arita article-no setting-off unfair preferences

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Edition: v2803

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Legal update

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No setting-off unfair preferences

Sub-headline:

Why s 553C of the Corporations Act should not apply to unfair preference claims.

Author: (name, title, organisation)

Matthew Hudson, Manager, SV Partners (SV Voidables)

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There has been much conjecture within the insolvency profession since the decision handed down by Searle DCJ in Moreton v Rexel Electrical Supplies Pty Ltd [2015] QDC 49 (the Rexel case). For those readers not aware, in the Rexel case, Searle DCJ held that the set-off provision in s 553C of the Corporations Act 2001 (Cth) (the Act) applied to reduce the recoverable amount of the unfair preference claim brought by the liquidator under ss 588FA, 588FC, 588FE and 588FF of the Act.

Before creditors, advisors and practitioners rely too heavily on the Rexel case, it is important to take a look at some issues not directly addressed in that case, which may otherwise have had a bearing on the decision.

For the reasons set out in this article, I submit that s 553C of the Act should not apply to unfair preference claims (and by extension all other voidable transactions),[1] notwithstanding the recent trend and weight of authority which seems to favour the application of s 553C to voidable transaction and insolvent trading claims.[2] The recent decision of Edelman J in the Hussain case delivered some important obiter comments regarding s 553C[3] and this aspect of His Honour’s judgment is briefly addressed in the discussion below.

Elements of a s 553C claim

Section 553C of the Act takes account of mutual debits, mutual credits and other mutual dealings between the parties with the net result taken to be a debt owing to or by the liquidated company. In the Rexel case, the Court allowed the defendant to use its proof of debt as a mutual credit causing the Liquidator’s preference claim to be reduced from $197,469.16 to $132,811.01.

Although not dealt with in the Rexel case, it is important to consider the word ‘mutual’, which has a long history of jurisprudence in common law set-off and statutory set-off throughout the United Kingdom and Australia, to which I make the following observations:

Mutuality

Section 553C requires the person seeking to rely upon s 553C to prove mutuality, in that the following elements must be met:[4]

1.The mutual debts, mutual credits and other mutual dealings must arise between the same persons

2.The ‘benefit or burden’ of the mutual debits, mutual credits and other mutual dealings must lie in the same interests, and

3.The mutual debits, mutual credits and other mutual dealings must be commensurable.

The date s 553C is assessed

There is a large body of law in the United Kingdom and Australia dealing with the nature and timing of statutory provisions similar to s 553C. Authority points to s 553C being a ‘self-effectuating’ event in that at the time of reckoning an account is automatically taken (as long as all of the elements of mutuality are met) and the balance of the account is either admissible as proof against the company in liquidation or payable to the company by the creditor. [5]

In other words, the time of reckoning is taken to mean immediately before the time that the winding-up is taken to have begun (as to which see ss 9, 513A, 513B and 513C of the Act).

What about contingent liabilities or contingent assets?

Australian law is unequivocal in that a contingent liability, which is provable in a liquidation, or a contingent asset may be set off.[6]

AASB 137, ‘Provisions, Contingent Liabilities and Contingent Assets’ sets out the recognition criteria for contingent liabilities. Paragraph 10 provides that a contingent liability is:

a)a possible obligation that arises from past events; or

b)a present obligation that:

i.is not probable to cause an outflow; or

ii.the amount of the obligation cannot be measured with sufficient reliability.

Four reasons s 553C should not apply

I submit that for the following reasons, s 553C cannot apply to unfair preference claims:

1. The most problematic issue that has not been addressed by the Rexel case is why the proof of debt should be deducted from the unfair preference claim twice, insofar as s 588FA(3) of the Act is concerned.

