Did you know your business might have to return payments if the paying company goes into liquidation? Many Australian business owners don’t fully understand that preferential payments during liquidation create one of the biggest risks to their operations.
The liquidator can recover these preferential payments during a creditor’s voluntary liquidation if the company was insolvent at the time of payment. The recovery window stretches to four years for payments made to related parties. Secured creditors and employees receive priority over unsecured creditors according to strict legal guidelines.
If you’re unsure whether your business is at risk, reach out to SV Partners today. Our insolvency experts can help you assess your exposure and put safeguards in place before it’s too late.
Legal Framework and Definition
The Corporations Act 2001 sets out Australia’s legal framework for preferential payments, with sections 588FA to 588FI. These sections create a well-laid-out system to identify and recover payments that give unfair advantages to some creditors over others.
Section 588FA(1) of the Corporations Act gives us a precise legal definition of an unfair preference. A transaction becomes an unfair preference under two conditions. The company and creditor must be transaction parties. The creditor must receive more money for an unsecured debt than they would get if they had to prove their debt during liquidation.
The law sees insolvency as not being able to pay debts when they’re due. Liquidators look closely at financial records to find the exact date of insolvency, which helps determine which transactions they can recover.
There are specific timeframes for recovery, which must be adhered to. Liquidators can recover payments made to ordinary creditors six months before liquidation starts. This extends to four years for “related parties” like directors’ family members or associated companies. The recovery period stretches to ten years for transactions that try to defeat creditors’ rights.
Australian courts use the “doctrine of ultimate effect” as their guiding principle to determine if a payment is truly preferential. This doctrine recognises that creditors might not be at a disadvantage if a payment leads to the company getting goods or services of equal or greater value.
The “running account” principle stands as another cornerstone of Australian preferential payment law, found in Section 588FA(3) of the Corporations Act. Courts can look at all transactions in an ongoing business relationship as one single transaction. Regular payments to suppliers who keep providing goods or services get assessed as a whole, not individually.
Creditors can defend themselves against preferential payment claims in several ways. Section 588FG(2)’s “good faith” defence needs proof that creditors received payment in good faith, without suspecting insolvency, and that reasonable people wouldn’t have suspected insolvency either.
The Liquidator’s Role in Identifying Preferential Payments
Liquidators take on the important task of breaking down and recovering preferential payments after a company goes into liquidation. These investigations need specialised forensic skills and a well-laid-out approach, unlike regular business transactions.
The team inspects transactions that happen within specific timeframes: six months for unrelated creditors and four years for related parties. Their initial focus involves a full picture of the company’s financial records, bank statements, accounting software, and creditor correspondence. This forensic work helps uncover unusual payment patterns that could show preferential treatment.
Liquidators must pinpoint the precise date of insolvency to determine if payments qualify as preferences. Several key indicators help build this picture:
- Cash flow statements and liquidity ratios
- Payment histories showing increasing delays to creditors
- Financial statements revealing accumulated losses
- Evidence of rejected finance applications
- Statutory demands or legal proceedings for debt recovery
- Director’s correspondence about financial difficulties
The team gets into all transactions during the relevant period once they establish the insolvency date. They look for creditors who got better treatment than others. The next step calculates how much these creditors benefited compared to a formal liquidation distribution.
Direct payments aren’t the only focus. The core team also inspects other transactions that reduce a creditor’s exposure, such as debt assignments, set-offs, or returned goods. Transactions through third parties might qualify as preferences if a specific creditor ended up benefiting.
A structured recovery process begins after identifying potential preferential payments. Liquidators send demand letters to recipients that explain the legal basis and open the door for settlement talks. Legal proceedings might start if these talks don’t work out.
There’s another reason liquidators consider pursuing recovery actions. They weigh the preference size, potential defences, and litigation costs. Sometimes, they negotiate smaller settlements to get the best returns for all creditors quickly.
Detailed documentation remains essential throughout. The team keeps complete records of their investigations, findings, and recovery actions to justify their decisions to creditors or the court. This evidence trail becomes vital if legal proceedings start or creditors question the liquidator’s work.
Recovery Process and Requirements
The formal demand letter explains why the liquidator believes the payment was preferential and includes:
- Details of the transactions alleged to be preferences
- The timeframe that makes these preferences
- Evidence showing the company’s insolvency at that time
- Reasons why the creditor should have known about the insolvency
- Calculations that show how the creditor gained an unfair advantage
Creditors who receive these demands should carefully get into the liquidator’s evidence. They can choose to repay the amount, work out a settlement, or challenge the claim with their defences.
The “running account” principle applies to creditors who have ongoing business relationships. Liquidators must think about how all transactions affect the overall picture during this period instead of looking at individual payments. They calculate the preference amount by finding the difference between peak debt and final debt, which often leads to a smaller claim.
Recovery of third-party payments comes with its own set of challenges. Payments made under valid garnishee notices don’t count as preferences. However, other third-party payments might be recoverable if the company controlled the funds.
Time limits are strictly enforced as part of the procedural requirements. Liquidators must start recovery action within three years of the “relation-back day” or 12 months from appointment, depending on which period expires last.. Courts might grant extensions in rare cases where liquidators show good reasons for delays.
The simplified liquidation process has its own limitations. This simplified process allows recovery of payments to unrelated creditors only if they were made within three months before liquidation.
Liquidators distribute recovered preferential payments according to a strict order. The liquidator’s costs come first. Priority creditors including employees are next. Unsecured creditors follow. Shareholders get paid last if any money remains.
