Sometimes, getting paid by a client for accounting or legal services can be like pulling teeth. Imagine then if you finally get paid and a liquidator comes knocking demanding the money back.
Under s588FA of the Corporations Act 2001, (and s122 of the Bankruptcy Act 1966 for individual client) you may have received an unfair preference and the liquidator may be legally entitled to have it back, thank you very much. The liquidator has 3 years to commence a preference recovery action after appointment, leaving the average adviser scratching their head thinking who is being treated unfairly! And just to rub salt into the wound, it may even be the liquidator you referred the job to.
The intent of these sections is to make sure that all unsecured creditors are treated equally if a company is wound up or an individual becomes bankrupt.
An unfair preference between a debtor and a creditor occurs if
- the debtor was insolvent when, or became insolvent as a result of, paying the creditor
- the transaction occurs within 6 months prior to the beginning of the liquidation (if voluntary liquidation) or relation-back date*
- the creditor and debtor are parties to the transaction
- the creditor is unsecured
- the creditor receives more benefit than if they had received the same liquidation dividend as other unsecured creditors.
* Relation-back date varies according to the circumstances for commencement of the winding up and is defined in Corporations Act 2001 .
There are precautions that business advisers can take to protect against having hard-earned money clawed back and there are defences if the liquidator comes knocking.
“Good Faith” defence.
It is a defence against an unfair preference claim if you did not know that a client was insolvent at the time that you received their payment.
It may be harder for business advisers on retainer to prove they had no reasonable grounds to suspect insolvency. If your relaxed approach to chasing payments from a client suddenly becomes more strident, possibly aggressive after seeing the writing on the wall… well, you know how that looks.
Don’t be a creditor. Get paid upfront or make your payment terms cash on delivery. Accept credit cards and/or set up a direct debit system.
Routinely follow up all payments to avoid an out-of-character demand for payment appearing like suspicion of a client’s insolvency. If you must be a creditor, be a secured creditor and register that security on the Personal Properties Security Register.
Make this a regular practice. Timing is everything. An out-of-the-blue registration on the PPSR or change of engagement terms to include a Director’s Personal Guarantee and charging clause within the statutory timeframe can itself be deemed a preferential act.
Running Balance defence.
Another situation where timing is everything is the running balance account (RBA). The running balance defence won’t completely defend a preference claim but can reduce the damage done.
A running balance is taken to exist where there is an ongoing trading relationship between the debtor and creditor, and where the balance of the account fluctuates due to payments received and services/ goods supplied. The running balance defence relies upon the continued supply of goods or services.
It is not a running balance account if each payment received relates to a specific invoice. A running balance account ends once the creditor requires cash on delivery, starts demands for payment or the predominant purpose is to pay the debt rather than continue supply.
The amount clawed back by the liquidator is the net benefit to the creditor during the relevant period.
Manage your RBA to minimise the net effect of transactions. And importantly, be aware that a liquidator may attempt to apply the Peak Indebtedness ‘Rule’ whereby they can calculate the net effect from the point of peak indebtedness (the largest outstanding amount) rather than the natural start of the six months prior. So, this should be a nudge to keep peak indebtedness to a minimum.
Doctrine of Ultimate Effect defence.
It is a defence if the payments are made to secure services that ultimately preserve or increase the value of the debtor company’s assets (and therefore the liquidation dividend to all creditors).
Like RBA, you must continue to provide services for this defence to apply.
Liquidators are commercial creatures. Cost v benefit rules when it comes to initiating legal action. Every liquidator has their own commercial threshold when it comes to deciding to risk scarce resources on legal actions.
Don’t let your client accounts get excessive. Pay regular attention to your slow paying clients. Be consistent in your collection policies. Inform your clients on what to expect from you if their accounts age.
Early involvement of insolvency professionals is the ultimate prevention
Prevention of unfair preferences is better than cure. Consistent implementation of a sound credit policy is the primary solution. Finally, early intervention with clients heading towards insolvency always gives better chance of turning the business around and avoiding the risk of having hard-earned professional fees clawed back.
Shaw Gidley are experts in restructuring, turnaround and insolvency and provide free initial advice on these matters. Please contact our offices on (02) 4908 4444 or (02) 6580 0400.