Ability of liquidator to recover against large creditors

By Karen O'Flynn.

Key Points:
Credit controllers in large companies have been given both good and bad news by a couple of recent court cases in relation to the receipt of money for potentially insolvent debtors. Both cases involved the ATO, but they are applicable to many other large organisations in which office functions are split between different divisions.

If a company pays money to a creditor while it is insolvent and shortly afterwards the company goes into liquidation, the liquidator can recover ("claw back") that payment from the creditor. However, the payment is protected from clawback if the creditor can prove that:

• it had no reasonable grounds for suspecting that the company was insolvent when the payment was made; and
• a reasonable person in the creditor's circumstances would not have suspected that the company was insolvent at that time.

How do these defences apply to very large creditors?

The left hand knows what the right hand is doing

Any large organisation will have multiple contacts with its customers. Salespeople will be talking to the customer's procurement section, delivery staff will be talking to the customer's warehouse and the credit controller will be talking to the customer's accounts section.

When it comes to claw back defences, this scenario raises an obvious question: if one section of an organisation knows that a customer is in terminal financial difficulties, does that mean that the organisation as a whole has "reasonable grounds" to suspect that the customer is insolvent? This is an important issue for a credit control section, because any payments that they receive may be tainted by information held by other sections of the creditor's organisation.

This was the issue faced by the ATO when it negotiated an arrangement for SJP Formwork (NSW) to pay outstanding tax debts in 1999. The tax officers who negotiated and received the payments worked in a different section from those who oversaw the receipt of reconciliation statements from taxpayers. In fact, SJP had not been filing group reconciliation statements for some time. When the reconciliation statements were eventually received, they showed that the company had been insolvent during the time it had been making the payments.

The ATO was ordered to repay $1.8 million to SJP's liquidator. According to the court, the creditor has to prove that it had no reasonable grounds to suspect that the company was insolvent. In this case, someone in the ATO must have known that SJP had not been lodging reconciliation statements. The onus was on the ATO to prove that, despite having that knowledge within its organisation, there were no reasonable grounds to suspect that SJP was insolvent. It had failed to do so.

It's a long way from Gladstone

This decision is reminiscent of another recent clawback case, involving a corporate creditor. Cook's Construction was an equipment hire firm. Its head office was in Victoria. DML hired equipment from Cook's Gladstone branch. The account was initially handled by the Gladstone branch. However, when DML failed to pay the account, enforcement was handed over to the head office, who eventually extracted payment.

When DML went into liquidation, its liquidators applied to court to claw back those payments.

Cook's main defence was that it had no reasonable grounds for suspecting DML's insolvency. At trial, its main witness was the company secretary from the head office in Victoria. However, it emerged that there had been communications about non-payment between the Gladstone office and DML. The content of those communications was unknown. The trial judge noted that Cook's did not produce the Gladstone office manager as a witness. She no longer worked for the company, but there was no evidence that she was uncontactable.

This failure to produce the Gladstone office manager was fatal to Cook's defence, and it was ordered to repay the money to the liquidator.

No duty to inquire

Even if no-one in the organisation has information to suggest that a debtor is insolvent, is there a duty to make inquiries before receiving payments from the debtor? Again, this issue arose in connection with a clawback claim against the ATO.

The liquidator of Akai Pty Ltd was trying to claw back tax payments that the company had made to the ATO.

The main issue for the court was not whether the ATO suspected that Akai was insolvent when the payments were made, but whether a "reasonable person in the ATO's circumstances" would have suspected that Akai was insolvent. The liquidator argued that a reasonable person in the ATO's circumstances would have suspected insolvency because:

• the ATO was a sophisticated creditor; and
• a reasonable sophisticated creditor would have made inquiries about Akai's financial state before accepting the payments - and those inquiries would have revealed Akai's insolvency.

The court dismissed this argument for two reasons.

The first was that the law doesn't make one rule for sophisticated creditors and another for unsophisticated investors. When the law talks about a reasonable person in the creditor's circumstances, it's talking about external factors (such as the time or the location in which the creditor finds itself), rather than the creditor's own financial acumen or perspicacity.

Secondly, a creditor has no general duty to make inquiries about a debtor before accepting payments from the debtor. The law only requires the creditor to take proper account of information that is actually in its possession. (The court did, nevertheless, warn that there may still be circumstances in which a duty to inquire does arise - the defence is what a reasonable person would have done - it doesn't invite creditors to turn a blind eye.)

The lessons

There are no cast-iron rules that come out of these cases: any clawback situation will depend greatly upon the facts of the case.

Creditors can take some heart from the fact that they're not required to positively establish a debtor's solvency before accepting payments. On the other side of the ledger is the problem of the creditor's deemed knowledge - all the bits of information about the debtor that are scattered through the creditor's organisation.

The issue here is more likely to be the quality of the information than its quantity. If a salesperson has heard an industry rumour that a customer is on the verge of collapse, does that mean that the creditor has reasonable grounds to suspect that the customer is insolvent? That sort of informal and vague information would probably not be enough to trigger the reasonable person test. However, the more formal and concrete the information, the more likely it is that a court would give it some force. In a commercial context, for example, unusual delivery instructions from the customer may suggest that the customer's directors are diverting goods in anticipation of the appointment of a receiver or liquidator.

Ultimately, as in normal credit control situations, the matter is one of risk assessment and risk management. A prerequisite to making an effective assessment is ensuring that all the relevant information has been collected. The law does not make allowances for the fact that that information may be spread through different locations within the organisation: at the end of the day, it's all the organisation's information.

For further information, please contact Karen O'Flynn.