Uncommercial Transactions and Insolvent Transactions - Essay Example

Voidable Transactions - Unfair Preferences, Uucommercial Transactions and Insolvent Transactions Introduction Under the Corporations Act 2001, the liquidators are given wide powers to set aside or vary the transactions entered into by insolvent companies which face subsequent winding up process. Part 5.7B of Division 2 of the Act governs the powers of the liquidator to so set aside the transactions.1 The liquidator has been vested with powers to set aside or vary the transactions which are categorized as unfair preferences or uncommercial transactions. By setting aside or varying these kinds of transactions the liquidators are empowered to recover the proceeds against such transactions to be distributed to the general unsecured creditors. The rationale behind awarding this power to the liquidator is to ensure the interests of the unsecured creditors are not unduly affected by the disposition of the assets or assumption of liabilities by a company during the intervening period that leads to the winding up of the company. Thus voidable transactions in general and unfair preferences in particular which are highly technical areas of insolvency legislation presuppose that there is the likelihood that individuals and businesses might become insolvent prior to formal declaration of their insolvency.2 Voidable Transactions The features that make a transaction voidable are described under Section 588 FE. This section covers all the transactions entered into on or after 23rd June 1993. Section 9 of the Act defines the term 'transaction' as one to which the 'body corporate' is a party. The transactions may include a conveyance, transfer or other disposition and a charge created or guarantee created by the body corporate. It also includes an obligation on the party of the body corporate or a release or waiver granted by the company. The term further extends to a loan extended by the body. The conditions under which a transaction becomes a voidable transaction are enumerated under Section 588 FE (2). According to this section a transaction to become voidable must be an 'insolvent transaction' of the company. Further the transaction should have been entered into or any act done to give effect to the transaction must have been done during the six months period ending on the relation-back day. Such transactions or acts done at any time after that day but on or before the day when the process of winding up began will also be treated as voidable transactions. The time period of six months is being extended to 10 years ending on the relation-back date in cases where the insolvent transaction has the effect of defeating, delaying or interfering with the rights of creditors of the company. Thus an insolvent transaction of a company entered in to during 10 years ending on the relation-back day would be considered voidable if the transaction was entered into with the specific intention of hindering the rights of the creditors of the company. Section 588FE (4) makes an insolvent transaction voidable when a related entity of the company is a party to such transaction. This Section extends the time period covering the transaction for a period of 4 years ending on the relation-back day. Under Section 588 FG a person against whom the liquidator proceeds for voidable transaction is eligible for some defenses which are available under that section. A party to a transaction will be able to defend the allegation that the transaction is voidable under the following circumstances; (i) when the party has become a party to the transaction in good faith (ii) he had no reasonable ground at the time of entering into the transaction to suspect that the company is insolvent or would potentially become insolvent (iii) there would arise no suspicion for any reasonable person and (iv) the party has made good the company with valuable consideration or altered his position based on the transaction. The party defending the voidable transaction should be able to prove all or any of these conditions to the satisfaction of the court. It was decided in the case of Levi v Guerlini3 that the onus of proving the innocence of the party rests with the person who wants to claim the defense. Views expressed in the case of RE Emayne Pty Ltd (1999)4 and Sutherland v Eurolinx Pty Ltd (2001)5 has insisted that good faith on the part of the party entering the transaction should exist naturally. Insolvent Transaction A transaction becomes voidable only when it is an insolvent transaction. An insolvent transaction is defined under Section 588 FC of the Act to include a transaction entered into at the time when the company is insolvent and the company becomes insolvent due to entering into such a transaction or by the act or omission of any person which gives effect to the transaction. Insolvent transaction is thus an unfair preference or uncommercial transaction entered into at the time the company is in the verge of becoming insolvent. Insolvent transaction also includes those transactions which had resulted in the insolvency of the company. From this it follows that the key issue in a voidable transaction relates to the solvency of the company. According to the decision in the case of Keith Smith East West Transport Pty Limited (in liquidation) v another v ATO (2002)6 the courts will