UNFAIR PREFERENCE CLAIMS AND THE OUSTING OF THE ‘PEAK INDEBTEDNESS’ RULE

by Shreya Dutt, Lawyer, MST Lawyers

Creditors faced with an unfair preference claim under the Corporations Act 2001 (Cth) (Act) will often try to show that its relationship with the company in question involved a running account, thereby bringing into play the defence in section 588FA(3)(c) of the Act.

Section 588FA(3)(c), in essence, provides that where a transaction alleged to be an unfair preference is part of a containing business relationship between the company in liquidation and the creditor and, in course of that business relationship, the level of the indebtedness to the creditor varies from time to time due to a series of transactions, then all such transactions would be treated as a single transaction and such single transaction needs to be an unfair preference for an unfair preference claim to be successful.

Until recently, in determining the extent of a preference in this scenario, Courts allowed liquidators to choose the point of peak indebtedness during the period of the continuing business relationship between the creditor and the company in liquidation and compare that amount to the amount owed to the creditor when the liquidator was appointed. The amount of the unfair preference claim was calculated as the difference between these two amounts.

This approach was developed following the decision of Chief Justice Barwick in Rees v Bank of New South Wales [1964] HCA 47 (Rees) and came to be known as the Peak Indebtedness Rule. This rule has since been followed by Australian Courts and liquidators in countless unfair preference claim matters.

However, the Peak Indebtedness Rule has recently been overturned by the Full Federal Court in the recent case of Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 (Badenoch).

The relevant facts

On 25 September 2012, the liquidators were appointed as the joint and several administrators to Gunn Limited, making it the applicable ‘relation-back day’ within the meaning of s 91 of the Act. The liquidators alleged that 30 March 2012 was the insolvency date and that between 26 March 2012 to 25 September 2012 (relation-back period), Gunns made 11 payments to Badenoch which were insolvent transactions and voidable payments under s 588FE. The liquidators commenced an unfair preference claim proceeding in the Federal Court of Australia against Badenoch that ultimately gave rise to the appeal discussed below.

Analysis of the statutory provision and the position at common law

‘Continuing Business Relationship’

The Court began its analysis with what constitutes ‘continuous business relationship’ and noted that where a payment forms an integral and inseparable part of a wider transaction or a ‘running account’, the determination of whether it is a preference payment involves looking at the effect of the whole transaction (Richardson v Commercial Banking Co of Sydney Ltd (1952) 85 CLR 110 ). This principle has been referred to as the doctrine of ultimate effect (Airservices Australia v Ferrier (1996) 185 CLR 483 (Airservices)). 

Relying on Airservices and other court decisions, the Court observed that:

(a)          for a payment to form part of the continuous business relationship, it should have been made with the ‘mutual assumption’ of a continuing relationship between the creditor and the liquidated company that future debits and credits will be recorded;

(b)          to maintain such an assumption, the predominant concern and the primary purpose of the impugned payment should not be to recover past indebtedness but inducement of further supply of goods or services. Simply put, the parties must be looking forward rather than backward;

(c)          if on the examination of the evidence it becomes clear that the sole purpose of the payment was to discharge an existing debt, then the assumption of ‘continuing business relationship’ would cease and the impugned payment may be a preference payment;

(d)          however, if the purpose of the payment was to induce the creditor to provide further goods or services to the liquidated company as well as to discharge an existing indebtedness, the payment would not be a preference unless the payment exceeds the value of the goods or services acquired; and

(e)          inducement of further supply should be the predominant purpose behind the payment and not second to the purpose of payment of debt.

Peak Indebtedness Rule

After determining that there was a continuing business relationship between the parties, the next question before the Court was essentially when would be the relevant start date for the s588FE transaction in a continuing business relationship.

The Court noted that section 588FA(3) was added by the Corporate Law Reform Act 1992 (Cth), the explanatory memorandum for which did not refer to a peak indebtedness rule or the observations made in Rees.  However, the explanatory memorandum did refer to the ‘ultimate effect’ of the dealings when determining whether payments were preferential or not.

The Court proceeded to examine the circumstances and the context in which Rees was decided by the High Court.  The Court did not discuss whether Chief Justice Barwick’s statement regarding the peak indebtedness rule was an obiter dictum. The Court noted that Rees was decided in context of a different statuary provision while the question before the Court was related to the current Act.

The Court also looked at the decision of the New Zealand Court of Appeal in Timberworld Ltd v Levin (2015) 3 NZLR 365 (Timberworld) wherein the application of the peak indebtedness rule in the context of an equivalent New Zealand statutory provision was rejected. Citing Timberworld, the Court noted that on its fact, section 588FA(3) did not contemplate that the liquidator looked only at part of the transaction in a continuous business relationship. 

