Restructuring and Insolvency

High Court strikes down ‘peak indebtedness rule’: what it means for liquidators

February 13, 2023

The High Court has delivered its long-awaited judgment in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (Bryant) and in doing so has emphatically confirmed that the ‘peak indebtedness rule’ was not incorporated into the unfair preference regime in the Corporations Act.

The Court’s decision, in addition to providing some degree of clarity to the law of unfair preferences, has broad implications for creditors and liquidators. Most significantly, the quantum recoverable by liquidators through unfair preference litigation will, in many cases, be substantially reduced if not extinguished entirely where the quantum of an account as between debtor and creditor remains static over the relevant ‘running account’ period, despite any peaks and troughs along the way.

The ‘running account’ principle

In circumstances where the company in liquidation and a supplier engaged in a ‘continuing business relationship’, all transactions forming part of that relationship will be treated as a single transaction for the purpose of determining whether an unfair preference has occurred.[1] This ‘running account’ principle is codified in s. 588FA(3) of the Corporations Act. This typically arises where during the time that the liquidator alleges that the creditor received payments which constitute a preference, the creditor has continued to supply goods or services to the company.

In this context, a ‘continuing business relationship’ will generally arise from arrangements for periodic supplies and reciprocal payments resulting in the amount owed to the creditor increasing and decreasing over time.

The ‘peak indebtedness rule’

The ‘peak indebtedness rule’ allowed liquidators facing a ‘running account’ scenario to select the company’s point of peak indebtedness to the creditor as the starting point of the single transaction. In practice, this maximises both the likelihood of proving an unfair preference and the quantum of any unfair preference claim.  Although the rule originally arose from judicial consideration of the Bankruptcy Act 1924 (Cth), [2] it was subsequently treated as being incorporated into the unfair preference provisions of the Corporations Act.

The rule continued to be treated as an implicit component of the statutory regime and was deeply entrenched within the law of unfair preferences until its rejection by the Full Court of the Federal Court – a decision now confirmed by the High Court.

Factual background

Gunns carried on a forestry business prior to being placed into administration on 25 September 2012. It subsequently went into liquidation. Badenoch was a creditor and supplier of logging and transport services to Gunns. That relationship commenced in 2003 i.e. well before the appointment of the liquidators.

Badenoch provided its services pursuant to an agreement with Gunns under which monthly invoices were issued for services rendered. Gunns frequently failed to meet its payment obligations, either missing payment dates or only making partial payment of amounts due. In response, Badenoch stopped supply, issued letters of demand, negotiated a payment plan and requested a bank guarantee. Badenoch and Gunns ultimately terminated the agreement in August 2012, subject to entry into a payment plan and interim arrangements for continued supply pending the engagement of a new contractor.

On 25 September 2012, at which time Badenoch was continuing to supply services to Gunns, Gunns, was placed into administration and subsequently, liquidation.

The liquidators of Gunns asserted that 11 payments made by Gunns to Badenoch during the relation-back period[3] were unfair preference payments and thereby voidable.

At first instance, the liquidators were largely successful and the primary judge held that the ‘peak indebtedness rule’ continued to apply in the context of s. 588FA(3). On appeal, the Full Court of the Federal Court of Australia concluded that the ‘peak indebtedness rule’ had not been incorporated into s. 588 FA(3) of the Corporations Act.

The central issue for the High Court was: was the Full Court of the Federal Court, correct?

The High Court’s Judgment

The High Court unanimously dismissed the appeal and affirmed the Full Court’s judgment. In doing so, the Court forever changed the law in relation to the ‘peak indebtedness rule’ (subject to any later statutory amendment) and also took the opportunity to make an authoritative statement as to what constituted a ‘continuing business relationship’ for the purpose of s. 588FA(3) of the Act.

The ‘peak indebtedness rule’

Whilst recognising s. 588FA(3) as a statutory embodiment of the ‘running account’ principle , the Court identified no legislative intention to also incorporate the ‘peak indebtedness rule’. Relevantly the Court determined that:

‘The fact that the liquidator determines which transaction is to be the subject of an application under s 588FF(1) does not enable the liquidator to determine the first transaction forming part of “the relationship” for the purpose of the deemed “single transaction” in s 588FA(3)(c). That date is dictated by the operation of s 588FA(3)(c). This is consistent with the fact that it is for the court, not the liquidator, to determine if it is satisfied that a transaction is voidable “because of” s 588FE, which, insofar as an “insolvent transaction” is concerned, relevantly requires the transaction to be an unfair preference as provided for in ss 588FC and 588FA.’

The Court went on to reason that the ‘running account’ principle raises a policy choice between (1) selection by the liquidator of the time of peak indebtedness; or (2) dictation by the facts as to whether an unfair preference exists.

Although both approaches are reconcilable with the ‘running account’ principle, the Court concluded that in enacting Div 2 of Pt 5.7B of the Corporations Act, Parliament’s language focused upon the first transaction in the relationship capable of being a voidable transaction and, accordingly, made the second choice:

‘The purpose of the “running account principle” is not to maximise the potential for the claw-back of money and assets from a creditor, but that is the effect of the “peak indebtedness rule”. The “running account principle” recognises that a creditor who continues to supply a company on a running account in circumstances of suspected or potential insolvency enables the company to continue to trade to the likely benefit of all creditors.’