always consider the entire position of the company in determining the insolvency of the company. What is important is the solvency of the company and solvency is defined in Section 95A of the Act. According to this section a person can be regarded as solvent only and only when the person is able to settle all his debts at the points of time when the debts become due and payable by the person. The automatic implication is that when a person is not solvent - that is when he is unable to settle his dues as they become due - he becomes an insolvent. Another condition set out in the legislation to make an insolvent transaction voidable is that such a transaction should be an unfair preference given to the company or it should be an uncommercial transaction. Section 588 FA defines unfair preferences to include a transaction when the creditor and the company are parties to the transaction and the transaction results in the creditor receiving amounts in excess of what would otherwise have been received by the creditor in respect of an unsecured debt on setting aside of the transaction and the creditor were to prove the debt in a winding up of the company.7 An uncommercial transaction also becomes automatically voidable. Under Section 588 FB a transaction becomes uncommercial when such transaction would not generally be entered into by any reasonable person having regard to the benefits of the company and the transaction so entered into would be to the detriment of the company. Under subsection (2) of the section the transaction becomes voidable whether or not a creditor of the company is a party to the transaction. The Act has set a time limit of 2 years ending at the relation-back day for reckoning the uncommercial transactions as voidable transactions. Normally it is necessary that an objective test is applied in deciding on the uncommercial nature of any transaction, As observed in the case of Lewis v Cook (2000)8 what is important is not what action the company might have taken but whether such transaction would have been entered by any reasonable person. A similar view was expressed in the case of Peter Pan Management Pty Ltd v Capital Finance Corporation (Australia) Pty Ltd9, where the court wanted to scrutinize a transaction by referring to the characters of a 'normal commercial practice'. Transaction Section 9 of the Corporation Act contains the definition of the term 'transaction' In the case of Commissioner of Taxation v Macquarie Health Corp Ltd and others (1998)10 the Federal Court of Australia considered the definition of a transaction as it related to Section 588 FA of the Act to determine whether the circumstances of the case warranted the transaction to be considered as voidable transaction. The Court observed that a transaction would become an unfair preference extended by a company to a creditor if and only if the company and the creditor are party to the transaction. The definition as contained in Section 9 also states that a transaction to be regarded as one must include the body corporate as one of the parties. In the instant case since the company was not one of the parties the Court ruled that there was no transaction within the meaning of Section 588 FA and 588 FE of the Act. The Court further observed that if there is no transaction there could be no unfair preference either11. Similar views were expressed in the case of Driver v Commissioner of Taxation (1999)12. Under Subsection (3) of Section 558 FA a transaction for commercial purposes is regarded as an integral part of the continuing business relationship. A running account between a creditor and the company may be cited as an example of this relationship. It is also essential that in the course of such relationship there should be changes in the level of the company's indebtedness to the creditor. These changes in the indebtedness may stem from a series of transactions forming part of such a relationship between the creditor and the company. The Subsection further states that the doctrine of unfair preference would become applicable to all the transactions forming part of the relationship as if all of such transactions have together constituted a single transaction.13 Thus a transaction is the essence of both unfair preferences and uncommercial practices. There have been a number of instances where the various Courts have determined whether a particular dealing or series of dealings constitute a transaction and thereby give rise to the question of unfair preferences. Similarly it is essential that a transaction has happened between a creditor and the company to determine whether such a transaction is an insolvent transaction or not. The provisions of the various sections of the Act have dealt with the unfair preferences, uncommercial transactions and insolvent transactions so that it will be easier for the liquidators to identify those transactions and suitably vary them or set aside them totally. This would greatly facilitate to protect the interests of the unsecured creditors of a company in liquidation due to insolvency. Creditors In the event of the liquidation of a company on account of insolvency unsecured creditors are treated equally if there is a possibility of sharing the assets of the company on a prorate basis among them. The objective of introducing the voidable transaction regime is to protect the interests