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That’s Just Unfair! Unfair Preferences in Insolvency Litigation
Substantive Law| What area(s) of law does this episode consider? | Recent developments in unfair preferences under section 588FA of the Corporations Act. |
| Why is this topic relevant? | An unfair preference occurs when there is a transaction to which a company and one of its unsecured creditors are parties, and that transaction results in the unsecured creditor receiving from the company more money than if the transaction had not happened and the creditor instead proved in the winding up of the company. Recent developments in insolvency litigation has seen changes to the calculation of the assets of insolvent companies, the law related to peak indebtedness, and set-off in unfair preference claims. |
| What legislation is considered in this episode? | Corporations Act 2001 (Cth) (‘Corporations Act’) |
| What cases are considered in this episode? | Airservices Australia v Ian Douglas Ferrier and Anor [1996] HCA 54
Cant v Mad Brothers Earthmoving Pty Ltd [2020] VSCA 198
Re Western Port Holdings Proprietary Limited (recs and mgrs apptd) (in liq) [2021] NSWSC 232
Badenoch Integrated Logging Pty Ltd v Bryant [2021] FCAFC 64
Morton & Anor v Rexel Electrical Supplies Pty Ltd [2015] QDC 49
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| What are the main points? |
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| What are the practical takeaways? |
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| David Turner:
1:00 | Hello and welcome to Hearsay, a podcast about Australian laws and lawyers for the Australian legal profession, my name is David Turner. As always, this podcast is proudly supported by Assured Legal Solutions, a boutique commercial law firm making complex simple. One would think that a cause of action that’s existed in its current form more or less for nearly 30 years would be pretty well settled in terms of its elements and defences, but a lot of ink has been spilled (or whatever the digital equivalent of ink in that metaphor is) on the topic of unfair preferences. The peak indebtedness rule, the defence of set-off and the ‘from the assets of the company’ requirement have all been the subject of recent decisions that have surprised, disappointed or intrigued plenty of us insolvency lawyers. Joining me today to discuss these current issues in unfair preferences is Nicola Bailey. Nicola, thank you so much for joining me on Hearsay. |
| Nicola Bailey: | Thanks very much for having me, David. |
| DT: | Nicola, tell me a little bit about your practise at the bar. Do you see a lot of insolvency litigation in your practise? |
| NB:
2:00 | I do. Throughout my career as a solicitor and now as a barrister, I’ve had about a decade worth of insolvency litigation experience. I’ve done a lot of work for insolvency practitioners, both in deeds of company arrangement, liquidations, bankruptcies. I’ve also acted on the other side, so acting for creditors defending claims, acting for directors in relation to insolvent trading claims and an aspect of my work, as well, is acting for and advising insurers, including where there’s a juicy insolvency element that arises in respect to the claim. So against that insolvency background, I would say unfair preferences, unsurprisingly to you, are probably one of the most common claims that are seen. Whether or not they always get to court is, of course, a different story and that can depend on a range of factors such as the quantum of the claim, the nature of the defence, if any is available or that is raised and the commerciality of proceeding. |
| DT:
3:00
4:00 | Absolutely. I’m certain plenty of our listeners who have dealt with unfair preferences before would be familiar with the portfolio of unfair preference claims that might come up of a fairly small value against a number of trade creditors that are kind of explored as a means of building a bit of a war chest for the main set of insolvency proceedings that don’t necessarily themselves go to court. TIP: Let’s get up to speed with the basics of unfair preference claims. Section 588FA of the Corporations Act tells us what an unfair preference is; it occurs when there is a transaction to which a company and one of its unsecured creditors are parties, and that transaction results in the unsecured creditor receiving from the company more money than if the transaction had not happened and the creditor instead proved in the winding up of the company. Under s 588FE, unfair preferences are recoverable from preferred creditors in the period six months before the company was placed into liquidation or voluntary administration – this is called the ‘relation-back period’. Let’s illustrate by way of example. Suppose a sporting goods store bought $1,000 worth of shoes from me a month ago. They pay me for those shoes, $1,000 in full, today. Tomorrow, the company goes into liquidation. The company owes all of its unsecured creditors $1 million, and the company’s assets are only worth $100,000, so creditors are only going to get 10 cents for every dollar they’re owed. But I’ve received payment in full – which means I’ve received an unfair preference. Whether I’m entitled to retain the unfair preference would come down to the defences available to me, including receiving the payment in good faith – but more on that later.
