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Third Party Payment Preference: What It Is and How to Avoid It

Preferential payment claims 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.

Understanding Third-Party Payment Preference - SBR AU Blog

The good thing is that there is a way for you to minimise the risks of being the subject of a preference payment claim. But before we discuss the pre-emptive steps that you can take, let’s first try to understand what a preferential payment is and how it comes about.

What Is 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 said 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.

So, when does 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. This happens when:

  • the third party is 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.

  • there is no written Quistclose trust between the debtor and the third-party payor

    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.

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 Reduce Risk of Exposure to Preferential Payments

  1. Vet your debtors properly
  2. One of the biggest indications that a transaction can become preferential payment is if it’s done within the 90-day period of a debtor filing for insolvency. You can avoid this tricky situation altogether by vetting your debtors carefully. Get as much information about your clients’ financial status before you decide to extend them credit. Ask to see their current financial statements and obtain credit reviews of that client from third-party firms.

    Once they belong on your list of debtors, keep a close eye on them and make sure you maintain open lines of communication. Plus, find out what others in the industry are saying about them. This way, you will be better informed of their financial condition and will be able to make proactive decisions about your credit risks.

  3. Invest in strengthening your payment terms
  4. Another sure-fire way to minimise the possibility of being exposed to preferential payment is to update your payment terms. Review these terms regularly to make sure they are in line with the standards of your industry. Keep in mind that the timing of the financial transaction between you and the debtor is crucial in a preferential payment claim. So to avoid this claim, the payment you receive from a debtor must be made within a period that’s reasonable for your trade. If the timing of the payments significantly deviates from the norm, that’s a red flag you must watch out for.

  5. Stick to your credit limit
  6. Letting a particular debtor exceed their credit limit is huge risk factor for preferential payments. If that debtor is already on the verge of insolvency, it will be extremely difficult for you to get back the excess credit amount from them. In this instance, any payments obtained from your collection efforts will highly likely be clawed back as a preference. To avoid this, it’s best that set a reasonable credit limit for your clients and make sure you stick to it.

Slater Byrne Recoveries offers credit consultancy services to help you prevent bad debt and protect your business interests. Give us a call today at 1300 794 290 or send us an email at [email protected].