In Rees v Bank of New South Wales (1964) 11 CLR 210, the High Court of Australia held that the applicable calculation in determining ‘the running account balance defence’ in s 588FA(3) of the Act was the peak debt of the running account less the provable debt owing on appointment. This gives effect to the ultimate effect of the series of transactions enunciated in Airservices Australia v Ferrier.[7]

In a recent case in which SV Voidables acted, an unfair preference claim was brought against a trade creditor who raised s 553C in defence. The impact of raising s 553C (if it applied) meant that the liquidator’s claim could be reduced as follows (using hypothetical figures):

Peak debt during the relation-back period

$170,000

  Less POD lodged by the creditor (s 588FA(3))

($75,000)

  Less POD lodged by the creditor (s 553C(1))

($75,000)

Recoverable preference

$20,000

Therefore, if ss 553C and 588FA(3) of the Act apply, in most cases (although, I admit, not all), the provable debt of $75,000 would be subtracted twice from the preference claim. This outcome to my mind would be wholly unsatisfactory.

It is arguable that the purposes of ss 553C and 588FA(3) of the Act are analogous. It is said that the purpose of the introduction of ‘statutory set-off’ (i.e. 553C) is to ‘protect those who engage in mutual dealings’[8] and to do that which is ‘just and equitable’.[9] Similarly, ‘the running account balance defence’ (i.e. s 588FA(3) of the Act) is said to give effect to the totality of the dealings between the creditor and the company,[10] such that there must be no cessation of the mutual assumption of payment (or part thereof) and an inducement of further supply.[11]

Both provisions seemingly give an assessment of the totality of the mutual dealings, such that only when one party receives a greater benefit should (in effect) a rectification occur.

However, this is by no means all encompassing. The early cases that applied an equivalent ‘running account balance defence’ did so on the basis that the former legislation required one to look at the ‘effect of giving the creditor a preference, a priority or advantage over the other creditors’[12] (emphasis added).

It was not necessarily applied as a matter of policy to protect defendants to unfair preference claims, but rather as a critical component in assessing the ‘ultimate or preferential effect’ of the transactions. Therein lies the difficulty, and one which will likely only be resolved by a Superior Court or the Legislature.

2. Until the appointment of the liquidator, there is no contingent liability that exists at law or otherwise.

My reasoning can be expressed by the following four propositions. Firstly, for s 553C to apply the contingency must have existed prior to the ‘time of reckoning’.[13]

Secondly, the right to pursue an unfair preference does not arise until the company is placed into liquidation and therefore only vests in the liquidator. This is reinforced by the terms of s 588FF(1) of the Act, which provides that the court may make orders about voidable transactions ‘on the application of a company’s liquidator’.

For instance, Street J has contrasted unfair preference claims with a ‘misfeasance claim’ by stating that the preference ‘became available only in, and for the purpose of, the winding up of the company.’[14]Section 588FF(3)(a) of the Act also provides guidance by declaring that the period during which a claim may be brought by a liquidator commences on and from the relation-back day (see ss 9, 513A, 513B and 513C of the Act).

Thirdly, throughout the period of trading between the creditor and the company, neither the creditor nor the company would have treated in their financial accounts the monies received by the creditor (later found to be unfair preference transactions) as a contingent liability or a contingent asset.

Fourthly, the definition of a contingent liability or contingent asset requires an ‘obligating event’ that can only arise where it can be enforced by law. As the right to pursue an unfair preference cannot be enforced at law until after the time of reckoning, no contingent liability can be said to arise in favour of the company at any time prior to the reckoning time.

3. The argument that the legislature intended to create mutuality.

Pursuant to s 588FF(1)(a) of the Act, the proceeds from a voidable transaction claim are required to be paid to the company. It has been argued that this requirement was the legislature expressing an intention to create mutuality. I disagree with this argument.

To begin with, the right to proceeds only comes about upon an application brought by the liquidator, or following an accepted offer of compromise out of court. As there is a long chain of events that need to occur in order for the right to proceeds to even arise, it is important to note what Rich J said in Hiley v The Peoples Prudential Assurance Co Ltd (1938) 60 CLR 468 about mutual dealings for the purpose of statutory set-off: it is a ‘right … without any new transaction, [that] grow[s] in the natural course of events.’

