Chapter 13Voidable transactions and unfair preferences
Introduction
13.1The previous two chapters discussed unsecured and secured assets that belong to a company at the commencement of liquidation (chapters 11 and 12). This chapter discusses voidable transactions and unfair preferences, which are another source of assets that liquidators may use to pay creditors (typically unsecured creditors). The structure of the chapter is as follows:
The first section summarises the main types of voidable transactions, the principles behind the regime, and a timeline indicating how far each type of voidable transaction reaches back.
The next section focusses on the operation of unfair preferences and suggestions for reform in this area, noting the significant amount of feedback received by stakeholders on this type of voidable transaction.
The final section discusses the important insolvency decision of the High Court case of Bryant v Badenoch integrated Logging Pty Ltd.
Voidable transactions
13.2The voidable transactions framework is set out in Part 5.7B of the Corporations Act 2001 (Corporations Act). The provisions enable a liquidator to apply to the Court to grant orders that certain transactions entered into with creditors of a company in liquidation are void. If such an order is granted, the creditor will often be required to repay the company an amount equal to or part of the money it had been paid by the company. There are several types of transactions that are voidable as follows:
(1)unfair preferences;
(2)uncommercial transactions;
(3)transactions with the purpose of obstructing creditors’ rights;
(4)unfair loans;
(5)unreasonable director-related transactions;
(6)creditor defeating dispositions; and
(7)circulating security interests.
13.3The purpose of the voidable transactions provisions is to support thepari passuprinciple of equal distribution of assets among creditors and to mitigate transactions that compromise that principle in the period immediately before liquidation begins. Transactions in the period immediately before liquidation may have intentionally or unintentionally benefited some creditors. The common law does not generally provide for voidable transactions even when a company is insolvent. Hence, the law on voidable transactions is predominantly determined by Part 5.7B of Division 2 of the Corporations Act 2001 (Corporations Act). Some types of voidable transaction (types 1–3, unfair preferences, uncommercial transactions, and transactions with the purpose of obstructing creditors’ rights) require the liquidators to prove the company was insolvent.
13.4The timeframes over which the liquidator can pursue voidable transactions vary with the transaction type and whether related entities or directors were involved, as set out in Figure 13.1.
13.5The relation back day is the date by which the prescribed period begins whereby transactions entered into by the company may be considered void. More formally, the relation-back day is a concept that specifies the commencement time of the liquidation that varies across 15 scenarios set out in section 91 of theCorporations Act. In many of those scenarios, the relation-back day refers to the date that a court application was filed for winding up or a special resolution was passed by the company for voluntary liquidation.
13.6The Treasury Laws Amendment (Combating Illegal Phoenixing) Act2020 implemented a suite of reforms to corporations and tax laws aimed at combating illegal phoenix activity. These included the following reforms to the Corporations Act:
New voidable transaction provisions to enable liquidators to apply to ASIC or the court to recover, for the benefit of a company’s creditors, company property disposed of, via a voidable creditor-defeating disposition (CDD).
A power for the Australian Securities and Investments Commission (ASIC) to make orders for the return of assets.
New criminal offence and civil penalty provisions for company officers who do not prevent CDDs or facilitate illegal phoenix activity through CDDs.
Provisions to prevent directors from improperly backdating resignations or ceasing to be a director when it would leave the company with no directors.
Figure 13.1Timeline for voidable transactions
Source: Mr Michael Murray & Professor Jason Harris, Keay's Insolvency: Personal and Corporate Law and Practice, Eleventh Edition, Pub. Thomas Reuters, July 2022, p. 557.
13.7The reforms relating to CDDs were tested Victoria in Re IntelliComms Pty Ltd (in liq) [2022] VSC 228. The Supreme Court of Victoria held that the Sale Agreement entered into by Intellicomms Pty Ltd wasa CDD within the meaning of section 588FDB(1) of the Corporations Act, and therefore voidable pursuant to section 588FE(6B) of the Act.
Unfair preferences
Background
13.8Liquidator recovery of payments made by insolvent debtors has been part of Australian insolvency laws for over 100 years. The right to recover a preferential payment to a creditor is fundamental in insolvency law. The rationale for recovery rights is that the creditor has jumped the queue in obtaining payment of its debt and it should repay the money and stand in line with other creditors. Preferences are intended to promote equality among creditors and to deter a race to the courthouse.
13.9The corporate insolvency law provisions on unfair preferences were inherited and adapted from theBankruptcy Act 1966. However, corporate liquidators pursue unfair preferences more frequently than bankruptcy trustees. Unfair preferences are the subset of voidable transactions that fit the following definition:
A transaction is an unfair preference if the company and the creditor are parties to the transaction and the transaction results in the creditor receiving from the company, in relation to an unsecured debt owed to the creditor, a greater amount than it would have received in relation to the debt in a winding up of the company.
13.10For a preference to exist, the burden of proof is on the liquidator (on the balance of probabilities) based on the following four conditions:
The transaction must satisfy the definition of ‘transaction’ in section 9 of the Corporations Act.
The liquidator must establish that the company was insolvent at the time of the transaction.
