On the Case: Issue 15

When is a company insolvent, when is a debt secured and what is its value - old insolvency issues return and new issues emerge

In this edition of On the Case, Adjunct Professor Philip Stern, who taught Insolvency Law at the School of Law, Sydney last year, discusses three recent Australian insolvency cases. These cases demonstrate that the longstanding concepts of what is necessary to prove “insolvency” for the purposes of actions by liquidators to recover unfair preferential payments and damages for insolvent trading by directors, and what constitutes a ‘secured’ debt, remain misunderstood or obscure to some insolvency practitioners with consequent benefit to defendants .They also raise fresh issues which remain undetermined.

Insolvency

All three cases dealt with the issue of proving insolvency1. In these cases the liquidators either failed to prove insolvency in entirety, failed to prove insolvency for a substantial part of their claim or failed to properly plead in their claim adequate particulars of the alleged insolvency.

Hussain’s case2

Edelman J of the Federal Court of Australia found that the entirety of the liquidator’s (self) expert evidence on insolvency in an unfair preference3 case was based on a false assumption, being whether there was ready cash available to cover the company’s commitments as they fell due for payment4. The liquidator failed to produce evidence concerning the availability of stock realisations and debtor recoveries5. He applied a wrong application of the “cash flow “ test for insolvency (correctly being whether a company can meet its debts as and when due and payable), because he applied a test of whether the company was unable to pay its debts when they actually became due and payable from ready cash at hand6. There was, inter alia, no evidence before the Court of the company’s relationship with its bankers, what the company’s debtors and inventory were on the relevant date and, in the absence of that information, whether the directors were likely to support the company7. There was evidence that the company met (revised) taxation payments when due and the defendant’s invoiced sums when promised8. There was no basis to even infer insolvency on the relevant date from the available evidence9.

Carrello’s case10

This case involved claims by a liquidator of insolvent trading against a company’s directors and its parent company11, and for, inter alia, an unfair preference. The liquidator claimed $5,692,896.24 plus interest for insolvent trading12. The liquidator failed to prove that the company was insolvent at the time most of the alleged corporate debts were said to have been incurred because: - the financial year end accounts tendered did not identify, with precision, the particular transactions predating the accounts upon which he contended insolvency could be concluded13; - he could not prove that a disputed creditor account was actually payable14, - it was established that certain large accounts were not actually payable until profits were realised from particular projects15, or were payable by the creditor taking equity in the company16. - some creditors were paid17; and - because of parent company, director and third party financial support18. It was only when the company had an adverse construction industry adjudication made against it (after fierce dispute and notwithstanding undetermined counter-claims) that the company was found to be insolvent19. The total of debts found to have been incurred by the company whilst insolvent and remaining unpaid at the time of hearing was $1,354,911.85 of which all but $30,144.84 was related company indebtedness 20 .

Blakeley’s case21

This case involved an Amended Statement of Claim initiated by a liquidator seeking to recover an asserted unfair preference payment received by the defendant. The defendant sought to stay or summarily dismiss the claim, and sought summary judgement on the basis that that the pleadings did not disclose a claim and effectively were an abuse of process22. Gardiner AsJ of the Supreme Court of Victoria found that assertions of insolvency were not properly pleaded as to their factual basis and that it was no answer to say that that the liquidator would put forward evidence of insolvency by way of discovery of documents or by expert report. He ordered that the pleading be amended23.

What is an ”unsecured debt” for the purposes of s588FA Corporations Act 2001 (Cth) (Corporations Act)?

Assuming insolvency24 at relevant times can be established, s 588FA(1) renders a transaction25 an unfair preference if the company and the creditor are parties to the transaction and the creditor receives more in respect of an unsecured debt that the company owes the creditor than if the transaction were set aside and the creditor proved for the debt in the winding up of the company (emphasis added). By s588FA(2), for the purposes of ss(1),a secured debt is taken to be unsecured to the extent of so much of it (if any) as is not reflected in the value of the security. Both defendants in Hussain’s case and Blakeley’s case supplied goods which were subject to title retention clauses whereby the supplier (defendants) retained title to those goods until all moneys owing to the suppliers were paid in full26. Both suppliers supplied goods to the debtor companies with retention of title27 provisions both before and after commencement of the Personal Properties Securities Act 2009 (Cth) (PPSA), and registered their security interests under those clauses upon implementation of the PPSA, being 30 January 2012. In neither case was there evidence to establish a breakdown of payments nor did a breakdown of the specific goods which were the subject of invoices supply pre –and post-commencement of the PPSA. Registration of security interests under the PPSArenders the creditor ‘secured’ for the purposes of the Corporations Act and under the PPSA28. ”Transitional security interests “ being security interests which arose prior to implementation of the PPSA, and which continue after the commencement of the PPSAare perfected (i.e. operative) from immediately before the registration commencement time29 i.e. 30 January 201230. The question arose in both cases as to whether the payments to the creditors were payments of “secured “ debts within s588FA (1). The decision in Blakeley’s case pre-dated the decision in Hussain’s case by 3 days and is not referred to in Hussain’s case. In Blakeley’s case Gardiner AJ said

