The Double Bite of Insolvency

When a debtor becomes a bankrupt or in the case of a corporation is placed into liquidation, not only is a creditor exposed in respect of the outstanding debt, the creditor may also be liable to the trustee in bankruptcy or liquidator to repay any preferences that the creditor may have received.

This results in a “double bite” for the creditor as a consequence of a debtor insolvency.

Not only will the creditor have to wade through the insolvency process and wait for a dividend on any realisation of the insolvent’s property, the creditor may face an expensive recovery action and be required to repay moneys that the creditor has already received from the debtor by reason of the payment being a preference.

The nature of a preference

It is fundamental to insolvency law that creditors share equally in the property of the insolvent debtor.

A preference is a transaction such as a payment between the debtor and one or more of the debtor’s creditors in which the creditor receiving the payment is preferred over the general body of creditors.

Where a creditor receives a preferred payment, the payment is voidable as against a trustee in bankruptcy or liquidator and is liable to be paid back to the liquidator subject to the creditor being able to successfully maintain any of the defences available to the creditor under either the Bankruptcy Act or the Corporations Act in the case of a company which is being placed into liquidation.

Preferences can be given for any number of reasons.

Some of the more common reasons include:

1. Where the officers of a company in financial difficulty recognising the company’s impending demise choose to satisfy debts owed to them, related persons or companies in preference to other creditors;
2. Where a creditor threatens to discontinue supply or commence winding up proceedings to recover an outstanding debt. The company may in reaction to such pressure pay out that creditor in preference to other creditors.
3. Where due to poor financial records and internal management, a company in financial difficulties haphazardly pays some creditors and not others.

Insolvency

The definition of a unfair preference is combined with the key factor of insolvency.

A payment will only be recoverable by a Liquidator if the payment falls within the definition of an unfair preference and is also an insolvent transaction.

Put simply, an insolvent transaction is defined under the Corporations Act as a transaction entered into when the debtor company was insolvent or which caused the debtor to become insolvent s588FC(b).

To therefore succeed in a preference recovery action, a Liquidator will have to prove that:

1. The payments were in fact preferences within the meaning of the Corporations Act
2. At the time of the giving of the preference, the company was insolvent or would become insolvent by reason of the payment; and, further
3. That the payments were made in the 6 month period before the date of the appointment of the Liquidator as administrator or the filing of a winding up summons in cases of a Court liquidation.

The liquidator must prove that the company was insolvent when the transaction was entered into or became insolvent by reason of the transaction.

The Corporations Act expresses insolvency as an inability to pay debts as they fall due out of the debtors own money.

According to the cases, in determining whether a company is insolvent, the court will take into account the company’s entire financial position and not just evidence of a temporary liquidity.

Proving insolvency at the relevant time can therefore be quite difficult.

To assist the liquidator in proving that the company was insolvent at the time the transaction occurred, the Corporations Act provides the following presumptions:

• A company will be presumed insolvent during any period where accounting records are inadequate.
  
• If a company is shown to be insolvent at any time within 12 months before the relation back date then the company is presumed to be insolvent at all times thereafter.

These presumptions can be rebutted by actual proof of solvency at the time of the transaction.

The responsibility for rebutting the presumptions lies with the beneficiary of the transaction.

Defences

To successfully establish a defence to a Liquidators' recovery action, a creditor will have to establish that:

1. The transaction was entered into between the creditor and the debtor in good faith;
2. At the time that the creditor received the payments; the creditor had no reasonable grounds to suspect that the debtor company was insolvent or would become insolvent as a result of the transaction;
3. A reasonable person would have no reason to suspect the debtor was or would become insolvent as a result of the transaction; and
4. The creditor Company provided valuable consideration or changed its position in reliance on the transaction.

These statutory defences place the onus on the creditor to:

Not only show that it acted genuinely but that it acted as a reasonable creditor would have acted in the circumstances; and
Prove a negative—that there was no reason for the creditor to suspect that the debtor company was insolvent at the time that it received the payments.

It may also be possible to defend a preference action on the basis:

• That the transaction formed part of a running account;
  
• Of the doctrine of ultimate effect;
  
• That the creditor is entitled to a set off.

What is suspicion of Insolvency?

For the purposes of the statutory defences, the Act does not define “suspicion”. The cases however state that suspicion is more than a “mere idle wondering” whether insolvency exists or not.

In the decision of Sydney Appliances Pty Ltd (In liquidation) v Eurolinx Pty Ltd [2001] NSWSC 230 Justice Santow gave the following summary of what constitutes “suspicion”:

There is no single factor whose presence invariably establishes that there was or should have been suspicion
It is a question of looking through the contemporary eyes of the parties at the commercial circumstances then prevailing
One must ignore hindsight and examine only the commercial circumstances as they existed at the time
One must identify which factors were apparent to the preferred creditor and the cumulative impact that knowledge of those factors should have had upon the creditor
One must apply commercial reality derived from the particular industry to the facts
Undue weight should not be placed on dilatory payments.

Consequences of finding that a preference has been given

If a Court decides that a transaction was a preference, the creditor will be required to repay the amount received to the Liquidator who will then use the money or property recovered for distribution among the general body of creditors.

The creditor can then prove in the liquidation in respect of the amount which is owed by the company to him.

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