The transaction must have occurred within:
six months of the relation-back day; or
if the creditor of the transaction was a related entity of the company, four years from the relation-back day.
The creditor received more than it would have received in a winding up.
Concerns about unfair preference claims in practice
13.11Mr Steven Golledge SC submitted that while the unfair preference laws serve the worthy principle of ensuring that some creditors do not receive an advantage over others by chance or design, in practice, that objective is rarely achieved. Complexity is the most significant reason for the ineffectiveness of unfair preference laws. The extent to which unfair preferences are pursued depends on the appetite of the liquidators and the availability of litigation funding, with not all creditors being subject to claims. To avoid legal costs that exceed the claim, creditors and liquidators often settle. As a result, much of the recovered money is absorbed by the liquidator's costs and fees, with limited returns to creditors. Mr Golledge concluded that while paying liquidators' fees is appropriate, the unfair preference claim process is not in practice meeting the objective of providing better returns to creditors.
13.12Mr Michael Murray and Professor Jason Harris also noted that many preference claims might be absorbed by liquidator's fees. While that is not unlawful or inappropriate, it may not meet the policy objective. Mr Murray and Professor Harris drew attention to the consideration of this issue by the courts:
…even if the proceedings were pursued to seek to recover the liquidators’ costs or funding which had been devoted to the conduct of the proceedings, it seems to me that that is a proper purpose, where liquidators would less readily accept appointment, and litigation funders would less readily fund proper proceedings in liquidation, if liquidators could not recover their remuneration or litigation funders could not recover the funding which they provided.
13.13ASIC noted the role of unfair preferences in funding liquidations and indicated it might be appropriate to consider reforms that balance the tension between the competing interests of creditors and liquidators:
ASIC is aware of tension between liquidators and company creditors over the unfair preference laws. Registered liquidators have stated that recovery of unfair preferences is a source of funding that enables further investigation and asset recovery action, payment of liquidator remuneration and increases the likelihood of dividends to creditors. Creditors raise concerns that they are penalised for actively managing collection of amounts owed to them when they are required to pay back such payments as unfair preferences if the company is wound up.
13.14The Business Law Section of the Law Council of Australia (BLS LCA) summarised the tension between a creditor subject to unfair preference claims and the whole creditor group:
The primary difficulty most people have with the unfair preference regime is that it takes money from people who have done nothing wrong. That is both incongruent (for most stakeholders) with ordinary business relationships and an affront to ordinary rules of law. However, the difficulty with those complaints is that, in insolvency, there are always people who miss out, and the system must decide a fair and equitable way to distribute the loss.
13.15KPMG noted that while the unfair preference provisions of the Corporations Act play an important role in discouraging individual creditors and related parties from seeking to better their position in the face of impending insolvency, the costs of recovering small claims often means there is no net benefit to creditors.
13.16Several other submitters shared their concerns about the objectives of the unfair preference claims not being met due to the complexity, cost, and the use of such claims to fund liquidator's fees.
13.17McGrath Nicol acknowledged that in its insolvency work, the process of formulating and recovering a preference claim has become more complicated and time-consuming, with an associated increase in both liquidator and legal fees. Accordingly, it advised that as a result, there is often a minimal return of availing company funds to creditors.
13.18On the use of unfair preferences for liquidator fees, ARITA submitted:
The insolvency profession is frequently unfairly maligned with a belief that unfair preference recoveries are only undertaken to get those insolvency professional’s fees paid. Unfair preference recovery plays an important role in funding an insolvency process, such funding is necessary to ensure insolvency practitioners can maximise returns to creditors. As the Chapter 11 Review Commission in the United States reads: 'the notion that money paid to professionals belongs to creditors is true only if the creditors could realize that value without the professionals'.
13.19In their respective submissions, the AICM and ACF submitted that unfair preference claims punish creditors who follow normal business processes to obtain payment and favour those that are inactive. The organisations were of the view that unfair preference claims also have more effects on creditors who work closely to support their customers to support the viability of their business.
13.20Submitters and witnesses also raised concerns that some liquidators issued unfair preference claims to a wide range of creditors rather than carefully targeting relevant claims. ARITA indicated that while it was aware of allegations of such practices by some liquidators, it is prohibited by ARITA's Code of Professional Practice. ARITA indicated that it takes enforcement action against such practices and noted it has not had any genuine and verifiable complaints against its members in the last decade.
13.21Chartered Accountants Australia and New Zealand (CA ANZ) indicated that unfair preference claims are not as easy for liquidators to pursue as people may assume:
It is very hard to get these preference proceedings on foot to an evidentiary level, because we don't want to be starting frivolous claims and we want to make sure our claims are viable. But to obtain that information is a long, drawn-out process, hampered not by the liquidator but by getting that information from third parties. That may include getting ASIC involved to obtain information from people that aren't complying with notices or going through the court process and getting notices to produce.
13.22The Institute of Public Accountants (IPA) indicated that there is a breadth of information that practitioners take into consideration when weighing up a preference recovery:
…when assessing a potential preference claim, you look at the steps that have been taken by that creditor to recover the claim and you look at the email communications or the correspondence that passes between the parties and the conversations that have been transpiring. Have they looked to enter into a repayment program? What are the reasons that they've provided for non-payment? How far has it gone beyond what may be argued as a reasonable debt recovery? Does it now extend to litigation, issuing stat demands, settlement on the court of a winding-up notice?