And I’m so glad you mentioned the debtor side insolvency litigation work because I think that having both the appointee or creditor side insolvency litigation work and the debtor side experience really gives you a better perspective on both. I know that, speaking for myself, when I first started practising insolvency law, I was doing so at one of the large law firms, it was exclusively insolvency practitioner and secured creditor work. I didn’t really have a lot of thought about, the position of directors, of creditors who’d received an unfair preference, perhaps, or the people who are usually on the other side of that, and perhaps had too little empathy for their position, but I certainly have more of it now and have you found that that mix of work makes you a more effective insolvency litigator for both sides of the coin? |
| NB: 5:00
6:00 | Absolutely. it’s not uncommon for liquidators or solicitors acting for liquidators to have a semi-template that they can roll out in terms of an unfair preference demand or a voidable transaction demand that just, rolls out some of the seminal cases and then leaves it up to the creditor to try and put forward a good defence or defend their position. So when you’re actually on the other side of that and having to think about what sort of defences might be available and what type of evidence would be needed, it certainly helps inform your view acting for the other side as well. recently, I was involved in a case in the local court where the magistrate stopped at one point and said ‘well, you’ve just handed me 2 volumes of authorities on unfair preferences and voidable transactions, isn’t there one seminal case that sums everything up and the other counsel and I looked at each other and back at the bench and said ‘ha, unfortunately, ha, no. There’s a range of cases that deal with very pointed aspects of the different parts of the legislation. So, apologies, but hopefully the several hundred pages that we’ve just given you covers the field.’ |
| DT: | It’s an interesting point you raise there because a lot of people will think, when they think of unfair preference litigation, that it’s being conducted in the corporations list of the equity division of a superior court and that you’re dealing with a specialist judge who is as familiar with, or perhaps the judge who’s handed down some of these decisions, in relation to the development of the body of unfair preference case law. Is it common to see unfair preference claims in the lower courts and what are some of the unique challenges in bringing a claim in a forum where maybe the judicial officer isn’t as familiar with that body of law? |
| NB:
7:00 | That’s a really good question, David. I wouldn’t say in my experience that it’s common to see unfair preference or voidable transaction claims in the lower courts. Certainly, though, the lower courts are capable of determining an unfair preference claim, obviously within their monetary jurisdictions and, you’re right, there’s certainly a difference between being in a superior court and perhaps making submissions or referring to cases that the judge that you’re appearing before, as you correctly identify, was the judge on that occasion or he’s, written half the law on the topic, versus appearing before a magistrate or a judicial officer who is really not as exposed to the Corporations Act and the various authorities that have developed. I suppose the benefit in the superior court is obviously you are dealing with a judge who has a lot more familiarity, so there’s a level of assumed knowledge up front. Depending on your case sometimes that can be a burden as well, because they know the right questions to ask to expose weaknesses but in the lower courts, in my experience, it’s not uncommon for the magistrate to frankly ask counsel for a helping hand, for a bit of an aide-mémoire, in terms of relevant authorities or parts of the legislation that apply or even to go off bench for a short period of time to read parts of the Corporations Act and then come back again. It certainly does present some differences and some challenges, but it’s not to say that it’s not something that can be done. |
| DT: 8:00 | To play that role assisting the court, you really do need to be up on your current cases because there have been so many recent developments, even over the last 12 months, in unfair preference jurisprudence. Let’s start with that last issue I mentioned in the introduction to the episode, that test about the unfair preference being paid from the assets of the company. Section 588FA says that the creditor has to receive from the company more than they would receive if they proved in the winding up. Why is that language so important? |
| NB:
9:00
10:00 | The language is important because, for one thing, it goes back to the whole policy of part 5.7B which includes the unfair preference legislation and that is fairness; fairness to creditors among creditors of the same class and the whole regime is designed to prevent one creditor from receiving a priority or advantage over other creditors. That’s implicit both in the explanatory memorandum as well as the case law, even going back to Airservices v Ferrier, this whole notion of fairness. The second part to your question, which is receiving more than they would if they proved in the winding up again, harping on the issue of fairness, apart from being uncommercial, it would be unfair for a creditor who receives a small payment in the lead up to a company winding up to have to repay that amount, have it recouped only to then be able to prove for the amount, and receive a larger distribution in the winding up at the end of the day. So, it’s really looking at; ‘did this creditor receive a priority over others if the payment were not to be set aside?’ And, in relation to the first part of your question, receiving from the company, and this certainly has been the subject of some judicial commentary lately, that I know we’ll get to. I think the principle, again, there is fairness. It was traditionally couched more in terms of making sure that, for instance, a guarantor who paid a guaranteed debt wouldn’t be subject to an unfair preference clawback but, as we’ve seen, there have been some recent decisions that have sought to delve a little bit more deeply into what it means to be received from the company. |
| DT: | Absolutely, and the decision we’re about to talk about is the one that’s really thrown this issue into sharp relief because it is an appellate decision and therefore binding on courts around Australia unless it’s obviously wrong. And that’s Cant v Mad Brothers Earthmoving, a 2020 decision of the Victorian Court of Appeal. Tell me a little bit about that case. |
| NB:
