Section 588FH - Preference Payments and attacking related parties who receive a benefit

Introduction

Section 588FH is one of the recovery provisions in the Corporations Act available to liquidators. The section allows liquidators to recover monies from entities related to the company.

The liquidator will be able to claim the unfair preference from the creditor, and claim the amount of the payment (or more correctly the amount of the reduction in the obligation) from the related entity. The maximum amount that the liquidator can recover from both parties combined is the amount of the payment – they cannot recover the full amount twice.

The reasoning behind this section of the Act, is that the creditor was likely to have been preferred (received the preferential payment) in Order that the related party (usually a family member of the director or the director them self) is released from a financial obligation. The creditor received preferential treatment by receiving the payment, but the related party also receives preferential treatment by having their obligation reduced or eliminated.

Proving the claim

The liquidator will need to prove two separate things to be able to make a claim against the related party. They are:

1. that the creditor received an unfair preference or was party to a transaction void under section 588FE; and

2. the related party had an obligation released.

The liquidator will not be able to take the claim against the related party if they cannot prove both of these components. The job is made slightly easier as the liquidator only needs to prove that the unfair preference to the creditor is “voidable under section 588FE”, not that the statutory defences available to the creditor can be defeated.

This could lead to a position where the creditor received a preferential payment and can rely on the defences, but the related party is still liable under the section.

To prove the positive factors of an unfair preference, the liquidator will need to show the transaction:

(i) gave the creditor a preference or advantage over other creditors;

(ii) was an insolvent transaction (it was done while the company was insolvent); and

(iii) was entered into within the relevant time period (usually 6 months before the relation-back day);

These factors are summarised below.

Preference to a third party

The transaction must be preferential to the creditor, but it does not have to be collectable from the creditor if the defences apply. To be preferential, the creditor must be an unsecured creditor and have received more from the transaction than they would have if they had proved for their debt in the liquidation and received a dividend. This is generally a simple mathematical calculation. Practically these positive factors are relatively easy to prove.

Insolvent Transactions

To be preferential, the transaction to the creditor must be an insolvent transaction as defined by the Act. A transaction is an insolvent transaction if it is:

1. an unfair preference or an uncommercial transaction, and

2. it was entered into at a time when the company was insolvent, or the company became insolvent because of the transaction.

If the company was not insolvent at the time of the transaction or did not become insolvent because of the transaction, there will be no unfair preference and no section 588FA or section 588FH claim.

The time period

To be a preferential payment, the insolvent transaction must be a voidable transaction under section 588FE. To be voidable, the transaction must have occurred within the relevant time periods as set out in section 588FE.

An unfair preference that is attached to the reduction of an obligation to that creditor is usually made to a non-related creditor who holds a guarantee from a related party. Therefore the most common time period considered under section 588FE starts six months before the start of the winding up (called the relation-back day). If the unfair preference was made to a related party a four year period will apply.

The relation-back day is variable depending on how the company was originally wound up. The three common ways for a company to be wound up and therefore three possible relation-back day calculations:

1. the date of the filing of the winding up application (Court appointment);

2. the date of the appointment of a voluntary administrator – if a liquidation results from that appointment; or

3. the date of the member’s resolution appointing a voluntary liquidator – if the company was wound up voluntarily. “relation-back day” , in relation to a winding up of a company or Part 5.7 body, means:

(a) if, because of Division 1A of Part 5.6, the winding up is taken to have begun on the day when an Order that the company or body be wound up was made-the day on which the application for the Order was filed; or

(b) otherwise-the day on which the winding up is taken because of Division 1A of Part 5.6 to have begun.

Once these three factors have been proved, the liquidator will determine whether the positive factors of an unfair preference apply and a prima facie claim can be made against the creditor, and whether or not a claim can be made against the related entity.

The related entity

What is related entity?

A creditor must have received the unfair preference, but the obligation that was released must have been given to that creditor by an entity related to the company as defined in the Corporations Act. The 588FH claim is brought about because the related party received a benefit from the fact that the creditor received an advantage from the original unfair preference.

The related entity is usually a director or member of the company; a beneficiary under a trust of which the company is the trustee; or a close relative of any of these entities.

The liquidator must show that the party that had the obligation released (not the creditor that received the payment) falls into one of these categories.

