Introduction
The economic uncertainty surrounding many months of interest rate rises, dampened business confidence and an ever-increasing focus on recovery of tax debts by the ATO puts insolvency back in the spotlight. From the Parliamentary Joint Committee on Corporations and Financial Services report to the High Court of Australia’s decisions regarding preference claims, there is a lot to report on in the insolvency space. This update discusses a number of recent developments in the insolvency space that advisers should be aware of given that they are likely to have an impact on their clients.
The Release of the Parliamentary Joint Committee report on insolvency laws
On 13 July 2023, the Parliamentary Joint Committee on Corporations and Financial Services released its final report into the effectiveness of Australia’s corporate insolvency laws. The Committee determined that the current corporate insolvency system is overly complex, difficult to access, and that it creates unnecessary cost. The Committee’s report was limited to identifying shortcomings of the current system and pointing out the areas which should be subject to further legislative reform. Some of the key recommendations of the report include:
- implementation of the recommendations of the Safe Harbour Review regarding protection for company directors from personal liability for insolvent trading if a company is attempting to restructure;
- reforms to the small business restructuring pathway and simplified liquidation pathway;
- review of the insolvent trading regime;
- review of the relative priority of employees, liquidators and secured creditors;
- review of franchising insolvency issues;
- review and consideration of unfair preferences and voidable transactions as a core aspect of potential insolvency reform; and
- improving the solvency process for trusts.
If the recommendations of the Committee are implemented, Australia can expect to see significant reforms to the legal framework for corporate and personal insolvency both in the short term and in the coming years.
Given the significant input from industry and stakeholders in this process, it is highly likely that this report will kick-start significant reform in Australia’s insolvency laws. The reforms will be the subject of future updates.
Recent developments in Unfair Preferences
The recovery of unfair preferences is a key focus of liquidators when they are appointed to an insolvent company. In broad terms, a liquidator can seek to recover payments that the company made to unsecured unrelated creditors in the relation back period, which is the period commencing at least six months before the start of the liquidation of the company. Advisers that are assisting clients which are subject to a preference claim by a Liquidator should understand what defences may or may not be available, and this part of the update deals with recent High Court decisions on the law of unfair preferences.
High Court of Australia rejects “set-off” defence in connection with unfair preference claims
On 8 February 2023 the High Court of Australia handed down its decision in Metal Manufacturers Pty Limited v Gavin Morton as liquidator of MJ Woodman Electrical Contractors Pty Ltd (in liquidation) & Anor, (Morton) and finally resolved the uncertainty surrounding the application of the “set-off’ defence in the context of unfair preference claims. This was an appeal from a decision of the Full Federal Court of Australia, in which the Court decided that “set-off” was not available as a defence to unfair preference claims.
Section 553C(1) of the Corporations Act (Act) provides that where there have been mutual credits, debits or mutual dealings between a company in liquidation and a creditor seeks to have their claim or debt admitted against the company, then account is to be taken of what is owed by one party to the other.
The High Court held that a right of set off under section 553C(1) of the Act is not available as a defence to a liquidator’s claim to recover an unfair preference. The High Court agreed with an earlier decision of the Full Federal Court which held that the defence was not available as there was a lack of mutuality between the indebtedness of the company to the creditor and the liability of the creditor to pay the company as a result of a court order obtained by the liquidator. Below, is a very simple example reflecting the effect of the High Court decision:
- Company A paid $100,000 to Company B.
- Company A is placed into liquidation.
- Company B owes Company A an amount of $50,000 at the time of being placed into liquidation.
- the liquidator of Company A establishes that the payment of $100,000 to Company B is an unfair preference.
- Company B cannot seek to offset the liquidator’s unfair preference claim against the $50,000 it owes to Company A. Therefore Company B remains liable to the Liquidator for the value of the $100,000 unfair preference claim plus the debt of $50,000 that remains owing to Company A.
After many years of controversy about the availability of the set-off defence under section 553C(1), the High Court has provided certainty on its application by rejecting the availability of that defence.
