13 September 2018

What to do when faced with a liquidator pursuing you for alleged Unfair Preference Payments? Here Daniel Turk looks at the latest defences that may be available to creditors and how to assess your potential exposure under the Unfair Preference regime.

About the Author
Daniel Turk is the practice head of Turks Legal Commercial Disputes and Transactions Group. He's been in practice for 20 years and leads a team across Sydney, Melbourne and Brisbane who provide advice and litigation in areas such as debt recovery, Retention of Title, Unfair Preferences, winding up bankruptcy proceedings and commercial settlements. Daniel is also a leading expert on rights and obligations under the PPSA.

What is an Unfair Preference claim?

To explain the meaning on an Unfair Preference claim, let’s look at this scenario:

A company is in financial difficulty and struggling to pay their debts. They owe three different creditors $5,000 for goods supplied to their business. The struggling company decides to pay only one of these three creditors – the one that has been applying the most pressure. Shortly after, the company is placed into administration and eventually into liquidation.

According to the legislative basis of Unfair Preferences (Corporations Act 2001), the liquidator can argue that it isn’t fair that one of the creditors received $5,000 and the other two creditors didn't get anything. The liquidator can attempt to reclaim the $5,000, adding it to the pool to pay all the creditors.

 A liquidator should seek to satisfy these four elements before bringing an Unfair Preference claim against a creditor:

  1. The debtor company (the company that has gone into liquidation) must be insolvent at time of payment. It's a cash flow test as to insolvency, and the courts will look at whether the company was unable to pay its debts as and when they fell due.

    Creditor Tip! As soon as you receive an Unfair Preference demand, try and get as much information from the liquidator as to the financial position of the company at the time the payments to you were made. If there was an administration period, the administrator might have a report on the past financial performance of the company and whether it was insolvent at a particular point in time.

    You can also request financial information from the liquidator like audited financial statements demonstrating the company was insolvent at that time. The liquidator is obliged to provide this information under the new Insolvency Practice Schedule Rules [Schedule 2 to the Corporations Act 2001 (Cth) (Act), and in Part 3 of the Insolvency Practice Rules (Corporations) 2016 (Cth) (IPR)].

  2. The payment made to the creditor is in relation to unsecured debt.
  3. The transaction gives the creditor an advantage over other creditors. In other words, the liquidator needs to show that the creditor was better off receiving the payment than not.
  4. The transaction occurs within a particular timeframe – commonly six months. Any payment the creditor receives in the six months before the company goes into liquidation is at risk of having to be repaid to the liquidator.

    This timeframe may extend to more than six months depending on what is determined as the actual date the liquidation commenced. If it were a voluntary liquidation, the backdate would be the date of the appointment of the liquidator. Alternatively, it is the date of the filing of the winding up application where the court appoints the liquidator to wind up the debtor company in insolvency. If this is the case, the Unfair Preference period may well extend beyond six months because the application may have been filed months before the winding up order was made.

Defences available to creditors

Let’s look at the defences that are available to creditors who've received an Unfair Preference claim.

Creditor Tip! Look through your email history over the year before your customer’s liquidation. Your correspondence should show that your customer did not indicate the real reason they were delaying payment.

  1. No suspicion of insolvency

    As a creditor, you can use the defence that you had no idea your customer was insolvent. Be prepared to show that there were no reasonable grounds to suspect the debtor was insolvent at the time payment was made.

  2. The debt was secured

    You need to show the debt was secured, not unsecured, which is an essential element of an Unfair Preference claim. See subheading Am I secured?

  3. The running account reduction applies

    Where there has been ongoing trade and ongoing supply during the relevant period where the debt has gone up and down, liquidators sometimes chase the payments back without considering that there was further supply in that period. You can use the running account reduction calculation to argue for reduced exposure based on ongoing supply. See subheading Running account reduction.

  4. Set-off unpaid debt

    As a creditor, you may be able to set-off what is owed to you at the time of the appointment of the liquidator or administrator against the Unfair Preference claims made. See subheading Set-off is available.

Am I secured?

For a liquidator to bring an Unfair Preference claim against a creditor, they should be satisfied the payment was made in relation to unsecured debts. While the Corporations Act doesn’t define unsecured debt, it does define ‘secured party’ as those with a PPSA security interest (Personal Property Securities Act). A trade creditor may have their debt be secured by:

  • Charge/mortgage
  • Consigning goods – a security interest over the goods until purchase and payment occurs
  • Bailment – handing over possession of goods to somebody else for two years or more (or for an indefinite period in certain situations)
  • Retention of Title over the assets supplied until payment occurs.