Possible reforms of unfair preference laws
13.23The committee received several recommendations for reforms on unfair preference laws which are summarised and discussed in the preceding sections as follows:
related parties;
defences for creditors;
claim periods;
thresholds for preference claim amounts;
Australian Taxation Office (ATO) indemnity; and
interactions with safe harbour provisions.
Related entities
13.24The term ‘related entity’ is defined in section 9 of the Corporations Act which provides that certain persons and entities are to be regarded as related to a body corporate. In relation to a company these persons and entities include:
… a promoter, a director or a relative of a director, a director of a related corporation, a related corporation itself and a beneficiary of a trust of which the company under examination is or has at any time been a trustee.
13.25The Harmer Review held that creditors who were related entities should not be treated equally because they may be more aware of the company's financial status and may be able to influence the owners and managers to obtain an advantage over other creditors. The main difference in the law is that liquidators may pursue unfair preferences of related parties over four years before the insolvency formally began (compared to six months for un-related creditors).
13.26Several inquiry participants suggested that unfair preferences should be confined to creditors who are related entities to the insolvent company. MrSteven Golledge SC indicated that the benefits of such a reform would include:
unrelated third-party creditors would not be subject to claims that do not meaningfully enhance the position of all creditors;
favourable treatment of related entities would be discouraged; and
inappropriate phoenixing may be more difficult.
13.27Mr Steven Golledge SC identified that a substantial part of the costs and complexity of insolvency litigation accrues in the proof or denial of insolvency. Removing those costs would increase returns to creditors. Hence, Mr Golledge suggested that in a preference case against a related party, a liquidator should not be required to show that the company was insolvent at the time of the transaction.
13.28ARITA proposed a different approach, suggesting that all related party transactions be automatically designated as unfair preference payments, with the onus on the related party to demonstrate to the liquidator that the payment was not an unfair preference.
Defences for creditors
13.29The BLS LCA drew attention to the differences between Australia's current defence provisions, historical provisions, and provisions of other jurisdictions:
The Harmer Review proposed that all payments close to the appointment of an insolvency practitioner should be considered as preferences.
The United Kingdom (UK) and Hong Kong require the knowledge or intention of the debtor company to be established.
Australian states all initially adopted the UK predecessor legislation.
In 1841, New South Wales (NSW) removed the requirement to establish the debtor's intention.
The NSW system was adopted when harmonised Commonwealth legislation was introduced.
13.30Currently, the defences for creditors of unfair preference claims are the same as those for the broader category of voidable transactions. If a liquidator has proven a voidable transaction, a creditor may subsequently seek to defend the claim using defences set out in section 588FG of theCorporations Act. The defences relate to:
acting in good faith in becoming a party to the transaction,
having no reasonable grounds for suspecting the company was insolvent at the time of the transaction;
a reasonable person in the same circumstance would have no grounds for suspecting insolvency; and
showing that the creditor provided valuable consideration under the transaction.
13.31The Turnaround Management Association (TMA) suggested consideration be given to overseas examples (UK, Singapore, South Africa) of subjective and more difficult tests that require the liquidator to establish the debtor's intent or state of mind. The TMA also identified the contrasting example of the US bankruptcy regime, which determines whether a transaction had a preferential effect in practice.
13.32The Australian Institute of Credit Management (AICM) suggested amending the legislation to require actual knowledge of insolvency rather than the current threshold of suspicion of insolvency. The AICM argued that such an approach would allow credit professionals to play a positive role in maximising the options available for their customers to avoid formal insolvencies, such as providing extended time and repayment arrangements. The Australian Credit Forum (ACF) supported changing the test from suspicion of insolvency to actual knowledge of insolvency.
13.33The AICM also identified that the ambiguity of available defences and calculation methods further penalises creditors with legal fees and protracted negotiations. AICM, therefore, recommended clarifying the appropriate defences to ensure clear and reasonable defences are available, enabling claims to be resolved with less requirement for court mediation and legal fees on both sides.
13.34Other submitters supported current defences. For example, DyeCo submitted that the current defences leave appropriate risks with creditors:
…creditors are making lending decisions to extend credit to another company and therefore should bear that risk, similarly they are also bearing a risk if they meet the elements of an unfair preference, ie they have knowledge or ought to have suspected the insolvency and received more than they would in the winding up of the company.
13.35Scanlan Carroll submitted on the importance of apply the defence correctly:
The vast majority of directors of businesses may not appreciate the strict definition of ‘insolvent’, namely, if a company cannot pay its debts if and when they fall due, this will be considered ‘insolvency’. Many businesses experience cash flow issues, and would be deemed insolvent should this test be strictly applied. Many trade creditors would be caught under the preference payment provisions, and will fail to establish the good faith defence as an awareness of cash flow issues can be deemed as a reasonable suspicion that the company is insolvent, when the two are vastly different. Broad scope education may assist in this regard.
