In a notable period in insolvency law, the High Court has now ruled on two of the biggest issues facing Liquidators’ unfair preference claims in the last decade – the application of the ‘peak indebtedness’ rule and ‘set off’.
These judgments were delivered on 8 February 2023. Both of the decisions have a huge impact on trade creditors, and address some of the uncertainties they have faced when served with a demand by a liquidator. We dive into the detail, including what it all means for SMEs, and provide some tips to help minimise your exposure.
So, What Exactly Are Preference Payments?
In Australia, transactions made by a company before liquidation that give a creditor more on its unsecured claim than it would receive in a liquidation are known as "unfair preferences." If a company's liquidator applies to the court, these unfair preferences can be reversed if they meet the requirements outlined in the Corporations Act 2001.
These requirements are complex, so if you need legal assistance, get in touch with us at BlueRock.
Quantifying The Preference
The relevant period in which payments to creditors may be considered a preference varies – but is commonly the 6 months prior to administration or liquidation.
Generally, all payments in that period can be considered to be a preference and recoverable by the liquidator.
However, if during that period there is a ‘continuing business relationship’ between the parties the liquidator must apply a running account analysis. This situation normally arises where continued supply on credit and payment of past invoices happens as a normal part of the trading relationship.
If there is a running account, the liquidator will not be able to consider every payment made as a preference, but instead the whole period will constitute a single transaction and the claim amount will be the relevant difference.
Until the recent decisions of the Full Court of the Federal Court of Australia in Badenoch, the use of the ‘peak indebtedness rule’ had been applied in unfair preference recovery actions to determine the amount recoverable by a Liquidator as a preference.
Basically, the peak indebtedness rule allows a liquidator to calculate the value of the preference by subtracting the debt owing to the creditor at the end of the relation back period from the debt owing at the point of peak indebtedness.
Here’s an example.
If:
- At the start of the relation back period a creditor was owed $40,000,
- The company then enticed the creditor to provide further goods valued at $30,000 so that two months into the relation back period, the company was indebted to the creditor for $60,000, and,
- At the end of the relation back period the creditor was owed $20,000.
In this example the Liquidator could claim the amount of $40,000, being the difference between the peak indebtedness of $60,000 to the amount owed to the creditor at the end of the period ($20,000). Put simply, it generally allows Liquidators to maximise their recoveries of unfair preference claims.
The Badenoch Decision
In Badenoch the High Court has upheld the Full Court’s earlier decision that the peak indebtedness rule should no longer be applied because it did not accord with the legislative intention of the unfair provisions to “do fairness between unsecured creditors”.
In essence it was held that a Liquidator cannot simply pick the highest debt within the period to identify the unfair preference amount. Instead, it is more appropriate to use the difference between the debt value at the start of the 6 month period and the debt at the date of liquidation.
If the debt in fact increases during that period (because further supply exceeded payments), there will be no preference.
Set Off
Set off has been a significant (and very controversial) issue over the last few years and has been the subject of much criticism in the insolvency industry.
The recent set off rule allowed a creditor to deduct from the preference amount any outstanding debt owed to the creditor as at the date of liquidation. In many cases, this would substantially reduce the amount claimable or reduce it to zero.
The High Court has now confirmed that the set off rule does not apply.
What Does This Mean For SMEs?
The outcome of these decisions will have a significant practical impact on SME businesses within Australia when dealing with insolvent customers. The abolishment of the peak indebtedness rule is welcome news for SMEs.
Trade creditors with a running account will benefit, as all supplies of goods or services in the relevant period will need to be considered, rather than a liquidator simply picking the peak indebtedness point in order to maximise the claim. Often the debt to a creditor will increase prior to a company going into liquidation. If a debt owed to a creditor increases during the ‘continuing business relationship’, there will be no preference claim.
Again, this will reduce the size of many preference claims, rendering them uncommercial to be pursued.
It will also mean that the burden or monitoring the financial position of a debtor is eased (given that temporary fluctuations in indebtedness are less likely to substantially increase or decrease a preference claim).
On the other hand, liquidators (and the creditor pool in general) benefit from the ruling that creditors cannot again set off their remaining debt against an unfair preference claim.
Take Away Tip
Dealing with preference payment claims in a technical field which we encourage you to seek professional advice on early.
To help minimise your exposure to the whole regime, making yourself a secured creditor (as preferences only relate to unsecured debts) is worth considering. This can be as simple as having an appropriate retention of title clause if you supply physical goods or having a security interest clause incorporated into your terms and conditions. Having good credit practices is also important.
If you or your clients would like to discuss how these changes could impact them, and how best to prepare to proactively minimise a future claim, please feel free to contact Claudia Baskett or Annabel Clarke .
Disclaimer: This article is a general commentary on a topical issue and does not constitute legal advice. If you are concerned about any topics covered in this article, we recommend that you seek legal advice.
