In the world of business, managing cash flow and ensuring timely payments are critical. However, there are legal challenges that can catch your business off guard: third-party payment preference.
They happen all the time and if your company is the subject of one, it can cause a huge disruption in your cash flow. After all, it’s frustrating to think that the money you received—which is rightfully yours and is done in payment for a service or product you provided—can just be seized because your debtor filed for bankruptcy or the company has entered liquidation.
For Australian businesses, understanding and mitigating the risks associated with third-party preferential payments is essential. This article will break down what these payments are, how they can impact your business, and what steps you can take to protect yourself.
What Is a Preferential Payment?
In essence, a preferential payment is any type of compensation or transfer of value that a debtor makes to a creditor within the 90-day period before the debtor files for insolvency. This payment must be made in connection with a pre-existing outstanding debt.
Payment preference claims are often controversial and challenging cases because what is contested is the debtor’s intent when they made the payment. It must be proven that the debtor indeed favoured one creditor over the others, leaving all the other creditors in the dust and circumventing the entire bankruptcy/liquidation process.
When Does a Third-Party Payment Become a Preference?
Oftentimes, debtors who find themselves in a financial bind turn to third-party firms to settle outstanding debts. This instance is quite tricky as there is a possibility that this transaction might be considered as a preference.
Here are two common scenarios where third-party payments might be classified as preferential:
- Third Party Discharging Its Own Debt to the Insolvent Debtor. In this case, a transfer of interest occurs, which means the money paid by the third party becomes the property/asset of the debtor and effectively theirs to do away with as they wish. If this money is then used to pay one specific creditor, it becomes vulnerable to a preferential payment claim. This is because the transaction effectively transfers value from the third party to the debtor, which then impacts the distribution of assets during insolvency.
- Absence of a Written Quistclose Trust Agreement. Both the debtor and the third party must agree that the money being lent by the latter to the former must only be used for a specific purpose. That is, to settle the debtor’s debt to the creditor. This agreement, also known as a Quistclose trust, must be properly documented in writing. Otherwise, the third-party payment can be claimed as a preference. Without proper documentation, it may be argued that the debtor had too much discretion over how the funds were used, which could harm other creditors.
Preferential Payments in Australia
In Australia, preferential payment claims are governed by the Corporations Act 2001 cth. The law is designed to ensure fairness in the distribution of assets when a company becomes insolvent. Australian courts examine these claims carefully, considering the timing of payments, the debtor’s financial state at the time of the transaction, and the presence (or absence) of proper legal agreements like a Quistclose trust.
Given the complexity of these cases, it’s crucial for Australian business owners to stay informed and proactive. A preference claim doesn’t just disrupt your cash flow; it can also lead to lengthy legal battles and damage your business relationships.
A Caveat…
It is important to remember that the outcome of third-party preferential payment claims depend highly on the circumstances of the transaction. So, if your business becomes subject to such a claim, it is prudent to take a step back and thoroughly analyse the conditions in which you received the payment. It is also wise to take extra precautions to minimise your company’s exposure to these types of transactions. Below are some tips you can use.
How to Protect Your Business from Preferential Payment Claims
While it’s impossible to eliminate the risk entirely, there are steps you can take to minimize your exposure to preferential payment claims:
- Thoroughly Vet Your Debtors
Before extending credit, ensure that you thoroughly evaluate the financial health of your debtors. Understanding their creditworthiness can help you avoid risky transactions that might later be subject to scrutiny. - Strengthen Your Payment Terms
Clearly define payment terms in your contracts, and ensure that they are adhered to. Consider including clauses that protect you in the event of insolvency, such as requiring payments to be made into a trust account or setting strict conditions on how funds can be used. - Adhere to Your Credit Limits
It’s tempting to extend additional credit to a debtor in financial distress, especially if they’ve been a long-standing client. However, sticking to your credit limits is crucial in protecting your business. Extending too much credit can increase your exposure if the debtor becomes insolvent. - Document Everything
Maintain meticulous records of all transactions, especially those involving third-party payments. Ensure that any special arrangements, such as a Quistclose trust, are documented in writing and clearly outline the terms of the payment.
Seek Professional Advice
Navigating the complexities of preferential payment claims requires a solid understanding of Australian insolvency law. If your business is facing such a claim, or if you want to take preemptive measures, consulting with a legal or credit recovery expert is essential.
At Slater Byrne Recoveries, we offer specialized credit consultancy services to help you safeguard your business against these risks. Contact us today at 1300 794 290 or email us at info@slaterbyrne.com.au for professional advice tailored to your needs.