13.36To assist creditors when they are subject to claims, ARITA suggested the development of an unfair preferences rights guide that is approved by the regulator.
Claim periods
13.37There are two time periods relevant to unfair preferences. Firstly, a liquidator could pursue unfair preferences against unsecured credits if the transaction occurred within six months prior to the relation back day or four years prior to the relation back day in the event the creditor is a related entity of the company.One suggestion put to the committee by MrMurry and Professor Harris involved a shorter time-period combined with a more automatic process to reduce costs:
…it may be preferrable to provide for automatic preferences that are recoverable within a limited timeframe prior to insolvency (such as 2 or 3 months), with a carve out available based on good faith and market value for the consideration provided for the transaction. This could be enforced by an administrative notice from the insolvency practitioner, or a notice being issued by ASIC, rather than needing to pursue litigation to obtain preference recoveries.
13.38DyeCo Solvency & Turnaround (DyeCo) did not support reducing the timeframe as they were of the view that it may be abused by directors of failing companies.
13.39Secondly, liquidators once appointed may bring a claim for preference payments within the three-year time period prescribed, which is currently three years with the potential for extensions. ACF suggested that such claim periods for unfair preference claims should be reduced to one year. AICM cited data indicating that approximately only 10 per cent of administrations were expected to take more than 12 months to complete. Hence, AICM suggested that the time to claim (which is currently 3 years as outlined above) be reduced to 12 months. This suggested change was supported by the ACF and Mr Grant Morris.
Thresholds on preference claim amounts and clawback time.
13.40There is no limit on the value of unfair preference payments that a liquidator can recover. Where a liquidator adopts a simplified liquidation process, a liquidator’s ability to recover payments from unrelated creditors that receive payments from the company is different. In a simplified liquidation, a payment or series of payments made to an unrelated creditor are not recoverable as an unfair preference unless:
the payment(s) is/are made at any time from three months before the liquidation is taken to have begun until the date the liquidator is appointed, and
the total of the payment(s) received from the company during this period is more than $30,000.
13.41Under the proposed reforms announced by the Morrison Government in the 2022–23 Budget, transactions that either amounted to less than $30,000 or that were made more than three months before the company entered external administration would not have been able to be clawed back—provided the transactions involved unrelated creditors and are made within the ordinary course of business. These unenacted changes were broadly consistent with the unfair preference rules that apply under the simplified liquidation process implemented in 2021.
13.42SCoLA and KPMG supported aligning the liquidation unfair preference provisions with the simplified liquidation unfair preference provisions. SCoLA further suggested including unfair preferences within the administrative recovery notice power of ASIC to help reduce costs of recovery.
13.43Financial Counselling Australia and the Small Business Dept Helpline supported expanding the $30,000 limit to all creditor voluntary liquidations and court liquidations. AICM members welcomed the restricted circumstances for recovery of preference claims under the simplified liquidation reforms.
13.44Dyeco supported the implementation a minimum sum on the preference amount. The Association of Independent Insolvency Practitioners (AIIP) preferred a threshold of $10,000. ARITA suggested that a $4000 threshold may be a more appropriate and would align with the recently adjusted minimum amount for statutory demands. IPA also offered a similar view:
There's currently a $30,000 threshold limit under the simplified liquidation process, and there is no limit in relation to the regular creditors voluntary or court liquidation process. There are probably avenues for harmonisation between the two legislations or the two insolvency streams. …You start to get a threshold limit where it becomes uncommercial and unreasonable for a liquidator to prosecute those matters, so $10,000 would probably be an appropriate limit, in my view.
13.45CA ANZ, CPA Australia, and the IPA did not support the proposed three-month clawback time:
Registered liquidators already have significant time pressures to complete the statutory requirements in external administrations. This time can rapidly expire waiting on a response from the Australian Taxation Office or if matters must be taken through the court system.
Limiting to a six-month period would also assume that the registered liquidator has the cooperation of the director, access to the company's records and sufficient resources and capacity to adequately investigate and assess each payment made to a creditor during the six months prior to the date of insolvency. Without adequate time to undertake thorough investigations, a reduced timeframe may have the unintended consequence of registered liquidators needing to send claims to all creditors paid in the 6months prior to the relation back date.
Interaction with safe harbour provisions
13.46The Safe Harbour Review (discussed in chapter 7) observed that creditors who assist a debtor during a safe harbour may still be subject to unfair preference claims. Some submitters and witnesses proposed that such creditors should have some protections against unfair preference claims.
13.47Treasury’s 2021 Review of the Insolvent Trading Safe Harbour (Safe Harbour Review) set out the rationale for calls for creditors who assist in safe harbour restructuring to be immune from unfair preference claims:
While safe harbour can be used without the knowledge of creditors, there are occasions where directors may need the support of key creditors to implement their restructuring plans. To obtain creditor support, management of a distressed company may provide financial information to a creditor which evidences a suspicion of the company’s insolvency. This in turn may create evidence of a creditor’s knowledge to be used in an unfair preference claim by a liquidator, should the company enter a formal process. Accordingly, a creditor will often be reluctant to engage in such discussions, which may frustrate implementation of the restructuring plan. Some creditors submitted they should be released from remitting preference payments received from a company during a period where its directors are relying on safe harbour.