11:00 | So in that case we had a number of companies. Eliana had incurred a debt to Mad Brothers for earthmoving services. Eliana went into voluntary administration. It had signed a settlement deed with Mad Brothers, under which it was required to make payment of a debt. The director of Eliana caused another company, of which he was a director, Rock, to pay the settlement amount to Mad Brothers and the important part here was that Eliana actually recorded that payment in its general ledger as an increase in the loan that it owed to Rock. Eliana was then placed into liquidation. The liquidator sought to recover the settlement payment as an unfair preference and the court, in that case, ultimately held that it wasn’t an unfair preference, this settlement amount, because it wasn’t paid from money of the company in liquidation, in that it didn’t result in a net decrease in the assets that would otherwise be available to creditors and this is, I think, probably the bit that caught most people’s attention, including some of your larger creditors. I suspect the ATO, in particular, would be all over this. A payment by a third party that doesn’t have the effect of diminishing net assets of the company isn’t a payment from the company and, in fact, can just be seen as a rearrangement between creditors. |
| DT: | I imagine that’d be particularly concerning for anyone who’s ever received a payment from the director’s personal bank account in satisfaction of a debt. |
| NB: | Credit cards is the other one. |
| DT: | Yes. |
| NB: 12:00 | If you’ve got a credit card facility that’s not secured, which as we know, many corporate entities do, particularly some of the smaller Mum and Dad businesses or even your SMEs, payments are frequently made by credit card, or, as you’ve said, from directors’ accounts. |
| DT: | Yeah, absolutely, or from an overdraft, I understand, as well. |
| NB: | Correct. |
| DT: | Now that case, as I said, has caused a bit of a stir because of the decision being made by an appellate court and therefore, being binding under principles of comity, unless it’s obviously wrong. Has that case been considered here in New South Wales, either by a single judge or by an appellate court? |
| NB:
13:00
14:00 | It has, in fact, it was handed down part way through another hearing which was Re Western Port Holdings Proprietary Limited, which was a matter decided by Justice Kelly Rees in March of this year. Justice Rees commented that the reasoning in Cant left her with some disquiet, but correctly pointed out, as you’ve just said, David, that because it’s a decision of an appellate court it’s binding and she has to follow its unless it was absolutely wrong and there was no reason to suspect that was the case. TIP: Let’s have a closer look at the facts of Re Western Port Holdings. Liquidators of Western Port applied to the Supreme Court of NSW to recover $2 million that they had paid under a deed to the ATO in satisfaction of their tax debts. Most of the payments were made by the company directly, however, some were also made by third parties. Those third parties included David O’Hare, the Chief Financial Officer of Western Port, paying the ATO about $81,000 from his personal bank account in part satisfaction of Western Port’s tax debt. There was a corresponding reduction in the debt he owed to Western Port, according to the general ledger. Other companies also paid the ATO amounts in satisfaction of Western Port’s debt, and again, the amount Western Port owed those companies was subsequently increased in Western Port’s books. Hermes Capital, a financier of Western Port, also paid around $290,000 to the ATO in satisfaction of Western Port’s debt. Now, the ATO argued, successfully, that the third party payments were not unfair preference becausethe payments weren’t made by the company as required by section 588FA subsection 1(b)and ultimately, Justice Rees was bound by the decision in Cant and, thus, the payments made to the ATO by the third parties could not be recovered as unfair preferences. |
| DT: | It’s quite a high bar to find that another appellate court of another jurisdiction has been obviously wrong in its findings is almost a level of offence to that finding, it’s not one to be made lightly, is it? |
| NB: | No, it’s absolutely not. |
| DT: | Now, why did Justice Rees feel some level of disquiet about the finding in Mad Brothersand what is controversial about that finding? |
| NB: 15:00 | This again comes back to his whole policy point of fairness. Re Emanuel and other cases that involve a third party or a series of transactions coming together to constitute the transaction that’s ultimately impugned, so that in itself is nothing new but what Cant was seen to do, particularly by Justice Rees, was to impose into the legislation, an additional requirement that is not present, which is the necessity of demonstrating a decrease in the company’s assets in order to establish a preference claim. Again, going back to the example that was used in Cant, payment from an unsecured facility such as an overdraft may simply result or be seen as a rearrangement between creditors, so again, theoretically a payment from a credit card or from a director’s account wouldn’t necessarily see a net decrease to the assets of the company and the element then of fairness again comes to play. |
| DT:
16:00 | It’s an interesting tension, isn’t it? Because we’ve mentioned fairness a couple of times already in this episode and, of course, the unfair preference replaced the undue preference in 1992, so fairness was definitely part of the purposive interpretation of these provisions and as we said earlier, this whole notion of fairness is around ensuring that creditors are treated pari passu and receive what they ought to receive in the distribution of the company’s assets and so you can see why a diminution in the company assets is kind of this issue that’s germane to the question of fairness, but there’s a great quote in Justice Rees’ Judgement in Western Port, I’m paraphrasing here, about looking to the statutory provision rather than old tests from old case law that’s been rusted on overtime and have become rules of thumb that depart increasingly from the case law. So it is an interesting tension there, isn’t it, between this purposive interpretation of the legislation and a more literal interpretation of the legislation. |
| NB: 17:00 | It is and we have talked a lot about fairness, obviously, as the section suggests. The flip side of the decision in Cant is that a company might unfairly be able to, have itself protected from potential clawbacks, simply by ensuring that any payments that are made come from its director or a friend or an unsecured loan facility and therefore seek to avoid the regime altogether, so that’s the flip side of the fairness argument. |
| DT: | Absolutely. I mean, you could certainly see credit managers all over the country thinking ‘well, we’ll just make sure that our bills can only be paid on credit cards and have a quiet word to the accounts payable people with our customers about paying things from overdrafts and we’ll be OK.’ |
| NB: | That’s right, it can have a real impact on the way that businesses conduct themselves. |
| DT: | And really passed that risk onto financial institutions because those are ultimately the parties who will be left as the unpaid creditors of the insolvent company. |
| NB: 18:00 | That’s right, and what that might ultimately mean is that banks and other financiers quickly rush in now and seek to ensure that any previously unsecured facilities are secured that might then have an impact on a reduction, for instance, in a line of credit, because they will only provide a facility up to some security that they know they can get their hands on in case the company goes into liquidation. |
