Debt collection and Insolvent Transactions

Are you likely to be forced to repay to a liquidator money previously received from a customer?

It has become relatively common for suppliers and others to be challenged by liquidators to repay funds that they have previously been paid.

Prior to the change of rules in late 2007, the contentious issue was determining what "the ordinary course of business" meant. The decisions surrounding liquidators' challenges did not discourage conventional or usual debt collection measures.

Since the McEntee Hire decision in August 2010 we have observed an increase in liquidators sending out letters seeking to challenge transactions.

It is disappointing that some liquidators seem to take an approach of challenging all payments made, rather than first considering whether there has been an actual preference to the creditor, any continuing business relationship (ie whether the contract was ongoing at the time of payment), industry practice (which may tolerate delays of payments), evidence and knowledge of credit concern, the nature of payments and trading history.

Consequently, we are sometimes asked to assist in reviewing Insolvent Transaction challenges taken by other liquidators.

As a result of such challenges, the Insolvent Transactions regime can be seen by suppliers in particular, to be at odds with prudent credit management. This is a conclusion that could be reached in light of the McEntee decision, but is that conclusion right?

We have also observed that suppliers are belatedly endeavouring to patch up holes in their procedures, in particular by late PPSR registrations of additional security rights to secure past indebtedness.

In our opinion, in some circumstances knowledge of a debtor's insolvency may be hard to avoid. It follows that the longer a debt goes unpaid the more likely it is that the supplier will be considered to be aware of the customer's inability to convert non-cash assets into cash, ie insolvency.

We consider that the consistent use of proper terms of trade, normal timely debt collection procedures, and asset protection mechanisms may protect a supplier from successful Insolvent Transaction challenges.

The regime therefore can be seen to encourage stricter credit terms and management, well defined trading terms and better security management. The mere fact of applying pressure to get payment does not in itself compel the conclusion that the payment is an Insolvent Transaction.

Insolvent Transactions regime

In an insolvent liquidation, unsecured creditors are treated equally and the company's assets are shared on a pro rata (or 'pari passu') basis. The term that is often used is to stop a creditor from 'stealing a march' on others. Where payments give individual creditors a preference, the regime enables a liquidator to set aside and claw back payments made within the two years before liquidation.

One feature of the current regime is the running account concept. This allows for the net effect of a series of invoices and payments in a "continuing business relationship" to be considered as one transaction. This is designed to stop liquidators challenging a series of payments to the same supplier, instead putting the focus on what the overall effect of the transactions was.

A continuing business relationship is established through a background of trading between the supplier and the customer. Factors such as the basis for the relationship, the business purpose and the character of the relationship, length of the relationship and frequency of transactions will usually be taken into account.

In McEntee Hire, it was agreed that a continuing business relationship existed, as McEntee had traded with its customer for over three years, with many sales and payments regularly in that period. However, the Court found that the continuing business relationship ended when McEntee issued a stop credit notice and referred the debt to a collection agency. It was noted that this was done four months after the last invoice for supply had been issued, and in circumstances where its policy in cases of suspected insolvency was to refer the debt to a collection agency.

McEntee argued that the stop credit notice was not the end of the continuing business relationship but more to "rebalance" and "preserve" the trading relationship, and did not reflect any concerns about the company's solvency. The liquidators successfully argued that payments were not being made to induce further supplies, and the relationship had shifted to one of pure debt collection.

We speculate that had the right to stop credit been with regard to a credit limit or other credit terms, and the referral to a debt collection agency been earlier and as a routine referral, the continuing business relationship may have endured.

Running account

An Insolvent Transaction claim is calculated in a number of ways; firstly where there is no running account, as a sum of payments, secondly when there is a running account, the net difference between the opening and closing balances and lastly, at the point of peak indebtedness - being the difference between the peak and the closing balance. This is illustrated as follows:-

Month Supply $ Payment $ Net Balance $
Nov-11 30,000   30,000
Dec-11   20,000 10,000
Jan-12 20,000   30,000
Feb-12   20,000 10,000
Mar-12 60,000   70,000
Apr-12   60,000 10,000
May-12 30,000   40,000
Jun-12   20,000 20,000

Possible scenarios:-

  1. No running account - sum of all payments $120,000
  2. Simple running account (opening - closing) $10,000
  3. Peak indebtedness (point of peak indebtedness - closing balance) $50,000

In this example, a supplier commenced trading with a customer in 2010. By November 2011, the customer owed the supplier $30,000. Six months later the customer owed $40,000. In June 2012, the company is placed into liquidation owing the supplier $20,000. Using this example, a liquidator could argue peak indebtedness and say the supplier was preferred by $50,000. The liquidator cannot cherry- pick a transaction (eg the April 2012 $60,000 payment) when there is a running account, and ignore that the creditor continued to trade with the company as a result of the payments made. Australian authorities have said, however, that liquidators ought to cherry-pick a date of peak indebtedness that best suits the general body of creditors. Section 292(4B) of the Companies Act 1993 does not limit a liquidator's ability to do so.

Summary

Insolvent Transactions will be a contentious but necessary feature of insolvency law for the foreseeable future. Creditors should review trade terms, and ensure that they have policies and debt collection processes and procedures that minimise the ability for liquidators to claw back valuable funds.

DISCLAIMER
This article is intended to provide general information and should not be construed as advice of any kind. Parties who require clarification on issues raised in this article should take their own advice.

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