13.48King & Wood Mallesons (KWM) suggested changes to the role of unfair preferences where debts are incurred whilst a safe harbour is in place. TheCorporations Act does not explicitly address the interaction between the voidability of transactions entered into as part of a safe harbour plan. KWM argued that a safe harbour would be unable to achieve its objective if transactions to explore remediation options during a safe harbour were liable to be set aside as voidable transactions. If the purpose of safe harbour is to balance the rigidity of the insolvent trading laws, then the unfair preference laws should not in turn maintain an inflexible regime unable to be remedied by the safe harbour provisions.
13.49Scanlon Carroll noted that prior to the introduction of the Safe Harbour, creditors may otherwise have had an avenue for relief against a director if payments were clawed back under the preference payments provision. Hence, Scanlon Carroll suggested that:
The reciprocal protections needed for creditors during the Safe Harbour period could include reducing the ability for voidable transactions and clawbacks to be applicable, automatic application of a running account during the 6 month period, or the good faith receipt defence remaining available. This would need to be restricted to arms-length transactions and perhaps further restricted just to trade creditors, to ensure that directors themselves cannot take advantage of further protection and enter into voidable transactions.
Allowing creditors automatic application of the running account (for the 6 month period only) if services are continued while Safe Harbour is utilised would mean that the liquidator’s starting point would be the balance of amounts paid in excess of goods and services provided, and would again limit protracted litigation.
Stakeholder concerns and observations about reforms
13.50The BLS LCA suggested that care should be taken in recommending or implementing any reforms to the unfair preference regime that might have the effect of incentivising directors to dispose of company assets before liquidator appointments.
13.51BlueRock indicated that, in its view unfair preference laws work well and may only need minor adjustments. BlueRock submitted:
Unfair preference claims are routinely criticised as being unfair themselves, with some groups going so far as to advocate for their abolition, but our position is that these claims go to the very heart of insolvency law and are a critical function in ensuring proportionate distributions to creditors.
To illustrate the importance of these claims, consider a landscape without them. Directors of companies approaching insolvency would then hold all of the power when considering which creditors will get paid and which creditors will be left with nothing, including secured creditors.
13.52CA ANZ argued that the unfair preference regime is designed to protect all creditors and that the insolvency regime might not work well without it:
The counterfactual that is not being spoken about is that if we don't deal with unfair preferences, then those creditors that have the financial nous will have suspicion of insolvency looming and chase the debt due to them. That's why it's an unfair preference: that creditor gets paid ahead of the other 10 creditors who don't have that financial nous. The unfair preference regime is a form of protection for all creditors. We need to be looking at both sides of this coin. The best practice question is about the registered liquidator using their experience and using their knowledge to issue only the correct claims.
13.53Deloitte raised concerns that repealing the unfair preference regime would benefit larger organisations with better credit control policies and more leverage. ARITA noted that large retail property landlords get daily trading data from their tenants and can see their financial performance. In contrast, most stock suppliers to that retailer would have no such insight. The landlord may be able to use this knowledge to force payments of debts while product suppliers would not be able to manage their credit exposure.
13.54The Safe Harbour Review noted that unfair preference claims significantly contribute to how liquidations are funded, which in their absence, would need to be funded by other means. That raises a question about the role of the state and the private profession in the insolvency system, what the insolvency profession should be asked to do in winding up companies, and who bears the cost of that. Hence, the Safe Harbour Review suggested that any removal or tweaking of unfair preferences requires further consideration (from a public policy and practical perspective) as to how liquidations could be funded.
13.55Associate Professor Mark Wellard observed that unfair preferences might be an appropriate topic for a comprehensive review because some of the challenges with unfair preference claims are a consequence of insolvent trading well before a liquidator is appointed:
In my submission, our economy needs our company directors, but use of a corporate form has to be for reasonable risk-taking, not excessive or reckless incurring of debt. In my view, the disenchantment we often hear about our insolvency system, whether it's liquidator remuneration or proceeds of preference claims not getting to creditors, is caused more by the reality that many company balance sheets are leveraged into oblivion well before a liquidator arrives on the scene. In short, you cannot get something from nothing.
If we want to improve returns to unsecured creditors, the prevalence of insolvent trading might be a good place to start. At the very least, in my view, it has to be front and centre in a root-and-branch review. It is an issue that, in my view, now extends beyond the mere enforcement outcomes of regulators. For financially distressed SMEs that end up in liquidation, antecedent—that is, pre-appointment insolvent trading—appears to be mainstream rather than exceptional.
Committee view
13.56The committee acknowledges the importance of the principles underlying the design of unfair preference and voidable transaction provisions—namely, to ensure that assets in a liquidation are distributed equally among the creditors and that no one creditor receives preferential treatment unless permitted by law. However, the evidence that the committee has received indicates that unfair preference provisions may not provide an overall benefit to creditors and may not provide efficient wind-up mechanisms for debtors.