| DT: | Yeah, absolutely it could affect the ability to obtain finance from another financier if those assets have already been the subject of a first charge, so could have wide ranging implications. |
| NB: | That’s right, and for the companies who often rely on a cash flow basis in that they might pay things by credit card knowing that there is a lump sum payment coming later in the month or part of a project is about to fall due. If the same facilities aren’t being extended by the banks because the banks have been scared off then it might mean that the ability of the company to make its payments, as it has been doing in the course of its business up into account might change. |
| DT: | Absolutely, now I understand you’ve recently worked on a case where this issue about payments being made from the company’s own money was an issue. Can you tell me a little bit about that? |
| NB: 19:00
20:00 | Yeah, sure so in this case I was actually acting for the creditor company, so the alleged impugned preferences that were being made to us. The company in liquidation had arranged for two other companies that weren’t related entities to make payments to the creditor and there were more than ten of them. On each of those occasions, the company in liquidation had recorded on its general ledger, the same as what we saw in Cant, that there was an increase in the company’s indebtedness to the company that ultimately made the payment, that is, there was a loan that was then recorded to the paying company. So, we argued that that was very factually analogous to Cant. You’ve got a company that is making payment on behalf of the liquidated company. The paying company is then having that loan amount recorded on the ledger of the company in liquidation and it can’t be said, therefore,that the net assets of the liquidated company actually decreased as a result of those payments. We’re still waiting on judgement in that one so fingers crossed and we had a few other arguments kicking around as well, including some secured creditor and retention of title type arguments but certainly the findings in Cant and the fact that Justice Rees in Re Western Port had openly and correctly acknowledged that she was bound by the appellate decision, were key parts of our argument there. |
| DT:
21:00 | Absolutely, it’ll be interesting to see what the result is there, and whether, as one would expect given the decision in Western Port, that that will continue to apply as the law in New South Wales. Let’s move on now to another recent development, again this is arising out of a 2021 decision, and this is in relation to what’s been called the peak indebtedness rule. Now let’s start with the rule from which the peak indebtedness rule arises, which is a rule that still very much applies; the net indebtedness rule under section 588FA subsection 3. Now, in a nutshell, what is the net indebtedness rule tell us to do when a creditor has an ongoing trading relationship with the debtor? |
| NB: | So, fondly known as the running account defence, obviously, you’re required to look at the trading relationship between the creditor and the company in liquidation. The notion of a continuing business relationship here is critical. So, you have to look at what was going on, as a whole, in the particular period, how the trade was occurring, whether supply was being made and payments were being made as furtherance of that business relationship and treat the series of those transactions, if there was a continuing business relationship, as one single transaction. |
| DT: | And when we’re talking about these continuing business relationships, the classic one we think of is supply of inventory which is made on credit but on a rolling basis, over the same period in which the invoice is due but it can take a whole bunch of other forms, can’t it? |
| NB: 22:00 | That’s right, a case that I was involved in was the provision of telecommunications services. So, again, not inventory per se or not, the classic widgets being provided, but telecommunications services in the form of a running account. |
| DT: | So that’s the net indebtedness rule, one that’s very much present in the legislation. What was the peak indebtedness rule? What are we talking about there? |
| NB: | So peak indebtedness is the power for the liquidator to have a look at the relation back period and choose the point in time that the debt owed was the highest and to use that as the starting point and compare whatever amount was owing there to what was ultimately found on the relation back day or the end of the continuing business relationship. So, by way of example if, six months before the relation back date, there was a debt of $100,000, it went up to 1,000,000 down to 800 up to 900, and then ultimately ended at 200,000, the liquidator would ordinarily pick that point of $1,000,000 being the highest point, or the peak indebtedness, and net that off against the 200,000 balance at the end of the day. |
| DT: 23:00 | Now, before we go onto the matter of Gunns, which is the decision that has affected this peak indebtedness rule, I have to say the peak indebtedness rule was just received wisdom for so much of the period in which I was doing unfair preference litigation for liquidators. I imagine it was the same experience for you. |
| NB: | Absolutely, and that’s also reflected in a number of judgments, including the Timberworldcase in New Zealand, where, and I am, perhaps, terribly, terribly, paraphrasing here, the court said ‘well, Australian courts seem to have just picked up this notion and run with it but originally it was just obiter dicta and there’s no basis for the courts to have continued to apply it and yet they seem to have in Australia but in New Zealand we don’t think that’s right at all and it should be the doctrine of ultimate effect.’ So, even the courts over time have been critical of this assumed notion of peak indebtedness that has otherwise so permeated our insolvency courtscape. |
| DT: 24:00
25:00