Liquidators have strong recovery powers but must weigh the cost of pursuing claims against possible returns. They won’t spend money unless there are enough assets to cover costs. Sometimes creditors fund these recovery actions and get priority access to recovered funds in return.
Defences Available to Creditors
A liquidator’s preferential payment claim can feel overwhelming. Australian law offers several defences that creditors can use to protect themselves. Learning about these defences is vital for any business in today’s commercial environment.
The “good faith” defence under section 588FG(2) of the Corporations Act stands as one of the most used protections. Creditors must prove three things at once to make this defence work: they got the payment in good faith, had no reasonable grounds to suspect insolvency, and gave valuable consideration. Courts look at objective factors rather than just what someone believed.
Recent cases show what courts might call “reasonable grounds” to suspect insolvency. Your defence could be at risk if you put a company on stopped supply, kept chasing payments, knew other creditors weren’t getting paid, or received lump sum payments not linked to specific invoices.
The “running account” defence works well when payments happen in an ongoing business relationship. The 2023 High Court ruling in Bryant v Badenoch Integrated Logging Pty Ltd (2023) changed things for trade creditors. Liquidators must now look at all transactions during the relevant period instead of choosing the “peak indebtedness” point. This change helps trade creditors who keep supplying goods or services.
The “set-off” defence is another option, but it has limits. The High Court’s decision in Metal Manufactures Pty Ltd v Morton (2023) ruled that statutory set-off doesn’t work in preference claims.
Suppliers should think about the “retention of title” defence. Courts might see you as a secured creditor if you traded under retention of title terms, even without PPSR registration. They look at the security’s value when payments came in, not at liquidation time.
Each defence comes with its own rules and limits. Courts now want to see hard evidence rather than just claims. Australian businesses need proper documentation of all their commercial dealings to defend against preference claims effectively.
Best Practises for Businesses and Creditors
Smart business owners protect themselves against preferential payment claims through proactive planning. They shield their interests early instead of waiting for liquidation to occur.
Getting prepayment is one of the best ways to protect yourself. You can’t be subject to preference payment provisions if you’re not a company’s creditor. Payment arrangements through outside parties might also keep you clear of the preference payment framework. Just remember that transactions between the company, creditor and third parties could still be seen as preferential.
Good security arrangements provide solid protection. Preference payment provisions rarely affect secured creditors. So register your interest on the Personal Property Securities Register (PPSR) before providing services. Your engagement terms should include a charging clause over business assets. Getting personal guarantees from directors is also essential.
The way you manage your running account can reduce risk by a lot in ongoing business relationships. Courts look at how all transactions add up during the relevant period. What matters most is whether your debt went up or down during this time. Good record-keeping of payment dates compared to invoice creation helps you prove ordinary course of business defences.
A resilient risk management system should include:
- Regular credit checks before extending terms
- Clear payment terms in contracts with insolvency clauses
- Adherence to established credit limits
- Meticulous documentation of all transactions
- Complete business continuity planning
You also need appropriate insurance coverage, especially cybersecurity and directors’ liability insurance.
Don’t tighten credit terms if you suspect insolvency, as this could hurt your ordinary course defences. Instead, ask for prepayment to use new value defences.
Note that third-party payment arrangements need careful structuring. Written Quistclose trust agreements that specify funds only for specific debts can protect against preference claims.
Quick action and early talks with insolvency professionals work best when dealing with customers in financial trouble.
Recent Developments and Legal Precedents
Australia’s preferential payment system has revolutionised over the last several years. These changes have altered the map of how liquidators and creditors handle their claims.
The High Court of Australia made two groundbreaking decisions in February 2023 that changed preferential payment claims forever. Bryant v Badenoch Integrated Logging Pty Ltd eliminated the long-established “peak indebtedness rule” that liquidators had used for decades. Liquidators must now get into all transactions within the continuing business relationship during the relevant period. This change has made the value of potential preference claims nowhere near what it used to be.
The Court also made it clear that running account analysis should start from the later of three points: the beginning of the statutory period, the date of insolvency, or the start of the business relationship. Liquidators now face more challenges when they try to establish preferential effects in running accounts.
The High Court’s ruling in Metal Manufactures Pty Ltd v Morton strengthened liquidators’ position. The Court decided that creditors cannot use statutory set-off to defend against preference claims. Justice Gageler explained that “there is no mutuality of interest between an unfair preference which a creditor is ordered to repay and a debt incurred by the company provable in winding up”.
Legislative reforms from 2022 suggest new exemptions from recovery. Transactions below $30,000 or those made more than three months before external administration would qualify. These exemptions would apply to unrelated creditors’ transactions that happen during normal business operations. The proposals line up with rules already active in the simplified liquidation process since January 2021.
The Australian Taxation Office (ATO) continues to be a major force in the insolvency world. It accounts for about 15% of system liabilities. The ATO’s payments received under effective garnishee notices cannot be treated as voidable transactions.
These changes are the foundations of the most substantial updates to Australia’s preferential payment system in decades. They create new challenges and opportunities for businesses dealing with insolvency proceedings.
Stay Proactive, Not Reactive
Preferential payment claims can hit your business when you least expect it, especially if you’ve unknowingly received payments from a company on the brink of collapse. As we’ve outlined, the risks are real, the rules are complex, and the financial fallout can be significant.
At SV Partners, we help businesses navigate these challenges with clarity and confidence. Whether you’re concerned about past transactions, want to strengthen your position with secured arrangements, or need help responding to a demand letter, we’re here to support you.
Don’t wait until liquidation puts you on the back foot. Contact SV Partners today for tailored advice on how to identify risks, defend claims, and implement safeguards that protect your business from preferential payment exposure.
