The Victorian Court of Appeal recently handed down its decision in Cant & Anor v Mad Brothers Earthmoving Pty Ltd  VSCA 198 (5 August 2020). This decision sheds light on what happens when liquidators try to claw back payments made by a third party.
Unfair preference claims are commonly made against creditors of insolvent companies, but when payments are made by parties other than the insolvent company, it becomes unclear whether the third-party payment is at risk of clawback by a liquidator as well.
Eliana Constructions Pty Ltd (Eliana) incurred a debt to Mad Brothers Earthmoving Pty Ltd (Mad Brothers) for earthworks at various sites, of which one was owned by Rock Development & Investments Pty Ltd (Rock). Eliana and Rock are related entities; they shared a common director in Magdy Sowiha (Mr Sowiha).
Mad Brothers served a statutory demand on Eliana. In the absence of satisfying the demand or commencing proceedings to set aside or vary the demand, Mad Brothers commenced winding up proceedings against Eliana.
On 15 September 2016, Eliana and Mad Brothers entered into a settlement agreement, in which Eliana agreed to pay Mad Brothers $220,000 in full and final settlement of the winding up proceeding.
On 16 September 2016, $220,000 was paid to Mad Brothers from Rock’s loan facility with its lender. Rock’s property was used as security for repayment.
Eliana was subsequently placed into voluntary administration. On 3 November 2016, creditors voted to place Eliana into liquidation.
Eliana’s liquidator claimed that:
- the payment to Mad Brothers from Rock’s loan facility (Transaction) was an unfair preference within the meaning of section 588FA of the Corporations Act 2001 (Cth) (Act);
- the Transaction was an insolvent transaction and a voidable transaction within Part 5.7B of the Act; and
- having regard to the above, the Court ought to order that Mad Brothers pay to Eliana the amount of $220,000, which Rock had paid to Mad Brothers.
Section 588FA(1) of the Act provides that:
1. A transaction is an unfair preference given by a company to a creditor of the company if, and only if:
(a) the company and the creditor are parties to the transaction (even if someone else is also a party); and
(b) the transaction results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company.
Proceedings in the Trial Division
Associate Justice Efthim found in favour of Eliana’s liquidator and held that:
- Eliana requested or authorised Rock to make the payment to Mad Brothers, which was sufficient to establish that Eliana was party to the Transaction such that Eliana gave unfair preference to Mad Brothers;
- on a balance of probabilities and despite incomplete books and records, Rock and Eliana were in a debtor/creditor relationship; and
- having regard to the foregoing, Rock’s payment to Mad Brothers was in fact made by Eliana. This was an unfair preference that was voidable pursuant to s 588FE(2) of the Act.
On appeal, Justice Robson set aside Efthim AsJ’s orders.
- Whether Rock owed money to Eliana ‘had a bearing on whether the payment constituted a payment by or from Eliana’, but on the evidence available, it had not been established that Rock was a debtor of Eliana at the time of the Transaction.
- However, even if Eliana authorised Rock’s payment to Mad Brothers, that there is no diminution of Eliana’s assets by reason of the Transaction indicates that no unfair preference was given by Eliana to Mad Brothers.
Decision by the Court of Appeal
The Court of Appeal dismissed the appeal brought by Eliana’s liquidator, and having regard to the historical authorities on unfair preferences, concluded at  that:
- The words ‘given by a company’ in s 588FA(1) do not form part of the definition of an unfair preference. They are descriptive of the position when the elements of the definition in paragraphs (a) and (b) are met.
- A company may be a party to a transaction for the purposes of s 588FA(1)(a) as a result of giving a third party a direction as to the making of a payment to a creditor, or by authorising or ratifying such a payment. However, this does not necessarily mean that the payment is received ‘from the company’.
- The words ‘from the company’ in s 588FA(1)(b) have the effect of retaining the requirement under the previous law that the preference be received from the company’s own money, meaning money or assets to which the company is entitled.
- It is necessary, in order for a preference to be ‘from the company’, that the receipt of it by the creditor has the effect of diminishing the assets of the company available to creditors.
- On the other hand, a payment by a third party that does not have the effect of diminishing the assets of the company available to creditors is not a payment received ‘from the company’ and is therefore not an unfair preference.
Applied to the present factual matrix, the existence or otherwise of a debtor/creditor relationship between Rock and Eliana was a matter of significance, but the diminution of assets point was critical.
Because the Transaction did not result in the diminution of Eliana’s assets and the incomplete books and records fell short of showing that Rock was indebted to Eliana at the time the Transaction was made, it could not be said that the Transaction was an unfair preference within the meaning of s 588FA of the Act and therefore the liquidator could not claw back the payment.
Significance of the Mad Brothers decision
In dismissing the appeal, the Victorian Court of Appeal clarified the operation of s 588FA in the context of third-party payments:
- The Federal Court decision in Burness, In the matter of Denward Lane Pty Ltd  FCA 893 is still good authority for a company being party to a transaction where the company directed, authorised and ratified the third party’s payment to the company’s creditor.
- The language of s 588FA requires a transaction to be made from the company’s own assets for it to amount to a preference. This is the result of the ‘ultimate effect’ doctrine: if there is no diminution of the company’s assets and the effect of the third party’s payment gives rise to a substitution of one creditor for another, such payment will not fall foul of s 588FA of the Act.
- The scope of relief available under s 588FF of the Act otherwise supports the proposition that the ‘ultimate effect’ doctrine is compatible with and necessary in the operation of s 588FA. Section 588FF does not allow a court to order that a person pay money to the third party, only to the company itself. If s 588FA were thought to extend to a payment made by a third party other than from the company’s assets, one would expect corresponding relief to be available in s 588FF such that a person may be ordered to restore payment to the third party. It would otherwise be a perversion of the underlying policy objectives of Part 5.7B of the Act to order money belonging to a third party to be paid to the company. Not only does it not unwind the unfair preference, it also provides an unacceptable windfall gain to the creditors in the liquidation at the expense of the third party.
It remains uncontroversial for s 588FA of the Act to be enlivened where a preference is received from the company; that is:
- the insolvent company pays its creditor from its own assets; or
- where the company is entitled to payment from a third party and authorises or directs the third party to make that payment to company’s creditor directly.
However, in the circumstance where a third party makes a payment to the company’s creditor in reduction of the company’s debt to the creditor:
- where, as a matter of evidence, it is not possible to determine whether there is a debtor/creditor relationship between the third party and the company; and
- where there is no diminution of the company’s assets as a result of the payment by the third party to the company’s creditors,
such payment cannot be regarded as an unfair preference within the meaning of s 588FA of the Act.
Creditors may manage the risks of an unfair preference claim by structuring their debtors’ payment arrangements to fall outside the s 588FA framework.
However, insolvency practitioners recommend that creditors and companies proceed with caution: other jurisdictions may regard the Victorian (and New South Wales) ‘economic’ approach as unorthodox and continue to adopt a black letter interpretation of s 588FA of the Act to find for the liquidator in a Mad Brothers-type situation. Although the Federal Court in Edenborn  FCA 715 recently confirmed the ‘ultimate effect’ doctrine applies to s 588FA, there are nuances that require careful consideration. Legal advice should be sought before parties curate payment arrangements designed to avoid the long arm of liquidators.
For more information please contact an author or any member of our Restructuring, Turnaround & Insolvency team.
This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.