Australia’s unfair preference laws

Introduction

There are provisions in Australia's corporate insolvency laws which enable a company's liquidator to recover a payment, that is made to a creditor within a prescribed period of time before the commencement of the company's insolvency case, if the payment amounts to an "unfair preference."

As Priestley LJ noted in his judgment in Harkness v Partnership Pacific Ltd (1997) 23 ACSR 1, the unfair preference provisions derive from 18th century English legislation, and further the bankruptcy principle that a single creditor cannot be preferred over the general body of unsecured creditors by way of the disposition of an insolvent company's assets outside the collective process provided for by the insolvency system. The unfair preference rules reflect and preserve the pari passu principle – that all unsecured creditors, subject to express statutory exceptions, are to rank equally in the distribution of the insolvent estate.

Unfair preference recoveries by a company's liquidator were previously based on provisions in the Bankruptcy Act 1996 (Cth) (Bankruptcy Act), which were incorporated by reference into the companies legislation. However, with effect from 23 June 1993, standalone provisions were included in the former Corporations Law, which are now reflected in sections 588FA to 588FI of the Corporations Act 2001 (Cth) (Corporations Act).

Those provisions are structured so that if a company enters into a transaction with a creditor, which:

• occurred during a prescribed period of time or claw back period – ranging from six months, to four years where a creditor is a related entity of the company, and to 10 years where there is an intention to defeat the rights of other creditors – before the "relation back day" (generally the time the winding up application was filed or a voluntary administrator appointed);
• occurred when the company was insolvent or caused the company to become insolvent; and
• enabled the creditor to recover more than it would if it had received a proportionate share of the company's assets, along with all other unsecured creditors, in the company's liquidation.

The transaction can be set aside upon the application of the company's liquidator (see sections 588FA, 588FC and 588FE of the Corporations Act).

This article seeks to explore some of the key issues canvassed by Australian courts in defining the purpose, scope and practical implications of unfair preference provisions as a feature of corporate insolvency law over the last 30 years, and looks ahead to the impact of two recent High Court of Australia decisions and impending legislative reform on liquidator recoveries.

The common law doctrine of ultimate effect

According to the express words in section 588FA(1)(b) of the Corporations Act, a payment to a creditor will amount to an unfair preference whenever the creditor receives more than it would by proving its debt in the company's winding up – even if the company receives equal or greater value in return. This is in contrast to the corresponding provision in section 122(1) of the Bankruptcy Act, according to which a payment must have the effect of "giving the creditor a preference, priority or advantage over other creditors" before it can be recovered by a liquidator.

Nevertheless, Australian courts have taken the approach that it is necessary to look at the ultimate effect of a transaction in assessing whether there is an unfair preference – in essence, imposing a requirement for a transaction to in fact be preferential and to give a creditor an unfair advantage before it can be recovered under section 588FA of the Corporations Act (see, for example, VR Dye & Co Peninsula Hotels Pty Ltd (in liq) (1999) 32 ACSR 27). This means that if, at around the same time when a creditor is repaid the outstanding debt owed to it by the company, the creditor provides identifiable new goods or services to a company, the payment is unlikely to be considered an unfair preference. That is because, rather than simply discharging pre-existing indebtedness, the company's payment can be considered to have been made to induce the supply of those new goods or services to the company. The company receives a tangible benefit linked to the payment, so that creditors have not suffered any element of disadvantage.

Running accounts

There is now a specific statutory codification of the doctrine of ultimate effect where there is a "running account" between a company and a creditor engaged in a "continuing business relationship", under which there are regular debits and credits arising from a company's payments to the creditor, and the creditor's ongoing supply of goods or services to a company over time.

The statutory provision was recommended in the Harmer Report, the first major inquiry into Australia's insolvency laws held in 1988.

Despite the difficulty of directly linking any individual payment to an identifiable "new" supply of goods or services in a running account scenario, section 588FA(3) of the Corporations Act expressly permits the court to examine all of the dealings as part of a single transaction in assessing whether a creditor has, on the whole, received an unfair preference across the running account period.

