With corporate insolvencies increasing, more companies are making payments to creditors in distressed circumstances.

In certain circumstances, when those companies subsequently go into liquidation, unsecured creditors who have been paid in priority to other unsecured creditors then face demands from liquidators to repay amounts received in the months leading up to the company’s liquidation commencing.

There may be defences available to such creditors, but even where a creditor has done nothing wrong, responding can be time-consuming and costly. The result is a frustrating reality: getting paid can suddenly become a financial liability.

What are Unfair Preference Claims?

Unfair preference claims are claims brought by the liquidator of a company under the Corporations Act 2001 (Cth) against a creditor which has been paid during the relevant period prior to the commencement of the liquidation (the relation-back period). While there can be some variation regarding the commencement of the relation-back period, it is typically the period which is six months prior to the commencement of the liquidation.

Its purpose is to prevent creditors from “skipping the queue” and being able to extract an unfair advantage over other creditors.

When a Payment Becomes a Preference

In addition to establishing the transaction occurred during the relation-back period, the liquidator bears the burden of proving:

1. The company was insolvent (i.e. unable to pay its debts as and when they fell due) at the time of the transaction.
2. The transaction was in respect of an unsecured debt.
3. The creditor must have received more than it would have in the liquidation (i.e. if a creditor would have receive 100c in the dollar by participating in the liquidation, there is no unfair preference, though this is obviously rare).

A quick example is as follows:

A supplier is owed $50,000 for goods supplied to a customer.

The customer pays the debt in full.

Two months later another supplier applies to wind the customer up, and the customer goes into liquidation.

Assuming (as is likely) the customer was insolvent when the payment was made, the liquidator may seek to recover the $50,000 from the supplier as an unfair preference.

Defences

There are a number of defences which might be available in respect of an unfair preference claim, including challenges to the above elements the liquidator is required to prove (i.e. denying that the company was insolvent, that transactions were made in the relation-back period or that the creditor was unsecured at the time of the transactions).

In addition to the above, common defences include:

Good Faith

The most commonly relied upon defence to an unfair preference claim is the ‘good faith defence’. To rely on it, creditors must demonstrate that:

1. They received payment in good faith.
2. At the time of the transaction, they had no reasonable grounds for suspecting insolvency.
3. A reasonable person in their position would not have suspected insolvency.
4. They provided valuable consideration or changed their position in reliance on the transaction.

This does not require a complete absence of knowledge of difficulty on the part of the company in paying. The fact a company is late making payment, or that demand has been made, does not of itself mean the creditor ought reasonably have suspected the company was insolvent.

Factors which may, however, be relevant to determining that question include:

1. Repeated and escalating demands.
2. Payment persistently outside terms or in amounts not referrable to invoices.
3. Proceedings being commenced.
4. Knowledge of other creditors.
5. Payment plans being breached (particularly repeatedly).
6. Creditors statutory demands being served.

On the one hand, it is understandable for companies to pursue payment of liabilities, however in pursuing such liabilities too aggressively, companies often inadvertently build a paper trail which limits the availability of a good faith defence and makes unfair preference claims easier for liquidators.

Running Account

A running account arises where a series of transactions occur between a company and a creditor as part of an ongoing commercial relationship. Obviously where the trading relationship breaks down but payments continue to be made a running-account defence will not apply.

The court looks at the net effect of the continuing business relationship as a whole, rather than treating each payment in isolation.

In many cases, further goods or services supplied after payments are received will reduce or eliminate the value of any preference.

The Takeaway

For business owners, the risk is not just whether a customer pays, but also whether that payment can later be challenged.

To limit the risk of an unfair preference claim being made in the future, businesses should consider:

1. Is there a formal agreement between the parties.
2. Is it appropriate to include security in any such agreement.
3. Has any security interest been properly registered.
4. Are debtors being carefully monitored and managed to prevent arrears from blowing out and necessitating aggressive action.

As with many commercial disputes, proper documentation, good business controls and timely legal advice may offer protection against unfair preference claims.