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Unfair Preferences Demystified

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by Olivia Roberts

If you operate a business, it is important to be aware of what can happen if you receive a payment from a customer who subsequently goes into liquidation or bankruptcy, and a liquidator or bankruptcy trustee tries to ‘claw back’ the payment on the basis that it is an ‘unfair preference payment’.

So, what does ‘unfair preference’ mean and what you should you be aware of?

An unfair preference is defined in s 588FA of the Corporations Act 2001 (Cth) (Act) as a transaction between a company and a creditor which results in the creditor receiving more for an unsecured debt, than the creditor would receive in a winding up of the company.

For individuals, s 122 of the Bankruptcy Act 1966 (Cth) contains an equivalent provision for unfair preferences and the circumstances in which a transfer of property in favour of a creditor can be declared void and clawed back by the trustee. 

The basic elements of an unfair preference are that:

  • there is a debtor/creditor relationship between the insolvent company and the creditor;
  • the creditor receives a payment from the insolvent company;
  • the payment is in respect of an unsecured debt[1]; and

as a result of the transaction the creditor receives more than the creditor would have received if the creditor had claimed the debt in the winding up.

How long does a liquidator have to bring a claim for an unfair preference?

The first notice that you may receive about an unfair preference payment, will be from a liquidator or bankruptcy trustee that has been appointed to one of your former customers. 

A liquidator can make a claim to clawback an unfair preference within the following time frames (unless a Court extends the time):

  • three years after the ‘relation-back date’; or
  • 12 months after the liquidator was appointed to the company.

Is it an insolvent transaction?

An unfair preference may also be what the Act calls an ‘insolvent transaction’[1] if:

  • the company was insolvent at the time the transaction was entered into; or
  • the company became insolvent as a result of entering into the transaction.

The Court could order a creditor to repay an unfair preference that is also an insolvent transaction if the transaction took place:

  • during the 6 months before the ‘relation-back day’; or
  • in the period between the relation back day and the day when winding up began; or
  • during the 4 years ending on the relation-back day if a related entity was a party to the transaction.

What is the Relation Back Day?

The Insolvency Law Reform Act 2016 (Cth) (ILRA)[2] introduced a section to the Act to help identify what the relation back day will be.  The ‘relation back day’ will usually (but not always) be the date that a wind-up application is filed.  The changes to the relation-back day definition now rectify what was a gap in the law when it came to assessing the following scenario:

  • an application to wind-up a company is filed into court;
  • administrators are appointed before the Court determines the winding-up application; and
  • the Court subsequently (despite the company being in Voluntary Administration) winds-up the company and Official Liquidators are appointed.

The relation back day will begin from step (a)[3].

Possible defences to an unfair preference claim

The following defences may be available to challenge an unfair preference claim:

  • the “running account” defence;
  • the “good faith” defence – that the party acted in good faith and had no reasonable grounds to suspect the company was insolvent: s 588FG(2) of the Act;
  • the doctrine of ultimate effect; and
  • mutual credit and set off: s 553C of the Act providing that at the time credit was given to the company, you were not aware that the company was insolvent[4].

“Running account” defence

The ‘running account’ defence is only available where there have been multiple transactions as part of an ongoing business relationship between the company and creditor (a running account).  The series of transactions are treated as constituting a single transaction, and the value of the preference is assessed as the difference between the maximum amount of the debt in the applicable period, and the amount owed on the relation-back day[5].  

‘Good faith’ defence

The ‘good faith’ defence is available if you prove that:

  • you became a party to the transaction in good faith; and
  • at the time when you became a party:
    • you had no reasonable grounds for suspecting that the company was insolvent at that time or would become insolvent; and
    • a reasonable person in your circumstances would have had no such grounds for suspecting[6]; and
    • you provided valuable consideration under the transaction or changed your position in reliance on the transaction[7].

Suspicion’ has been interpreted by the courts to involve a feeling of ‘apprehension or mistrust’ without sufficient evidence of ‘actual and existing insolvency’ and must have been felt at the time at which the payment was made[8].

Reasonable grounds for ‘suspicion’ include:

  • a history of late or unpaid sales and deliveries;
  • dishonoured payments;
  • the absence of transactions or orders over selective periods;
  • the negotiation of an instalment arrangement;
  • a request for extended credit terms;
  • provision of post-dated cheques; and
  • if the creditor had to issue a statutory demand to enforce payment.

What is the ultimate effect defence?

This will involve consideration of the net or ultimate effect of the transaction, i.e. whether the transaction has ultimately decreased the net value of assets available to meet the competing demands of other creditors[9].

For example, where it is claimed that a landlord’s receipt of rent was an unfair preference, courts have held that the purpose of a payment by the tenant of rent in advance is to secure a continuing right of occupation, without which the tenant’s business could not survive.  Accordingly, when the “ultimate effect” of the transaction is considered, it may not be a preference.

Set off provisions

It may be possible to “set-off” an unfair preference claim where there have been mutual credits, debits and mutual dealings between the parties, such that a creditor may be able to have the preference payment set-off against money owed to it by the debtor company.  A set-off cannot be claimed if the creditor had notice of the fact that the company was insolvent at the time of giving or receiving the credit from the company.

The Bankruptcy Act contains an equivalent provision for creditors who have had dealings with insolvent individuals.

How to manage exposure to unfair preference claims

The most obvious (but sometimes not the most practical) way to avoid an unfair preference claim is to avoid being a creditor, which means getting paid up front or cash-on-delivery.

If you are a creditor, then obtaining security from the debtor will help to avoid unfair preference claims, but only to the extent that the value of the security is more than the debt.

Contracts with terms of trade and indemnities should be obtained; however, this will not assist you in resisting an unfair preference claim; rather, it will assist you to recoup money paid to settle an unfair preference claim.

Obtaining personal guarantees from the directors of the company can be invaluable. If the company goes into liquidation and you must repay a preference payment, you could claim the amount in question from the guarantors.

If you have a client or customer in financial difficulty and are concerned that a payment might later be clawed back as an unfair preference, or you receive a claim from a liquidator or trustee in bankruptcy, contact Olivia Roberts or John Warlow at McCarthy Durie Lawyers:

Olivia Roberts (Senior Associate):  Oliviar@mdl.com.au  /  07 3517 6388

John Warlow (Director):  Johnw@mdl.com.au  /  07 3002 7419

Both Olivia and John have considerable experience in insolvency and bankruptcy law.

[1] s 588FC of the Corporations Act

[2] s 91 1 – 15 of the ILRA which is now section 91 of the Act, and s 513C of the Act

[3] Brereton J held otherwise in Chief Commissioner of State Revenue v Rafferty’s Resort Management Pty Ltd (in Liq) [2008] NSWSC 452. Brereton J held that the relation-back day is the date Administrators were appointed

[4] S 553C(2)

[5] S 588FA(3)

[6] S 588FG(2)(b)

[7] S 588FG(2)(c)

[8] s 588FG(2)(b) of the Act; Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266.

[9] Air Services Australia v Ferrier (1996) 185 CLR 483

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