When a head contractor goes into liquidation, the subcontractors (“creditors”) are usually owed substantial debts. In most cases, debts owed at liquidation are not fully paid. Creditors might receive a small dividend from the liquidator years later. Adding insult to injury, months or even years after the liquidation date, creditors might receive a letter from the liquidator asking them to repay all the money they obtained from the head contractor in the six months prior to the date of liquidation as an “unfair preference”.
The law as to unfair preferences is complex. The law tries to prevent a creditor from applying pressure to an insolvent head contractor (“insolvent company”) to get paid when the creditor knows that the insolvent company is having trouble paying their other creditors. The law takes this position so as not to disadvantage those who are patiently waiting for their debts to be paid and do not apply any pressure. The law considers that creditors who knew of the financial difficulty of the insolvent company and hassled them into paying just before liquidation, have received a preference in comparison to the other creditors who have to submit a proof to the liquidator and will receive a lesser amount, if anything at all. The liquidator requests the repayment of the unfair preferences in order to increase the pool of money available for a distribution equally to all creditors.
Often parties will be able to rely upon a range of defences when faced with an unfair preference claim, including the “good faith” defence under s 588FG of the Corporations Act (“Act”), or the running account defence under s 588FA(3) of the Act. To use the “good faith” defence, the creditor needs to show that they were not aware of the perilous financial state of the insolvent company when they were paid. To use the “running account” defence the creditor needs to establish that they had a longstanding debt with the insolvent company which for good reasons unrelated to the state of the insolvent company’s financial position fluctuated during the months prior to the date of liquidation.
A recent decision in the Queensland District Court offers some additional hope for creditors faced with unfair preference claims. It held that even if a liquidator can establish an unfair preference payment, the creditor may be entitled to set-off against those payments the debt owed to it at liquidation.
In summary, the Court held that s 553C of the Act allows a creditor to set-off the debt it is owed by the insolvent company against the repayment of an unfair preference on the basis they constitute mutual debts. This means that a creditor facing an unfair preference claim, can off-set any pre-liquidation debt owing to it against the amount of those preferential payments.
The creditor, trading as Inaco Automation Controls (“Inaco”) provided electrical products to the insolvent company prior to liquidation. Upon delayed payment by the company of outstanding invoices, the parties then entered into an instalment plan, some instalments of which were paid by the company prior to liquidation. These were the payments that the liquidator sought to recover in its unfair preference claim.
Inaco defended the claim on a number of grounds; however the good faith and running account defences were unsuccessful. It also argued that a debt that it was owed at the time of liquidation should be set-off against the preferential payments under s 553C of the Act.
The liquidator rejected s 553C of the Act had the effect claimed by Inaco and said if it was to be accepted, it would result in an unjust situation where a creditor who was paid its entire debt by preference payments would suffer disadvantage to the creditor who was paid only part of its debt by preference payments.
The example that was given by the liquidator was that if Creditor A was owed $100,000 and was paid the entire amount by preference payment, it would have to repay the entire amount and would have no debt which it could set-off against the preference payments. On the other hand, Creditor B who was owed the same amount of $100,000, and had been paid only $30,000 by preference payment, could set-off the outstanding $70,000 against the $30,000 preference payment and would not have to repay any amount. That is, while both parties were owed the same amount, Creditor B would have $30,000 in its pocket, while Creditor A would have nothing (subject to any dividends of course).
Notwithstanding those submissions, the Court ultimately found that any potential unsatisfactory outcomes did not justify disregarding the plain language of s 553C of the Act.
However, the Court made it clear that the set-off would not be available to a party who, at the time of giving or receiving credit, had notice of the fact that the company was insolvent. The Court further found that this notice included actual notice of facts that would have indicated to a reasonable person in Inaco’s position that the company was unable to pay all of its debts as and when they became due and payable.
Accordingly, the Court only allowed a set-off for the amount that remained outstanding on one of the earlier invoices, which was paid at the time Inaco did not have actual notice of the insolvency.
As a result of the decision, it may be available for a creditor defending an a preferential payment claim to off-set any pre-liquidation debt against preferential payments if it can show that it did not have notice of the company’s insolvency.
In the current difficult economic climate, it is important to understand how the preference payment provisions of the Act operate so that you can take any necessary measures.
Fenwick Elliott Grace offers a range of services, including advice on issues relating to insolvency, particularly insofar as they are relevant to the construction industry.