Set-off as a defence to an unfair preference claim

Insolvency: 23 March 2019

In the case of Morton & Anor v Rexel Electrical Supplies Pty Ltd [2015] QDC 49 (Morton v Rexel),theQueensland District Court considered whether set-off under section 553C of the Corporations Act (the Act)could be used as a defence to a liquidator's claim that payments made by a company in liquidation to a creditor were unfair preference payments.

The Court found that in the circumstances before it, the debt owed to the defendant, which arose by way of mutual dealings between the companies, could be set off against amounts it had received as unfair preference payments, which the Court ordered the defendant to repay.

Relevant Facts

• South East Queensland Machinery Manufacturing and Distribution (Mining) Number 1 Pty Ltd (formerly known as Aran Management Pty Ltd) (in Liquidation) (the Company) appointed the plaintiff, Gavin Morton, as liquidator on 14 August 2012.
• Prior to insolvency, the Company was one of a group of companies, whose sole business activity was the supply of mixing plants for road construction and roller compacted concrete for dam construction, an activity which it undertook in the mining industry.
• The defendant supplied electrical components to one of the group of companies, and invoiced the Company for its supply.
• The liquidator was of the opinion that the Company was insolvent from at least 1 March 2012 and he based his opinion on the following:
  • The company was balance sheet insolvent for at least 6 months prior to the (liquidator's) appointment;
  • The company was cash flow insolvent from at least 1 March 2012.
  • The company had a liquidity ratio of point 0.03 as at the appointment date and 0 as at 1 March 2012.
  • The company had been paying creditors outside trading terms from at least 1 March 2012 the Appointment.
  • The company had incurred trading losses from at least July 2011.
  • There is no evidence that the company would have been able to secure any funding from any other sources during this period.[1]
• The Company's failure to keep proper records is noted in the case, as the defendant attempted (unsuccessfully) to question the accuracy of the liquidator's opinion as to the date that the Company became insolvent, citing the poor record-keeping by management of the Company.[2] It is relevant to note that the Company had at one time been keeping its accounting records using QuickBooks, but after 31 January 2012, changed to the ACCPAC system "which had serious issues correctly recording the transactional accounting.€[3]
• The liquidator's estimated return to unsecured creditors in the winding up of the Company was zero cents in the dollar.

Payment Arrangement

On 31 January 2012, the defendant invoiced the Company for $215,421.80 (January Invoice). Records of the trading relationship between the Company and the defendant were said to be "sparse€, and the Company's internal accountant said that previous payment terms between the entities prior to March 2012 was "mainly on 30 or 60 day accounts€[4].Despite this, within two weeks of rendering an invoice, the defendant's director had contacted the Company to ascertain when the account would be paid. Over the course of the following weeks, a payment arrangement was negotiated and entered between the parties.On the basis of the payment arrangement, the defendant lifted a stop credit temporarily and continued to supply materials to the Company.

Between 26 March 2012 and 6 June 2012, the defendant received seven payments totalling $197,469.16. After the defendant's January Invoice, between 20 February 2012 and 24 April 2012, the defendant rendered invoices to the Company to a total value of $31,302.12.

Defence arguments

The liquidator alleged that the payments totalling $197,469.16 received by the defendant were unfair preferences, and thus voidable under section 588FE of the Act. In turn the defendant argued it had three defences to the liquidator's claim, namely:

1. It had received the payments in good faith (section 588FG of the Act);
2. The payments it received were part of a running balance between the entities (section 588FA(3) of the Act); and
3. If the payments were unfair preferences, the defendant was entitled under section 553C(1) of the Act to set-offdebts that the Company owed the defendant for which it remained unpaid.

The defendant's argument (pursuant to s 588FG of the Act) that it entered the transaction in good faith failed because the Court found in accordance with section 588FG(1)(b), that at the time it received the first payment on 26 March 2012, the defendant, or a reasonable person in the position of the defendant, had reasonable grounds to suspect that the Company was insolvent. The defendant's running balance arguments also failed.

Section 553C of the Act

1. Subject to subsection (2), where there have been mutual credits, mutual debts or other mutual dealings between an insolvent company that is being wound up and a person who wants to have a debt or claim admitted against the company:
   1. an account is to be taken of what is due from the one party to the other in respect of those mutual dealings; and
   2. the sum due from the one party is to be set off against any sum due from the other party; and
   3. only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be.
2. A person is not entitled under this section to claim the benefit of a set-off if, at the time of giving credit to the company, or at the time of receiving credit from the company, the person had notice of the fact that the company was insolvent.

