Elements of Insolvent Transactions – Bankruptcy Act

The Bankruptcy Act defines solvency as the ability to pay one’s debts as and when they fall due and payable and a person who is not solvent is “insolvent”.

Evidence of insolvency may include invoices unpaid long beyond accepted trading terms, dishonoured cheques, payments on account, bank statements and correspondence and demands from banks, creditors and the like.

It is important to take into account the fact that simply because a debtor company pays late this does not necessarily mean that the creditor should or does suspect insolvency.

The case Sydney Appliances Pty ltd (In liquidation) v Eurolinx Pty Ltd [2001] NSWSC 230 explores the care which creditors need to adopt when trading with entities, which they suspect, or reasonably should suspect, cannot pay their debts as and when they fall due.

Justice Santow gave the following summary of how to treat a concept like “suspicion”:

• analysing factors which may help establish that there was or should have been suspicion
• assessing the commercial circumstances as they existed at the time
• applying the commercial reality derived from the particular industry to the facts
• undue weight should not be placed on dilatory payments.

In relation to running accounts, the discussion of an ‘ultimate effect doctrine’ as affirmed by the majority of the High Court in Airservices Australia v Ferrier (1996) 185 CLR 483, suggests that once the doctrine of ultimate effect was applied, the payments made to Air Services gave it no preference, priority or advantage over the general body of creditors.

For the purpose of s122 (of the Bankruptcy Act), it was held that one cannot ignore the practical relationship between the payments and the subsequent supply of the services and the ultimate effect of the dealings between the parties.

In bankruptcy, a recipient of a preference can have no defence if the payment or transfer was made outside the ordinary course of business. In defining the ordinary course of business, the Courts will assess the normal transactional relationship between the debtor and the creditor, and any knowledge of approaching bankruptcy that may exist.

We will stress here however, that a payment made in response to a bankruptcy notice is likely to be outside the ordinary course of business.  In line with common law doctrine, here are some examples of payments which were held to be outside the ordinary course of business:

• payment under a cheque initially dishonoured.
• part payment of a judgement debt after the initial cheque was dishonoured.
• when goods are repossessed and future deliveries are only made on a COD basis.
• payments on account that do not bear relationship to particular invoices
• repayment of a loan by a company to a director’s mother-in-law
• delivery of finished

Good faith implies that the parties entering into a transaction are doing so in all honesty, with no knowledge of any impropriety or insolvency. When working with our clients, we tend to adopt the argument that the concepts of good faith and ordinary course of business are intertwined, and should be assessed individually and also as part of a larger argument.

The onus of proving the defence of good faith falls on the creditor claiming protection. What is important is whether the creditor knew or had reason to suspect insolvency, not whether he had doubts as to the insolvency of the debtor.

To clarify this considers that if a bank is aware that a client is experiencing financial difficulties, any action taken to reduce the overdraft cannot be said to be in good faith.

In the Sydney Appliances case, the creditor claimed that all payments were made in good faith, that it did not suspect insolvency, nor would any reasonable person have done so.

However, the judge concluded that the supplier should have had suspicion of the debtor’s insolvency and the defence of good faith was not available due to:

• receiving financial information on the company
• extending credit terms because it was aware that the debtor required the support of its suppliers
• payment by post-dated cheques and undated cheques for round-dollar amounts which were applied against older debts and
• the inability of the debtor even to stick to the new credit terms

In order to seek protection under this section, the consideration given must at least equate to the market value of the property transferred. The value must be assessed on an objective basis and not dependent on a special value that the transferor may subjectively have placed on the property or consideration.

In those situations, where a book debt is discharged by payment of cash or cheque, the discharge of the debt is deemed to be valuable consideration, as the payment of a book debt discharges a debt of the same value.