Capital Mgmt Litigation: UNFAIR PREFERENCE CLAIMS AND COMPENSATION UNDER SECTION 553C – NO COMPENSATION “DEFENSE” AVAILABLE

JURISPRUDENCE ALERT: UNFAIR PREFERENCE CLAIMS AND COMPENSATION UNDER SECTION 553C – NO COMPENSATION “DEFENSE” AVAILABLE (PART 2 of 3)

The section: Section 553C of the Companies Act 2001 (Cth) (“Act”) provides for statutory netting between an insolvent company and a party seeking to have a debt or claim admitted in the winding up of the company. Provided the creditor was not notified of the company’s insolvency at the relevant time, the section is brightened where there have been “mutual credits, mutual debts or other mutual dealings” between the parties , and allows an account and set-off of sums due between them under such mutual transactions, only the balance of such account being enforceable against the company or payable to the company as the case may be.

The evolution of case law: In Morton as liquidator of MJ Woodman Electrical Contractors Pty Ltd (in liquidation) against Metal Manufacturers Pty Ltd [2021] FCAFC 228, the Full Court of the Federal Court held that Section 553C does not do not provide creditors with the benefit of statutory compensation in response to a liquidator’s claim for the recovery of an unfair preference under Section 588FA of the Act[1].

why it matters: Whether compensation under Section 553C is available as a full or partial “defense” to a creditor facing an unfair preference claim has been the subject of ongoing debate and opinion. contradictory. Although many industry players have long held the view that compensation should not be available, the position in the courts was unclear and various authorities have taken the contrary position. With the certainty offered by MJ Woodman, liquidators seeking the return of inequitable preferences no longer need to accept or compromise for the risk previously associated with the compensation defense. Funders considering such claims will also have increased certainty on the issue, which will likely lead to an increase in the number of claims receiving funding.

Actions to take: Liquidators are encouraged to review any unfair preference claims that were previously considered non-commercial due to the risk of compensation. Such actions may now have a much better chance of attracting litigation funding and otherwise being monetized.

Facts: In MJ Woodman, the liquidator is suing the defendant for an unfair preference of $190,000 (“preferentially paid debt”). In defense, defendant pleads a separate and admitted debt of $194,727.23 (“unpaid debt”) and seeks set-off under Section 553C. The issue of set-off is important because, with the benefit of set-off, the defendant would retain the amount of the paid debt in preference and reduce the amount of the unpaid debt by that amount. Without compensation, the defendant would be required to repay the full amount of the Preferentially Paid Debt, and would then have to seek payment of both debts (the Preferentially Paid Debt and the Unpaid Debt) in the ordinary course of the winding. high and on a past bet basis with all other creditors.

The reasoning : Part 1 of this case law update (link here) considered the arguments presented by the parties before the Plenary Assembly. In deciding the interaction between Section 553C and the unfair preference regime, Chief Justice Allsop (with whom Justices Middleton and Derrington agreed) reviewed these submissions and, noting that the issue before the Court was one of statutory interpretation, undertook a detailed analysis of statutory texts, history, context and evident legal purpose, as well as recent authorities and scholarly commentary.

With respect to the legal purpose of the relevant schemes, the Court noted that the provisions of the Unfair Preferences Act (among others) were intended to redress the imbalance which resulted from the favorable treatment of certain persons in transactions undertaken while the business was still in operation. . Without repair, such an imbalance interferes with the proper functioning of the past bet principle by exhausting the resources that should be part of the insolvent estate for the benefit of all creditors.

The Court favored the liquidator’s argument that this statutory objective would be undermined by allowing set-off under Section 553C. On the contrary, it has been found that the denial of compensation in such cases:

“… best reflects and justifies the underlying objectives of both the law of set-off in insolvency and the law of preferences: by protecting creditors fairly when there are genuinely mutual debts, credits or transactions reciprocal or mutual by compensating them to determine what is owed by and to the insolvent mass, this process not interfering in any way with the past bet distribution from the estate as part of a previous process to establish the estate and claims thereon; and ensuring that past privileged transactions are unwound to restore the estate to the position it would have been in had the preferential transaction not taken place, so that thereafter all creditors (including the former preferred creditor) can equally share an estate unaffected by previous transactions. preferential operations”

The question of mutuality was also at the heart of the Court’s conclusion.

It is a requirement of the set-off provision that there has been a “reciprocal” relationship between the parties. As His Honor acknowledged:

“…If there is a real reciprocity of debts or credits or a real reciprocity of transactions between debtor and creditor, an insistence that the creditor pay his debt in full and be bound to prove (and receive only a distribution pari passu) for the mutual fund of the debtor the obligation to pay his debt can be considered as unjust”

However, the Court held that such mutuality did not exist in cases such as the present.

First, this turned out to be the case because the transactions concerned were not between the same parties: on the one hand, the parties to the Outstanding Debt are the creditor and the company. On the other hand, the parties to the claim of unjust preference on the Preferentially Paid Debt are the creditor and the liquidator:

“There is no reciprocity between the company’s indebtedness to the creditor and the creditor’s liability under a court decision to pay the company at the request of the liquidator. The the lack of reciprocity arises from the different interest in which the company owes money to the creditor and in which the company receives money under the obligation to repay not as a creditor of the preferred creditor, but as a beneficiary pursuant to a court order in an action brought by the liquidator in performance of his obligation to collect the estate of the insolvent company for the benefit of all unsecured creditors and the administration of the estate.

Second, the Court found that the timing of the two transactions also indicated a lack of reciprocity: unlike the timing of the unpaid debt (which arises while the business is in operation), a liquidator’s right to claim the debt preferential payment may arise only after the liquidator has made his claim for unfair preference, i.e. after the liquidator has been appointed. The liquidator cannot bring the action in abusive preference before his appointment and, consequently, the Preferential Debt cannot be payable before the liquidation of the company:

“The absence of mutuality also results from the absence at the relevant date of any right or equity (vested or contingent) in the company or of any duty or obligation (vested or contingent) for the creditor to recover or repay the preference , respectively. Thus, the essential requirements of s 553C are absent”

Watch this place: On 13 January 2022, the creditor applied for special leave to appeal to the High Court. In Part 3 of this case law alert, LCM will report on the High Court’s decision once rendered.

[1] While the decision does not affect other defenses and exceptions that may be available to creditors responding to unjust preference actions, including the “checking account” defense available under section 588FA(3) of the Law.

Contact LCM