Be mindful of unfair preferences

There’s no doubt that we are entering a difficult economic climate characterised by increased prices of goods and materials, slimmer margins, increasing interest rates and more wage pressure.

For suppliers - particularly in building & construction and electronics, exposed to global shortages - there is a real increased risk of customer insolvency.  Suppliers need to pay careful attention to trading accounts, in particular:

• Temporary 'holds' or 'stops' on accounts; and
• Payment plans.

These may be perfectly reasonable solutions with customers at the time but can have significant implications if the customer subsequently goes into liquidation. Ultimately after the fact, 'holds' and payment plans can be used against the supplier to claim a voidable transaction because they are an unfair preference.

As you can imagine there are significant implications of unfair preference - the liquidator of the customer company can 'claw back' payments, with no guarantee the equipment or material the payments relate to will also be returned.

In practice, this means that your company may end up significantly out-of-pocket paying back funds it just received from a customer. There is no limit on the amount of funds that can be 'clawed back', only the timeframe for how far the liquidator can reach back. In some cases, it can amount to millions of dollars, but even small unfair preference claims can seriously disrupt a company that had recently been paid money it was owed.

It is therefore important for people on the front line - i.e. the finance department, sales persons, people managing trading accounts - to be across this, but they often don't have it front of mind, because they are focused on supporting their own business needs, prioritising their own business cash flow, and providing great customer service.

What are “Unfair preferences”?

'Unfair preference' is a legal term for a payment received from a company or person shortly before going into liquidation. It is one of several types of 'voidable transactions' the liquidator of the failed company can pursue against creditors. 

In practice what occurs is that after a company goes into liquidation, the liquidator investigates its recent transactions. If a liquidator identifies any voidable transactions - including any unfair preferences - they have the power to 'claw back' any money that changes hands under that transaction. 

Once the money is clawed back, the creditor is treated the same as any other unsecured creditor.  Typically, an unsecured creditor only receives a fraction of the total amount they are owed. 

A creditor is deemed to have received an unfair preference payment from a company if:

• The payment is shortly before the company making the payment goes insolvent;
• The creditor suspects the company is trading insolvent; and
• They receive payment for some or all of their debt ahead of other creditors. 

Importantly: unfair transactions can be identified up to 6 months prior to the 'relation back day'. The 'relation back day' is usually the date administrators or liquidators are appointed to a company, but can be earlier than this - in circumstances which are not explored here.

Liquidators typically have 3 years from the date of their appointment to claim an unfair preference in Court (i.e. by commencing proceedings). Otherwise, they needs to seek an extension or time or are locked-out from pursuing the claims.

The policy justification for the unfair preference regime is that it is unfair for one creditor - where they knew or suspected the debtor was about to go bankrupt - to be put in a better position in terms of recovering an unsecured debt ahead of other unsecured creditors.

Defences to unfair preference claims

There are various defences available unfair preferences claims. 

Two defences that are particularly relevant to trading accounts for suppliers: 

• The 'good faith' defence - whether the creditor had means to suspect a customer was insolvent; and
• The 'running balance' defence - where there were numerous transactions leading up to insolvency, which should be treated as one netted-off transaction, rather than a series of individual voidable payments.

First, the good faith defence. The key element to the good faith defence is the creditor - i.e. the supplier - did not know, or ought not to have known, the company was insolvent. It is both a subjective and objective test.  The supplier will ultimately need to satisfy a Court that it became a party to the transaction in good faith, it did not suspect the debtor was insolvent (a subjective test) and that a reasonable person in the supplier's position would have had no grounds for suspecting insolvency (an objective test).

Ultimately if the creditor did suspect insolvency, the defence fails. If the creditor ought to have suspected insolvency, the defence also fails.

As you would expect, a large number of cases are fought on what a creditor ought to have suspected. 

There are no strict criteria for suspicion. The Courts emphasise the need to look at the all of relevant facts as a whole in determining whether there were objectively good reasons for suspicion. But they have found these signs are particularly relevant, if the supplier: 

• Knew that the debtor was facing cash flow constraints;
• Was concerned that the customer could not pay accounts in full or on time;
• Knew that the customer was having trouble paying other suppliers;
• Knew that the customer was selling assets to pay for debts;
• Knew that the timing of payments coincided with the customer selling assets;
• Took 'drastic steps' such as ceasing to provide services for non-payment of invoices. 

The last point - ceasing to provide services - can be particularly dangerous for suppliers with trading accounts. It is not uncommon for suppliers to apply 'holds' on accounts to prevent further transactions when an amount is owing. Sometimes this even happens automatically.  But to a liquidator - and, ultimately, the Court - this could look like evidence that the supplier suspected the customer was insolvent, or ought to have suspected that it was.  If there are multiple holds, or they take a long time to clear, the situation is worse.

Another risks factor is payment plans - if a supplier requires a payment plan at any stage - and even if that payment plan is paid-off by the customer - the fact there was a need for one can, in some circumstances, be construed as evidence that the supplier suspected the customer had cash flow issues, or ought to have had that suspicion.

Secondly, the running-account defence. The running account defence is effectively that where there are multiple transactions over the 6 month period before the relation back day, then all the transactions are dealt with as one transaction to take into account the value of any goods or services provided over that period. This means that rather than adding up each transaction and adding it to a total amount of unfair preference claims, instead the value of the goods and services are off-set against the payments received. 

Often the amounts will not completely cancel each other out (for various reasons), but it can significantly reduce the amount ultimately clawed-back by the liquidator. However, the running account defence is only available where the transactions are:

• For a commercial purpose; and
• An integral part of a continuing business relationship - i.e. providing something important to allow the customer to keep functioning, rather than something non-core to the customer's business.

There is also no running account defence if:

• There has been a demand for payment of outstanding debt and the predominant intention of the parties is to repay old debt, rather than continue providing services; and
• The supplier ceases supplying services or goods to the customer company.

Again, for the running account defence - trading account 'holds' are dangerous, because they can look like ceasing to provide goods or services, even if that wasn't the true intention.  

Making demands for payment or consistently referencing old debts when providing new services can also undermine the running account defence.

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Final thoughts

Trading account holds, payment plans and demands for payment are all part and parcel of commercial relationships. It happens.

Before taking any of these steps, you should stop and consider:

• How will this look in 6 months if the customer goes under?
• Will applying a trading account hold or insisting on a payment plan look like I suspected that the customer might not be able to pay all of its debts on time? 
• Even worse, now I think about it, do I in fact suspect the company might be insolvent?

If so - there is a real risk that the short-term gain of being paid by the debtor might come undone and the company will need to 'refund' those amounts at some time in the future.

If an email from a customer talks about cash flow issues or the customer regularly does not pay accounts in full or on time, these are red flags that need to be addressed.

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The contents of this article do not constitute legal advice and it is not intended to be a substitute for legal advice and should not be relied upon as such.  It is designed and intended as general information in summary form, current at the time of publication, for general informational purposes only.  You should seek legal advice or other professional advice in relation to any particular legal matters you or your organisation may have.

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