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Preferences in bankruptcy: What is a preferential payment in bankruptcy?

Preferential payments or ‘preferences’ are payments or asset transfers to creditors that give them an advantage over the other creditors. This factsheet outlines the basics of how preferences in bankruptcy works.

What are preferential payments?
Preferential payments or ‘preferences’ are payments or asset transfers to creditors that give them an advantage over the other creditors. Bankruptcy trustees can recover these payments or transfers under the provisions of the Bankruptcy Act 1966. Preferences are usually payments of money, although a variety of transfers of assets can be deemed as preferential.

Who may recover preferential payments?
In personal insolvency administrations, only trustees of bankrupt estates and personal insolvency agreements—where the agreement allows—can claim the return of preferential payments.

Why do trustees void preferential payments?
The trustee’s main role is to distribute a bankrupt’s assets fairly between their creditors. To do so a trustee must identify whether any creditor received a distribution—prior to the bankruptcy—that was not equitable when compared to the distribution to other creditors in the bankruptcy. Trustees can void transactions that involve one creditor to make a more equitable distribution to all creditors.

What are the elements of a preferential payment?
Before a court will void a payment or transfer, it must be satisfied that:

  • a transfer of property was made (usually a payment of money)
  • something passed from the bankrupt to a creditor, or on the creditor’s instructions
  • it occurred at a specific time when the bankrupt was insolvent
  • it occurred within the relevant period before the bankruptcy
  • the transaction gave the creditor an advantage over other creditors—usually determined by the creditor receiving more than if they had proved for that amount in the bankrupt estate
  • the creditor suspected—or should have suspected—that the bankrupt was insolvent at the time.

When is someone insolvent?
The Bankruptcy Act defines being insolvent as “not being able to pay all your debts as and when they become due and payable”. To have a preference voided, the bankrupt must have been insolvent at the time of the transfer or payment. The reasoning is that a solvent person has the capacity to pay all their debts (regardless of whether they actually did), and therefore no creditor could have been advantaged over other creditors by receiving the transferor payment.

Who has to prove insolvency?
The onus of proving insolvency is on the trustee.

Must there be a debtor–creditor relationship?
Yes. The transaction must involve or have been done at the direction of a bankrupt’s creditor, and must have satisfied a debt that would have been provable in the estate if the transaction had not been undertaken.

Must there be a transfer of an asset?
Yes. There must have been a transfer of some property between the parties. Commonly a transfer is a payment of money, but any asset passing from the bankrupt to the creditor—even an asset that is created by the transaction, e.g. a security—is sufficient to be a transfer of property. The amount of the preference claim is the value of the asset transferred.

What is the relevant period?
The transfer of the asset must occur during a specific period before bankruptcy, which depends on how the bankruptcy was commenced:

  • Creditor’s petition—six months before it was filed.
  • Debtor’s petition—six months before it was presented.
  • Debtor’s petition where a creditor’s petition is pending—on the commencement of bankruptcy, which is the earliest act of bankruptcy within the six months before the creditor’s petition was filed.

Must the debt be unsecured?
Yes. A preference cannot be given to a creditor holding a security over assets. However, if the security was not properly created (i.e. not valid), or the value of the security is less than the payment amount, then the transfer, or the excess value over the security’s worth, may be deemed as preferential.

How is preferential treatment determined?
The creditor must have received more than if they had refunded the monies and proved for that amount in the bankruptcy. This is purely a mathematical calculation. If the creditor did not receive more in the payment than they would have received from a dividend in the bankruptcy, there is no advantage or preferential treatment.

What statutory defences are available to creditors?
There are three conditions of statutory defence:

  1. The transfer was in the ordinary course of business.
  2. The recipient acted in good faith.
  3. The recipient gave market-value consideration, or at least market value.

The creditor must prove all three conditions of the defence, otherwise the entire defence fails. The transfer is not voidable if it was made following a maintenance agreement or order under the Family Law Act 1975, or was made under a Part IX debt agreement under the Bankruptcy Act.

What is the ordinary course of business and good faith?
The creditor must not have acted in any manner that would give the impression that they were not acting in good faith or under normal trading conditions. For example, actions that may refute good faith are issuing proceedings or statutory notices to the debtor (prior to being a bankrupt), or ceasing supply of goods and services. The creditor must not have forced the payment by way of threat or action.

What is market value consideration?
Usually the easiest condition to prove is that a creditor gave market-value consideration. If the creditor is a trade creditor, the initial supply of goods or services that created the debt provides the market-value consideration. A loan creditor can rely upon the initial loan to the bankrupt. A creditor will only have to show that they have given something of similar value in consideration for receiving the payment.

When will the statutory defences not be available?
A creditor cannot rely on the statutory defences when they knew—or had reason to suspect—that the bankrupt was insolvent and that the transaction would give them a preference over the other creditors.

What should creditors do if a trustee claims a preferential payment?
Broadly, creditors should make sure that:

  • the transaction happened within the relevant period
  • they are not a secured creditor
  • they were a creditor when the payment was made and that it was not a cash-on-delivery type transaction
  • the trustee shows that they received an advantage over the other creditors.

The following points are more detailed and complex to determine:

  • Whether the creditor gave extra credit to the debtor after the payment in question was received. The claim may be reduced, or eliminated, by the amount of extra credit the creditor granted. This is commonly known as the ‘running account defence’.
  • That the trustee can show insolvency at the time of, or before, the payment was received.
  • Whether the creditor is likely to convince a Judge that all three of the statutory defences are available to them.

What can creditors do if they have to refund money to a trustee?
Creditors that refund preferences can lodge a proof of debt in the bankruptcy for the amount refunded. Creditors may also have rights under any guarantees given by other parties that support that debt.

How long does the trustee have to make a claim?
A preference claim must be commenced within six years after the bankruptcy commenced. A trustee must issue legal proceedings within the six-year period—not just make a formal demand.

The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Last Updated: 3.11.2017