Answering an Unfair Preference Claim- The Good Faith Defence

Construction Litigation

Insolvency in the construction industry is on the rise. It should come as no surprise then that liquidators will reach for the low hanging fruit of an unfair preference claim to claw back payments from unsecured creditors.

We published an article last year on unfair preferences which provides a good introduction as to what they might entail.

In short, unfair preference claims in the construction industry can occur when a contractor shows potential favouritism by paying off one unsecured creditor (such as a supplier) before other unsecured parties, right before going bust. This type of transaction is ‘voidable’ under the Corporations Act 2001, meaning that a liquidator can attempt to recover this payment from the recipient down the track.

However, not all is lost if you find yourself on the receiving end of an unfair preference claim. As we set out below, there are a range of legal responses available to unsecured creditors. For today we will focus on arguably the most common one: the good faith defence.

What is the good faith defence?

The good news is that liquidators can’t simply reach into the pockets of innocent, unsecured creditors and take money back on a whim. The good faith defence is designed to shield innocent recipients of money from being caught up in the mess of other creditors who are trying to recover their unpaid invoices.

One test, two limbs

The good faith defence involves two ‘limbs’ that an unsecured creditor must establish to avoid an unfair preference.

Creditors must show:

  1. First, that they received the payment in good faith;
  2. Second, that they had no reasonable grounds to suspect insolvency (the first limb) – this is the subjective element of the test; and
  3. Third, that a reasonable person in the same circumstances would also have no reasonable grounds to suspect insolvency (the second limb) – this is the objective element of the test.

Most of the attention tends to focus on points (2) and (3).

Section 588FG(2) of the Corporations Act 2001 sets out these two limbs to the good faith defence:

But what are “reasonable grounds” and who is this “reasonable person”?

The first limb

The first limb is a subjective test. This means courts will take into account a range of factors unique to the unsecured creditor and their specific circumstances. Relevant information may include the unsecured creditor’s:

  • training;
  • skills;
  • experience; and
  • knowledge of or communications with the company in question.

For example, a bank may be, or should have been in a better position to appreciate facts pointing towards the company’s impending insolvency than a sole trader.

The court describes reasonable suspicion as:

“a positive feeling of actual apprehension or mistrust, amounting to a slight opinion, but without sufficient evidence”

The court has held that “mere speculation” is insufficient to constitute a reasonable ground for suspecting insolvency.

To take a practical and common example: you submitted your claim and there is no dispute about it. You follow up and are promised payment, but it does not come through. You follow up again, with no answer. Eventually you threaten legal proceedings, and then you are paid a round figure (say, $10,000) towards the debt but not the entire debt. Eventually you are paid the balance.

In those circumstances, the court may find that you had reasonable grounds for suspecting insolvency. That said, it really depends on the context as a whole.

The second limb

The second limb is an objective test. Inquiry is directed to the facts and mind of a hypothetical “reasonable person”.

The reasonable person is assumed to possess the knowledge, skills and experience of an average prudent businessperson, regardless of the experience and skills of the actual unsecured creditor.

The point of this test is to avoid the “turning a blind eye” problem that the subjective test might have. It avoids the chance that a business owner might lack any of the normal behaviours or experiences and, in doing so, meet the subjective part of the test.

The court will assess what suspicions a reasonable person would have ascertained in “the person’s circumstances”. That is, the Court will ask what conclusions a reasonable person would have reached when presented with the same facts as the creditor.

The good faith defence: like rain on your wedding day

The good faith defence essentially allows unsecured creditors to throw their hands in the air and say, “I didn’t know, and I shouldn’t have known”. In other words, it’s the “total ignorance” defence.

Ironically, if you’ve run a tight ship, followed up invoices and continued to reach out to a prospectively insolvent company as part of your effective debt collection process, and the company still isn’t paying you until an unexpected last-minute payment – maybe you should have seen the insolvency coming?

On the other hand, if you haven’t got around to setting up a streamlined debt recovery process and  you haven’t really been chasing the other company for the money, you’re probably going to have fewer opportunities to suspect insolvency by virtue of the fewer interactions along the way.

In other words, the more diligent and effective your business practices are, the harder it may be to argue a good faith defence. It’s a bit of an ironic situation.

Stuck between a liquidator and a hard place

So where does that leave the creditor? Is ignorance really bliss? Or is it better to keep chasing your invoices?

In the event of an insolvency, a single unsecured creditor recovering anything more than cents in the dollar is quite unlikely.

It’s generally more advantageous to stay ahead of the curve and secure payments owed to you when you can, rather than worrying about liquidators coming to claw back the payment if the debtor goes into liquidation. That is, it’s better to get paid now and simply argue later.

So our view remains that it’s best practice to remain diligent in collecting payments and look out for signs of insolvency to avoid the issue altogether. If you do receive an unfair preference claim at some point, the good faith defence may still be available to you depending on the facts.

If you have noticed a demand for an unfair preference claim, your best option is to obtain legal advice on it as soon as possible. Our experienced team can guide you through what legal defences or responses may be available to you based on your circumstances.

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