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Can a payment made by a related third-party be an unfair preference?

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By Benjamin Caddaye, Law Clerk and Alicia Hill, Principal, MST Lawyers

On 5 August 2020 the Victorian Court of Appeal handed down its judgment in Cant & Anor v Mad Brothers Earthmoving Pty Ltd [2020] VSCA 198. In this case, the liquidator of Eliana Construction and Developing Group (Eliana), Mr Cant, was pursuing Mad Brothers Earthmoving Pty Ltd (Mad Brothers) for an alleged unfair preference. A related company to Eliana had paid $220,000 to Mad Brothers in satisfaction of Eliana’s debt. The Court of Appeal, in finding that the transaction was not an unfair preference as it did not come ‘from the company’ provides useful guidance on how to deal with a third-party paying the debt of an insolvent company. The decision touches on the operation of the good faith defence to voidable transactions contained in the Corporations Act 2001 (Cth) (Act).

Background

Eliana owed $236,952.31 to Mad Brothers for earthworks conducted at various construction sites in Victoria. $87,236.15 of that amount related to work performed at a site in Taylors Hill. This site was owned by Rock Development and Investments Pty Ltd (Rock), which was a related company to Eliana with the same sole director and shareholder, Mr Sowiha.

Eliana did not pay Mad Brothers and in April 2016 Mad Brothers served a statutory demand which went unanswered. In May the Victorian WorkCover Authority filed an application in the Supreme Court seeking an order winding up Eliana. Then in June Mad Brothers also filed an application seeking an order Eliana be wound up based on its failure to comply with the statutory demand.

In August, Eliana ceased trading, suspended its employees and was placed into voluntary administration. Then in September Eliana executed an agreement with Mad Brothers where it agreed to pay $220,000 in settlement of Mad Brothers debt claim. This amount was paid later in September by Rock from a facility it had obtained from Nationwide Credit, which had been secured using Rock’s Taylors Hill property.

In November, the creditors of Eliana resolved to place the company into liquidation. The liquidator then initiated proceedings against Mad Brothers, claiming that the payment from Rock to Man Brothers was an unfair preference and therefore a voidable transaction.

Legal Background

The Corporations Act 2001 (Cth) (Act) contains in Part 5.7B a series of integrated provisions which permit a liquidator in certain circumstances to claw back amounts paid away by an insolvent company.

An unfair preference is defined in section 588FA of the Act as a transaction that:

(i)                the company and the creditor are party to; and

(ii)               results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, 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.

An unfair preference can also be an insolvent transaction under section 588FC of the Act if, in addition to being an unfair preference, any of the matters in section 588FC(a)-(b) occur while the company is insolvent. Specifically in section 588FC(a)(ii), if an act is done to give effect to the transaction.

If a transaction is found to be an unfair preference and an insolvent transaction, and it occurred within the six month preceding the relation-back date, then the liquidator can apply under section 588FE of the Act to have the transaction voided and repaid to the liquidator.

However, even if the payment is a voidable transaction, section 588FG(2) of the Act provides a defence if it is proved that the person became a party to the transaction in good faith and at the time when the person became such a party:

(a)               the person had no reasonable grounds for suspecting that the company was insolvent at that time or would become insolvent; and

(b)              a reasonable person in the person’s circumstances would have had no such grounds for so suspecting; and

(c)               the person has provided valuable consideration under the transaction or has changed his, her or its position in reliance on the transaction.

Trial Judge

At first instance the matter was heard by an Associate Judge. There were two related main issues which were first, whether Eliana was a party to the transaction as required by section 588FA(1)(a) and second, whether the payment of $220,000 was ‘from’ Eliana within the meaning of section 588FA(1)(b).

The Associate Judge held that a request or authorisation on the part of Eliana in respect of the payment sufficed to establish that Eliana was a party to the transaction. Then, as the payment was ‘from’ Eliana, nothing more was required as it was not in doubt that Mr Sowiha had directed Nationwide to pay the money to Mad Brothers. Therefore, the payment was found to be an unfair preference.

The Associate Judge then rejected the good faith defence relied on by Mad Brothers.

While it was accepted Mad Brothers had acted in good faith, the Associate Judge held that, for the purpose of section 588FG(2)(b), a reasonable business person would have no basis to believe that Eliana was solvent at the time of the payment. Relevant factors included the fact that Eliana had made offers to pay by instalments, a statutory demand and winding up application had been served and at least one other creditor (WorkCover) had applied to wind up the company.

