Peak indebtedness rule is abolished.
The Corporations Act 2001 (Cth) (‘the Act’) includes a number of mechanisms to ensure that creditors of an insolvent company are treated fairly and (approximately) equally. One of those mechanisms is intended to allow the liquidator of a company to ‘claw back’ preferential payments received by one creditor to the detriment of others.
When assessing what payments are preferential, the Act requires liquidators to consider the true, cumulative effect of a continuing business relationship between the creditor and the insolvent company, and not simply claim for the total of all payments received by the creditor.
The Full Court of the Federal Court of Australia ('Full Court') has recently held that liquidators are not permitted to apply what is known as the 'peak indebtedness' rule when assessing the amount of unfair preferences received in the course of a continuing business relationship.[1]
Instead, liquidators must take into account all transactions between the company and the creditor from the commencement of the continuing business relationship, or the commencement of the ‘relation-back period’ (whichever is later), through to the end of the continuing business relationship, or the ‘relation-back day’ (whichever is later).
What are unfair preferences?
Section 588FA(1) of the Act defines an unfair preference as a transaction between a company and a company's creditor, which results in the creditor receiving more than it would have received if the company was wound up and the creditor were to prove for the debt in the ordinary way. In other words, a transaction is an unfair preference when one creditor receives more than it would have received if all of the assets of the company (including the amount of that transaction) were pooled and distributed according to the rules in the Act.
For there to be an unfair preference:
the company must have been insolvent at the time of the, or as a result of, the transaction (section 588FC); and
the transaction must have been entered into during the period of six months ending on the relation-back day (the 'relation-back period') (section 588FE(2)).
In general, the 'relation-back day' is the day the company goes into administration or liquidation.
What is a continuing business relationship?
Sometimes, a transaction between a company and a company's creditor may form an integral part of a continuing business relationship. An example is what is known as a ‘running account’ in which a company's net indebtedness to a creditor may fluctuate as a result of many supplies and payments.
Section 588FA(3) of the Act provides that an unfair preference will arise if all of the transactions integral to a continuing business relationship are treated as a single transaction, and in that single transaction, the creditor receives more than it would have received if the company was wound up. In other words, the intention is to consider the net effect of the whole series of transactions.
What was the 'peak indebtedness' rule?
Liquidators have traditionally applied the 'peak indebtedness' rule when assessing the amount of the 'single transaction' in a continuing business relationship. The 'peak indebtedness' rule has enabled liquidators to choose any point in the continuing business relationship within the 'relation-back period' as the beginning of the 'single transaction'.
Practically, this means that liquidators would choose the point which would show the highest amount of indebtedness, so that all payments reducing that debt would be treated as unfair preferences.
The 'peak indebtedness' rule was propounded by Chief Justice Barwick in the High Court case of Rees v Bank of New South Wales ('Rees').[2] It was later endorsed in the South Australian Supreme Court case of Olifent v Australian Wine Industries Pty Ltd ('Olifent').[3] Since that decision, liquidators have regularly applied the 'peak indebtedness' rule in Australian courts.
The case of Gunns
Gunns Limited ('Gunns') was a large forestry enterprise located in Tasmania. On 25 September 2012 ('the relation-back day'), Gunns went into voluntary administration. On 5 March 2013, Gunns went into liquidation.
The appellant, Badenoch Integrated Logging Pty Limited ('Badenoch') was an unsecured creditor to Gunns. The respondents were the liquidators of Gunns.
The liquidators of Gunns alleged that in the 'relation-back period', Gunns made eleven payments to Badenoch which were unfair preferences.
Badenoch defended this claim. It contended that the eleven payments were not unfair preferences for the following reasons:
The eleven payments formed part of a 'continuing business relationship' between itself and Gunns, such as to constitute a 'single transaction' for the purpose of assessing whether they were unfair preferences.
The liquidators were not entitled to apply the 'peak indebtedness' rule when assessing the amount of that single transaction.
The primary judge's decision
The primary judge concluded that only two of the eleven payments between Gunns and Badenoch formed part of the 'continuing business relationship'. Her Honour found that the other payments were made in circumstances where Gunns and Badenoch looked ‘backwards rather than forwards’, or in other words, looking to the 'partial payment of the old debt rather than the provision of continuing services'.[4]
The trial judge also concluded that the liquidators were entitled to apply the ‘peak indebtedness’ rule when claiming that the single transaction was an unfair preference. Her Honour’s reason was that the peak indebtedness rule was confirmed in the case of Olifent, had since been applied in a number cases, and had not ever been called into question.[5]
The trial judge was not persuaded by the recent decision of the New Zealand Court of Appeal in the case of Timberworld Ltd v Levin ('Timberworld'),[6] where the Court examined a number of Australian cases and determined that the peak indebtedness rule did not apply in the context of the equivalent New Zealand statutory provision.
