The Full Federal Court denies insolvency set-off to unfairly preferred creditors

What you need to know

A creditor who has received an unfair preference cannot rely on set off under s 553C of the Act to reduce the amount it must repay to the liquidator in respect of the preference.

The facts of the case

• A company obtained goods on credit on two separate occasions, giving rise to two separate debts. The debtor company later entered into liquidation.
• Before the company's liquidation, it paid $190,000 to the creditor in respect of one of those debts. The liquidator successfully sought to claw back the payment as an unfair preference under s 588FA of the Corporations Act.
• The creditor was owed approximately $194,000 by the company in respect of the other debt.
• The creditor argued that it should not have to pay anything to the liquidator. It argued that it was entitled to set-off its liability to pay back the preferential payment of $190,000, against the other debt of $194,000 that it was owed.
• The question was referred to the Full Court of the Federal Court of Australia.

The Court's reasoning

• In a unanimous decision, the Court held that set-off was not available to the creditor. The leading judgment was delivered by Allsop CJ, with whom Middleton and Derrington JJ agreed.
• The Court considered how the Act's unfair preference provisions interact with insolvency set-off under s 553C. Crucially, this included analysis of the requirement of "mutuality". That is, the claims which are sought to be set-off against one another must be between the same parties, and those parties must hold those claims for their own benefit and interest. Also relevant was the requirement that the liability being set off must already exist (even if in the form of a contingent liability) at the commencement of the liquidation.
• The creditor argued that the "mutuality" requirement was satisfied because the liquidator held merely the "dry legal right" to bring the preference claim. The benefit of that right belonged to the company. Moreover, the creditor argued that its liability to repay the preference to the company existed (albeit as a contingent liability) at the time when the liquidation began. The creditor's position was that all the relevant requirements for insolvency set-off under s 553C were met.
• But the Court (we would suggest, correctly) rejected these arguments. The mutuality requirement was not satisfied, because the right to seek repayment of the preference is not a right of the insolvent company, and it does not exist (even contingently) at the relevant time. It is a right of action held and exercised by the liquidator, not for the benefit of the company itself, but in the interest of all those entitled to claim against the company's estate—principally, its general unsecured creditors. And, the right to repayment only arises if a liquidator successfully brings a court application to set aside the preferential payment. Unless and until that happens, the (preferential) payment is effective to discharge of the company's debt to the creditor.
• The Court also rejected set-off in these circumstances on a broader basis, which is equally important. Denying set-off to the preferred creditor is necessary to achieve the statutory purpose of the unfair preference provisions. That purpose is to uphold the Act's scheme for distributing the insolvent company's assets in favour of its creditors (which includes the Act's provisions regarding priority creditors, as well as the pari passu rule requiring rateable distribution for all other creditors).

Our analysis

• In our view, this is not a surprising outcome. However, the decision provides welcome clarification on the interaction between unfair preference law and insolvency set-off under s 553C of the Act. This is particularly so in light of earlier authorities which had been read as supporting the creditor's argument that a liability to repay a preference could be set-off against another debt owed to the creditor.
• The Court distinguished the first instance Federal Court decision in Re Parker. That case allowed a set-off of a holding company's liability in respect of its subsidiary's insolvent trading. It was said to support the proposition that set-off would also be available in relation to an unfair preference claim. That proposition was accepted on several occasions by other first instance judges, albeit usually in a context where detailed submissions and argument were not presented on the issue. As the Court noted here, Re Parker could be distinguished because the type of liability concerned in that case, and the nature and purpose of the statutory provisions in question, differed materially from the unfair preference liability.
• It is worth noting this decision does not deal with the question of set-off against other forms of claim which might be brought by a liquidator.

Authors: Tony Ryan, Partner; Alinta Kemeny, Partner;  Camilla Clemente, Partner and Tim Ancev, Associate