Major change for unfair preference claims as Federal Court rules on the peak indebtedness rule

21 May 2021

Publications

A recent decision of the Full Court of the Federal Court (Court) will significantly affect the way in which many unfair preference claims are run and defended: it may kill off many of them for good.

In Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns [2021] FCAFC 64 (Badenoch), the Court found that the ‘peak indebtedness rule’, often relied upon by liquidators to frame claims in a manner favourable to them and unfavourable to those who have dealt with a company before liquidation commences, can no longer be relied upon by liquidators.

Legal Background

In certain circumstances, when a Company is being wound up, some of its transactions with creditors in the 6 months preceding the date when its winding up commences, a period described as the Relation Back Period, can be set aside by a court pursuant to the Corporations Act 2001 (Cth) (Act). These types of claims are colloquially referred to as ‘preference claims’. The practical effect is that parties can be required to repay payments they received from the Company, often many years earlier, to a liquidator of the Company.

One of the key concepts which underpins Australia’s insolvency laws is the concept of ‘pari passu’ which tries to ensure that unsecured creditors of an insolvent company are treated equally unless there is a specific policy reason to distinguish between them (for example, a statutory priority is given to most employees for employee entitlements). The preference regime is intended to prevent unsecured creditors in a liquidation being better or worse off than others through their dealings with the company before the liquidation commences.  Examples can be readily found where this might occur such as a company that holds a guarantee from a director and which is paid out in full so the director is not exposed to a personal claim, while not paying creditors who did not get such guarantees. The preference regime allows liquidators the ability to undo certain transactions which have resulted in some creditors being preferred to others.

Under s 588FA(3) of the Act, if a company in liquidation and a supplier engaged in regular dealings – for example, periodic supplies and reciprocal payments resulting in the amount owed to the creditor increasing and decreasing over time, such that payments made during the Relation Back Period formed an integral part of a ‘continuing business relationship’ between the creditor and debtor, then, according to the Court in Badenoch, the creditor will only be preferred if there is a net payment to it during the Relation Back Period after tallying up the value of all payments and supplies made during that period. This is commonly referred to as the Running Account Defence.

Prior to Badenoch, the prevailing position of Australian courts since 1964 has been that, in the context of a Running Account, the liquidator could pick a date during the Relation Back Period as the starting date for calculating the amount of a claim, and pursue the difference between the debt owed on the date of their choosing and the debt owed, if any, when the liquidation commences. In order to maximise the amount claimed as an unfair preference, liquidators tend to choose the date within the Relation Back Period when the company was most indebted to the creditor – the day after a major supply is made, for example. Courts have, until now, allowed liquidators to do so under what is known as the ‘peak indebtedness rule’.

As a result of the Court’s decision in Badenoch, the peak indebtedness rule is no longer the law in Australia and liquidators pursuing unfair preferences will be stuck with the entirety of dealings when a running account exists.

Factual Background

Badenoch Integrated Logging Pty Ltd (Supplier) provided logging and transport services. Gunns Limited (Gunns) was a forestry enterprise that used the Supplier’s services.  The Supplier issued monthly invoices, which became due on the last working day of the following month. Gunns rarely paid on time and often, instead of paying amounts due under specific invoices, paid lump sum payments.

Administrators were appointed to Gunns and they subsequently became Gunns’ liquidators.  The liquidators claimed that 11 payments Gunns made to the Supplier during the Relation Back Period were unfair preference payments and consequently, voidable under s 588FE of the Act.  They sued for about $3.4m. During the same period, the Supplier issued invoices totalling about $3.1m.

The Supplier argued that all payments it received formed part of a continuing business relationship with Gunns.  The Supplier also argued, relying on a decision of the New Zealand Court of Appeal (Timberworld v Levin (2015) 3 NZLR 365) under equivalent legislation in New Zealand, that the peak indebtedness rule, a common law (judge made) rule, had been abolished in Australia when s 588FA(3) was introduced into law in 1989. That rule has been applied in Australia many times since then and, as far as could be identified, not challenged in the subsequent three decades.

If a running account existed and the ‘peak indebtedness rule’ did not apply, the liquidators’ claim was worth the difference (about $250k), compared with a claim of about $1.4m if a running account existed but the rule did apply.

At first instance, the Court (Davies J) found that a running account existed at only limited points in the relevant period because her Honour found that at other times the Supplier was interested in debt collection rather than receiving payments as part of an expectation of making further supplies, and rejected the submission that the peak indebtedness rule was no long applicable in Australia.

In total, Her Honour found that the liquidators were entitled to about $2.1m of the $3.4m claim plus interest of about $500k and costs that would no doubt run in to the hundreds of thousands.

The Supplier appealed.  Amongst other things, the Supplier challenged the findings of Davies J in relation to the existence of a running account, and the peak indebtedness rule.

The Court’s decision and its practical implications

In line with the judgment at first instance, the Court decided that, based on the facts that existed in that case, a Running Account applied to only four of the 11 payments, because they and they alone formed an integral part of the continuing business relationship between the parties. That meant on the facts of the case, the appeal was only of limited success. It will, however, have a greater significance to other cases because, in relation to those four payments, the Court found that the peak indebtedness rule had been abolished by statute in 1989, which had the effect that all payments and transactions within the period when the continuing business relationship existed had to be taken into account.

The Court identified the start date of the single transaction as the date of the first transaction of the continuing business relationship, unless the relationship began before the start of the Relation Back Period in which case only transactions within the Relation Back Period should be taken into account.[1]

The practical implications of the Badenoch decision are likely to be far reaching. Badenoch had a relatively complicated set of facts in which a running account was found to exist for some but not all of a period. More common is where it subsists for the entirety, or most of, the Relation Back Period. In those cases, liquidators will no longer be able to frame a case in a manner that optimises the value of the claim, but will be stuck with the entirety of dealings during the relevant period. This is likely to reduce the potential value of claims and risk to liquidators who contend that a running account should not apply despite mutual credits and debits by creditors with a company that subsequently goes in to liquidation. This may cause liquidators to be more cautious before issuing proceedings and also reduce the amount that they can recover.

Time for the liquidators to seek special leave to appeal the decision in Badenoch to the High Court has not expired and they may seek to do so.

For further information on this decision or if you have any questions in relation to other insolvency matters, please contact a member of our national Restructuring and Insolvency team.

Authors

Michael Barrett | Partner | +61 3 8080 3772 / +61 8 8236 1130 | mbarrett@tglaw.com.au

Cameron White | Special Counsel | +61 8 8236 1174 | cwhite@tglaw.com.au

Alexandra Smith | Law Graduate

[1] Ibid [87]; Timberworld v Levin (2015) 3 NZLR 365 [99].