As a trade credit supplier, including a Retention of Title clause in your terms of trade, may give you a security interest over your customer. With this security interest, you can register on the Personal Property Securities Register (PPSR) and claim to be a secured creditor.

If you’ve received payments before your customer goes into liquidation and you’re being pursued for Unfair Preferences, you may be able to use the defence that you were secured at the time the payment came in.

How is security valued?

Just because you have security over an asset, doesn't mean the security has any value. Take this hypothetical example:

You have two mortgages over your house. The house is worth $500,000, and you owe the the first mortgagee  $400,000. The bank is secured for $400,000 because the house is worth $500,000. But if there was a second mortgagee who was owed $200,000 and they were registered on the house, they wouldn't be secured for the whole $200,000. They would only be secured for the difference between how much the bank is owed and the value of the property. So, although a second mortgagee would be owed $200,000, they're only secured for $100,000.

This example shows us that a creditor is only secured to the value of the security held. So, when raising a defence that you're a secured creditor, you need to show the liquidator that your security actually has value. Security includes:

Creditor Tip! If you've got a Retention of Title clause and you've received an Unfair Preference claim, find out what stock the customer had of yours at the time the preference payment came in. 

Creditor Tip! When you’re trying to assess what your security interest is worth, ask the liquidator for a stock list for the particular point in time and the company unpaid debtor list for on-sold the goods you supplied.

Creditor Tip! You’re entitled to request the liquidator’s reports. If you can see from the reports that there was an invoice financier aboard, you may be able to make a claim on that money as far as it relates to the financing of invoices for the on-sale of your goods.

  • Unpaid stock on hand
  • Unpaid debtor receipts for the on-sale of goods. If your customer uses the goods you supply to manufacture another product and sell it to a third party (or they sell your goods to a third party), any receipts that are due become part of your security interest.
  • Invoice finance monies. Invoice finance companies take a security interest over the invoices, and under the PPSA they have first rights to the payment that comes in from the debtors. If any of the finance money that has been paid by the finance company to your customer relates to the financing of the invoices where you supplied the goods, the PPS legislation states that this finance becomes part of the security interest.

What if the creditor is not registered on the PPSA? We all know that when you've got a security interest against one of your customers, it's crucial that you register on the PPSA. If you don't register your security, when your customer goes into administration, your security interest becomes void against the debtor company. Failing to register on the PPSR or making an error in registration can leave you with no security to claim at the point of liquidation.

What recent case law shows us

Here are three cases where creditors who had Unfair Preference claims made against them, used the defence that they were secured creditors.

  1. Ross Andre Blakely & Australian Music Pty Ltd v Yamaha Music

    [2016] VSC 231 – delivered on 10 May 2016

    • Victorian Supreme Court
    • $3.6 million of potential Preference Payments
    • Yamaha had credit applications in 2008, 2010 and 2012 which had Retention of Title
    • Most of the $3.6 million payments they received were before the PPSA commenced in January 2012.
    • Yamaha defence: they were a secured creditor.

    Liquidator argument: A secured party is defined as holding a PPSA security interest, yet the PPSA didn’t start until January 2012. The Retention of Title clause pre-dated the PSSA; therefore, there is no security interest.

    Court findings: The three creditor payments were definitely in relation to an unsecured debt because the PPSA wasn’t in existence. The Retention of Title clause couldn’t be regarded as security at that point in time. Yamaha was also asked to repay the small portion of payments they received after the PPSA had started as transitional interests are not secured interests under the legislation.

    How security was valued: at the date of winding up, not when the payments were received.  

  2. Hussain v CSR Building Products Ltd in the matter of FPJ Group Pty Ltd

    (in Liq) [2016] FCA 392 (13 May 2016)

    • Australian Federal Court
    • Preference Payments totalled $153,000
    • 2010 credit application which had a Retention of Title clause
    • Never registered on the PPSA
    • CSR Building Products defence: they were a secured creditor.

    Liquidator argument: The debt was unsecured as it was a pre PPSA credit application and not registered

    Court findings: CSR is a secured creditor even though it didn’t register its interests on the PPSR as  as payments CSR’s Retention of Title clause was considered “in substance” a security.

    How security was valued: no comment from the court.

  3. Trenfield & Ors v HAG Import Corporation (Australia) Pty Ltd

    [2018] QDC 107

    • Queensland District Court
    • HAG Import had accidentally registered a transitional PPS registration when it should have been non-transitional
    • HAG Import defence: they were a secured creditor because even though they didn’t have a valid PPS registration, there was a Retention of Title clause in their 2011 credit application, which they updated in 2013.