of the unsecured creditors by preventing any preferential payments to a creditor who is a favored one during the period prior to and leading up to the liquidation and to prevent such acts do not hinder the pro-rata sharing among the creditors. In respect of the creditors any transaction with the company will be treated as a preference in the event of the transaction resulting in the creditor receiving in relation to an unsecured debt more than the creditor would receive if the transaction were set aside. This implies that the liquidator has to first ascertain whether there exists a debtor-unsecured creditor relationship in fact exists. Therefore it becomes important for the creditors to structure their dealings with the company in such a way that there is no debtor-unsecured creditor relationship. The creditors may well take care of this situation by doing any of the following things; (i) by obtaining a security from the company against the monies advanced by them, (ii) by changing the terms of dealing to cash on delivery or delivery against advance payment, (iii) by making the supplies with an associated retention of title basis, (iv) by getting the payments secured by a bank guarantee or letters of credit opened in their favor or (v) by getting paid out of a trust fund established prior to the insolvency of the company.14 In cases where the creditor gets an adequate security before making funds available to the company the creditor will not become an unsecured creditor. In that case the provisions of preferences will be attracted only when the creditor gets paid by the company in excess of the value of the security. The amount paid by the company in excess of the value of the security only will be treated as preferred payments as the creditor is effectively an unsecured creditor in respect of that excess portion paid. With respect to the security in personal properties normally two different categories are recognized. These categories depend on the kind of assets charged. They are (i) physical chattels and (ii) chose in action. Physical chattels include movable properties which are physically available like machinery or automobile. Chose in action are intangible legal or equitable proprietary rights available to the creditors. Against the fixed assets the creditors may get a fixed charge or a floating charge. Section 553C contain provisions that makes it mandatory for an unsecured creditor to set off mutual credits and mutual debits in the event the creditor is putting up his claim on the winding up of the company. The mutual credits and mutual debits should have arisen out of transactions between the creditor and the insolvent company in liquidation. The creditor thus should prove the net amount due to him from the company. The decision in the case of Gye v McLntyre15 substantiates the fundamental policy behind the operation of set off in the case of an insolvent company. The purpose of this section is to protect the interests of the persons having mutual dealings with the bankrupt company. Decision in the case of Forster v Wilson16 also supports this view. It has been held in the case of Calzaturificio Zenith Pty Ltd (in liquidation) v NSW Leather and Trading Co Pty Ltd17 that there can be no situation of setting off of the debt owed to a creditor who had received payment as a voidable preference and the sum to be repaid to the company because of the reason of the preference. This issue was taken for decision in the case of Re Buchanan Enterprises Pty Ltd (No 2)18 Similarly there cannot be any set off of any debt due to a person guilty of misfeasance with respect to a company in liquidation and the money ordered to be repaid to the company as a result of the misfeasance proceedings. The idea behind this provision is that when an amount is recovered from a creditor as a preference amount, then that amount cannot be adjusted or offset against any debts due to such creditor. It is for the creditor to repay the amount in full to the company which he received in preference to make him eligible to be considered as a creditor.19 Conclusion It may reasonably be concluded that the liquidator of a company may not possess the required ability and expertise to identify and avoid a transaction on the reason that the transaction was an insolvent transaction. It is for the parties who deal with the company and who have reasonable grounds to believe that the company is likely to face the situation of insolvency, to be more informed that their dealings may be subjected a detailed scrutiny by a liquidator in the event of the company going into winding up on account of insolvency. There are many examples to this situation like the payments being made to service providers of the company and the banks making security arrangements in the normal course of transactions. It is to be appreciated that the liquidator is also empowered to assess the commerciality of such transactions. The commerciality of the transactions is assessed by the courts on the basis of the potential benefits being received by the company from out of the transactions as well as on the basis of any rational explanation for entering into the transaction. If the transaction is found to provide any unfair benefit to a third party to the detriment of the interests of the Company the liquidator may decide to set aside such a transaction. Read More