When the PPSA was introduced ,provision was made that retention of title arrangements be considered, by a statutory construct, to afford a security interest….These arrangements are styled as Purchase Money Security Interests(“PMSI’s”) …They only have effect in respect of dealings which took place after the PPSA was introduced...32

...It is clearly arguable that the PPSA Terms of Trade only operate prospectively and do not purport to create any security interest in the stock which was supplied prior to the introduction of the PPSA. This is because the PPSA Terms of Trade do not create a security interest in any stock supplied…unless the stock is supplied under ”this agreement” (thus excluding pre-PPSA stock)33

Edelman J in Hussain‘s case considered that the retention of title provision constituted security for the purposes of s 588FA. He considered it satisfied traditional notions of security by a case analysis34, that other Corporations Act provisions regarded such a clause effectively as security35 and because as the clause was a transitional security agreement within the PPSA definition of that term, a mere a “timing issue “would not prevent the clause negating the unsecured nature of the debt.36” He considered that a contrary conclusion would give rise to a surprising result because if the clause was enforceable, but not a security within s 588FA(1), a creditor could recover the goods but remain an unsecured creditor for the purposes of proving in the insolvency37.’

When is the value of the security determined for the purposes of s588FA(2)-at the time of the transaction or the date of liquidation?

This issue was recently considered in South Australian proceedings but remains undetermined38. Blakely’s case appears to have assumed the appropriate date is the date of liquidation39. Hussain’s case considers the countervailing issues without determining them, particularly in the absence of a pleaded case on the issue40. An argument in favour of the date being the date of liquidation is the fact that that date is consistent with the rationale of the unfair preference legislation. This legislation seeks to ensure equality between creditors and applies at the date of liquidation41. A contrary argument is that the section which awards compensation for, inter alia, an unfair preference, viz s588FE, requires payment for an amount that represents the benefits the person has received because of the transaction (emphasised in the judgement). If the orders focus on the benefits the person has received then symmetry requires that the security that the person held should also be assessed at the time of the transaction42. This important issue still remains to be judicially determined.

Running account

Section 588FA(3) states that if a transaction is commercially an integral part of a continuing business relationship between the company and its creditor and in the course of the relationship the company’s net indebtedness increases and decreases then s588FA(1) operates to treat all of the transactions forming part of that relationship as if they were a single transaction for the purposes of determining whether there is an unfair preference.

Carrello’s case considered whether the existence of knowledge or suspicion of insolvency by the creditor deprives the relationship of the vital characteristic of a continuing business relationship . Chaney J followed an earlier decision that reasonable grounds to suspect insolvency does not of itself destroy a relationship of mutual benefit44. Hussains’s casefollows Carrellos’s case in this regard45. However Edelman J raised another issue, without determining it, in relation to a running account. That question is whether the statutory mutual set-off provision applicable in liquidations, s553C, operates to a running account .He says that as s588FA(3) was intended to codify the principles of a running account, there is an issue as to whether the set-off provision can apply, although they are conceptually different concepts46.

Parent company debt –ss 588W and 588Y(2)

Carrello’s case found that the parent company was liable pursuant to s588V to pay damages under s588W to the company for insolvent trading due primarily to intercompany indebtedness arising whilst the subsidiary company was insolvent47.

Section 588Y(2) states:

where: 
(a)under s588M or 588W ,a court orders a person to pay to the company …an amount equal to the loss or damage suffered by a person in relation to a debt because of the company’s insolvency; and 
(b)the court is satisfied that ,at the time when the company incurred the debt, the person who suffered the loss or damage knew that the company was insolvent by incurring the debt …. the court may order that the amount paid to the company is not available to pay that debt unless all the company’s unsecured debts (other than the debts to which orders under this subsection relate) have been paid in full...

Chaney J considered his decision gave rise to a “harsh outcome’, because the recoverable amount was measured by the loss suffered by the entity to which the debt was incurred. Here the holding company suffered the loss and then, by ss 588V and 588W, it had to pay that same amount to the liquidator i.e. it suffers the same loss twice (less any dividend payment in the liquidation).That is consistent with the scheme of the Act being to discourage insolvent trading48. He made an order pursuant to s588Y(2)49, whereby the amount paid by the defendants was not available to pay the debts of the parent company unless all the debtor company’s other unsecured debts were paid in full50.