The running account principle reflects the idea that an insolvent company's general body of unsecured creditors are not disadvantaged by payments made to trade creditors that cause further goods or services to be supplied to the company that are of an equal or greater value.

Even where the parties do not have a running account in place as part of a continuing business relationship, the courts will resort to the broader doctrine of ultimate effect as a general law defence to an unfair preference claim (see VR Dye & Co).

The Badenoch case: Rejection of "peak indebtedness"

In assessing the preferential effect of payments to a creditor under the statutory running account exception, a liquidator was previously entitled to compare the peak indebtedness of the company to the creditor during the relation back period to the lowest point of indebtedness during that time, and to claim the difference as the value of the unfair preference (see Rees v Bank of New South Wales (1964) 111 CLR 210). This maximised both the likelihood of ascertaining an unfair preference and the amount of any unfair preference.

The peak indebtedness rule was not without controversy – and has often been criticised on the basis that it cuts across the policy rationale to encourage trade creditors to continue to provide value to companies in financial distress, thereby enhancing the prospect of a distressed but viable business being able to trade while it negotiates with creditors and works to implement a restructuring plan (whether informally or as part of a formal insolvency process).

The controversy has now been settled by the High Court of Australia in a recent landmark decision. In Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (Badenoch), the High Court unanimously rejected the application of the peak indebtedness rule in assessing the preferential effect of transactions arising as part of a continuing business relationship.

The High Court held that the peak indebtedness rule is "unexplained in the decisions which embody it" (at para 58). According to Jagot J, the natural and ordinary meaning of section 588FA(3) of the Corporations Act is that all transactions forming part of a continuing business relationship under the running account principle must be taken into account in assessing if there has been a net unfair preference. Allowing the liquidator to select the peak indebtedness of a company to a creditor as the starting time to assess the net preferential effect is "arbitrary" and does not "serve the purpose of the running account principle". Indeed:

The purpose of the running account principle is not to maximise the potential for the claw-back of money and assets from a creditor, but that is the effect of the peak indebtedness rule. The running account principle recognises that a creditor who continues to supply a company on a running account in circumstances of suspected or potential insolvency enables the company to continue to trade to the likely benefit of all creditors (at para 70).

The High Court resolved the uncertainty that remained from the decision of the Full Federal Court – which had suggested that, if the peak indebtedness rule did not apply, the "single transaction" arising from a running account could begin prior to the statutory claw back period – potentially requiring a liquidator to investigate years of trading history between the company and a creditor to assess, over the entire business relationship, if there was a net preference.

The High Court determined that, where the continuing business relationship started before the prescribed claw back period, the relevant transactions forming part of the relationship – in the context of an unfair preference claim – must be transactions within the claw back period and those which were entered into when a company was insolvent or had the effect of causing the company to become insolvent.

The High Court also clarified that, in determining whether a transaction forms part of a continuing business relationship, it is necessary to look to the objective character of the payment and the actual business relationship between the parties (at para 81). The subjective intention of the creditor is not conclusive – so even if a creditor receives a payment with the intention of continuing to supply services to the company, the payment could still be an unfair preference if, on an objective assessment, the payment is primarily explained as a reduction of past indebtedness (at para 85).

The decision in Badenoch makes it considerably more difficult for a liquidator to recover unfair preference claims from creditors. Liquidators no longer have the benefit of being able to select the most optimal time period from which to calculate the net preferential effect of payments made while a running account was in place between a company and a creditor during the statutory claw back period. Instead, liquidators will have to assess the net effect of all transactions over the period, and this will likely mean that preference claims will be less frequent and, when made, will be of a lesser amount particularly where the continuing business relationship is established. This, however, is faithful to the policy principle underlying the common law and now statutory ultimate effect defence.

