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Third-party payments and unfair preference claims- effective shield or not?

By Sam KingstonIsabella Pierri

• 09 July 2020 • 6 min read
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Unsecured creditors receiving payments in the current COVID-19 induced economic climate clearly do so at a heightened risk of being forced to repay anything they receive as an unfair preference.

In the absence of legislative reform similar to the relaxation of the insolvent trading provisions (see our alert Softening the financial blow of COVID-19: Sweeping temporary changes made for directors and debtors here) it is expected that many creditors will have difficult retaining payments they receive. Could the common strategy of insisting on payment from a third party help?

Key takeaways

In summary:

  1. A liquidator is likely to attack a payment made by a third party as an unfair preference where, amongst other things, the insolvent debtor has arranged for the payment to be made and the payment results in a reduction of the debtor’s assets. Recent cases give some useful guidance to insolvency practitioners and creditors alike on the factors a court will take into account in assessing whether a third party payment amounts to a preference.
  2. In a related and commonly raised example, a creditor who receives monies from a bank after calling on a bank guarantee does not receive an unfair preference.

Payments from third parties

It is common practice for creditors to attempt to reduce the risk of payments received on account of unsecured debts being clawed back as unfair preferences by requiring payment to be made by a third party rather than the potentially insolvent debtor. The desired result is that payment from a third party will break the nexus of the transaction between the creditor and debtor, meaning that the payment will not be recoverable as an unfair preference. The difficulty for creditors is that the courts do not rely on one particular consideration as determinative, but rather the circumstances are considered as a whole.

What factors are relevant?

Case law in recent times generally focuses on the “ultimate effect” of the payment, namely whether the competing creditors’ interests have been unfairly compromised by a third party payment.[1] Further factors to consider in determining whether a third party payment is an unfair preference include whether the payment can be characterised as a payment by the debtor or whether it merely involves the debtor, as well as the purpose for the payment. [2] The outcomes can be inconsistent; for example:

  1. In the recent case of Johnson as trustee of bankrupt estate of Portellos v J.S.J. & A. Nominees Pty Ltd,[3] the Federal Circuit Court found that payment from a trust account maintained by the bankrupt’s solicitor holding funds contributed by a related entity of the bankrupt was a payment made using the bankrupt’s own funds, the payment was preferential and void against the trustee. A comment by the bankrupt’s solicitor that the creditor “should be aware that the payment is being made by a third party and as a consequence [the creditor’s] risk of accepting the funds is substantially reduced” ultimately highlighted the sham nature of the transaction. The key factor in this case was that the bankrupt was using various companies as “bank accounts” to create the appearance of an arm’s length transaction and avoid the unfair preference regime;
  2. In Re Eliana Construction and Developing Group Pty Ltd (No 2)[4], a payment made by a related company of the debtor using money that was borrowed on security provided by the related party was not an unfair preference as the payment did not diminish the debtor’s assets. The Court considered that, although the debtor had authorised the payment, this was insufficient to constitute a payment by the debtor to the creditor. However, had the related party been indebted to the debtor, the transaction would be voidable as it would have diminished the assets of the debtor;
  3. In Re Cyberduck Software Pty Ltd,[5] the application by the Australian Tax Office of a GST refund owing to Cyberduck against a tax debt of a related party was an unfair preference. The court accepted arguments that all that was necessary to show an unfair preference was that the third party was authorised by the debtor company to make the payment, but ultimately did not order that the transaction be set aside on other basis (see our alert Voidable transactions- falling at the final hurdle here); and
  4. In Re Evolvebuilt Pty Ltd,[6] payments made by a head contractor to subcontractors of an insolvent contractor in the context of union threats to halt construction were not unfair preferences. Relevantly, the head contractor made the payments without any direction from the contractor and for its own benefit to stop union action. The contractor also had no claim against the head contractor.

What’s the outcome?

The above cases demonstrate that whilst it has been recognised that payment from a third party rather than an insolvent debtor may break the link required for an unfair preference, the circumstances of payment will ultimately determine the outcome. As such, receiving a payment from a third party will not provide any guarantee that the payment might not be later set aside as an unfair preference.

A related example - calling on bank guarantees

A common question for landlords and construction principals is whether they may be exposed to unfair preference claims when calling on performance securities such as bank guarantees.

Typically, a bank guarantee requires the bank to pay out the guarantee on demand and without regard to the company’s direction or objection. Although no cases appear to have directly considered the position, by analogy to payment by a guarantor, it is generally considered that payment by a bank will not be a payment from the debtor’s assets or made with the debtor’s direction and no unfair preference can arise.

[1] Re Eliana Construction and Developing Group Pty Ltd (No 2) [2019] VSC 546 (in the context of section 588FA of the Corporations Act).

[2] Re Evolvebuilt Pty Ltd [2017] NSWSC 901 (in the context of section 588FA of the Corporations Act).

[3] [2020] FCCA 934.

[4] [2019] VSC 546.

[5] [2018] VSC 122.

[6] [2017] NSWSC 901 affirmed on appeal in Hosking v Extend N Build Pty Ltd [2018] NSWCA 149.

By Sam KingstonIsabella Pierri

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