What are Unfair Preference Claims by a Company Liquidator?

Estimated reading time: 5 minutes

In this article, we look at the definition of ‘unfair preference’ claims — a mechanism used by liquidators to claw back some prior payments to creditors. We also look at the available defences for an unfair preference claim, and how the new ‘simplified liquidation’ procedure for small businesses deals with unfair preference claims.

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The rationale for unfair preference claims

When a company goes into liquidation due to insolvency, a registered liquidator is appointed to investigate the circumstances of the insolvency and gather any remaining assets for distribution to unsecured creditors. As a general rule, unsecured creditors recover “pari passu” – ‘on an equal footing’ with each other in proportion to the debt owed. 

However, through their investigations, liquidators may discover transactions that are ‘voidable’. One common form of voidable transaction is an ‘unfair preference’ claim. This is a claim that the debtor company has given ‘unfair preference’ to one creditor over the other. This might occur, for example, when a director of a company knows that it is likely to become insolvent and decides to pay debts back to friends or key suppliers before the liquidator is appointed.

As favouring one creditor in this way interferes with the pari passu principle, liquidators have the power to ‘claw back’ these amounts under certain circumstances. Once recovered, that payment is added to the general pool for distribution to unsecured creditors. It is also possible that liquidators may seek to recover this amount to further fund their investigation into the circumstances of the insolvency (liquidators have priority in winding up to recover their fees and expenses over all unsecured creditors). 

For more information on how unfair preference claims relate to the liquidation process read The Ultimate Guide to Liquidation Part 2: Preparing for Liquidation.

Note, recovering unfair preference claims is not usually the first step for a liquidator. They will first attempt to recover as much as possible directly from debtors of the company. Furthermore, even where a liquidator does attempt to recover via an unfair preference claim, they are often willing to settle for a lower amount than they may be legally entitled to. 

What is the definition of an unfair preference under the Corporations Act 2001 (Cth)?

Section 588FA(1) of the Corporations Act 2001 (Cth) provides that a transaction is an unfair preference where: 

(a) both the debtor company and the creditor are parties to the transaction; and
(b) the transaction results in the creditor receiving more in payment for an unsecured debt than they would have received if the transaction were set aside and the creditor were to recover in a standard liquidation process. 

Note there are certain restrictions on these claims and defences available for creditors, which we explore below. 

What is the permissible time period for ‘clawing back’ unfair preferences? 

The liquidator can only claw back transactions (and the payments that occurred under them) when they have occurred in the six months prior to the liquidator being appointed. This is known as the ‘relation back period’ and the point of appointment of the liquidation is usually the ‘relation back date’. 

How long does liquidator have to bring a claim?

A liquidator must bring a claim for unfair preference before three years after the date of relation-back.

What defences are available to an unfair preference claim?

Understandably, most former or current creditors who have received payments under an alleged ‘unfair preference’ claim will likely seek to fight any action from a liquidation to recover that amount. In this case, what defences does the creditor have? 

Several defences are available, though it must be noted that all require that the creditor didn’t know, nor had reasonable grounds for suspecting, that the company was insolvent. 

The defences are: 

  • Good faith. This defence is available where
    • the creditor provided valuable consideration, or altered their position in reliance on that transaction, and 
    • the benefit was received in good faith, and 
    • at the time there were no reasonable grounds for suspecting that the company was insolvent, and a reasonable person in that situation would have no reason to suspect insolvency. 
  • Running Account. This is a partial defence available where there is an ongoing business relationship between the creditor and the debtor company, involving multiple transactions over a 6 month period (see section 588FA(3) of the Corporations Act 2001 (Cth)). Where this defence applies, recovery by the liquidator is limited to the difference between the company’s highest level of indebtedness to the creditor over the relation back period and its final indebtedness on the relation back date. 
  • Set off defence. This applies where both the debtor and the creditor owe money to each other. In some cases, it can be argued by the creditor that the amount of the ‘unfair preference’ can be ‘set off’ against the amount they are owed. This can significantly reduce, or in some cases, eliminate the unfair preference claim altogether.  

Unfair preferences and simplified liquidation

Under an amendment to the Corporations Act 2001 (Cth) (the Corporations Amendment (Corporate Insolvency Reforms) Act 2020) and associated regulations (the Corporations Amendment (Corporate Insolvency Reforms) Regulations 2020), there is a new simplified liquidation process available for small businesses (ie. where less than $1 million is owing at the time of liquidation being initiated). 

In the interests of streamlining the liquidation process, these law changes limit the circumstances under which an unfair preference payment can be ‘clawed back’. The liquidator cannot claim back any transaction that occurred within 3 months of the relation-back date unless that individual was a related entity of the debtor company. 

In addition, amounts cannot be claimed if the transaction occurred after the relation-back date, but before the beginning of the winding up, where it is less than $30,000 and the creditor is not a related entity of the company (see clause 5.5.04 of the Corporations Amendment (Corporate Insolvency Reforms) Regulations 2020). 

Conclusion 

Unfair preference claims are an important tool available for liquidators who wish to ‘claw back’ amounts that have been paid to creditors by an insolvent debtor company in violation of the ‘pari passu’ principle. However, there are a range of defences available for unsecured creditors. Furthermore, this power is severely limited in the case of a simplified liquidation. 

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Simplified debt restructuring is a new process available as of 1 January 2021 to support financially distressed small businesses. In simplified debt restructuring, an independent professional known as a ‘small business restructuring practitioner’ is appointed to a distressed debtor company to assist with restructuring the company’s debt via development of a ‘restructuring plan’.