Creditors cannot set off unsecured debts with unfair preference claims. What about other voidable transactions?

For some time, controversy surrounded the question of whether unsecured creditors of an insolvent firm can use set-off under section 553C of the Companies Act 2001 (Cth) (Act) against unfair preference claims. In the recent decision of Morton as liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited [2021] FCAFC 228 (Mr. J. Woodman), the court clarified that the recipient of an unfair preference cannot set off their unsecured debt with the preference claim.

Fund

Article 553C of the Law

Section 553C permits the set-off of mutual credits, mutual debts or other mutual transactions between an insolvent firm and its unsecured creditors. For example, when an insolvent company owes a debt to an unsecured creditor, it may be offset by an unrelated debt that the creditor owes to the insolvent company.

Compensation Against Unfair Preference Claims Before MJ Woodman

Prior to the MJ Woodman decision, it was believed that unsecured creditors could use Section 553C set-off against unfair preference claims. In other words, when a creditor had an unsecured debt provable on liquidation, that unsecured debt could be deducted from the amount of any unfair preference claim against the creditor. Controversy has long surrounded the idea that a claim against an insolvent company could be deducted from the recovery by a liquidator.

MJ Woodman’s decision and outcome

The context

The liquidator filed an unfair preference claim under section 588FA of the Act to Metal Manufacturers Pty Ltd for unfair preference payments in the amount of $ 190,000 received during the relationship period. Metal Manufacturers claimed to be entitled to compensation for debts totaling $ 194,727.23 owed to it by the insolvent company against the unfair preference claim.

Conclusion of the Plenary Court

The court in the MJ Woodman case ruled that unsecured creditors cannot claim legal compensation for unfair preference claims. The main finding of the tribunal was that there was a lack of reciprocity between an unsecured debt owed by the company in liquidation to the creditor and an unfair preference claim owed by an unsecured creditor at the request of the liquidator. The two main reasons given by the tribunal for finding a lack of reciprocity were as follows:

1. the right to seek reimbursement of an unfair preference is not a claim of the insolvent company, but rather a claim acquired from the liquidator for the benefit of unsecured creditors (and not of the insolvent company); and
2. a liquidator’s right to claim unfair preferences only arises when the liquidator files a lawsuit to set aside the unfair preference payment. Thus, there is no temporal reciprocity between the creditor’s claim (which arises before the liquidator’s legal action) and the liquidator’s claim.

As such, the tribunal held that due to the lack of reciprocity, the basic elements of Section 553C could not be established.

Applicability of the MJ Woodman Decision to Other Cancelable Transactions

There are a range of other cancellable transaction claims that accrue to a liquidator, for which compensation under Section 553C has previously been applied. One example concerns non-commercial transactions under section 588FB of the Act.

Importantly, the court in MJ Woodman expressly declined to rule on whether Section 553C would continue to apply to other voidable transactions. Despite this, given the reasons why the tribunal concluded that Section 553C set-off does not apply to unfair preference claims, it can be argued that Section 553C does not apply to certain other voidable transactions. . It’s because:

1. Voidable transactions do not create a cause of action for the company, but rather allow the liquidator to seek court orders to increase the insolvent estate (see for example: Fortress Credit Corporation (Australia) II Pty Ltd v Fletcher (2014) 87 NSWLR 728 at [127]). Thus, there may be a lack of reciprocity; and
2. it is likely that there is a lack of temporal reciprocity.

So, while it remains to be seen, liquidators should take a close look at whether Section 553C can no longer apply to other voidable transactions. In particular, there are good arguments that compensation under Section 553C should not apply to non-commercial transactions. Indeed, unfair preferences and non-commercial transactions share an essentially similar legal regime. If it turns out that offsetting does not apply to non-commercial transactions, this may make non-commercial transactions worth pursuing where it would not have been otherwise viable to do so. For example, when an insolvent firm agrees to pay a price for services in an amount that far exceeds market value, liquidators may be able to sue service providers with greater capacity for return.

Key points to remember for liquidators

1. while the case of Badenoch Integrated Logging Pty Ltd v Bryant, in Gunns Limited (in liq) (named receivers and managers) [2021] FCAFC 64 could have been viewed as reducing the amount of unfair preference claims available to a liquidator by removing the peak debt rule, the MJ Woodman decision could have the effect of increasing the amount of unfair preferences recoverable by a liquidator
2. liquidators should review their records for any unfair preference claims they may have deemed non-commercial to pursue due to the applicability of Section 553C – these claims may now be worth pursuing
3. it will remain to be seen whether the set-off applies to the liquidator’s other claims, but liquidators should consider challenging the applicability of Section 553C to other voidable transactions, in particular non-commercial transactions.
4. it should be remembered that even with regard to netting with other types of claims, when, at the time of granting the credit to the company, or at the time of receiving the credit from the company, the defendant had been informed that the company was insolvent, set-off will not apply (see section 553C (2) of the Act).