Vol 1 (2004) - Issue 6

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Unfair Preferences in Australia and Letters of Credit

This article considers the regime for challenging preferences in Australia and in particular the ability of Australian liquidators to challenge as preferences letters of credit issued by an insolvent company to one of its creditors prior to liquidation. The issue has recently been the subject of judicial consideration in Australia. As discussed below, the courts have held that the Australian legislative provisions enabling a liquidator to challenge preferences are sufficiently wide to encompass the provision of a letter of credit by a bank to a creditor of an insolvent company in respect of pre-existing debt.

Preferences

Australian insolvency law, in common with most insolvency regimes, provides a liquidator with the ability to unwind certain transactions entered into by an insolvent company prior to the winding up. A preference (or ‘unfair preference’ as it is referred to in the Australian legislation) is one type of antecedent transaction which a liquidator typically has the ability to avoid, unwind or otherwise remedy in certain circumstances.

A preference occurs where a creditor has received more from a debtor before liquidation than that creditor would otherwise have received in the liquidation. It will involve a transaction between an insolvent company and one of its creditors that has the effect of favouring that creditor over the company’s other creditors. The key rationale for unwinding a preference is to uphold the primacy of the pari passu principle (equality of division among creditors). It is also intended to have the effect of deterring the disorganized scramble for assets which results from creditors chasing payment from a company in financial difficulty.

Although the concept of a liquidator being able to unwind an otherwise valid transaction between the insolvent company and one of its creditors as a preference is common amongst many jurisdictions, there are significant differences in the way in which this concept has been embodied.

The unfair preference regime in Australia

Compared to many jurisdictions, it is relatively straightforward for an Australian liquidator to establish that a payment made to a creditor prior to the liquidation is a preference and liable to be repaid to the insolvent company for distribution by the liquidator to creditors generally. Accordingly, the pursuit of preferences by Australian liquidators is frequently a significant element of a liquidator’s administration of the estate.

The test for establishing a preference is an objective test. In broad terms, in order to establish a preference, an Australian liquidator need only show that a ‘transaction’ occurred between a creditor and a company at the time the company was insolvent, and that this had the effect of the creditor receiving more for its unsecured debt from the company than it would have had the debt been proved for in the company’s winding up. It does not prima facie require proof of the intention of either the insolvent company or the creditor in entering into the transaction. Section 588FA(1) sets out the key elements:

[Where transaction unfair preference] 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);