Supplying goods or services to a company in financial trouble – the unforeseen risk
The effect on your business of a client’s financial woes may extend beyond unpaid accounts. A payment made on your overdue invoice by a debtor that ends up in liquidation may be recoverable by the debtor’s liquidator if that payment constitutes a voidable transaction pursuant to the Corporations Act 2001 (Cth).
A voidable transaction is typically one of three kinds of transaction – an insolvent transaction; an unfair loan; or an unreasonable director related transaction. As regards the former, a transaction can only be an insolvent transaction if:
it amounts to either an unfair preference or an uncommercial transaction; and
the company either carried out the transaction whilst insolvent or became insolvent as a result of the transaction.
Our focus is on payments in the nature of an unfair preference (often referred to as a preferential payment). According to the Corporations Act, an unfair preference occurs when:
there is a creditor / debtor relationship;
the debtor company makes a payment to the creditor in respect of an unsecured debt;
the creditor receives a sum greater than what it would receive if the transaction were set aside and the creditor were to prove for the debt in the course of the company’s winding up; and
the payment is made during the 6 month period immediately prior to the date known as the “relation back date”, which is usually the date on which either the company went into administration or the application to wind up the company was made.
A liquidator may seek repayment of an unfair preference up to 3 years after the relation back date (or even later, in limited cases). If you do not voluntarily comply with a liquidator’s request for repayment, the liquidator can make an application pursuant to the Corporations Act for a court order compelling your compliance.
The main objective of such an order is to restore the company in liquidation to the position it would have been in if it had not entered into the voidable transaction.
A business ordered to repay money duly earned could be forgiven for feeling such is unfair. Then again, underpinning the unfair preference claim regime is the notion the recipient of an unfair preference has pretty well jumped the queue, thereby gaining an unfair advantage over the other creditors waiting in line to be paid.
The recovered payment will go into the pool of funds available (after the winding up expenses are paid) for distribution to the company’s creditors in accordance with the priority system under the Corporations Act. In particular, debts payable to secured creditors take precedence over debts payable to unsecured creditors.
There are a number of defences available in circumstances where a payment is being sought to be clawed back as preferential payment.
The “running account”
This is not a complete defence to an unfair preference claim, but having a “running account” may decrease the amount repayable to the liquidator. The central feature of a running account is that it predicates an ongoing commercial relationship between debtor and creditor with the expectation further debits and credits will be recorded.
In these circumstances, rather than assessing the amount to be repaid in terms of the total payments received during the 6 month period prior to the relation back date (which is ordinarily the case), the amount repayable will be the difference between the peak amount owing by the debtor during the 6 month period and the balance outstanding on the relation back date.
The benefit of establishing the existence of a running account is that only your actual profit is considered an unfair preference to be repaid.
Trading in good faith, without knowledge or suspicion of the debtor’s insolvency
Except where the transaction is an “unfair loan”, the Corporations Act stipulates the court shall not make an order for repayment to the liquidator if to do so would materially prejudice a person’s right or interest provided the person became party to the transaction concerned:
in good faith and without knowledge of, or reasonable grounds for suspecting, the debtor’s insolvency; and
either in exchange for valuable consideration (for example, the supply of goods or services) or having changed its position in reliance on the transaction.
The onus of proving you had no knowledge of, or reason to suspect, the debtor’s insolvency is on you. In considering this defence, the court may take into account the factual background and prevailing business practices. Further, and perhaps surprisingly, if your business has issued follow up notices and demands for repayment such may be used as evidence against you to demonstrate your awareness or suspicion of the debtor’s insolvency.
The doctrine of ultimate effect
By definition, an unfair preference does not include a payment of a sum less than that which you would receive if you were to prove for the debt in the winding up of the company. Even so, along similar lines is the doctrine of ultimate effect, whereby the court will consider the business purpose and context of the payment to ascertain whether it gave you a preference, priority or advantage over other creditors.
Ultimately, for the payment to be recoverable, it must lead to a reduction in the net value of assets available to meet the competing claims of the other creditors.
Unsecured creditors – avoiding the risk
The best approach to minimising the risk of surprise by an unrelenting liquidator varies from business to business, as do the options available.
Your options (whether in relation to problem clients or more generally) may include – requiring advanced payment or cash on delivery; obtaining security; insisting on payment either by a third party or under a bank guarantee / letter of credit; supplying goods on a retention of title basis; and taking payment from a trust account established for that purpose.
At Taylor Smart we draw on our established expertise and extensive experience to cater for all manner of business needs, including advising and representing clients in commercial and corporate matters.