To my mind, this ‘dealing’ (if that is what the fruit of a voidable transaction claim is) cannot possibly be said to ‘grow in the natural course of events’.

The next consideration is to look at the works of the published author and Sydney barrister, Mr Rory Derham, especially where Mr Derham describes the right to the proceeds from s 588FF in terms of ‘beneficial ownership’.[15] It is contended by Mr Derham that because the company does not ‘own’ the proceeds for its own benefit and does not have the right to deal with the proceeds in its own right, the company does not hold the beneficial ownership of the proceeds. Rather this beneficial ownership is said to vest in the liquidator and the company’s creditors.[16]

Mr Derham describes this limitation as follows:

Prior to liquidation, the company could not charge or assign the claim as future property … Nor could it give an effective release in relation to any such claim in a future liquidation. The claim is given for the benefit of others (the company’s creditors), and the company could not deal with it as its own.[17]

I would add to these limitations the fact that no company in Australia would make contingency disclosures in their financial reports that each payment they receive from their customers could be clawed back as unfair preference claims in the event of a customer’s liquidation. To the average businessperson, such payments would never be considered as contingent liabilities.

Notwithstanding this, should it be accepted that unfair preference proceeds should be construed as contingent statutory debts, other fundamental concerns arise for consideration:

Does this mean that s 477(2A) of the Act requires liquidators to seek approval of creditors, a committee of inspection (if formed) or the court every time it wants to compromise an unfair preference or other claim (i.e. ss 588FF or 588M of the Act) of more than $100,000? (Brereton J answered this in the negative in In the matter of 246 Arabella Investments Pty Limited (In Liq) [2012] NSWSC 1212.)

Does the so-called ‘debt’ then fall within the ambit of general security agreements, thereby recoverable by secured creditors in priority to all other creditors? This was decided in the negative in the cases of NA Kratzmann Pty Ltd v Tucker [No 2] (1968) 123 CLR 295 (Kratzmann); Sheahan v Carrier Air Conditioning Pty Ltd (1997) 189 CLR 407; and Re Yagerphone Ltd [1935] CH 392.

In Kratzmann the High Court said ‘a statutory right in and only in the liquidator to make such a claim could never have been property of the company subject to the charge. However, in Re Cook; Italiano Fruit [2010] FCA 1355, Finkelstein J cast doubt upon the issue.

Does this statutory debt concept then extend to exposing liquidators to the scenario in which a liquidator can sue another liquidator that has recovered an unfair preference from a creditor that subsequently goes into liquidation?

4. The application of s 553C to voidable transactions defeats the objective of Part 5.7B of the Act.

Cases confirming the application of 553C to insolvent trading claims and voidable transaction claims have rejected arguments pointing to the purpose of Part 5.7B as an answer to why s 553C does not apply. Notwithstanding this, s 15AA of the Acts Interpretation Act 1901 (Cth) requires the court to consider the purpose of Part 5.7B as part of its reasoning.

As readers well know, the primary purpose of the unfair preference provisions is to promote equality of distribution among creditors. This purpose is directly undermined by the application of s 553C to allow a pre-liquidation debt to be set-off against a liquidator’s unfair preference claim. Various cases have expressly rejected the application of a statutory set-off to voidable transaction claims.[18]

Looking ahead

Further jurisprudence and attention needs to be directed towards statutory set-off law, especially the long history of case law dealing with concepts such as mutuality, before stakeholders readily begin applying s 553C to set-off pre-liquidation debts against liquidators’ unfair preference claims.

It will be interesting to see how the courts clarify this issue in the future.

 

[1] This article only deals with unfair preferences, however, many of the concepts are transferable to all types of voidable transaction and insolvent trading claims.

[2] See for instance Shirlaw v Lewis (1993) 10 ACSR 288; Re Parker (1997) 80 FCR 1; Re Pipeline Induction Heat (Australia) Pty Ltd; Duncan v Vinidex Tubemakers Pty Ltd [1999] SASC 157; Hall v Poolman (2007) 65 ACSR 123; Buzzle Operations Pty Ltd v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47; and Smith v Bonѐ [2015] FCA 319.