26:00 | It’s a shame to have to admit that New Zealand was ahead of us on something else, yet again, but it does seem like they were. The decision that brought this peak indebtedness rule to an end was in the matter of Gunns, which did identify that there really was no basis in statute or in common law for the rule. TIP: That Gunns decision is the latest decision in a long-running Gunns saga, with the matter coming before the court in 2020 under the name Badenoch Integrated Logging v Bryant, this time on the issue of unfair preferences. Now for those who don’t know, Gunns Limited was a company which operated a forestry investment schemes – a type of managed investment scheme created for the purpose of investing in commercial timber growing. In an earlier 2018 judgment, the Court found that Gunns became insolvent on the 30th of March, 2012. Gunns made payments to Badenoch totalling approximately $3,360,000 from the 30th of March 2012 to the 24th of September that same year. As we’ve been discussing with Nicola, the chief issue in dispute in Gunns was whether the peak indebtedness rule applies in cases involving a running account – in other words, whether the liquidator, when dealing with a running account, can choose the point in the six-month relation-back period where the company owed the most to the creditor, and look at the reduction in the indebtedness of the insolvent company between that point and the end of the period, or alternatively, whether the liquidator had to look at the level of indebtedness at the start and at the end of the statutory relation-back six month period. At first instance, the Court affirmed the peak indebtedness rule, but in 2021 the full Federal Court overturned that decision and rejected the peak indebtedness rule, finding that the rule was arbitrary, and inconsistent with the doctrine of ultimate effect, which is the principle that payments of debts to induce further supply should be examined and evaluated by the ultimate effect that they have on the relationship between the parties, not the effect that they have on the indebtedness of the parties in isolation. You won’t find the ultimate effect doctrine anywhere in the Corporations Act, it has its roots in a 1996 decision of the High Court of Australia called Airservices v Ferrier. What are liquidators supposed to do with the net indebtedness rule now. Where do they count from for the purposes of the unfair preference? |
| NB:
27:00 | Pending any appeal, and I’m sure that there are plenty of insolvency practitioners out there who are crossing their fingers for a successful appeal to revert back to peak indebtedness, what liquidators have to do now obviously is look at the trading relationship, the credit balance at the beginning of your relation back period and then look at what that balance was at the end of the continuing business relationship. Now sometimes, as you know, that can be the date that the liquidators were appointed, so it can run that full span of time. It might be though, in certain cases, that the continuing business relationship finishes earlier than that because there has been a break in the relationship and this is usually where a creditor starts to get a little bit nervous that perhaps the company that ultimately goes into liquidation is heading south and starts demanding payment to try and pay down its indebtedness rather than demanding payment as part of the ongoing supply payment regime. So, whereas before liquidators had the luxury of choosing the most advantageous point in time during that period of setting up preference claim. Now, they are stuck with the beginning of the period and then at whatever point in time that continuing business relationship ends. |
| DT:
28:00 | It’s interesting, I think, an argument that was raised and was ultimately unsuccessful in the case was that point, at the beginning of the relation back period, the six months, is really as arbitrary as any point that the liquidator might choose that the continuing business relationship and the net balance owing in respect of its, could change over that period, over a much longer period, and there really is no difference in terms of arbitrariness between the six months and the point that a liquidator might choose to be advantageous to all creditors. |
| NB: | It is, as you say, a difference in who gets to pick the arbitrary time frame. The court acknowledged that there was a degree of arbitrariness, even if you do apply the ultimate doctrine effect but I think took some comfort in looking back to the actual wording of the section and saying ‘well, if there is arbitrariness then that’s what the section actually requires’ and it comes back to that principle of fairness. This is an arbitrary point that we think the legislation picks rather than the liquidator picking a point that might be more beneficial to creditors as a whole but possibly less fair to the creditor with particular impugned transactions. |
| DT: 29:00 | Yes, we should just mention, because some of our listeners might be wondering what we mean there, the break in a continuing business relationship where a supplier might start to suspect or have reasons for suspecting, to use some of the statutory language, that the debtor might be insolvent. The classic example of that is imposing a cash on delivery requirement in that continuing business relationship or requiring some other security to be given by the debtor as a condition of that supply continuing. Have you seen any other examples of the sorts of events that can signal a break in that continuing business relationship? |
| NB: | I’ve seen some fantastic examples from a liquidator perspective where internal records of the creditor say things like: File note: suspect that this company is insolvent, as it’s unable to pay its debts as and when they call you. |
| DT: | Yeah, you must be very happy to find something like that. It’s like they read the legislation first. |
| NB:
30:00
31:00
32:00
33:00 | Unfortunately though, I’ve also seen that when I’ve been appearing for the creditor and have seen copies of their files and come across notes like that and gone ‘hmmm maybe we need to have a bit of a lesson here in the types of things that you record on your internal memos or the types of things that you put in emails’ because of course, another classic example, David, is the email correspondence either internally within the creditor or from the creditor to the debtor saying ‘I’m really concerned that you’re not able to pay these debts and they’re now overdue,’ things like that are unfortunately red flags to a bull in terms of indicating a knowledge or an awareness of suspicion or grounds to suspect insolvency and then a change to the creditor relationship. Going back to your question about whether or not I’ve seen examples other than the cash on delivery, of course stop supply is another really classic one or the change in payment terms. TIP: Companies which supply goods on credit are well aware of the risk that a payment they receive from a company in distress can be clawed back as an unfair preference. So, ifa supplier begins to suspect a company is insolvent, they may end their provision of credit to the company and instead insist on cash on delivery. In a cash on delivery arrangement, no relationship of creditor and debtor ever exists between the customer and the supplier. No debt is owed because the goods are paid for in full when delivered – so payments made in that arrangement cannot be considered unfair preferences. On the other hand, switching a customer to a cash on delivery arrangement speaks volumes about the supplier’s suspicions that the company was insolvent. So, any payments in reduction of the outstanding debt for the goods supplied on credit are much more likely to be found to be unfair preferences.
Similarly, where a company opts to stop supply, well that’s just what it says on the tin, Itmeans they are refusing to continue supplying goods or services to that company until their outstanding debt is paid in full. Now, a move like that might seem like a good way to exert some pressure to clear some aged debt – but that payment could be clawed back as an unfair preference, and the stop supply arrangement used as evidence that the supplier suspected insolvency.
