Six tips for advisors to consider when providing services to an insolvent entity.

We often hear business advisors concerned about payments of their fees clawed back by a liquidator as a "preference payment". And just as often we're asked how advisors can protect themselves from becoming embroiled in such a claim in the first place.

Here is a brief background to the preference payment provisions and some useful tips to help advisors not fall in the realms of having received a preference claim.

A preference payment or "preferences" as they are known in the industry, are payments (or transfers of assets) that give one creditor an advantage over other creditors. Put simply, it is where one creditor is paid more than another creditor in the lead up to a liquidation. Payments that are seen to have preferred a particular creditor within a certain period before a company is placed into liquidation, may, be recovered by a liquidator (i.e. clawed back).

For a liquidator to successfully prove a preference payment was made to a creditor, they must first establish the following points prescribed in section 588FA of the Corporations Act 2001:For a liquidator to successfully prove a preference payment was made to a creditor, they must first establish the following points prescribed in section 588FA of the Corporations Act 2001:

  1. The company in liquidation, and the relevant creditor (the advisor in this case), were both parties to the transaction.
  2. The creditor that received the payment (the advisor in this case) was an unsecured creditor.
  3. The transaction occurred within six months before the liquidation "commenced" (i.e. six months before the relation-back day).
  4. The company made the payment when it was insolvent, or the company became insolvent as a result of the payment/transaction.
  5. The payment resulted in the creditor (the advisor in this case) receiving more than they would have in a liquidation scenario. That is, they received more "cents per dollar" on their debt than other creditors did or will receive.

Assuming a liquidator can establish these points, they have a fair chance of convincing a court that the monies should be repaid to the liquidator (noting that the vast majority of preference claims are in fact settled outside court).

However, there are ways for advisors to protect themselves, so that they have not been party to a transaction that could be deemed a preference claim in the first place. The options explored below are designed to give some guidance and help advisors from being caught in the crossfire when their client becomes insolvent.

Some things for advisors to consider include:

  1. Get your fees pre-paid wherever possible—especially if you're dealing with a potentially insolvent client

If you're never a 'creditor' of the company, you will not be subject to the preference payment provisions. Getting pre-paid (either upfront or by monthly fee instalment arrangements) for your services is a great way to ensure a preference claim will never be a consideration.

  1. Get paid by a third party outside of the company

Consider seeking payment from a director, shareholder, or other party. A payment from a third party will mean you and the company were not "parties to the transaction"—though proceed with caution as there is a very wide definition of "transaction" under the Corporations Act that applies to unfair preference provisions. A transaction between a creditor and a third party can still arguably be regarded as preferential unless (for example) the third party made the payment as a volunteer.

  1. Work the running account

If there is a 'continuing business relationship' between you and the client that gives rise to a running balance account (i.e. a fluctuating debt balance), then it is the net position of all the transactions over the relevant period that is important—this is known as the "ultimate effect" of the transactions.

The relevant period is six months prior to the start of the liquidation if the appointment type is a voluntary liquidation (it is a longer period for a court liquidation and is dictated by the date the winding up application was filed).

Work the running account in your favour to limit or extinguish any potential preference claim. The key for a liquidator is to show whether the debt owed to you increased or decreased during the relevant period. If the balance owed to you decreased, this amount is the potential preference amount (with all other factors being considered). If the balance owing increased, there is no preference as you were actually disadvantaged by continuing to transact with the client over the relevant period.

Also give consideration to the implication of the peak indebtedness rule that denotes the point (or peak) of when the debt decreased and to what value. Call us to discuss how this works and how it can impact preference claims.

  1. Take security where you can

Secured creditors are not subject to the preference payment provisions. Where possible and appropriate, and before services are incurred: seek security and register a security interest over the company (e.g. PMSI, ALLPAAP). Ensure your engagement terms contain a charging clause (including over the business assets if possible). Obtain personal guarantees from directors and ensure they take the form of an equitable charge over their real property.

If you are going to take security, make sure you act quickly as the granting of the security itself may be deemed a preferential act.

  1. Stay on top of your debtor's ledger and talk to Worrells early

It's only a preference if there were reasonable grounds for you to suspect the impending or actual insolvency. If you have a client that's tinkering on the edge, the best thing to do is contact your local Worrells office and get the client informed about their financial issues. Minimise having insolvent clients that drag their financial issues out.

And while there is no minimum amount defined to pursue a preference claim, as a rule of thumb payments to a creditor during the relevant period for less than a few thousand dollars are generally not commercial for a liquidator to pursue. Therefore, being on top of your debtor's ledger and proactively getting clients to address any financial issues they have, the more likely you will not be caught up in a preference payment claim.

  1. Talk to the liquidator, negotiate, and if required seek legal advice

As insolvency practitioners we are commercially-minded people. If you are the subject of a preference claim, it is best to deal with matters head-on. Talk it through—obviously if you or your clients receive a demand from a liquidator, then you should obtain appropriate legal advice before seeking to defend any such claim yourself.

While these considerations are relevant to advisors and their fees, some of these tips might apply to business clients with the same concerns.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.