- What is an unfair preference?
- The Liquidator needs to prove their case
- Defending an Unfair Preference Action: Good Faith Defence
- Defending an Unfair Preference Action: Running Account Balance
- Defending an Unfair Preference Action: Set-Off
- Preventing an Unfair Preference Action: Use of the PPSR to register a security interest
- Potential fishhooks of a PMSI
- Other options for securing credit
- It is common when a company is wound up for liquidators to send out demands to any creditor paid in the last six months attempting to set aside that payment as an ‘unfair preference’
- Creditors who receive these demands, ‘preferred creditors’, should consider their legal position carefully. There are several defences available to them including good faith, running account, set-aside defences, and claiming a security interest (PPSR)
- Creditors should consider mitigating the risk of future ‘unfair preference’ claims by registering a Purchase Money Security Interest – PMSI. This gives them a ‘super-priority’ against other creditors and a defence to an unfair preference claim
- If registering a PMSI, creditors should be careful to ensure they follow all the requirements in order to ‘perfect’ their interest.
What is an unfair preference?
In the process of winding up a company, the liquidator is interested in achieving the largest pool of assets possible for distribution amongst creditors and to pay for the costs of the liquidation. A Liquidator will be looking at any payments prior to the liquidation to see whether they can ‘clawback’ any of those transactions and increase the pool.
One way in which liquidators seek to increase the pool of assets available for distribution is to investigate whether there have been any ‘unfair preference’ transactions. A transaction may be categorised as an unfair preference if the creditor receives more of an unsecured debt than the creditor would have received if the company had been wound up.
The justification for this law is the principle of “pari passu”: the idea that each creditor of a liquidated company should receive an equal distribution of net assets. The liquidator can claim preferential payments made six months before the commencement of a winding-up (legal terminology: six months before the ‘relation-back date’).
Unfortunately for creditors, liquidators may not always be motivated by the “pari passu” principle: In many cases the monies recovered through an unfair preference action are only applied to the liquidator’s own fees and disbursements, leaving nothing extra for the creditors.
In this article, we are focused on the question: what should a creditor do if they are in receipt of a demand from a liquidator for reimbursement of an unfair preference? Creditors should always consider the possibility that this is a fishing expedition for the liquidators and unlikely to result in court action. Some liquidators have been known to send out letters of demand to any creditors who have been paid over the preceding six months in the hope they will parties will automatically pay up.
Should the creditor just bin the demand then? As the liquidator may be genuinely considering court action, any creditors need to consider carefully their legal position and any possible defences available to them before making a rash decision. In this article we look at three key defences that are set out in the Corporations Act 2001 for creditors that are looking to defend their position (good faith, running account and set-aside). The focus however is on how a creditor can prevent such an action in advance by registering a security interest on the Personal Property Security Register (PPSR) at the time of the lending.
The Liquidator needs to prove their case
If the claim goes to Court, keep in mind that the liquidator still needs to prove that the debtor company was insolvent at the time the payments were received. It is usually a safe bet that a liquidated company was insolvent but it is a factual matter that needs to be proven by the liquidator.
In light of this, it may be advisable for a creditor, on receipt of an unfair preference demand, to ask the liquidator for up front evidence of insolvency at the time the first payment was received.
For more information, read our blog post on ASIC v Plymin about the indicators of insolvency that a court will accept.
Defending an Unfair Preference Action: Good Faith Defence
Other than putting the liquidators to proof, what other possible defences are available to the creditor? In this article we consider the most common defences to an unfair preference claim as set out in sections 588 FA-FG of the Corporations Act 2001. The first of these, the good faith defence, requires that the preferred creditor prove the following:
- That the payment was accepted in good faith (nothing smells);
- That valuable consideration was provided by the creditor (the creditor sold the debtor a product or service); and
- That the creditor or a reasonable person in their position had or would have had no reasonable grounds to suspect the debtor was insolvent (you had no reason for concern regarding repayment).
In practical terms, how does an individual go about proving this defence? The first a creditor might have heard of a company’s insolvency is in its receipt of a demand from a liquidator. However, a simple lack of awareness is not enough. The difficulty is in proving that the preferred creditor had no reasonable grounds for suspecting that the company was insolvent or that a reasonable person would not have such grounds.
In White v ACN 153 152 731 Pty Ltd (In Liq)  WASCA 119, The Court of Appeal of Western Australia clarified some aspects of this defence, including the difficulty for a creditor in meeting the ‘reasonableness’ requirement. The court confirmed there that the ‘reasonable person’ standard concerns the knowledge or experience of the “average business person”. Therefore, you can’t claim to be an idiot!
In determining what was reasonable for the preferred creditor to think, the court will take into account a range of different considerations including, but not limited to:
- account emails
- bounced cheques
- part payments
- instalment arrangements
- deteriorating terms of payment and other factual matters in consideration against the preferred creditor.
Defending an Unfair Preference Action: Running Account Balance
This defence means that where there is an ongoing commercial relationship for the six months prior to the debtor company going into liquidation, then the court must consider the total effect of all the transactions that formed part of that relationship to determine whether the payments amounted to an unfair preference.
This means, for example, that in the context of an ongoing commercial relationship, if a debtor ended off a part of a debt, but overall increased its level of indebtedness, that payment may not count as an unfair preference.