Something that’s quite common, particularly in trade industries, is invoices will get sent out with payments of say net 14 days or COB+30 but the actual business relationship has always been that everyone knows that the conditions on the invoice are never adhered to or expected to be adhered to and really so long as payment is made within a month and a half or two months or whatever the case may be, then that’s acceptable but when the threat of insolvency or the debt starts rising a bit too high, you start seeing the creditor wanting to actually impose the payment obligations that are written on the actual invoices. They then turn around and say ‘there’s no change in our business relationship because our invoices always required payment within this time’ but that can unravel when you start looking at what the actual conduct between the parties was and if it is the case that the written terms were never actually imposed then that’s another potentially damning implication for the creditor. |
| DT: | Isn’t that an interesting example? I’ve always thought of it as either a change to payment terms or a change the terms on which suppliers made something that changes the legal nature of the terms but this idea of being free to waive the extant legal terms or the extant payment terms on which payments made and then making a decision not to waive them anymore and to enforce them, that’s a really fascinating example that I’ve not come across, so, thank you for that. It seems that with both the from the assets of the company tests that we just discussed and now this end of the peak indebtedness rule and also when we come on to discuss, very briefly, the availability of set-off as a defence to unfair preferences. All of these developments in the last year-18 months have really been very creditor friendly changes. Do you see that trend? |
| NB: 34:00
35:00
36:00 | I do and I understand where you’re coming from in terms of it being creditor friendly on an individual basis, I suppose there’s an argument that it’s less creditor friendly to the body of creditors. Of course, if you’re an unsecured creditor, you’re always happy for some other poor creditor to have unfair preference payments being impugned if it results in more money in your pocket at the end of the day but no one wants to be that poor creditor. In terms of where it might head and what it might mean in terms of what we see in the courts and the decisions that now follow. As we discussed at the beginning, unfair preferences and certainly demands for preferences are extremely common. It’s also very common for those demands to ultimately not require determination by the court, either because there’s a commercial rationale and the parties see light and decide to resolve it or when the liquidators have been able to use the peak indebtedness rule, you’re starting from a position where the liquidator is possibly already on the front foot because if you’re a creditor and you’ve seen the debt that’s owed to you gradually escalate then certainly at some point you do want to take steps to try and have that paid down, and that is often where the liquidator picks up the peak of point indebtedness. So the type of communication that you’re likely to see after that point will often negate any available good faith defence to the unfair preference regime. If we’re now though, having to look at the whole of the period, it might be that we actually see less claims making it to court and that could be for a number of reasons. Firstly, it might be that liquidators decide either that the quantum of the potential claim isn’t worth it from a commercial sense and obviously liquidators having duties to creditors and not to expend costs and commence proceedings and spend court costs with inherent uncertainty. But it might also mean that if a proceeding is commenced, that the creditor who now has, in one sense, the luxury of the period of time to demonstrate what was actually going on in the relationship, is more confident in its ability to prove that there was this continuing business relationship for the whole period. So, we might see less cases, but the ones that we do see may be more heavily defended. |
| DT:
37:00 | It’s an interesting development. It’s one that ultimately had to happen because as we both recognised, although we might have been happy to follow that assumed knowledge or received wisdom for quite some time, there really was no basis in law for following it. It’s a shame that New Zealand worked that out before us though. The last controversy or recent development in unfair preference jurisprudence that I want to discuss today, and it’s a big one and I think we can really only scratch the surface, it’s probably something for another episode to really do a deep dive into, is the availability of the defensive of set-off in unfairpreferences, a bit like our ‘from the assets of the company’ tests that we were discussing earlier, this is one that’s been the subject of plenty of disquiet expressed in obiter. We’re talking about set-off here under section 553C of the Corporations Act rather than equitable set-off, for example, or set-off at common law. Tell me a little bit about section 553C? |
| NB:
38:00 | So, as you have correctly said, David, obviously, 553C provides an ability for a creditor to try and reduce the claim that the liquidator is making by reference to a set-off, by saying ‘dear liquidator, it might be that I owe the company in liquidation some money, however the company liquidation also owes me some money and therefore we set them off and the net effect is a lesser claim and sometimes can even the debt situation completely’. The case that a lot of people refer to in the statutory sense is the case of Rexel v Morton, which was a case in the District Court of Queensland. We spoke before about whether or not voidabletransaction claims can have any appearance in the lower courts, and here is a classic example of where that might happen. |
| DT:
| Yeah, absolutely and that is the case that kicked off this whole discussion about the availability of the set-off in unfair preferences. It was preceded by another case, a decision of a superior court in terms of the availability of set-off in voidable transactions more generally, that was Buzzle Operations, but that was in relation to a different kind of voidable transaction, wasn’t it? |
| NB:
39:00 | It was and part of the judicial commentary and the criticism and the difference, perhaps in opinion, has been the availability of set-off and whether it can only apply to certain transactions and not others and there has been, as I said, a difference of how the courts have interpreted that for a while there was, as you said with Buzzle, the indication that set-off was available. There was some criticism in the Victorian case of Hussain. So, the pendulum has swung both ways in recent times, whether or not there will be a crystalising case in the same way that we have started to see in Gunns in terms of the peak indebtedness or in Cant in relation to 588FA, remains to be seen. |
| DT:
40:00 | Mmmm, absolutely, because we’ve had, as you say, comments both ways since Morton v Rexel but only by single judges and often in obiter. You mentioned Justice Edelman and Hussain delivered some obiter against the availability of set-off and, of course, that judgement is now looked back on with some greater weight because of the position he now holds. Justice Markovic in the Federal Court in Stone v Melrose Cranes delivered a judgement where set-off was applied in an unfair preference matter and then Justice Gleeson, here in New South Wales, again, just obiter against it in Force Corp. So, it has been really back and forth and another one of these developments that does seem to favour the individual defendant creditor over the greater body of creditors. I don’t know that any lawyer would be prepared to bet on where this issue is ultimately going to land, but Nicola, if you had to throw your chips in on one side of this controversy or the other, do you prefer the view that set-off applies, or that it doesn’t? |