Badenoch was therefore required to return over $2 million that it had received from Gunns throughout the relation-back period.
Badenoch appealed the decision.
The appeal
Continuing business relationship
The Full Court partially overturned the primary judge’s decision by concluding that the first four of the eleven payments were part of the 'continuing business relationship'. The Full Court accepted evidence that the remaining payments were primarily for the purpose of ‘getting Badenoch’s debt paid down’, thus ceasing the 'continuing business relationship'.[7]
The Full Court cautioned against adopting the strict principle that the 'continuing business relationship' will end once the purpose of inducing further supply is ‘subordinated to a predominant purpose of recovering past indebtedness.[8] As the Full Court stated, such an approach would be inconsistent with ‘the rationale behind section 588FA(3) of the Act – which recognises that a series of payments made by an insolvent company to induce creditors to provide further supply do not cause any disadvantage to the general body of creditors unless the total payments made exceed the total value of goods or services acquired'.[9]
That said, the Full Court also stated that 'a creditor will not be permitted to hide behind the façade of a continuing business relationship when the true nature of what he or she is doing is seeking to recover past indebtedness in priority to other unsecured creditors.[10]
Accordingly, the Full Court concluded that it must look at the ‘practical relationship’ between the payments and the subsequent supply of services, and the ‘ultimate effect’ of the dealings.[11]
Peak indebtedness rule
The Full Court disagreed with the primary judge’s decision and concluded that the peak indebtedness rule does not apply under the Act.
The Full Court made this decision by examining the Explanatory Memorandum to the Corporate Law Reform Bill 1992, which inserted section 588FA(3) into the Act. The Court concluded that the Explanatory Memorandum (and the cases referred to within) did not refer to the ‘peak indebtedness' rule, nor did it refer to the decision of Chief Justice Barwick in Rees. Their Honours stated:
'There can be no room for the implication of a rule that is inconsistent with the express language of the statute.’[12]
The Full Court also noted that the ‘peak indebtedness’ rule was incompatible with the doctrine of ‘ultimate effect’, which recognises that the general body of creditors are not disadvantaged by payments made to induce trade creditors to supply goods of equal or greater value.[13]
On this note, the Full Court followed the decision in Timberworld in concluding that the case of Olifant, and the decisions that followed it, were wrongly decided where the peak indebtedness rule was applied.
Badenoch was therefore only required to pay $1,200,633.68 plus interest to the liquidators of Gunns.[14]
Key takeaways
This decision is clearly disadvantageous to liquidators. This is because it significantly lowers the amount of money a liquidator may 'claw back' from a creditor as an unfair preference, and potentially increases the difficulty in proving that a normal ‘continuing business relationship’ has changed to ‘seeking to recover past indebtedness in priority to other unsecured creditors’.
This decision will however provide comfort to unsecured creditors seeking to maintain ongoing trading accounts with companies suspected to be in financial difficulty.
We would not be surprised if the liquidators of Gunns appeal the Full Court's decision to the High Court.
To discuss your concerns about unfair preferences, or other insolvency issues, please contact James Cudmore, Adam Rosser, John Vozzo or Hamish Gillis.
This article provides general comments only and does not constitute legal advice. You should always seek specific advice on your particular circumstances.
[1] Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 (10 May 2021) ('Gunns appeal').
[2] (1964) 111 CLR 210.
[3] (1996) 130 FLR 195.
[4] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713 at [99].
[5] Ibid at [102].
[6] (2015) 3 NZLR 365.
[7] Gunns Appeal at [78].
[8] This was approach taken by Judge Santow in Sutherland (as Liquidator of Sydney Appliances Pty Ltd (in liq)) v Eurolinx Pty Ltd (2001) 37 ACSR 477 at [148].
[9] Gunns Appeal at [54].
[10] Ibid at [55].
[11] See Airservices Australia v Ferrier (1996) 185 CLR 483 at 501-503, 509.
[12] Gunns Appeal at [112].
[13] Ibid at [118].
[14] Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) (No 2) [2021] FCAFC at [32].