Demystifying the defence to unfair preferences and the scope for liquidators to recover benefits from third parties

By Alistair Fleming, Fiona Schmedje and Rebecca Hing

02 Aug 2018

The two limbs of the defence to an unfair preference claim under section 588FG(1)(b) and (2)(b) of the Corporations Act have separate work to do.

In a useful decision for liquidators and the insolvency industry, the WA Court of Appeal has clarified the nature of the tests creditors need to satisfy to maintain a defence to a liquidator's unfair preference claim in section 588FG(1)(b) or (2)(b) of the Corporations Act (White & Templeton v ACN 153 152 731 Pty Ltd (in liq) & Anor [2018] WASCA 119).

It also considered the circumstances in which liquidators may recover the benefit of the unfair preference transaction from a third party. 

Port Village makes some payments

Port Village Accommodation Pty Ltd (PVA) was constructing a mixed-use accommodation facility. It entered into a contract with the first respondent, then known as Hickory Group (WA) Pty Ltd (HWA), to supply pre-fabricated modules for the development. In the six months prior to its liquidation, PVA made payments totalling approximately $10.4 million to HWA. HWA then paid corresponding amounts to its parent company, the second respondent, Hickory Group. 

The liquidators of PVA sought to recover the Payments as unfair preferences and argued that, as Hickory Group had ultimately received the benefit of the Payments, it should be required to repay those amounts to PVA.

At first instance, the trial judge found that Hickory Group had made out the defence under section 588FG of the Corporations Act. The liquidators appealed.

The defence under section 588FG                

The key issue in the appeal was the distinction between the two limbs of the defence under section 588FG(1)(b) or (2)(b), where the person (that is, the creditor) must prove that:

  • it had no reasonable grounds to suspect insolvency (the first limb); and
  • a reasonable person, in the person's circumstances, would have had no reasonable grounds to suspect insolvency (the second limb).

The trial judge had found, in relation to the first limb, that, based on the matters known to its director, Hickory Group had no reasonable grounds to suspect that PVA was insolvent. On the second limb, the trial judge held that the starting point was that Hickory Group's director was a reasonable person, such that a hypothetical person slotted into the circumstances as they existed would not have suspected PVA's insolvency.

The Court of Appeal allowed the liquidators' appeal and held that this approach was incorrect.

No reasonable grounds to suspect insolvency

The Court of Appeal held that the first limb is directed to the facts and matters actually (or subjectively) appreciated by the particular creditor. In considering what facts and matters the creditor appreciated, the training, skills and experience of that creditor will be a relevant consideration. As a result, the first limb of the defence takes into account the different circumstances of different creditors. For example, a bank, with its accounting and economic expertise, may appreciate facts and matters in relation to a company's financial position that may not be appreciated by a relatively unsophisticated sole trader.

A reasonable person, in the person's circumstances

The second limb, however, is an entirely objective test. It is directed to the facts and matters appreciated by a hypothetical, reasonable, person in the creditor's circumstances.  The Court of Appeal observed:

  • The hypothetical person is assumed to have the knowledge and experience of the average business person. The court cannot take into account whether the particular creditor, with their skills, training and experience, acting reasonably, would have had reasonable grounds for suspecting insolvency. The second limb asks whether a hypothetical person, with the knowledge and experience of the average business person, in the creditor's circumstances, would have reasonable grounds to suspect insolvency.
  • The words "in the person's circumstances" refer to the external, objective factors or circumstances that existed at the time and not to any factors personal to the particular creditor, such as their financial acumen or optimism. For example, the objective circumstances may include the nature of and practices of the relevant industry, but they may not include the particular creditor's subjective views as to the operation and practices of the industry.

Recovery from third parties

At first instance, the liquidators sought an order under section 588FF(1)(c) that Hickory Group pay to PVA the amount of the Payments, being the amount of the benefit that it had received because of the unfair preferences.

The trial judge did not determine this issue, having found that Hickory Group had made out the defence under section 588FG. However, on appeal, Hickory Group argued that the liquidators could not recover the Payments under section 588FF(1)(c) because it received a benefit from the Payments as a creditor of HWA and not "because of" any unfair preference.

The Court did not ultimately determine this issue, but it made some useful observations about when a benefit could be received "because of" a voidable transaction.

The Court said that the fact that Hickory Group was an existing creditor of HWA did not necessarily mean that it received no benefit because of the Payments. Whether it received a benefit, and the amount of that benefit, depended upon an examination of all the relevant facts and circumstances, including the financial position of HWA, and its financial relationship with Hickory Group, at the time of each transaction.  

The Court considered several hypothetical scenarios in relation to a liquidator's ability to recover preference payments from third parties, noting that it would be difficult to prove that any "benefit" was received by a third party or there was any causal link between the payments where:

  • the receiving party is a solvent company, that then uses the sum of any unfair preference payment to pay third party unrelated creditors;
  • the receiving party is a company reliant on a parent company's funding; and
  • even if the receiving company was insolvent, any payments made to third party creditors of the insolvent company would not prima facie be "because of" the original voidable transaction.

The Court noted that other considerations may be relevant, such as where the receiving party has no assets of its own and relies on the parent company's funding exclusively. The cash received from the preference payment may be the only asset of the receiving company. Any repayment of the parent company's debt by the receiving company may be a benefit, as without it the parent company would not recover its debt. In such circumstance, that payment received by the parent company would be "because of" the voidable transaction.

The Court noted that an order made under section  588FF(1)(c) may raise a theoretical difficulty as a result of the concurrent liquidations of PVA and HWA. The liquidator of HWA may also seek to recover the Payments from Hickory Group as an unfair preference. In such circumstances, the Court noted it is prima facie difficult to see how the liquidator of PVA could have an equal claim to the Payments under section  588FF(1)(c). The Court did not make any findings on this issue.

Key lessons from the Port Village decision

This decision clarifies that the two limbs of the defence under section 588FG have separate work to do. A creditor may successfully prove that it had no reasonable grounds to suspect insolvency, but may ultimately be unsuccessful in making out the defence if a reasonable person in its circumstances would have had reasonable grounds to suspect insolvency.

The second limb is an objective test, and the standard or measurement is the average business person. The fact that the creditor in question is a "reasonable person" does not satisfy the second limb of the defence. The second limb does not require any examination of the particular skills, training and experience of the creditor in question.

Further, in appropriate circumstances, liquidators may recover unfair preferences or other voidable transactions from third parties who have received the benefit of those payments or transactions. Liquidators should closely investigate all the circumstances surrounding any potential voidable transaction to identify whether some or all of any payments or other assets have been transferred to third parties.

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