13.57The committee notes that evidence it has received suggests that the interaction of unfair preference laws and the ineffectiveness of prohibitions on insolvent trading are leading to unintended consequences. Many insolvencies are formalised so late that few assets remain for liquidation—the companies are deeply insolvent. As a result, often the funds liquidators obtain from unfair preference claims only cover the liquidator's fees and expenses. These problems are exacerbated for small companies whose narrow business and capital structures present few opportunities for restructuring.
13.58The committee welcomes suggestions from submitters and witnesses on reforming aspects of unfair preferences claims, including (but not limited to) related entities, defences for creditors, claim periods, caps, and interactions with safe harbour provisions. The committee is particularly concerned about the interaction of the safe harbour provisions and unfair preference claims. The committee agrees that those suggestions should be considered in examining possible reforms to unfair preference provisions.
13.59However, the committee observes that while potentially beneficial, those reforms may not address the fundamental practical problems arising from deeply insolvent liquidations. If unfair preference claims were made less onerous for creditors, liquidators' costs and fees would need an alternative funding source, or insolvencies would need to be formalised much sooner so that assets are less depleted and deep insolvencies are less common. There are significant policy, economic, and cultural challenges in finding alternative funding (as discussed in chapter 9) and in formalising insolvencies sooner to prevent deep insolvencies from occurring. However, if either of those were to be addressed, the unfair preference provisions may not present as many challenges as they do presently.
13.60Therefore, the committee considers that there are better prospects of finding a long-term sustainable solution for unfair preference claims through the comprehensive review.
13.61The committee recommends that the comprehensive review consider unfair preferences and voidable transactions as a core aspect of potential insolvency reform.
The Badenoch (Gunns) decision
13.62During the inquiry a High Court case made a significant alteration to the unfair preference regime. This section discusses the High Court’s decision in Bryant v Badenoch Integrated Logging Pty Ltd (Badenoch (also referred to as the Gunns decision)) and its implications, including the following areas:
a summary of the High Court case;
the peak indebtedness rule and continuing business relationships; and
issues identified by participants in the inquiry.
The High Court case
13.63 The use of the peak indebtedness rule in the determination of unfair preference claims where the transactions subject to the claim may have formed part of a continuing business relationship (such as a running account) was considered by the Court in Badenoch. Significantly, the High Court established that the peak indebtedness rule does not form part of subsection 588FA(3) of the Corporations Act.
13.64Division 2 of Part 5.7B of the Corporations Act provides for the recovery of property or compensation for the benefit of creditors of an insolvent company. One such basis upon which this may take place, set out in section 588FA of the Corporations Act, is that a transaction may have been an unfair preference given by a company.
13.65Subsection 588FA(3) refers specifically to the context of transactions forming part of a continuing business relationship. Materially, it provides that where such transactions form an integral part of this continuing business relationship, then:
for the purposes of establishing an unfair preference, all transactions forming part of the relationship are to be considered as if they constituted a single transaction (paragraph 588FA(3)(c)); and
the transaction may only be considered to be an unfair preference if this single transaction results in the creditor receiving more than the creditor would receive from the company in respect of the debt in the course of a winding up of the company (paragraph 588FA(3)(c) read together with paragraph 588FA(1)(b)).
Background
13.66Gunns Limited (in liquidation) and its wholly owned subsidiary Auspine Limited (together Gunns) conducted a timber felling business located in Tasmania, which operated sawmills and plantations across several states of Australia. The respondent, Badenoch Integrated Logging Pty Limited (Badenoch) provided logging and transport services to Gunns in accordance with an agreement which had been entered into in 2003 and renewed in 2008 for a further five-year period. Under the agreement, Badenoch supplied Gunns with a specified amount of timber per annum. In turn, Badenoch provided an invoice to Gunns at the end of each calendar month, with payment due on the last working day of the following month.
13.67Badenoch continued to supply its services to Gunns through the latter’s decline in financial position, despite it receiving late or partial payments. To protect its position, Badenoch took steps such as threatening to cease supply and ceasing supply for short periods, issuing letters of demand, negotiating a payment plan, and seeking a bank guarantee. In August 2012, the agreement was terminated on the basis that Badenoch would continue to supply some services to Gunns until a new contractor could commence operation.
13.68On 25 September 2012 (the relation back day), while Badenoch was still supplying services to Gunns, liquidators were appointed to the company. After their appointment, the liquidators applied to the Court to have a series of 11 payments made by Gunns to Badenoch from 26 March to 25 September 2012 (relation back period) in connection with the agreement declared void under section 588FE of the Corporations Act (the section relating to voidable transactions).
13.69At trial, the primary judge determined that nine of the 11 payments were voidable as unfair preferences and could therefore be subject to a court order returning those payments to the company. In doing so, the judge applied the peak indebtedness rule in considering the continuing business relationship under subsection 588FA(3). This matter was appealed to the Full Court of the Federal Court, which determined that the peak indebtedness rule should not have been applied. The Full Court overturned the primary judge’s decision in respect of two further payments, meaning that while seven of the payments were voidable as unfair preferences, four were not.