Notice of Insolvency

In respect of the defendant's arguments over section 553C of the Act, the Court found that the provision relied upon a narrow definition of what constituted 'notice of insolvency', and that this did not include 'constructive knowledge'. Furthermore, the relevant time for consideration was 'the time for giving of credit', which in this case was 31 January 2012. Put simply it was a threshold that was more readily met by the defendant than the test applicable in the 'good faith' defence.

The principle of set-off was examined in the decision of the Court of Appeal of the Supreme Court of Victoria in the case of Jetaway Logistics Pty Ltd & Ors v The Deputy Commissioner of Taxation [2009] VSCA 319. In that case, it was found that "the test that the Liquidators have to establish is that the Commissioner had notice of facts that would have indicated to a reasonable person the fact that Jetaway was insolvent€[5]. Ultimately, the Deputy Commissioner of Taxation had not prevailed in that case.

The defendant also referred the Court to the decision in Re Parker (1997) 150 ALR 92, which was considered in Buzzle Operations Pty Ltd v Apple Computers Australia (2011) 81 NSWLR 47, which the defendant cited as authorities for the proposition that "section 553C of the Act permitted the setting off of pre-liquidation debts against the post liquidation claim for insolvent trading€[6]. In his judgment, Searles DCJ found arguments persuasive, stating that he "should not depart from€¦ (the reasoning of Mansfield J in Re Parker) unless it is 'plainly wrong'€[7].

The plaintiff submitted that if the defendant succeeded in its arguments regarding set-off, this would frustrate the purpose of the unfair preference provisions of the Act "because the starting point for its set-off amount is the preference payments€[8]. It was further submitted that a creditor who was paid in full would be at a disadvantage if a creditor like the defendant who received partial payment, was entitled to set-off the unpaid portion.

The Decision

Searles DCJ found that the payments were unfair preferences and ordered that the defendant repay the monies to the company in liquidation, however whilst the defendant did not succeed on the first two defences, the Court found that it partially succeeded on its third ground. Whilst it was not entitled to set off the full amount claimed (being $92,323.88) as it was found to have notice of the Company's insolvency from the date that the defendant began contacting the Company seeking payment of its January Invoice (which occurred in mid-February), the defendant was entitled to set-off the unpaid portion of its January Invoice (in the amount of $64,658.15) against the payments voided as unfair preferences. In dollar terms, the order reduced the amount that the defendant had to repay to the plaintiff from $197,469.16 to $132,811.01.

Aitken Partners Comments

1. The decision may be relevant for unsecured creditors who have received payments from a company prior to the appointment of liquidators, but who remain unsecured creditors in the winding up of a company. For commercial reasons an appeal of the decision in this case would seem unlikely, the decision is nevertheless noteworthy and will stimulate debate.
2. Timing is important. In the 'good faith' and the 'running balance' defences to unfair preference claims, the relevant time is the time at which the payments are received. In the case of a set off argument under section 553C of the Act, the relevant time for consideration is the 'time of giving, or receiving credit'. In some cases where credit is given much earlier than payment, this may assist a defendant to succeed on a 'set off' argument where it would not succeed on other defences. Where debts arise on the rendering of invoices and payments received by a creditor are applied to the oldest invoices first, and where creditors usually seek to recover their debts in full, the circumstances giving rise to a 'set-off' are less common than those which give rise to 'good faith' and 'running balance' defences.
3. It is unclear what role was played by management's poor record-keeping in the decision. Had the liquidator been able to furnish particulars of the previous trading relationship between the companies (perhaps providing evidence that the defendant was on notice of the Company's insolvency prior to mid-February 2012), the defendant would have been much less likely to succeed with its set-off argument. On the other hand, in different circumstances the defendant's submissions on the breaches of section 286 of the Act (failure to keep records) could have been counterproductive in that a company which fails to keep financial records in accordance with this provision is presumed to be insolvent under section 588E(4) of the Act. Whilst this provision cannot assist a liquidator to prove that an unfair preference is an insolvent transaction of the company, it may work against a defendant who is seeking to prove that it had no notice of a debtor's insolvency.

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[1] Morton v Rexel at [25], citing the Liquidator's report to creditors.

[2] Potentially a counterproductive argument, in view of the presumption of insolvency in section 588E(4) of the Act.

[3] ibid at [23].

[4] Ibid at [22].

[5] Jetaway Logistics Pty Ltd v Deputy Commissioner of Taxation [2009] VSCA 319 at [22].

[6] Morton v Rexel at [67].

[7] ibid at [78].

[8] Ibid at [75].