Release from an obligation

The provisions allow recovery of compensation from a related entity when a transaction was entered into that:

(a) disadvantaged the body of creditors by reducing the available assets (the unfair preference), and

(b) advantaged the related entity by releasing a obligation that they had granted.

The amount of the compensation claim is the amount of the advantage received by the related party, which is the amount of the obligation released because of the payment. That advantage may not be the same amount of the payment – but it usually is.

For example: A creditor is owed $1,000 and the related party had guaranteed that debt to a limit of $800. An unfair preference is paid to the creditor of $1,000 leading to a 588FA claim against the creditor for $1,000. But because the obligation released was only for $800, the 588FH claim against the related party is limited to $800.

Also: If the creditor was owed $2,000 and was fully guaranteed by the related party (to the amount of $2,000), but only received an unfair preference of $1,000 – the creditor would be subject to a $1,000 claim and the related party would be subject to a $1,000 claim as their obligation had been reduced by that amount. But only one of these amounts (or a combined total of $1,000) maybe collected.

That obligation released is commonly a guarantee given by the related entity, but it can be any obligation and under any other form of security or document (e.g. a registered security or mortgage over the related party’s property). The liquidator just needs to show that this commercial obligation existed and was at least partially released.

Limitation of claim

The Act limits the amount that may be claimed from the creditor to the amount of the unfair preference less what has already been collected from the related party, if anything. The claim against the related party may be limited to the amount of the reduction in the obligation less any amount already recovered from the creditor, if anything. The Court will look at what amounts have already been recovered and adjust the amount of any later claims accordingly.

The unfair preference recovery – a claim under 588FA – is sought under section 588FF of the Act. That section provides relief for all claims that are void under section 588FE. Claims under section 588FH are not void under section 588FE, they are void under 588FH. The 588FH claim against the related party is sought under subsection (2).

But the amount of any recovery under section 588FF for the unfair preference, the Court must take into account any recovery made against the related party.

There is no particular Order in which the liquidator has to take these two actions. They are likely to take the easiest claim first, and due to the fact that the statutory defences are not available to the related entity, the easiest claim is likely to be against the related entity.

Once a recovery action is taken against the related party, that party will then gain the same rights that they would have received if they had discharged the obligation to the extent of the payment. For example the related party made a payment to the creditor under the guarantee. These rights would generally arise from a right to indemnities or subrogation into the creditor’s position.

Defences and Timeframe

Statutory Defences – Not Available

The Act provides statutory defences for creditors against claims by liquidators for recovery of unfair preferences. These defences are set out in section 588FG of the Act.

Importantly, these defences are only available to the creditor that received the preference, and not to the related entity that had the obligation released. That is, they are not technically available when considering whether the creditor received a preference or not for the purposes of this section. In Order to make a claim against the related party, the liquidator only needs to show that the transaction (the preference) is a voidable transaction under section 588FE, not that it is actually recoverable from the creditor when the defences are taken into account.

The reasoning is that the defences apply to the actions and knowledge of a party that has had dealings with the company, usually at arm’s-length. The related party has not had those types of dealings in relation to the obligation released and is not at arm’s-length.

Because the defences are available to the creditor, it is possible that recovery may be possible against the related party, but not against the creditor.

Timeframe for claims

A liquidator does not have an endless time period to investigate and commence claims against creditors for unfair preferences. The Act provides that these claims must be made within three years after the relation back day, that is, an application to Court must be made within that three year period. It is insufficient for the liquidator to only have made a demand within that period.

An extension may be granted by the Court, but the application for the extension must be made within the three year period, and the liquidator will need a good reason for the delay.

Section 588FH does not require an Order under section 588FF and the section does not set any time limit for the claims to be made against the related entity.

Corporations Act – Sect 588FF

Courts may make Orders about voidable transactions pursuant to Section 588F(1) of the Corporations Act, if a Court is satisfied, on the application of a company’s liquidator, that a transaction of the company is voidable because of section 588FE.

The claim against the related party can be made even though no claim has been made against the creditor within the time period. Using the same logic as is the case with the statutory defences, the preference only needs to be void under section 588FE. The time limit applies to claims made against the creditor under section 588FF, which does not apply in relation to claims made against the related party.