Insolvency Law Update - No peaks in preference claims – abolition of the peak indebtedness rule for unfair preferences

Insolvency Law
Kearney Sophie
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In Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 (Badenoch), the Full Court considered whether certain payments to a creditor by an insolvent company were voidable as unfair preferences.  In particular, the Court considered the “continuing business relationship” exemption under s 588FA(3) of the Corporations Act 2001 (Cth) and the validity of the “peak indebtedness” rule as a matter of Australian law. 

The Court found that:

  1. the trial judge had taken an unduly narrow assessment of the continuing business relationship exemption and the focus should be on whether there is a mutual assumption of continued supply (rather than if the creditor had taken action to ensure payment); and
  2. the peak indebtedness rule should not be applied in relation to the continuing business exemption as it was contrary to the wording of, and rationale behind, that exemption.

Background

The appellant (Badenoch Logging) is a family-owned business that provides logging and transport services. The respondents are the liquidators (Liquidators) of Gunns Limited and its wholly owned subsidiary (together, Gunns).

The Liquidators alleged that 11 payments made by Gunns to Badenoch Logging were voidable under s 588FE. The primary judge found that all but two of the impugned payments were voidable as unfair preferences, meaning that the court could make orders under s 588FF including that monies be paid to the company. In doing so, the primary judge applied the “peak indebtedness” rule in considering the “continuing business relationship” exemption in s 588FA(3). 

The principal issues on appeal concerned the application of the continuing business relationship exemption to the impugned payments and the validity of the peak indebtedness rule. 

Continuing business relationship

In assessing whether a transaction is an unfair preference, commercial transactions which are “an integral part of a continuing business relationship (for example, a running account) between a company and a creditor” (s 288FA(3)) are treated differently.  The rationale underpinning this is the necessity of balancing the interests of unsecured creditors with those of persons who have engaged in fair transactions with the insolvent company.[1] 

As the Full Court observed, if there is a continuing business relationship where a creditor is induced to continue to supply goods or services of equal or greater value to an insolvent company, there is no disadvantage to the general body of creditors: [54].  Rather, there may in fact be a benefit due to revenues generated.[2]  Therefore, there is no unfairness to be remedied unless there is a net gain to the creditor overall.  The court will therefore approach the assessment by considering the whole of the transaction.[3] 

However, this approach will only be taken if there is “a mutual assumption of a continuing relationship of debtor and creditor, with an expectation that further debits and credits will be recorded”: [48].  This criterion will not be satisfied where the purpose of inducing further supply is “subordinated to a predominant purpose of recovering past indebtedness”.  In considering these principles, the Court found that it would not be consistent with the rationale behind s 588FA(3), and with the reality of continuing to do business with a company in financial distress, to take an unduly restrictive approach to this assessment: [54].  Rather, the assessment must look at “the practical relationship” ([56]) between the payments and the subsequent supply of services and “the ultimate effect of the dealings” ([56]) in order to assess whether what occurred was effectively payment of an old debt (which would not be part of a continuing business relationship) or payment for the provision of continuing services or supply of goods: [57].

In the circumstances of this case, the Court found that the primary judge erred in concluding that the first two of the impugned payments fell outside this exemption as even though Badenoch Logging applied additional pressure to have the two invoices paid, and there was a temporary cessation of supply, there was no cessation of the mutual assumption of payment and reciprocal supply: [68], [72].  However, the Court upheld the primary judge’s conclusion that the last six payments did not fall within the exemption, as the payment plan (pursuant to which those payments were made) was agreed with a view towards cessation (not continuation) of future supply: [77], [79].

Application of the peak indebtedness rule to a transaction under s 588FA(3)

The peak indebtedness rule is the common law principle that a liquidator is free to choose any point during the statutory period, including the point of peak indebtedness, to establish a preferential payment.[4]  This means that the transactions prior to the point of peak indebtedness are not considered as part of the preference analysis. 

The Court overturned the primary judge’s decision and found that the peak indebtedness rule should not be applied to s 588FA(3) as:

  1. the rule is contrary to the express language of the statute (which uses the language “all the transactions forming part of the relationship”) ([82]-[83]) and impermissibly severs the single transaction: [112]-[113];
  2. the single transaction analysis permitted by s 588FA(3) embodies 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 of greater value and the peak indebtedness rule “does violence to that principle”[5]; and
  3. the abolition of the peak indebtedness rule is consistent with the voidable transaction regime, which is to do fairness between unsecured creditors (and, in contrast, the peak indebtedness rule can be arbitrary and actually create unfairness by treating like creditors differently if they have different credit terms): [119]-[120].

The Court acknowledged at [121] that there may be arbitrariness or unfairness in this approach, including the practical difficulty that it seems that trade creditors may effectively be immune from the voidable preference regime, as when a company has gone insolvent, it is almost inevitable that the closing balance of a running account would exceed the opening balance: [83]-[84].  However, the Court found at [121] that the balance weighs in favour of not applying the peak indebtedness rule and to the extent previous decisions had applied it, they were wrongly decided: [111].

 

[1] Explanatory Memorandum to the Corporate Law Reform Bill 1992, [1034].

[2] Airservices Australia v Ferrier (1996) 185 CLR 483, 509 (Dawson, Gaudron and McHugh JJ); cited in Badenoch, [47]. 

[3] Richardson v Commercial Banking Co of Sydney Ltd (1952) 85 CLR 110, 129 (Dixon, Williams and Fullagar JJ); cited in Badenoch, [46].

[4] Rees v Bank of New South Wales (1964) 111 CLR 210, 220-221 (Barwick CJ); cited in Badenoch, [93]. 

[5] Timberworld Ltd v Levin (2015) 3 NZLR 365, [81] cited in Badenoch, [118]. 

Kearney Sophie
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Sophie Kearney practises primarily in commercial law and public law

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