Appeal to Single Judge

The decision of the Associate Judge was appealed to a single judge of the Supreme Court where the appeal was upheld by His Honour Justice Robson.

Robson J considered the question whether or not Rock owed money to Eliana had a bearing on whether or not the payment constituted a payment by or from Eliana within the meaning of ss 9 and 588FA(1) of the Act. He held that it had not been established that Rock was a debtor of Eliana at the time of the payment was made, as Eliana had very poor financial records. However, he considered that, on any view, what had taken place in relation to the payment amounted to a transaction within the meaning of section 9 of the Act and Eliana was party to that transaction. If Rock was not indebted to Eliana, then the transaction involved Eliana incurring an obligation to Rock. If Rock was indebted to Eliana, then the transaction involved a release by Eliana of part of that debt.

However, in dealing with whether the payment was ‘from the company’ for the purpose of section 588FA(1)(b), Robson J held that the payment does not constitute a payment by the debtor to the creditor within the meaning of section 588FA(1)(b) where:

  • a payment by a third party which discharges the debtor’s debt to the creditor which is authorised and ratified by the debtor; and
  • only involves the debtor incurring a liability in favour of the third party and no reduction of assets of the debtor.

He found the fact Eliana authorised and ratified the payment by Rock was insufficient to constitute a payment by Eliana to Mad Brothers. Thus, it was is insufficient to establish that an unfair preference had been given by Eliana to Mad Brothers

Finally, His Honour considered the good faith defence. He held that the material provided to Mad Brothers and the facts that subsisted when the payment was received were not sufficient to induce a ‘positive apprehension’ as to actual insolvency.

Justice Robson found that the associate judge had erred by failing to have proper regard to information provided to Mad Brothers and other events which occurred after the statutory demand was served and the winding-up proceedings commenced, but prior to the payment. Among other things, the judge referred to documents filed by Eliana in the winding-up application directed at establishing its solvency. Therefore, and Mad Brothers had established the defence, even if an unfair preference had been established.

Appeal to the Court of Appeal

The case was then appealed to the Victorian Court of Appeal which allowed the appeal but dismissed it, largely upholding the findings of Robson J.

There Honours held that a ‘transaction’ within the meaning of section 9 was capable of being made up of a series of interrelated or composite dealings. That definition extended to a dealing by which the third party authorises or ratifies that person’s conduct in making the payment. However, the Court noted that just because the company was a party to the transaction did not mean it followed that the payment was ‘from the company’.

After an extensive consideration of the authorities, the Court held it was quite clear that section 588FA(1)(b) required that a payment, in order to amount to a preference, be made from the company’s own money, and not simply be ‘made by’ the company. The company’s own money extended to money or assets to which the company is entitled which has the effect of diminishing the assets of the company available to creditors.

Therefore, in line with Robson J, the Court of Appeal held that Eliana was a ‘party to’ the transaction for the purpose of section 588FA(1)(a), as it had authorised or ratified the payment.

However, the payment was not ‘from the company’ for the purpose of section 588FA(1)(b) as they payment was not from the company’s own money and it did not result in an diminution of the company’s assets. Therefore, there was no unfair preference.

However, their Honours disagreed with Robson J in relation to the good faith defence. They noted it could not be said that a reasonable person, knowing the history of the matter would not have suspected that Eliana was insolvent. Relevant factors included the two winding-up applications against Eliana, Eliana undertook to pay, then contested the debt before proposing to pay it by instalments, before revising its offer by wrongly discounting the amount by $80,000. Thus, if a preference had been proved, the good faith defence under s 588FG(2) would not have been established and we would have upheld this ground.

Commercial considerations

This decision reiterates for liquidators that where a payment is made by a related party discharging the debt of the insolvent company it will only be an unfair preference if it ‘comes from the company’ in the sense of coming from its money and reducing its assets.

The decision also reinforces the difficulty in establishing the good faith defence where winding up applications and payment arrangements are part of the knowledge in the possession of the paying party.

Please contact Alicia Hill on (03) 8540 0200 or Alicia.hill@mst.com.au if you would like to discuss any aspect of insolvency or unfair preferences raised by this article.