Defending unfair preference claims: set-off and security revisited

In brief

A recent Federal Court decision has highlighted two grounds on which creditors should consider defending unfair preference claims which are brought by liquidators. Partner Chris Prestwich and Lawyer Tim Chiang look at a case that deals with what constitutes an unsecured debt and the extent to which creditors are able to set off unfair preference claims. 

Background

Unfair preference claims remain a staple of many liquidations. There are a number of grounds on which creditors can seek to defend those claims, and the Federal Court¹ has recently considered two areas in which the law is far from settled:

• What constitutes an 'unsecured debt' for the purposes of ascertaining the types of payments that can be challenged as unfair preferences; and
• Whether a creditor is entitled to set-off any outstanding debts they are owed against any unfair preference payments they are required to pay. 

The Federal Court's decision highlights that both issues should be considered by a creditor seeking to resist an unfair preference claim. That is in addition to the usual arguments available to a creditor, being whether the company was solvent at the time of the payment, whether a 'running account' was in place and the 'no reasonable grounds to suspect insolvency' defence.

The facts

The relevant facts of the case are as follows:

• FPJ Group Pty Ltd (FPJ) purchased building supplies from CSR Building Products Limited (CSR) under a credit agreement. CSR retained title to the goods until such time as payment was made;
• FPJ Group was wound up in insolvency and the liquidator challenged payments made to CSR under the credit agreement in the relevant six-month period as being unfair preferences; and
• CSR defended the claim on grounds which included that FPJ was not insolvent when it made the payments and the payments were not unfair preferences as CSR was a secured creditor.

The liquidator's claims were dismissed on the basis that the company was not insolvent at the time of the payments. The court went on to consider whether there were other grounds on which CSR could have resisted the claim, including whether the debt owed was a secured debt given the retention of title arrangements and whether CSR was entitled to set-off other monies owing to it against any unfair preference claim.

Unsecured debts and retention of title arrangements

A payment can only be an unfair preference if it is made in respect of an 'unsecured debt'. The issue that arose here is whether CSR's retention of title rights were sufficient to make its debt a secured debt, repayment of which would not be an unfair preference.

In construing what constitutes an 'unsecured debt' for the purpose of the unfair preference provisions, the court considered that the very broad definition of 'security interest' in the Personal Properties Securities Act 2009 (Cth) (the PPSA) provides relevant context. Having regard to the treatment of retention of title clauses in a voluntary administration, the court held that a retention of title clause will constitute a security for the purposes of the unfair preference provisions of the Corporations Act 2001 (Cth). CSR was accordingly a secured creditor and had not received payments in respect of an unsecured debt.

A 'security interest' under the PPSA also includes hire purchase agreements, pledges, consignments, certain types of leases and assignments. It remains to be seen whether holders of 'security interests' of that type will also be able to establish that payments they receive are payments made in respect of a 'secured debt'.

When is it assessed whether a creditor is secured or unsecured?

The court went on to consider whether the question of whether a debt is secured or unsecured should be assessed at the time that the payment is made, or at the time the company goes into external administration. Secured debts are taken to be partially unsecured if the security is of insufficient value.

This question of timing has important ramifications:

• If the value of the security is assessed as at the date of external administration (as the liquidators contended in this case), secured creditors who realise their security in the months leading up to external administration could still be left exposed to unfair preference claims, even if they were wholly secured at the time of realising the debt; and
• If the value of the security is assessed as at the time of receiving the payment (as has been the standard approach), a more limited range of payments are open to challenge by liquidators.

The court noted the lack of authority on this point, although an overturned decision of the South Australian District Court supports the liquidator's contention. The court also noted that arguments are available to support either construction. Ultimately, as the case was decided on other grounds, this question was not resolved.

Can an unfair preference claim be defended on the basis of an off-setting claim?

A further issue in the proceeding was whether a defendant could set-off any liability to repay an unfair preference against other debts owing by the company. This question is not new see the discussion at the end of our paper 'Don't take a slice of my pie': Defending Your Position as an Unsecured Creditor of a Company in Liquidation.

The court highlighted:

• A number of decisions which support the proposition that set-off is available as a defence to unfair preference claims; and
• Some 'powerful contrary arguments' as to why those decisions should not be followed and a set-off should not available as a means of defending unfair preference claims.

This question was also left undecided, as the liquidator's claim was dismissed on other grounds. This remains an issue which is ripe for determination in an appellate court. Until such time, it remains open to creditors to put forward set-off as a basis for resisting unfair preference claims.

Conclusion

Unfair preference claims can be costly and complicated claims for liquidators to pursue. There are a number of grounds on which creditors can either seek to resist claims or negotiate a favourable early settlement of claims which are asserted.

Nonetheless, unfair preference risk, and the basis of ongoing trading, remains an issue which needs to be carefully managed by creditors if one of their counterparties appears to be approaching insolvency.