Consider two conflicting public policy goals:
1. In a liquidation all creditors are to be treated equally, paid according to the priority set down by Schedule seven (staff first, overdue GST and PAYE, then unsecured creditors).
2. It is important that suppliers to firms in trouble continue to supply, enabling struggling firms an opportunity to trade out and return to profit.
During the insolvent period of the company it is common for the director to make preferential payments to some creditors. Those creditors are often connected to the director, hold some commercial power or the director has a personal guarantee.
The purpose of introducing voidable transactions is to give the liquidator power to unwind payments if the liquidator considers that a payment has given the one creditor a better result than what could be achieved in a liquidation.
Because of this power, firms became very wary of dealing with other firms if insolvency is suspected. In an attempt to meet the first goal, the second objective was compromised. This thinking was behind the legislative change from the ordinary course of business defence to the running account test.
For a transaction to count as insolvent, and therefore voidable, the liquidator must establish that the transaction enables one party to receive more towards satisfaction of a debt owed by the company than the party would receive, or would be likely to receive, in the company’s liquidation.
Previously, if the recipient of the funds could prove that the payment was made in the ordinary course of business, the payment was not recoverable by the liquidator. This was a difficult test, especially if the supplier changed terms from credit to Cash-On-Delivery as a result of non-payment problems.
A significant change to the legislation made by the Companies Amendment Act 2006 is the inclusion of the running account exception, replacing the ordinary course of business test. When challenged over insolvent transactions, many creditors are still relying on the old exception rule, unaware that the legislation has changed.
The government’s decision to introduce the continuing relationship or running account exception was based on a perception that this new test had worked well in Australia, appeared to be more certain than the ordinary course of business test, and would encourage creditors to continue to deliver to their probably insolvent customers.
Section 292(4B) of the amended act directs the courts to view a series of transactions that are part of a continuing business relationship between the company and its creditor as a single transaction. When deciding whether that transaction is one that enables another person to receive more towards satisfaction of a debt owed by the company than the person would receive, or be likely to receive, in the company’s liquidation.
Put simply, if in the six months before your customer’s liquidation you provide goods and services worth $X, and you receive more than $X, then only the payments that you received over $X can be challenged under the running account test. If you are paid for the goods and services you provided in the last six months, payments equal to the value of the work done are safe. It does not matter if the payments were credited to older invoices.
As an example: assume a firm where it was standard practice for goods to be supplied in one month with payment to be made on the 20th of the following month. Suppose this practice was followed by a company and its main supplier. When the company became insolvent it owed the supplier $50,000. The supplier became aware that the company had cash flow problems, but agreed to continue to supply goods to a value of $5,000 a month so long as the company paid at least $5,000 a month at the start of each month (not on the 20th of the month as had previously been the normal practice). The supplier also demanded a one-off payment of $10,000, which was paid. The supplier was also made aware that the company was attempting to delay payment to some of its less important suppliers. In this case, supplies continued to be made and payments continued to be received for the next 6 months. At the end of that 6 month period the company went to liquidation.
In some cases the liquidator can go back 24 months but normally they stop at six months.
Under the previous rule each of the ten payments of $5,000, plus the extra $10,000, made by the company to its supplier following its insolvency but before its liquidation could be challenged by the liquidator as a voidable preference. The payments all took place in the 2 year specified period, while the company was unable to pay its due debts. It is likely that such payments would have enabled the main supplier to have received more towards its debts than it would have otherwise have received in the liquidation of the company.
The ordinary course of business defence is unlikely to be of help given the knowledge that the main supplier had regarding the company’s financial difficulties and the way in which the company was paying its creditors during the last 6 months of its existence. Under the new rules, the payments, even though they were in advance, were for work done during the specified period, and are safe. Only the one off payment of $10,000 was a payment for old debt, and is an insolvent transaction.
The running account exception is a more equitable regime and gives suppliers of insolvent firms confidence that payments they receive for work done is safe.