Against this background, the Court found that the ‘peak indebtedness rule does not arise from the ordinary meaning or operation of the legislation. The Court identified that earlier authorities said to support the application of the peak indebtedness rule did no such thing. It followed that:

The cases which concluded that the “peak indebtedness rule’ is to be read into s 588FA(3) of the Corporations Act wrongly assumed that the “running account principle” included the “peak indebtedness rule”, did not involve full argument or reasoning about the issue, or must now be considered to be wrong in that respect’

On these grounds, the Court identified the date of the first transaction in the relevant relationship between Gunns and Badenoch as 30 March 2012, being the later of the date of the start of the relation-back period and Gunns’ insolvency.

This conclusion amounts to no less than a total abrogation of the ‘peak indebtedness rule’ and a recognition that the ‘running account principle’ is about assessing the economic (or ultimate) effect of a trading relationship between a debtor and creditor during the relation-back period, and not an opportunity for a liquidator to maximise the quantum of a preference claim by arbitrarily choosing the most advantageous point during that period when the debt owing to the creditor is at its peak and comparing that amount with the amount owing at the end of that period.

‘Continuing business relationship’

The second major issue considered in Bryant was the proper approach to determining whether a ‘continuing business relationship’ existed as between the company and a creditor (as such a relationship is critical to establishing that a running account can be established by the creditor. If no such relationship exists, each payment is individually assessed in isolation as being preferential or not).

The Court described this task as the ascertainment of the ‘business character’ of the relevant transaction, that is, whether a transaction is, for commercial purposes, an integral part of a continuing business relationship.

What one or both of the parties thought at the relevant time is not determinative, but rather is only relevant to the extent it sheds light on the objective business character of the transaction. In this regard, the Court rejected the notion that payments must be made solely to reduce past indebtedness in order to end a ‘continuing business relationship’.

It follows that, even if a creditor receives a payment with the subjective intention of continuing to supply services, such a payment may still be characterised as an unfair preference outside of the ‘continuing business relationship’ if the objective context indicates that the payment was made ‘looking backwards rather than forwards; looking to partial payment of the old debt rather than the provision of continuing services‘.[4]

The payments by Gunns

Payments 1 and 2

The Court considered two payments made by Gunns on 30 March 2012 and 13 April 2012 respectively (Payments 1 and 2), which occurred in circumstances where;

  1. Badenoch had issued a letter of demand to Gunns for outstanding debts as well as ceased supply; and
  2. the parties had entered into a payment plan.

The payments were made in order to ‘get deliveries back on track’ and supply had subsequently continued.

Against this background, the Court held that Payments 1 and 2 occurred in the context of a ‘continuing business relationship between the parties’ on account of:

  1. the controlling minds of Badenoch believing Gunns would eventually pay all outstanding invoices; and
  2. the mutual assumption or purpose as between the parties, objectively inferred, being that the payments were to induce supply and continue the business relationship.

Owing to this conclusion, two following payments (i.e. Payments 3 and 4) in respect of ongoing supply formed part of the same ‘continuing business relationship’ and were not the subject of further scrutiny.

Payments 5 to 11

The Court went on to consider further payments made between 6 August 2012 and 21 September 2012 (Payments 5 to 11), which followed another cessation of services. In this instance, Badenoch had written to Gunns proposing:

  1. termination of the supply agreement;
  2. entry into a new payment plan for the outstanding debt; and
  3. cooperation with Gunns to meet its supply requirements whilst it transitioned to a new contractor.

Gunns accepted this proposal and subsequently made Payments 5 to 11. Badenoch submitted that, in context, these payments also formed part of the same ‘continuing business relationship’ with Gunns.

The Court rejected this argument, and held that:

  1. in a practical business sense, the pre-existing business relationship between Gunns and Badenoch had ceased; and
  2. the fact that some supply continued after the new agreement was immaterial because that supply was under the new arrangements, not the pre-existing relationship.

However, the Court did find that a debt pertaining to an invoice issued on 31 July 2012 (i.e. after the ‘continuing business relationship’ had ceased) still formed part of the ‘running account’ because the invoice related to work undertaken at a time when the relevant ‘continuing business relationship’ remained on foot.

Take outs

The entrenched assumption that a liquidator could select the peak indebtedness in a trading account between a creditor and a company when determining the quantum of an alleged unfair preference is no longer the law in Australia.

As it pertains to an established ‘continuing business relationship’ a liquidator will be required to assess the actual ‘preference’ (if any) received by a creditor for the entire relation-back period (or if the relationship commences later, at commencement) to determine whether, at the end of that period, the creditor has received a preference or not. A liquidator can no longer nominate the peak indebtedness in that period for the purposes of maximising the quantum of the alleged preference received.

In terms of whether a continuing business relationship exists at all times during that period, it is clear that a liquidator remains burdened with the unenviable task of assessing the objective nature of the ongoing relationship between creditor and the company and determining when, if ever, the nature of that relationship changed to one of ‘looking backwards rather than forwards; looking to partial payment of the old debt rather than the provision of continuing services’.

In circumstances where it cannot be said that there is (or still is) a continuing business relationship, then each payment received by the creditor is assessed individually to determine whether or not it is preferential.

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