13.70On appeal, the High Court was asked to consider whether the so-called peak indebtedness rule is part of, or is excluded by, subsection 588FA(3) of the Act. Other questions put to the Court concerned the proper approach to determining whether a ‘transaction is, for commercial purposes, an integral part of a continuing business relationship’ as referred to in paragraph 588FA(3)(a); and whether certain payments in this case fell within the meaning of a ‘continuing business relationship’ for the purposes of paragraph 588FA(3)(a). The High Court delivered a unanimous decision on 8 February 2023. The substantive decision was delivered by Justice Jagot.
The peak indebtedness rule and continuing business relationships
13.71The peak indebtedness rule previously allowed a liquidator to choose the starting date within the relevantly prescribed statutory period, to prove the existence of an unfair preference given by the company to a creditor. In Badenoch the Court described the peak indebtedness rule, originally sourced in the judgment of Chief Justice Barwick in Rees v Bank of New South Wales, as follows:
The rule, if it may be called such, merely reflects that a liquidator discharging their functions and powers under ss 477 and 478 of the Corporations Act to collect the assets of a company in liquidation would seek to identify any unfair preference in the prescribed period ending on the relation-back day in the context of a running account by comparing the position at the end of that period with the position at the point of peak indebtedness; the effect of so doing will be to maximise both the likelihood of ascertaining an unfair preference and the amount of any unfair preference.
13.72Having regard to the Explanatory Memorandum and relevant case law, the High Court articulated that in incorporating the running account principle, for which subsection 588FA(3) is the statutory embodiment, it cannot be assumed or inferred that the legislature also intended to incorporate the peak indebtedness rule in that provision. It further stated that where courts had concluded that the peak indebtedness rule is to be read into subsection 588FA(3), they had:
…wrongly assumed that the ‘running account principle’ included the ‘peak indebtedness rule’, did not involve full argument on or reasoning about the issue, or must now be considered to be wrong in that respect.
13.73The High Court reasoned that the peak indebtedness rule would not serve the purpose of Pt 5.7B of the Act, which is to ensure equality of distribution amongst creditors of the same class. It stated:
The purpose of the ‘running account principle’ is not to maximise the potential for the claw back of money and assets from a creditor, but that is the effect of the ‘peak indebtedness rule’. The ‘running account principle’ recognises that a creditor who continues to supply a company on a running account in circumstances of suspected or potential insolvency enables the company to continue to trade to the likely benefit of all creditors. The prescription of periods within which all transactions in a continuing business relationship are deemed to be a ‘single transaction’ and, accordingly, may be netted off against each other to determine any unfair preference serves this purpose.
13.74Instead, in order to determine whether an unfair preference has been given in this context, liquidators must consider all transactions relevant to the continuing business relationship during the time period in order to determine whether the ultimate effect is that the debt owed by the company has increased or decreased.
13.75In respect of the second question put before it, the Court held that answering the statutory question under subsection 588FA(3)(a) of whether a transaction is, for commercial purposes, an integral part of a continuing business relationship is ‘one of characterisation of the facts involving an objective ascertainment, on the whole of the evidence, of the business character (for commercial purposes) of the transaction in issue’.[87] The Court agreed with the Full Court’s position that the first four of the 11 payments could be properly considered as forming an integral part of the continuing business relationship, and upheld the unfair preference claim against the remaining seven.
Potential implications for running account versus one-off supply
13.76Associate Professor Mark Wellard identified some implications of the High Court's decision for continuing business relationships (using the running account principle) versus one-off supply relationships. The following paragraphs summarise these possible implications.
13.77To determine whether an unfair preference may exist under a continuing business relationship, it is necessary to find the net preference by comparing the level of indebtedness at a starting point with a level of indebtedness at the endpoint (the relation-back day). Prior to the High Court's decision, liquidators used the time of peak indebtedness as the starting point. Associate Professor Wellard observed that now that the High Court has removed the peak-indebtedness rule, the relevant starting point for assessing unfair preference claims in a continuing business relationship is the later of:
the start of the six-month period before the relation-back day; or
the beginning of the continuing business relationship.
13.78Associate Professor Wellard explored the potential implications of the High Court's decision through three hypothetical scenarios. Firstly, under Scenario A (see Figure 13.2), the potential unfair preference was $40,000 before the High Court's decision and now would be $10,000. Hence, the High Court's decision means that fewer continuing business relationship transactions will be subject to unfair preference claims by liquidators. All the scenarios discussed here assume that the supplier creditor is not a related entity and is not able to use defences for voidable transactions.
Figure 13.2Scenario A: continuing business relationship starting before the start of the six-month period
Source: Associate Professor Mark Wellard, The High Court’s decision in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2, The decision, anomalies and policy considerations, additional information, 23 March 2023, p. 4.
13.79Secondly, Scenario B (see Figure 13.3) shows a continuing business relationship beginning after the start of the six-month period. Before the High Court's decision, the peak indebtedness rule could identify a potential unfair preference of $50,000. Associate Professor Wellard observed that in the absence of the peak indebtedness rule if the start of the continuing business relationship was used, the debt at that time would be zero. Hence, there may be zero transactions subject to unfair preference claims. Therefore, a supplier creditor in Scenario B may have fewer unfair preference claims than a supplier creditor in ScenarioA.
