Preferences in liquidation: What is a preferential payment?

Preferences are payments or transfers of assets that give a creditor an advantage over other creditors. Any payments or transfers made to a creditor before to liquidation may be recovered by liquidators in certain circumstances.

What are preferences?
Preferences are usually payments of money, although a variety of transactions could be deemed ‘preferential’.

Who may recover preferential payments?
Liquidators can recover preferential payments; however, recovery may require a court order to perfect the entitlement to recovery. Recovering preferences is not available to provisional liquidators, voluntary or deed administrators, or receivers and managers.

Why do liquidators void preferential payments?
The liquidator’s main role is to distribute a company’s assets between its creditors on an equal basis (pari passu). Liquidators must determine whether any creditor received treatment, prior to liquidation that was not equitable compared to the distribution to other creditors in the liquidation. Liquidators can void transfers that involve one creditor to make a more equitable distribution to all creditors, including the creditor who received the preference.

What are the elements of a preferential payment?
When considering whether a payment is preferential, a court must be satisfied that:

a transaction was entered into (this is usually a payment of monies)
was between the company and a creditor of the company
happened when the company was insolvent
happened within the statutory period before the liquidation started
the transaction gave the creditor an advantage over other creditors
the creditor suspected, or had reason to suspect, that the company was insolvent.

When is a company insolvent?
The definition of solvency is being able to pay one’s debts as and when they fall due. Conversely, if a company is not solvent, it is therefore insolvent. In the context of preferences, the company must have either been insolvent at the time of the transaction or became insolvent because the transaction was made. The reasoning is that a solvent company has the capacity to pay all of its debts (whether they actually did or not) and therefore no creditor could have been advantaged over others.

Who has to prove insolvency?
The onus of proving insolvency lies with the liquidator.

The main elements of a preference

There must be a debtor–creditor relationship
The transfer of property must have involved or been done at a creditor’s direction, and must satisfy a debt that would be a provable debt if the transfer had not been made. A cash-on-delivery (COD) payment for goods is not a payment to a creditor, so is never deemed preferential.

However, suppliers often supply goods on COD with a requirement for further payment towards satisfying an existing debt. This additional payment is deemed preferential and is therefore recoverable by a liquidator.

An advance payment for future works, or the future supply of goods, cannot be preferential, but would be required to be repaid to the liquidator if the services/products have not been used by the company

2. There must be a transaction
There must be a transaction between the company and creditor. Commonly, a transfer is a payment from a company’s bank account, although any asset passing from a company to a creditor is sufficient to establish a transaction.

For example, the return of stock that is not subject to the Personal Property Securities Act 2009 (PPSA), or assignment of a debt, would be a transaction for the purposes of the preference provisions.

3. The relevant time period
The transaction must have occurred during a specific period before the ‘relation back-day’. The actual period depends on whether the recipient is related to the company, and on the company directors’ intention. The periods are:

six months for non-related parties
four years for related parties
ten years for any evidence of “attempt to defeat, delay or interfere” with the rights of creditors.

The relation-back day is the date that the liquidation is deemed to have started. For the various types of liquidations, the relevant days are:

for a liquidation that follows a voluntary administration or Deed of Company Arrangement (DOCA), it is the day that the voluntary administrators were first appointed
for other voluntary liquidations, it is the date of the members’ meeting that the liquidators were appointed
for a court appointment it is the day that the application was filed in the court.

4. The debt must be unsecured
A preference does not apply to a creditor holding a valid and subsisting security over company assets pursuant to the PPSA, where the value of the assets secured is greater than the payment amount. But, if the security is not properly created or registered, or the value of the security is less than the payment amount, the liquidator may render it void and the debt may be deemed unsecured.

Other provisions also apply to securities provided to related entities and created within six months of the start of the liquidation. The creation of a security itself within the six months can also be a preference.

5. Continuing business relationship
The continuing business relationship provision is similar to what was previously known as a ‘running account’. The business relationship provision is used to determine the amount of any preference received by a particular creditor; it takes into account all transactions between relevant dates. It shows whether the owed debt increased or decreased to the creditor during that period.

If the balance owing decreased, this amount is the potential preference amount, with all other factors being considered. If the balance owing increased, there is no preference as the creditor is actually disadvantaged by the transactions.

The liquidator determines the start date and concludes on the date the winding up commenced.

6. The creditor must obtain a preference
The creditor must have received more than they would have received if they refunded the monies and proved for that amount in the liquidation process. If the creditor did not receive more by way of the payment than they would have received from a dividend, there is no advantage or preferential treatment.

What defences are available to creditors?
Section 588FG of the Corporations Act 2001 provides defences that may be available to creditors who received preferential payments. To rely on a defence, a creditor must be able to satisfy all three conditions of the defence. The onus of proving the defences is on the creditor, it is not for the liquidator to disprove them.

The three conditions of the statutory defence are:

the creditor gave valuable consideration for the payment
the creditor received the payment in good faith
the creditor had no reason to suspect the insolvency of the company.

Each of these conditions is outlined as follows:

What is valuable consideration?
Usually, the easiest condition to prove is the creditor gave valuable consideration. For trade creditors, the initial supply of goods or services provides the valuable consideration. A loan creditor can rely on the initial loan to the company. The creditor will only have to show that they have given something of value in consideration for receiving the payment.
What is good faith?
The creditor must not have acted in any manner that would indicate they were not acting in good faith or under normal trading conditions. Actions that may repute good faith are: commencing proceedings or issuing statutory notices; ceasing supply; or changing to a COD basis. They must not have forced the payment by any form of threat or action.
What is needed to suspect insolvency?
The creditor must not have received or have known of any information or circumstance that would lead them (or a reasonable person in their position) to suspect that the company was insolvent. It is not necessary that the creditor knew, or believed, or even expected that the company was insolvent to lose the benefit of this defence. The mere suspicion of a reasonable person is enough.

Actions such as receiving post-dated cheques, dishonouring cheques, entering into repayment agreements, knowing of other creditors that are unpaid and pressing for payment can reasonably lead to this suspicion. Whether or not a person should have suspected insolvency is often difficult to determine particularly as the courts recognise a distinction between a short-term cash flow problem and insolvency.

What should creditors do if a liquidator claims a preferential payment?
Creditors should ensure that:

the transaction was entered into within the relevant period
they are not a secured creditor
they are (or were) a creditor when the transaction was made, and that it was not a cash on delivery payment
the liquidator demonstrates they received an advantage over other creditors by virtue of the payment.

These basic points are usually easy to demonstrate. The following points are more difficult
to determine:

whether the creditor gave extra credit to the company after the payment or transfer was received, whether it is possible that the claim may be reduced or eliminated by the amount of extra credit granted, that is, to determine whether the creditor had a continuing business relationship with the company
that the liquidator can show insolvency at the time of, or before the payment was received
whether the creditor has a realistic chance of convincing the liquidator that the statutory defences apply.

What can creditors do if required to refund money to a liquidator?
Creditors refunding preferences may lodge a proof of debt with the liquidator for the amount refunded. They may also have some rights under any guarantees.

How long does the liquidator have to make a claim?
Claims must be commenced within three years after the relation-back day. A liquidator must issue proceedings within three years—not just make a formal demand. A time extension may be granted by the court, but the application must be made within the three-year period after the relation-back day, and the liquidator must demonstrate a reasonable cause for the delay in initiating the claim.

Disclaimer
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