| NB:
41:00 | It’s a difficult question. I’m certainly attracted to the reasoning in Buzzle and in Rexel and I can see the commercial and the legal rationale for it. That said, though, I think that unlike perhaps the peak indebtedness and doctrine of ultimate effect where it is an arbitrary benefit to the liquidator and creditors in one sense if we’re looking at just the doctrine of ultimate effect This question is perhaps a little more complicated and involved in the legislative framework and, similarly with Cant, there was a focus specifically on whether or not the words from the company were incorrectly imposed into the wording of the section and the issue of set-off in 553C crosses a few more legislative provisions and considerations then we’ve seen in some of the recent cases. |
| DT: | Absolutely. One of the arguments that comes up in the theoretical discussion of the availability of set-off here is the existence of mutual credits and debits at the time that the unfair preference comes to exist because there’s this argument that because the liability, in respect of the unfair preference, can only ever arise after the company is wound up. It’s not in existence at the time that any setting off debt arises. |
| NB:
42:00
43:00
44:00 | I’ve seen arguments run where set-off has been disputed on the basis that either the arrangement involves a different party or a third party, or it’s somehow not arising from the same transactional relationship. So, certainly there are lots of tentacles to be considered. TIP: Now, between the date of recording our interview with Nicola and the date of publication of this episode, there has been a very important development in this area. In Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited [2021] FCAFC 228, the full Federal Court has held, in answer to a separate question reserved to the Court, that s 553C set-off is not available as a defence to an unfair preference claim. Allsop CJ delivered the main judgment, with whom justices Derrington and Middleton agreed. Poetically, Gavin Morton, the liquidator in Morton v Rexel, the District Court of Queensland decision that kicked off this whole controversy, is also the liquidator in this case. The answer to this controversial question of the availability of set-off ultimately came down to statutory interpretation. The Full Court found that on a proper construction of the unfair preference provisions, the nature of a creditor’s liability for an unfair preference was such that there was no mutuality between that liability and the company’s own debt to the creditor to permit a set-off to apply. In particular, the Full Court held that the purpose and object of the unfair preference provisions – alluded to in s 588FI of the Corporations Act as being to “put the company in the same position as if the transaction had not been entered into” – was inconsistent with a reading of the Act that permitted set-off under s 553C. Now, as I said, while Allsop CJ delivered the 216-paragraph main judgment, Middleton J’s 4-paragraph judgment probably contains the most digestible, nutshell version of the Court’s finding, which I’ll recite an extract of now: The ultimate conclusion is that the relevant legislative provisions deny the character and quality of mutuality to the debt of the company to the creditor and the obligation of the creditor to pay the company under s 588FF. The significant point (again as observed by the Chief Justice) is that the obligation to pay under s 588FF arises from an order of the Court sought upon the application of the liquidator. It is not an obligation owed to the company arising from a right it has against the creditor. |
| DT:
45:00
46:00
47:00 | Yeah, absolutely and 553C it’s a legislative set-off, it’s not the same as an equitable set-off where if the equities permit it then even in the absence of a mutuality of parties it might be permissible to allow that set-off. It’s a statutory provision and has to be applied according to the language of the legislation. TIP: Equitable set-off does not merely arise where there is a demand and a cross-demand. Equitable set-off arises where a defendant can show that the existence of their cross-demand “impeaches the title” of the plaintiff to their own demand. That test has also been described as being a circumstance where it would be unjust to allow the plaintiff’s claim to proceed without allowing for the defendant’s claim. Unlike set-off between liquidated claims under the Civil Procedure Act, equitable set-off can arise between unliquidated claims; and unlike set-off under s 553C, for example, equitable set-off can even arise where the parties to the claims are not mutual. For example, say there is a dispute between the landlord and a tenant. The tenant is successful in suing the landlord for a breach of the lease, and obtains a judgment for damages against the landlord, that’s the demand. If the landlord were to transfer the land to a related party, the tenant would be entitled to set-off the damages claim against the rent due under the lease, that’s the cross-demand, under equitable set-off, even though the damages claim is against the related party; the damages claim impeaches the title of the new landlord to the rent. Now for a time, it was thought s 553C was the only right of set-off available against a company in liquidation – that s 553C was ‘a set-off code’ that excluded other rights of set-off like equitable set-off. However, the Western Australia Court of Appeal’s decision in Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd [2018] WASCA 163 confirmed that s 553C is not a code – it doesn’t exclude pre-existing set-off rights like equitable set-off – so it’s worth remembering these other kinds of set-off rights, even in insolvency. We’ve covered today two still developing issues in relation to the from the assets of the company tests and the availability of set-off in unfair preferences and we’ve also covered an issue that now seems to be well settled, but certainly in a surprising way for a lot of insolvency practitioners and insolvency lawyers. We really have to keep an eye on all three of these issues and how they affect the pursuit of unfair preference litigation and, as we were discussing a little bit earlier, the availability of credit more broadly from trade creditors and financial institutions. We’ve talked about 3 quite recent developments in this area and for someone who doesn’t practise in this area all day, everyday it would be easy to miss something like this. How important is it to be keeping on top of these kinds of developments in the common law that might be coming about, you know, when we’re talking about Gunnsevery six months or so? |
| NB:
