Voidable Preference: a Worked Example

Insolvency law shares a failed company's assets among its creditors in a set order. A company that sees the end coming can undo that order in advance, by paying the creditor pressing hardest, the one its directors have guaranteed, or a business its owners control. The preference rules let a liquidator reverse such payments made within a defined period before the insolvency, and bring the money back for creditors as a whole.

A bank meets the rules from two sides. As a recipient, it can be asked to repay what came into an overdraft or loan account in the borrower's last months. As a creditor of the estate, it gains when a payment to someone else is recovered, which is why payments to connected parties in the same weeks are worth noticing while the borrower is still trading.

The common elements are a payment or transfer to a creditor, made while the company was insolvent or that made it so, which leaves that creditor better off than it would be in the liquidation, within a period that runs back from the start of the insolvency.

In the UK, the court must find the company was influenced by a desire to put the creditor in a better position; that desire is presumed when the creditor is connected with the company. The rules also reach a guarantor, so a payment that reduces a debt a director has guaranteed can prefer the director. In Australia no intent is needed; the creditor's defence is to show good faith, no reasonable grounds to suspect insolvency, and valuable consideration, and a narrower rule applies in the simplified liquidation process for small companies. In New Zealand insolvency is presumed for transactions in the last six months, and the defence also turns on good faith, no reasonable grounds for suspicion, and value. Australia and New Zealand treat payments in a continuing business relationship as one transaction, so the net effect over the period counts. New Zealand's two years for every creditor is the law at the time of writing; a government proposal of four years for related parties had not been enacted.

A commercial flooring contractor, constructed for this page like every figure in it, has an overdraft secured by a general security agreement. Its director has guaranteed it. Four months before liquidation the overdraft stands at US$700,000. The debtors and plant would realise US$300,000 in a liquidation, net of costs. The company then sells a vacant site it owns, which the bank's security does not cover, and US$450,000 of the proceeds goes into the overdraft, which the bank does not allow to be redrawn.

The 10% dividend to unsecured creditors is the example's assumption. The part of the receipt at risk is the US$400,000 that paid down debt the security did not cover. If the liquidator recovers it, the bank's claim revives by that amount: the US$50,000 of headroom left in its security covers the first part, and it proves for the rest as an unsecured creditor. Paid from the bank's own collateral, the money would have been far less exposed.

How the claim runs depends on the market. In Australia the bank's defence turns on what it knew, and a file showing a missed covenant, a transfer to workout and a director's warning about cash makes 'no reasonable grounds to suspect insolvency' hard to show. In New Zealand the receipt falls inside the six months in which insolvency is presumed. In the UK the liquidator must show the company desired to prefer, which an arm's-length bank that simply held its limit may resist. The director, whose exposure under the guarantee fell by US$450,000, is a connected person, so desire is presumed as to the director, and the court can revive the guarantee.

The same statements show a second payment: US$180,000 a month earlier to a supply company the director also owns, clearing its old invoices. It falls inside every market's period, and in the UK and Australia a payment to a related party stays open to challenge for years, not months. A liquidator recovering it adds to what every unsecured creditor, including the bank on its shortfall, receives.

A preference pays a real debt, but to one creditor ahead of the rest. A transaction at an undervalue, called an uncommercial transaction in Australia, gives value away: an asset sold cheaply, a guarantee given for nothing in return. The first reorders the queue; the second shrinks what the queue shares. Each market treats the two separately, and a liquidator often pleads both.

Each market also has rules that can invalidate security, in particular floating or general security, that a company grants shortly before an insolvency for money it already owed. A lender that takes new security in a workout for an existing loan, rather than for new money, meets those rules and should expect the timing to be examined.

DEFINED IN ONE PARAGRAPH → · WHEN A LOAN GOES BAD → · THE RECOVERY WATERFALL →

It decides what a recovery is worth. A credit officer who reports that an overdraft was cut from US$700,000 to US$250,000 in a borrower's last months has to say how much of that reduction a liquidator could reach. That depends on the security cover, the market and what the bank's file shows it knew. A bank in workout is rarely able to say it had no reason to suspect insolvency, so its protection is usually its security, not its ignorance.

It also decides when to act. Payments to connected parties, transfers of assets out of the borrower and a sudden appetite to repay the debts its directors guaranteed are signs that the end is closer than the forecast says. A lender that sees them is choosing whether to keep supporting the business or to enforce while there is something left to enforce against, and the shortfall it will chase afterwards is shaped by that choice.

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