The High Court abolishes the “peak indebtedness” rule relation to unfair preference claims
In a further significant decision relating to unfair preferences, the High Court of Australia in a judgment handed down on 8 February 2023 in Bryant v Badenoch Integrated Logging Pty Ltd (Bryant), abolished the “peak indebtedness” in relation to preference claims that involve running accounts.
Prior to the decision in Bryant, the peak indebtedness rule allowed a liquidator to choose the point of highest indebtedness during the relation back period, compare this to the account balance at the time of appointment, and if this figure had decreased over this time, liquidators could seek to recover the difference as an unfair preference.
In Bryant the High Court stated the “peak indebtedness rule” had no place in a liquidator’s analysis, rather the liquidator should instead look at the entirety of the running account over the specified period in order to determine whether there had been an increase or decrease in ultimate effect in relation to the debtor’s debt.
The decision in Bryant makes it harder for liquidators to recover unfair preferences and/or can significantly reduce a liquidators claim.
Setting aside a Deed of Company Arrangement as an abuse of process
Advisers are often asked to provide guidance to clients around insolvency and restructuring options. A restructure of an insolvent company by way of entry a deed of company arrangement (DOCA) is common. A DOCA is an agreement between a company and its creditors that sets out how the company’s affairs and assets are to be dealt with. A DOCA is agreed to after a company enters voluntary administration. If a DOCA is agreed to by the majority of creditors by number and in value, the DOCA binds all creditors.
However, unhappy creditors can challenge a DOCA especially if the restructure does not appear to be a genuine one. A recent case in the Supreme Court of New South Wales considered such a scenario. Where a DOCA is either successfully challenged in Court, or is terminated, the company will usually enter liquidation.
In the matter of ACN 613 909 596 Pty Ltd (formerly Minle Wine Negociants of Australia Pty Ltd) (subject to Deed of Company Arrangement) [2023] NSWSC 753 (Minle Wine) the Supreme Court of New South Wales terminated a DOCA by applying the provisions of section 447A of the Act. The DOCA was terminated in the following circumstances.
Minle Wine was a business engaged in wholesale liquor, export sales and excise duty drawbacks which accounted for nearly all its revenue. Minle Wine sustained foreign exchange losses that resulted in it being sued. Minle defended the proceedings. At the same time, Minle Wine’s director set up a new export company. Minle Wine’s stock was transferred to the new company. Minle Wine ceased trading and started to wind down its business. Minle Wine then went into voluntary administration. A DOCA was proposed which extinguished the foreign exchange claim and prioritised payments to the sole director of Minle wine and interests associated with him.
In setting aside the DOCA and ordering that the company be wound up, the Court found that the company’s creditors would only benefit minimally from the DOCA, the only creditors who voted for the DOCA were creditors related to the Company and its director and the DOCA did nothing to promote the continued operation the Company’s business which had ceased.
DOCAs proposed without showing any genuine intention of restructuring a company are likely to be challenged by dissatisfied creditors and set aside by a Court. Such an outcome is even more likely if there are transactions involving directors that might be in breach of their duties.
The termination of Deed of Company Arrangement because of a misleading administrators’ report
In Sino Group International Ltd v Toddler Kindy Gymbaroo Pty Ltd [2023] FCAFC 110, the Full Federal Court of Australia recently dealt with an appeal which considered whether a Deed of Company Arrangement should be terminated.
The Full Federal Court found that the administrators’ report (Report) was materially misleading or omitted material information in circumstances where the estimate contained in that Report outlined that unrelated creditors would receive a return of 100 cents in the dollar.
Among other matters, the Court held that the Report did not state why it did not include a worst-case comparison for the purpose of assessing the return to creditors in a DOCA scenario, however a worse case comparison had been provided in the winding up scenario.
The absence of a worst-case analysis in a DOCA scenario without any explanation for its absence caused the Report to suggest that a return of 100 cents in the dollar was highly likely and a worst-case scenario unlikely so that it was not necessary to include in the Report. This made the estimated return of 100 cents in the dollar misleading.
Conclusion
The above issues are very complex and you should seek advice from an insolvency practitioner on a timely basis.
