Accountants, lawyers and advisors often find themselves acting for companies facing financial uncertainty that are borderline insolvent. In some circumstances, a decision is made to place the company into voluntary administration or liquidation and these professionals are asked to do a substantial amount of work prior to the appointment.
The fear these professionals quite rightly have is that any payments they receive leading up to the appointment may be treated as preferential payments and be clawed back under the provisions of the Corporations Act 2001 (Cth).
So, what can you do if you’re asked to provide professional services in the above scenario. Let’s start by gaining an understanding of preferential payments before taking a look at the Doctrine of Ultimate Effect, a recognisable defence.
What is a preferential payment?
Section 588FA of the Corporations Act 2001 (Cth) defines an unfair preference as a transaction, such as payment of an outstanding debt, between a company and a unsecured creditor, which results in that unsecured creditor receiving more than it would have received if it had to prove the payment in the winding up of the debtor company.
If a transaction is deemed as preferential, the external administrator can commence proceedings to claw it back.
In order for a liquidator to successfully prove a preference claim, they must establish the following in accordance with section 588FA of the Corporations Act 2001 (Cth):
- The creditor receiving the payment is deemed an unsecured creditor.
- The debtor company and the creditor were parties to the transaction.
- The company made the payment when it was insolvent, or the company became insolvent as a result of the transaction.
- The transaction took place within six months of the commencement of the winding up
- The payment resulted in the creditor receiving more than they would in a liquidation scenario.
As previously stated, the Doctrine of Ultimate Effect is a defence to an unfair preference claim. The doctrine states that if the payment results in the debtor company being in a better asset position because of the payment, the ultimate effect has not been to decrease the net value of the debtor company’s assets.
The Doctrine of Ultimate Effect is a recognised and solid defence that can be used by professionals in the circumstances described above. The following 2 cases clearly illustrate how the doctrine is applied.
Applying the Doctrine of Ultimate Effect
Airservices Australia v Ferrier
One of the leading cases in the area of preferential claims is Airservices Australia v Ferrier.
Compass Airlines was operating a commercial passenger airline service; its aircraft flying at altitudes only possible under the Instrument Flight Rules and requiring the use of air traffic control. At the time, the Civil Aviation Authority (CAA) provided route and terminal navigation services, firefighting and meteorological services for a fee.
From June 1991, Compass Airlines paid CAA approximately $10.3 million for those services, but the cost of those services to CAA was approximately $19 million. The payments made were in discharge of specific debts, not in the reduction of the balance of a running account.
The High Court held that:
- the value of the services provided exceeded the amount of the payments received during the relevant period
- the payments did not deplete or diminish the assets of Compass available for distribution to other creditor
- had the services not been provided by CAA, Compass would have had far less means to pay any creditors
- the payments did not decrease the amount of money available to other creditors.
As a result, the ultimate effect of the payments were not deemed to be preferential.
Beveridge v Whitton
Another example of a preferential payment claim being overruled was the case of Berveridge v Whitton. In Beveridge v Whitton, a company owed the Australian Tax Office $200,000 and a bank an overdraft.
In July 1994, the bank recommended that the company engage Mr Beveridge, an accountant, to get the company’s books and accounts into order and advise on financial matters. It was agreed his fees would be paid within one week of an invoice being issued.
The company was placed into liquidation in February 1995.
In the first instance, it was found that by July 1994 the company was insolvent and that this was known to Mr Beveridge. The payments to Mr Beveridge were not held to be beneficial to any other creditors and therefore unfairly preferential.
On appeal, Beveridge argued that:
- he only accepted the engagement on the provision that he was paid on terms
- the services he provided were necessary whether the company was solvent or not
- even if they did not immediately increase the company’s income, management of the company’s finances was clearly a required action.
Event though the liquidator argued Mr Beveridge’s services did not increase the amount of money available for other creditors, the Court of Appeal held the Doctrine of Ultimate Effect did not depend on the “transaction’s ability to improve or worsen a company’s position, but it was the ultimate effect of the transaction itself”.
It further found that Mr Beveridge’s services were needed for the trading life of the company which was to the benefit of the company. The decision was overturned on appeal.
As you can see, while it’s often challenging to deal with companies facing financial uncertainty or liquidation, an understanding of the Doctrine of Ultimate Effect can allow professional services businesses to provide services with more confidence around how to avoid having fees clawed back as preferential payments.
If you’re a professional services business with some questions or concerns about the above topic, feel free to get in touch with our Director of Law, specialising in Liquidation and Insolvency, Wojtek Randla.