The Court noted that:

(a)          there was no legislative intent to adopt the peak indebtedness rules when s588FA(3) was introduced;

(b)          the peak indebtedness was inconsistent with the express language of s588FA(3)(c) and (d) and the application of the rule essentially severed a single transaction into two, which is contrary to the statutory intention;

(c)          s588FA(3) incorporated the doctrine of ‘ultimate effect’ which is consistent with intention of Part 5.7B to maintain a balance between the interest of the unsecured creditors and the creditor in receipt of the transactions;

(d)          as highlighted in Timberworld, there needs to be an incentive for creditors to continue providing services and goods to other companies in financial distress, a purpose which the doctrine of ultimate effect seeks to achieve; and

(e)          In operation, the peak indebtedness rule creates an arbitrary situation if each creditor demonstrated a different credit term.

Consequently, the Court decided that the liquidators were not entitled to apply the peak indebtedness rule for the purpose of determining whether there was an unfair preference under s 588FA(1) of the Act. 

Following Badenoch, the results which otherwise would have been obtained by applying the rule are different from the result post Badenoch.

This is best illustrated by the example below (which assumes the relation back period started on 1 January 2020 and ended on 30 June 2020 (relation back day), that the continuing business relationship was for the whole of that period and the sum owing at the start of that period was $500,000 and the sum owing at the end of that period was Nil).

Date	Transaction	Debit	Credit	Balance
01.01.20				$500,000
31.01.21	Purchases	$100,000		$600,000
31.01.20	Payment		$400,000	$200,000
28.02.20	Purchases	$150,000		$350,000
28.02.20	Payment		$100,000	$250,000
31.03.20	Purchases	$250,000		$500,000
31.03.20	Payment		$450,000	$50,000
30.04.20	Purchases	$250,000		$300,000
31.05.20	Purchases	$350,000		$650,000
31.05.20	Payment		$200,000	$450,000
30.06.20	Purchases	$100,000		$550,000
30.06.21	Payment		$550,000	Nil
Totals		$1,250,000	$1,750,000

In this example, although there were potentially $1,750,000 in payments in the relation back period, the effect of 588FA(3) pre Badenoch was that the preference would be $650,000 being the difference between the point of peak indebtedness in the relation back period and the final balance.

Following the rejection of the rule in Badenoch, if the debt owed to the creditor at the start of the continuous business relationship on 1 January 2020 was $500,000.00 and $0.00 at the end, the unfair preference would be $500,000.00.

The decision Badenoch will certainly have an impact on the on-going and future unfair preference claims commenced by liquidators. With liquidators unable to pick the point of peak indebtedness, it may not be commercial for liquidators to commence unfair preference claim proceeding. This would ultimately affect unsecured creditors of liquidated companies who were disadvantaged even when the peak indebtedness rule was applied by liquidators to include the maximum amount within their claim.

Set Off

In Badenoch, the liquidators alleged that as a matter of law, the Court could not permit the use of set-off under s553C of the Act against any monies ordered to be repaid by Badenoch to the liquidator under s588FA.

Sub-section 553C(1) of the Act provides that where there have been mutual credits, mutual debts or other mutual dealings between an insolvent company that is being wound up and a person who wants to have a debt or claim admitted against the company:

(a)          an account is to be taken of what is due from the one party to the other in respect of those mutual dealings; and

(b)          the sum due from the one party is to be set off against any sum due from the other party; and

(c)          only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be.

Sub-section 553C(2) of the Act provides that a person is not entitled to claim the benefit of a set-off if, at the time of giving credit to the company, or at the time of receiving credit from the company, the person had notice of the fact that the company was insolvent.

There have been conflicting decisions by single judges as to whether a section 553C set off is available as a defence to an unfair preference claim.

In Badenoch, the Full Federal Court avoided answering this difficult question because it held Badenoch, at the time of the impugned payments, had notice of the fact that Gunns was insolvent and therefore it would not have been entitled to a set off in any event.

We can report that the issue of whether a set-off under section 553C can be relied upon as a defence to an unfair preference claim has been referred to the Full Federal Court in Gavin Morton As Liquidator Of MJ Woodman Electrical Contractors Pty Ltd (In Liquidation) & Anor v Metal Manufacturers Pty Limited with the hearing scheduled for 26 August 2021. The position that will follow from the decision in this case will no doubt prove to be an interesting read.

MST can help

The lawyers in MST’s Litigation and Dispute Resolution Team have substantial experience in acting for and advising liquidators and creditors in relation to unfair preference claims. Please feel free to contact us on (03) 8540 0200 or at shreya.dutt@mst.com.au.