Why These Cases Are Worth Knowing about

The decisions in Hussain’s case, Blakely’s case and Carrello’s case reemphasise the imperative of liquidators proving insolvency at the times they say relevant obligations arose in voidable transaction and insolvent trading actions. The cases also consider important questions on whether title retention contractual clauses are security (at least for pre-PPSA terms and upon which there are inconsistent judicial views); whether a running account can exist without ongoing good faith relationships and with knowledge of insolvency by the creditor; at what date is a security to be assessed for the purpose of determining an unfair preference; whether set-offs can apply to a running account; and the application of s588Y(2) to parent company indebtedness in an an insolvent trading action against that same parent company51. Many of the issues raised will need await further judicial determination for definitive answers possibly at an appellate level.

This article was originally published by Woodgate & Co, Level 8, 6-10 O’Connell Street, Sydney and their willingness to permit its republication is gratefully acknowledged.

1 see Corporations Act 2001 (Cth) (Corporations Act) s9 definition and s95A
2Hussain v CSR Buiding Projects Limited;in the matter of FPJ Group Pty Ltd (in liq) [2016] FCA 392,13 May 2016 3 see Corporations Act ss 588FA,588FC, 588FF 4Hussain’s case [5]
5 Ibid [5]
6 Ibid [114]-[115]
7 Ibid [125],[127],[128]
8 Ibid [131],[135]
9 Ibid [138]
10Carrello as liquidator of Perrinepod Ptd Ltd v Perrine Architecture Pty Ltd [2016] WASC 145,12 May 2016
11 see Corporations Act ss 588G,588M,588V,588W
12Carrello’s case [4]
13 Ibid [35]
14 Ibid [41]
15 Ibid [58],[84]
16 Ibid [84]
17 Ibid [116],[120]
18 Ibid [110]
19 Ibid [135]
20 Ibid [218];query why the directors of the related companies did not release their indebtedness prior to trial and then pay the remaining debt (which was for accounting services),thereby leaving the liquidator without any judgment sum 
21Blakeley and Australian Music Pty Ltd v Yamaha Music Australia Pty Ltd [2016] VSC 231,10 May 2016
22 Ibid [3],[4]
23 Ibid [47],[48],[49],[52]
24 s 588FC Corporations Act
25 see s9 Corporations Act definition
26 For the full terms of the respective clauses see Hussain’s case [17], [18], [26] and Blakeley’s case [27]
27 See new definition in s 9 Corporations Act
28 See Corporations Act ss51,51A,51E,PPSA s12;see also discussion [149] – [159]
29 PPSA s310 ;see also ss 306, 307,308
30 Prior to the PPSA, the High Court had held that a title retention provision did not constitute a formal security ,although in an appropriately drafted provision the proceeds of sale by the debtor could be held in trust for the supplier - see Associated Alloys Pty Ltd v ACN001 452 106 Pty Ltd (2000)CLR 588,[2000] HCA 25
31 s14 PPSA
32 [36]
33 [38]
34 see [145]-[148] and cases referred to thereat
35 ss 442CB,422CC, [161] – [164]
36Hussain’s case [151]
37 [166];this scenario was operative in insolvency administrations at least prior to the PPSA. 38 See Matthews v The Tap Inn Pty Ltd[2015] SADC 108 where the District Court on a separate question determination held that the appropriate date is the date of liquidation; the Full Court overturned the decision, without deciding the issue, on the basis that the original determination was hypothetical-The Tap Inn Pty Ltd v Matthews [2015]SASFC 188.
39 [37]
40 see [170]-[172],[176]
41 [178].
42 [179]
43 [150]; s588FG Corporations Act requires a defendant to, inter alia, negate these elements in substantiating a defence to an unfair preference claim.
44 [252]-[255],see Clifton v CSR Building Supplies Pty Ltd [2011]SASC 103 cf Olifent v Australian Wine Industries Pty Ltd (1996) 19ACSR 285 referred to at [251]
45 [222]
46 [239].In addition, he also raises another question, without determining the answer. That issue is whether a contingent debt,such as a claim under s588FA, can apply to s553C- [244]-[245]
47 [221]
48 [222]
49 [223]-[224].Thus presumably the liquidators fees and expenses, and the unpaid accounting fees of approximately $30000 would be paid in full from the judgement proceeds before the inter-company debt is to be repaid .Query why the parent entity did not seek to invoke the discretionary exoneration ss 1317S and 1318 in whole or part.
50 [ 291]
51 Both Hussain’s case and Carrello’s case also considered good faith and reasonable grounds to suspect insolvency defences for voidable transactions under s588FG(2),and, Hussain’s case also considered claimed uncommercial transaction (s588FB) and unreasonable-director related transactions (s588FDA),which are not the subject of discussion in this edition of On The Case.