The Morton case: A creditor cannot set-off against an unfair preference claim

The question of whether a creditor may rely on statutory set-off in section 553C of the Corporations Act as a defence to an unfair preference claim had remained unresolved for two decades. However, in a long-awaited decision handed down on the same day as the decision in Badenoch, the High Court determined this issue in Metal Manufactures Pty Ltd v Morton [2023] HCA 1 (Morton).

The High Court unanimously held that statutory set-off is not available in this circumstance. The result is that a creditor is not entitled to deduct any outstanding claim that it might have against a company from its liability to repay the company's liquidator any unfair preference.

The High Court held that a debt owed to a creditor, and a creditor's liability to repay an amount as an unfair preference, lack the requirement of there being mutual credits, mutual debts or other mutual dealings between a creditor and the insolvent company (as prescribed by section 553C of the Corporations Act). Specifically, an outstanding debt is owed by the company to a creditor, while an unfair preference liability is owed by the creditor to the company's liquidator. Additionally, the interest of the parties in these amounts differs – the payment of the debt is for the benefit of the creditor, while the recovery of the unfair preference is for the benefit of the company's creditors (see at paras 52-53). Further, it was held that section 553C of the Corporations Act limits the pool of claims that are provable in a winding up to those debts payable by and claims against the company, "the circumstances giving rise to which occurred before the [winding up]." Yet amounts owing as an unfair preference only arise upon the making of a court order after the commencement of the winding up – another basis for set-off being unavailable in a preference claim (at para 49).

This case is welcome news to liquidators – with a significant obstacle to the recovery of unfair preference claims being removed. This will result in enhanced returns for the general body of unsecured creditors – due to both the unavailability of the substantive set-off defence itself, as well as the time and cost savings from litigating the set-off issue in the absence of a final High Court position on its application in a preference matter.

Takeaways

Unfair preferences have traditionally formed an important component of a liquidator's prospective recoveries when a company is wound up. The frequency of preference claims is reflected in the significant body of court decisions on important principles, such as the doctrine of ultimate effect, running accounts, the peak indebtedness rule, and statutory set-off.

Over the last three decades, preference recoveries have been especially aided by the ability of a liquidator to rely on the peak indebtedness rule in the context of a continuing business relationship between a company and a creditor.

The recent decisions of the High Court in Badenoch and Morton present a mixed bag for liquidators. On the one hand, the rejection of the peak indebtedness rule will inevitably reduce the value of preference recoveries, as liquidators are now required to examine all transactions made between the company and a creditor in a continuing business relationship (provided they occur during the statutory claw back period) in assessing whether there has been a net preference.

On the other hand, the inability of creditors to rely on set-off as a defence will remove a key obstacle that has previously hampered liquidator recoveries.

The net result is that liquidators will now need to recalibrate their strategy and resources in assessing preference claims – in many cases, the commencement of unfair preference proceedings will no longer be viable because establishing an advantage to a creditor will be difficult due to the decision in Badenoch.

That said, the battlefield may shift with liquidators' focus likely turning to seeking to establish that a continuing business relationship ended due to circumstances perhaps indicating that payments to a creditor were motivated to secure the discharge of past indebtedness rather than induce ongoing supply

Outside of a continuing business relationship, creditors will no longer be able to rely on set-off as a defence to an unfair preference claim by a liquidator.

We can also expect future legislative change to unfair preferences. In May 2022, the former Coalition Government announced that transactions that either amounted to less than AUD $30,000, or that were made more than three months prior to the company entering external administration, will no longer be able to be clawed back, provided those transactions involve unrelated creditors and are within the ordinary course of business.

These amendments are yet to be enacted under the new Labor Government, although new reforms could be announced following the conclusion of the current broad-based inquiry into the effectiveness of Australia's corporate insolvency laws being conducted by the Parliamentary Joint Committee on Corporations and Financial Services. The inquiry intends to report to the Parliament in May 2023

Unfair preferences will remain an area of dynamic change in Australia, and it will be important for all practitioners to keep a close eye on future developments.