Defending an Unfair Preference Action: Set-Off
In a set-off defence a creditor argues that the transaction ‘sets off’ outstanding debt owing to it by the company. A set-off defence allows a creditor who receives a payment that would otherwise constitute an unfair preference payment to off-set any outstanding debt owing to it by the company against an unfair preference claim. This will only be available where there was no knowledge of the insolvency and where there are mutual dealings between the parties.
Preventing an Unfair Preference Action: Use of the PPSR to register a security interest
The defences set out above, good faith, running balance and set-off are relatively limited in application. The good faith defence is difficult for a creditor to prove and the other two defences rely on a creditor having a specific kind of commercial relationship. A better option for preventing a (successful) unfair preference action is for the creditor to consider registering a security interest in advance.
It is fundamental to unfair preference claims that they relate to unsecured debts. In light of this, a creditor could consider adding terms to their contract which establish that money is held on trust. For a long time, it was common to claim a security interest via a contractual clause asserting ownership of goods through ‘retention of title’.
Terms of a contract, however, are not sufficient protection for a creditor, and were never a guaranteed method of defeating an unfair preference action. It is far more preferable to have a security interest registered on the Personal Property Securities Register (PPSR). Once a secured creditor, the liquidator cannot maintain unfair preference claims against that party.
In addition to gaining a security interest which has priority over unsecured creditors, the PPSR gives ‘unsecured’ creditors an opportunity to acquire a ‘super-priority’ over other secured creditors in the event of insolvency via a Purchase Money Security Interest (PMSI). A PMSI is defined broadly in the Personal Property Securities Act 2009 (PPSA) to include a security interest granted in exchange for finance or value required to purchase or acquire rights in collateral, and includes the interest of retention of title suppliers. In plain English, what does this mean? It means that someone who sells goods on credit can retain their interest in those goods. Registration of a PMSI may be available in four key cases:
- Where a financer or other lender provides funds to a grantor specifically for the purchase of personal property and a security is taken over that property. This could include, for example, a loan for purchase of motor vehicle at point of sale;
- Personal property advanced to the grantor with an outstanding debt. This could include, for example, where machinery is supplied to a company with the creditor retaining title in the property until it is fully paid;
- A Personal Property Security Lease transaction. In this arrangement, a bailor or lessor takes a security interest in the property bailed or leased for payments due in relation to the lease. This is a common arrangement for equipment hire companies;
- A commercial consignment transaction. In a typical commercial consignment transaction, a person (the consignor) delivers possession of personal property to another person (the consignee) for the purpose of selling or disposing of it on their behalf. This could include, for example, a business which agrees to another business selling its cars on their behalf.
This means that if you trade under a retention of title clause and register your interest on the PPSR, you will gain ‘super-priority’ in the event of liquidation of a company and you will be protected from potential unfair preference claims by liquidators. It provides a ‘super-priority’ as your interest in the property will override claims of prior, non-PMSI, secured creditors (in most cases, see below).
Potential fishhooks of a PMSI
There are a few matters to be aware of if seeking to establish a PMSI:
- A security over the collateral and its proceeds (if sold). The creditor needs to ensure that if the collateral is on-sold by the company before winding up, that it has a protected interest in the receivable arising from that sale. Note, however, that even then it is possible for the PMSI to be defeated by another secured creditor in some cases;
- In order to achieve that ‘super priority’ a creditor needs to ‘perfect’ that security interest by accurately and validly registered under the PPSR. For example, in the case of inventory, a security interest must be registered within 15 days of possession. If other tangible property, the registration must happen before possession. In the recent case ofTrenfield & Ors v HAG Import Corporation (Australia) Pty Ltd  QDC 107 a security interest being incorrectly registered as ‘transitional’ was enough to mean that it was not perfected. It should be emphasised though that that case confirmed that a creditor can still be secured creditor even where the security is not perfected;
- An important qualification when using a PMSI to defend an unfair preference case is that the preferred creditor would need to prove the amount of their security. This may mean demonstrating (for a Retention of Title supplier) the amount of product held by the purchaser at the time the preferential payment was received.
Other options for securing credit
An even more powerful option for a creditor to protect their interests is to go beyond the security of personal property in the company and look to real property and personal guarantees. For example, it is common for banks to seek a mortgage over the real property of a director and a personal guarantee of the loan. A personal guarantee means that the Director is obligated to pay irrespective of the limited liability of the company.
A related option, instead of acquiring a mortgage, is for a creditor to include a ‘charging clause’ in the personal guarantee. This means that, in the case of non-payment, a creditor can immediately place a caveat over real property owned by the Director, and if necessary, take court action to enforce the sale of the property.
Whenever a business considers lending money or selling goods it should consider whether it might be worthwhile to protect that lending with a personal property security, such as a PMSI. This will place the business in a much better position if the debtor goes bust. However, if you are creditor (or former creditor) and end up receiving a demand from a liquidator relating to an unfair preference, don’t despair. Seek professional advice to determine whether one of the defences in the Corporations Act 2001 is available to you. As these defences can be difficult to prove, if your situation does not look promising, consider whether it is worth making a peace offering to the liquidator (e.g. 20 per cent of the claimed transaction) to put the matter to rest.