[3] Hussain v CSR Building Products Limited, in the matter of FPJ Group Pty Ltd (In Liq) [2016] FCA 392, 226-246.

[4] See Facade Treatment Engineering Ltd v Brookfield Multiplex [2015] VSC 41, 64 citing Gye v McIntyre (1991) 171 CLR 609, 623-624.

[5] Gye v McIntyre (1991) 171 CLR 609, 18; Barry Smith Grains Pty Limited (In Liquidation) v Riordan Group Pty Limited [2010] NSWSC 1072, 19; Barton v Atlantic 3 Financial (Aust) Pty Ltd [2004] QSC 376, 40-51 citing Stein v Blake [1996] 1 AC 243, 622, Citicorp Australia Ltd & Anors v Official Trustee and Bankruptcy & Anor (1996) 71 FCR 550, 551, GM and AM Pearce & Co Pty Ltd v RGM Australia Pty Ltd [1998] 4 VR 888, Metal Manufacturers Ltd v Hall & Hall (2002) 41 ACSR 466, 469, Re Capel; Ex parte Marac Finance Australia Ltd v Capel & Anor (199) 48 FCR, 195; Derham, R ‘Recent Issues in relation to set-off’ (1994) 68 ALJ 331, 358. 

[6] Day & Dent Constructions Pty Ltd v North Australian Properties Pty Ltd (1982) 150 CLR 85.

[7] (1996) 185 CLR 483, 503. See also Jetaway Logistics Pty Ltd & ORs v Deputy Commissioner of Taxation [2008] VSC 397.

[8] Grapecorp Management Pty Ltd (in liq) v Grape Exchange Management Euston Pty Ltd [2012] VSC 112, 57 citing Day & Dent Constructions Pty Ltd (in liquidation) v North Australian Properties Pty Ltd (Provisional Liquidators Appointed) (1982) 150 CLR 85, 107.

[9] Collins v Collins (1759) 97 ER 579, 582-583.

[10] Rees v Bank of New South Wales (1964) 11 CLR 210; Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266; Airservices Australia v Ferrier (1996) 185 CLR 483.

[11] Sydney Appliances Pty Ltd v Eurolinx Pty Ltd (2001) 37 ACSR 477, 148.

[12] For instance, see Richardson v Commercial Banking Company of Sydney Ltd (1952) 85 CLR 110, 6 citing s 95 of the Bankruptcy Act 1924-1950 (No. 37 of 1924 – No. 80 of 1950).

[13] See Grapecorp Management Pty Ltd (in liq) v Grape Exchange Management Euston Pty Ltd [2012] VSC 112, 52.

[14] Re Fresjac Pty Ltd (1995) 65 SASR 334, 38 citing Re Asiatic Electric Co. Pty Ltd (In Liq) [1970] 2 NSWR 612.

[15] See Derham, R, ‘Set-off against statutory avoidance and insolvent trading claims in company liquidation’ (2015) 89 ALJ 459, 469-476.

[16] Cf the thoughtful corollary by Finkelstein J in Re Cook; Italiano Fruit [2010] FCA 1355, 62.

[17] Derham, n 28 above, 475. See also Lygon Nominees Pty Ltd v Commissioner of State Revenue (2007) 23 VR 474, 32.

[18] Calzaturificio Zenith Pty Ltd (In Liquidation) v NSW Leather & Trading Co Pty Ltd [1970] VR 605, Re Amour ex parte Official Receivers v Commonwealth Trading Bank of Australia (1956) 18 ABC 69, Cashflow Finance Pty Ltd v Westpac Banking Corporation [1999] NSWSC 671, 574, Re Anglo-French Co-operative Society; ex p Pelly (1882) 21 CH D 492, Re Etic Ltd [1928] 1 CH 861, 873 and Re Buchanan Enterprises Pty Ltd (No 2) (1982) 7 ACLR 407.

 

This paper first appeared in the ARITA Journal.

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