Figure 13.3Scenario B: continuing business relationship starting after the start of the six-month period
Source: Associate Professor Mark Wellard, The High Court’s decision in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2, The decision, anomalies and policy considerations, additional information, 23March 2023, p. 7.
13.80Thirdly, Scenario C (see Figure 13.4) sets out a one-off supply and repayment relationship, beginning after the start of the six-month period. Associate Professor Wellard observed that there is no continuing business relationship in this scenario, so the running account principle does not apply, and the whole transaction may be subject to an unfair preference claim by a liquidator. While considering that it is helpful to incentivise suppliers to operate a running account to support the customer through tough times, Associate Professor Wellard suggested further reform may be required to simplify the law and improve efficiency, noting that:
So we do have, in my view, a serious question as to whether there is a new anomaly and a situation where we are now treating two creditors differently. In fact, the continuing business relationship principle now is not simply levelling the field by giving you that netting arrangement; it is actually putting you in a better position than the one-off supplier.
Whichever way you choose the starting point, you're going to end up with anomalies; that's the takeaway point. I'm very sympathetic to the view taken by the court that the peak debt rule, or the language of the provision, is not justified or sustained. But whichever starting point you choose, you're going to end up with, in my view, some anomalies.
Figure 13.4Scenario C: one-off supplier and repayment starting during the six-month period
Source: Associate Professor Mark Wellard, The High Court’s decision in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2, The decision, anomalies and policy considerations, additional information, 23 March 2023, p. 8.
13.81Mrs Robyn Erskine, Director of INSOL International, welcomed the High Court's decision and acknowledged the issues raised by Associate Professor Wellard. MrsErskine indicated that it may take some time to step back, digest the decision, and find a simpler way forward that stakeholders are comfortable with. Mrs Erskine stated that:
I've always felt that the peak indebtedness rule was arbitrary and unfair, and this decision rights something that had grown up over a period of time. I think, if we all put our hands on our hearts and said, 'Did we really understand where the peak indebtedness rule came from?' there'd not be many people who could actually do that. So, to me, it's a good decision.
13.82Mrs Erskine also noted the importance of incentivising creditors to continue supplying goods and services and that unfair preferences can be a disincentive if creditors are concerned about a customer's viability. Commenting on calls to remove the unfair preference regime to enhance such incentives, Mrs Erskine noted that the unfair preference regime provides a more level field for creditors and commented that without an unfair preference regime:
…you're going to have the consequence of the survival of the fittest. You're going to have the creditors that are savvy and have the resources, financially, to be able to engage the best lawyers in town, and they will get their money, and the other creditors who are less sophisticated and don't have the resources will be left behind. They won't get paid.
13.83Associate Professor Anil Hargoven suggested that a comprehensive review may need to consider whether thepari passuprinciple on the equal treatment of creditors remains a foremost policy principle in insolvency. The pari passu principle significantly influences the choices on reform options for unfair preferences, and it may not always align with practice. Associate Professor Hargovan indicated that some options for unfair preference reform following the High Court's decision might include:
retaining the status quo following the High Court's decision, but with fine-tuning to reflect the US approach, which incentivises creditors and removes the need to consider each transaction;
the much simpler automatic avoidance scheme, which takes a stricter approach and automatically captures all transactions within a shorter period as unfair preferences; or
a concession scheme with minimum preference thresholds.
Comments by other submitters and witnesses
13.84Several submitters and witnesses commented on the Badenoch case and its implications for unfair preference laws.
13.85BlueRock (a multidisciplinary professional services firm), referring to the Full Federal Court's decision (before the High Court had decided), indicated that it considered the removal of the peak indebtedness rule to be:
…undesirable to the industry, as the trade creditors with those continuing business relationships are exactly the type of creditors that an unscrupulous director would choose to preference with a view to maintaining a business relationship subsequent to a liquidation.Regardless of the way the High Court decides the appeal, this rule should be codified.
13.86In contrast, Mr Michael Brennan from Offermans welcomed the clarity provided by the High Court's decision and noted that:
I can see there was a real imbalance there. Liquidators could pick the most advantageous peak indebtedness. From my understanding of that case, that will mean that liquidators, for any claim to be brought, will have to be able to show that there was a real preferential effect of the transaction, taking into account the credits and debits through the relation back period.
13.87ACF also welcomed the High Court's decision and indicated that it now expects the number of preference claims to be reduced and that there will be greater consideration of the trading relationship by insolvency practitioners.
Committee view
13.88The committee observes that the High Court's decision in the Badenoch case is a significant development in the law for unfair preference claims. The removal of the peak indebtedness rule provides clarity on the future operation of the running account principle. The committee notes Associate Professor Wellard's observations that the High Court's decision may identify other areas for reform in striking an appropriate balance on unfair preference claims between one-off and continuing business relationships. The committee welcomes suggestions by Mrs Erskine and Associate Professor Hargovan that the High Court's decision and its implications may require some time to reflect on and digest. The committee considers that it would be appropriate to consider any further reform of the running account principle for unfair preferences as part of a comprehensive review.