48:00 | It’s always important to keep abreast of the developments but I think at the moment when there has been so much movement, it’s even more important. I had an experience not too long ago where I referred to the case of Cant and then Western Port for the bar table and I could see from the corner of my eye opposing counsel quickly getting out their phone and Googling the decisions to see what it was that I was talking about and we then received a slightly different set of submissions overnight. So, at the moment when there is, in particular, so much flux on such critical issues that for years people have assumed have been interpreted one way, that it’s more important than ever to make sure that insolvency practitioners follow what the developments are and how they might impact the cases. The unfair preferences and voidable transactions regime, yes, there are some key cases that everyone can roll off the tip of their tongue but it always will come down to the particular facts of each case and the nuances from one case to another. If you are a defending creditor or from the liquidator’s side, if you’ve got a wealth of material and documentation that might tell for or against the good faith defence, being up to date on not only the overarching commentary, but also the nitty gritty of some of these cases, can really mean the difference between resolution in your favour or an early settlement that’s more palatable than might otherwise be. |
| DT:
49:00 | Absolutely, and these aren’t issues at the margins either. If we’re talking about the from the assets of the company test, that’s really one that’s going to determine whether you’ve got an unfair preference cause of action at all. We’ve got set-off which is really about whether there will be a defence available to that claim at all, and then the peak indebtedness rule, at the very least, could substantially affect the quantum of an unfair preference claim. So, certainly not issues at the margins, and certainly ones that you do need to keep abreast of and, as you say, not just the overall flow of these cases over the past few years, but really the detail of them to identify how they’ve come to arrive at these different results over the years. I have to say even researching the position in terms of set-off for this episode, I had to remind myself of where things were up to. Was set-off in again, or was it out? I couldn’t quite keep track of it myself. |
| NB:
50:00 | In relation to the position that we’ve discussed in Cant, the particular facts of a case might dictate whether or not you’ve got a transaction that happens to include a third party, but with assets properly flowing throughout each of those three parties or whether it is simply a third party independently making a payment to the creditor that doesn’t result in a net decrease. So, it will really only be incumbent upon liquidators to make sure that they get to the bottom of the transactions and how they were conducted and what the threads were in all respects, it won’t simply be enough now to say ‘well, you were a director of A and B, and A owes the debt, but we can see that on the same day B paid it’ that might no longer be sufficient. |
| DT: | No, not if there’s no demonstrated diminution in the assets of the company. That story you told about seeing your opponents frantically searching on the phone it makes you cringe, but you also have to have a bit of empathy for someone who finds themselves in that position. If when you’re in a hearing, you’re confronted with a decision that you aren’t familiar with or you’re confronted with a submission on a decision that you’re not familiar with, and perhaps you asked a question about that. In practical terms, what should you be doing? Hopefully, not just searching it on your phone and trying to make do with the five minutes you’ve got. |
| NB: 51:00 | Never bluff the court is something that I’m sure someone imparted to me once and I’ve taken to heart. If you’re up in the corporations list before Justice Black, for instance, you’ve got zero chance of trying to bluff him on a corporations issue if you simply don’t know the case that is being referred to, especially if he was the presiding judge. Some advice that I gave recently to a mooting team that I was coaching was to find a good phrase or series of words that buys you some time, whether that’s just ‘let me collect my thoughts’ or ‘I’ll take the question on notice and might I have a few minutes’ but I think you never be afraid of telling the court that you need some time before you provide your response because you could be cutting off your nose to spite your face otherwise. |
| DT: | Absolutely, I think, ultimately, people are worried about losing their credibility before a judge, especially one they appear in front of frequently but it enhances your credibility really to be able to admit that you haven’t read a judgement that’s being referred to, and that you do need some time to reflect on it. That’s a credit to an advocate rather than a mark against them. |
| NB:
52:00 | I certainly hope so because it’s a practise that I adopt but particularly when we’re talking about cases that have such significance and these are not two page judgments that you can wrap your head around by doing a quick Google search, so I think it’s always worth the time to make sure you have a proper understanding before making any submissions or response about it. To the extent that you can do a quick Google, especially at the moment where hearings are being conducted by Teams or by telephone, at least you can Google something to see if the case actually exists or have an idea of what it is that they’re talking about so I suppose that’s as good a start, at least, as any. |
| DT: | It does help that you can have AUSTLII open next to the Teams window, that does help. |
| NB: | It does. It does or just dialling in by phone. As I said, you can have all sorts of court books and computer aids around you and be in pyjamas and nobody knows. Not that I’m suggesting that that’s a practise I do adopt. |
| DT: | But you’re not saying that you don’t either. |
| NB: | Look, I’ve never appeared in pyjamas. |
| DT: | Nicola thank you so much for joining me today on Hearsay to talk about these issues. |
| NB: | Thank you very much for having me David. It’s been a pleasure. |
| DT: 53:00
54:00 | As always, you’ve been listening to Hearsay The Legal Podcast. I’d like to thank my guest today, barrister Nicola Bailey for coming on the show. Now, if you’ve been listening to Hearsay for a little while, you’d know that we have plenty of insolvency law episodes, so I’m sure you’ll be able to find those on our website. So, instead, why don’t you grab a practise management and business skills point with episode 31 on employee engagement or listen to my interview with Roger Gimblett from the Office of the Legal Services Commissioner, that’s episode 34, for an ethics point. If you’re an Australian legal practitioner, you can claim one continuing professional development point for listening to this episode. As you know, whether an activity entitles you to claim a CPD unit is self-assessed, as you well know, but we suggest this episode entitles you to claim a substantive law point. More information on claiming and tracking your points on the Hearsay platform can be found on the website. Hearsay The Legal Podcast is proudly supported by Assured Legal Solutions, a boutique commercial law firm making complex simple. You can find all of our episodes, as well as summary papers, transcripts, quizzes and more, on our website and if you’re a subscriber, we’ll let you know by email whenever we release a new episode. Oh, and by the way, our free trial episodes are available on Apple Podcasts and on Spotify, so if you like us and you haven’t already done it, give us a rating on your preferred platform and maybe tell a friend to listen to an episode as well. Thanks for listening. |
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