    Liquidator argument: HAG wasn't entitled to have a transitional registration because their terms of trade postdated the PPSR commencement and therefore was unsecured.

    Court findings: Security is valid at the time of payment due to the retention of title clause even if the registration didn’t protect the supply.

    How security was valued: at the date of payment.

These later cases show that secured creditors with Retention of Title can use this as a defence in Unfair Preference claims. What's important is to show that you have security. In the recent Queensland District court case, the court looked at what the unpaid debt was and subtracted the stock on hand value. If there was anything left over that was unsecured, any payment coming in was deemed to be part of the unsecured portion of the debt.

There is no preference when the stock value on hand far exceeds the value of the debt (as there is more than enough security).

Running account reduction

The running account reduction can be an effective way to reduce your risk of Unfair Preferences if there has been ongoing trade. This calculation considers that there has been continuous supply during the relevant Unfair Preference period, rather than the more common approach by liquidators of just looking at the payments received over that time.

Australia and New Zealand have a different way of doing this calculation.

In Australia, we look at the peak indebtedness. Create a chronological list for the six-month period (or the relevant period of the Unfair Preferences) that shows what the outstanding debt was. Add in invoices on a sequential basis and deduct credits where payments have been - this gives you a running balance through the whole period. And where you've got a peak indebtedness ($A), liquidators can look at the peak point at any time in that six-month period and the final amount owing ($B). The difference between the two is used to determine the potential preference.

If $A > $B there is a potential preference

If $A < $B there is no preference

The New Zealand calculation is one to watch, as some academics believe it is the better option. You deduct the difference between the payments ($A) the vendor receives and the supply invoices ($B). If you received more payments than debts incurred in that period, there is a potential preference.

If $A > $B there is a potential preference

If $A < $B there is no preference

Set-off is available

Section 553C of the Corporations Act can assist creditors under which mutual debts are set-off in a liquidation. Liquidators are allowed to set-off mutual claims as against each other in proofs of debt. For example, a creditor may put in a proof of debt for $100,000, but if the creditor actually owes $50,000 to the customer, then the liquidator can argue that this has to be reduced down to $50,000 on the basis of the set-off.

There has been some case law that has allowed setting-off by creditors on debts owed to them as against the liquidator’s Unfair Preference claims. Examples include:

Morton v Rexel Electrical Supplies Pty Ltd [2015] QDC 49

District Court of Queensland, 2015

  • Morton owed Rexel monies
  • There was an attempt by Rexel to set-off the unpaid debt against the he Unfair Preference claims that had been made by the liquidator
  • The legislation doesn’t permit the claiming of set-off if the creditor actually knew of their customer’s insolvency at the time the debt occurred.

Court findings: the court looked at the notice of insolvency and the debts that Rexel claimed were unpaid. They decided that for some of these, especially towards the end, Rexel should have known before supplying the goods that Morton was insolvent. Therefore, they didn’t allow Rexel to set these later unpaid debts off. However, they did let them set-off the earlier debts as the court believed they couldn’t have known Morton was insolvent when they supplied the goods. This outcome significantly reduced the Unfair Preference claim.

Stone v Melrose Cranes and Rigging Pty Limited [2018] FCA 530

Federal Court of Australia

  • A set-off claim was lodged in relation to the unfair preference claim
  • The court had to determine whether 1) there can be a set-off for unpaid debt, and 2) did Melrose Cranes have actual knowledge that Stone was insolvent when they continued to supply goods.

Court findings: The Court confirmed set-off is available to creditors but was not available to the creditor as the Court found it had actual knowledge of insolvency of the debtor at the time the debt was incurred.

Creditor Tip! Look at what your debt is. Tell the liquidator that this amount owed to you at liquidation is coming off the Unfair Preference claim as a starting point even before all other arguments.

Keep in mind that the seven-year anniversary of the PPSR is approaching, which means all businesses that made seven-year registrations (the most common registration period) will find their registrations expiring from 30 January 2019. If you allow these registrations to expire, you will lose security from that point forward, which will affect your defences against Unfair Preference claims, particularly your ability to recover goods on a winding up.

Visit the Equifax PPSR Knowledge Hub for PPSR help and advice. We take the complexity out of registering security interests, renewing existing registrations and dealing with issues like Unfair Preference Claims. Or email us to discuss your specific PPSR requirements.

Disclaimer: The information contained in this article is general in nature and does not take into account your personal objectives, financial situation or needs. Therefore, you should consider whether the information is appropriate to your circumstance before acting on it, and where appropriate, seek professional advice from a finance professional such as an adviser.