the debt owing on the relation-back day = $520,000 less $100,000 = $420,000.

This is because, arguably, some of the payments were made to induce further supply of goods by the creditor to the company (which totalled $40,000).

The company was insolvent at the time of the transaction or the transaction caused the company to become insolvent

The test of insolvency incorporates what are colloquially known as the cash flow tests and balance sheets tests of insolvency. Basically, where a company is unable to pay debts as and when they fall due and payable, then the company is insolvent.

What is the balance sheet test?

  • Not the definitive test of insolvency
  • An assessment of the company’s financial reports (eg balance sheet and profit and loss statement) to ascertain a snapshot of the company’s financial position at the time of the transaction
  • A comparison of current assets to current liabilities is regularly used to measure the working capital of the company (known as the liquidity ratio)
  • Requires an assessment of the financials, and potential adjustments, to ascertain the correct position or performance of the company

What is the cash flow test?

  • Regarded as the best test of insolvency
  • Looks at all of the available assets of the company, including those assets or funds it may otherwise be able to acquire (eg from bank loans, undrawn overdraft facilities, related parties, equity contributions), and assesses whether the company can pay its due and payable debts now and into the immediate future

Please view a checklist of indicators to look for that may point to one of your creditors being insolvent. 

By receiving the transaction the creditor received more than what they otherwise would have received in the Liquidation of the company, if the creditor was forced to repay the transaction and instead prove in the Liquidation

By way of example:

  1. A liquidator claims that a creditor received $100,000 in preference payments and demands repayment
  2. The liquidator has not realised any cash in the liquidation (and does not expect to realise any other assets, except this preference claim)
  3. The total creditors in the liquidation are owed $500,000
  4. The creditor is still owed $50,000 in the liquidation
  5. Simply put (assuming no fees are paid to the liquidator and no priority creditors exist), if the creditor was ordered to repay the preference payments, then:
  6. The $100,000 would be evenly distributed amongst all creditors totalling $600,000 (being $500,000 + $100,000), meaning a dividend of 16.67 cents in the dollar would be paid (ie $100,000/$600,000)
  7. The creditor would receive approximately $25,000 (calculated as $150,000 (being the $100,000 repayment + $50,000 already owed) x 0.1667 cents in the dollar)
  8. Accordingly, the creditor would have received $75,000 more than what they otherwise would have received in the liquidation

It is important to note that the courts have determined that the relevant date for testing this calculation is not as at the date of each transaction, rather during the actual liquidation. 

The creditor knew, suspected or ought to have known that the company was insolvent when it received the transaction

Creditors can defend themselves from unfair preference claims where they can prove that they did not know and ought not to have known that the company was insolvent. Being a defence, this means that it is the creditor that carries the burden of proof.

Any of the following characteristics may mean that a creditor is barred from arguing that they received the payments in good faith and without knowledge of the company’s insolvency:

  • Excessive pressure by debt collection teams within companies;
  • Statutory demands and other informal demands;
  • Long outstanding debts;
  • Round payments; or
  • Dishonoured payments or post-dated cheques.

What can creditors do?

Call or contact SV Voidables. We specialise in assisting creditors defend unfair preference claims, by utilising unique strategies and tactics to minimise the amount of money you have to pay to the liquidator (if any) or fees to defend in court.

 

 

Contact our Voidables team

If you have any questions relating to our Voidables services, please contact one of our expert advisors.

 

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Secured creditors, unfair preferences and Liquidators

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