In our 25 March 2020 Alert titled COVID-19 Insolvency Update: Temporary Relief for Financially Distressed Businesses we highlighted the then proposed urgent amendments to the Corporations Act 2001 (Cth) (Corporations Act) and the Bankruptcy Act 1966 (Cth), which the Federal Government was has now passed into law, to provide temporary relief to individuals and corporations suffering financial distress during the Covid-19 crisis.
In this article, we discuss voidable transactions, particularly unfair preferences, in this context of the current Covid-19 amendments to the Corporations Act.
The current state of the law
Despite the generally welcomed relief provided to directors under the now temporarily relaxed insolvent trading laws, the current amendments to the Act have not amended the voidable transaction law.
Generally speaking, the voidable transaction law provides that if a company in financial distress pays its creditors and shortly thereafter the company is wound up and a liquidator is appointed, the liquidator may seek to recover those payments from the company’s creditors as ‘voidable transactions’. The usual defence to these ‘clawback’ claims is to prove that before a creditor received the payment from the insolvent company that it had no reason to suspect insolvency and a reasonable person would not have so suspected insolvency.
Whilst there has been a call from some for the voidable transactions law be amended to provide relief to creditors, the Federal Government has not yet flagged this issue in its Covid-19 stimulus plans.
Practically speaking, it is uncertain how creditors who trade with distressed businesses during the Covid-19 period (or who come out on the ‘other side’ of the crisis) will be able to successfully make out a defence to a voidable transaction claim brought by a liquidator. The net effect of this could have dire financial consequences for creditors and for the economy generally.
We now explain what voidable transactions are in the context of corporate insolvency with a focus on unfair preferences.
What is a voidable transaction?
The Corporations Act contains ‘clawback’ provisions which identifies the types of pre-liquidation transactions that are voidable by a liquidator.
Voidable transactions are defined at section 588FE of the Corporations Act, which includes:
- unfair preferences;
- uncommercial transactions;
- unfair loans; and
- unreasonable director related transactions.
Importantly, unlike unfair loans and unreasonable director related transactions, unfair preference and uncommercial transactions are only voidable where they are also ‘insolvent transactions’. That means the insolvency of the company must be proved for a liquidator to successfully set aside those transactions.
Unfair preferences
A transaction is an unfair preference if:
- it is a transaction between a company and a creditor; and
- the transaction results in the creditor receiving from the company, in respect of an unsecured debt, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company.
It is also a requirement that the unfair preference occurred during the 6 months ending on the relation back day. For related party creditors that time frame is 4 years ending on the relation back day and 10 years ending on the relation back day, if the intention of the transaction is to defeat creditors.
The relation back day is usually the commencement of the winding up, which can vary depending on the circumstances but is often the date of the winding up application was filed.
Whilst unfair preferences relate to unsecured debts, you need to be mindful that if you are a secured creditor you can be subject to an unfair preference claim if the amount received by you in respect of a secured debt is more than the value of your security. In those circumstances, the unsecured amount received by you may be recovered by a liquidator.
It’s my money, so how
is this fair?
The voidable transaction law can have harsh consequences.
The underlying rationale of the voidable transaction regime
in the Corporations Act is to prevent creditors from stripping an insolvent company
of its assets and decimating the asset pool available to all of the unsecured
creditors.
In other words, the regime operates as a way to secure and
maximise the assets of the company available for a fair distribution to the
unsecured creditors as a group.
How do I protect my business from unfair preference claims?
A number of options exist for businesses to protect themselves against unfair preference claims including:
- creating a security interest under a General or Specific Security Agreement and registering your interest on the Personal Properties Security Register (PPSR). In the absence of a formal security agreement it is still possible to register a security interest such as circulating assets on the PPSR;
- ensuring your engagement terms have suitable charging clauses to allow for PPSR registration in the absence of formal security agreements;
- obtaining bank guarantees or personal guarantees from the directors of your debtors;
- amending your trading terms to trade on a cash-on-delivery basis.Companies who do so do not become ‘creditors’ thus offering some protection;
- exercising liens; and
- invoicing progressively where possible. A liquidator is arguably less likely to pursue lower value payments to a creditor.
COVID-19 and beyond
In the current economic environment, the viability of many businesses is a week-by-week or even day-by-day proposition.
Whilst the temporary relaxed insolvent trading laws are a welcome economic stimulus at this difficult time, those measures do not currently relieve the risk of a liquidator ‘knocking on your door’ trying to recover payments you have received from a business in distress.
This is not only a major disruption to your precious cash flow but it could, ironically, cause your business to suffer an unexpected insolvency event.
For further information
For further information on how you can protect your business during these uncertain times please contact Andrew Parlour (Melbourne) on 03 9609 6818, Rory Maguire (Melbourne) on 03 8602 7246, Nahum Ayliffe (Melbourne) on 0413 022 940, Walter MacCallum (Sydney) on 0417 771 535, Joe Denina (Sydney) on (02) 8987 0029 or a member of our Corporate and Commercial team.
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