No more peak indebtedness in unfair preferences - 3 things you should know

Introduction
The Full Court of the Federal Court of Australia in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 (Badenoch No. 1) has decided that the peak indebtedness rule, often relied upon by liquidators in calculating the quantum of unfair preference claims in situations where there was a continuing trading relationship between the company in liquidation and the creditor under section 588FA(3) of the Corporations Act 2001 (Cth) (the Act), does not apply.

In Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) (No 2) [2021] FCAFC 111 (Badenoch No. 2), the Court declined to clarify what the commencement date should be for the continuing business relationship, where the liquidators can no longer rely on the peak indebtedness rule and discretionarily choose a particular point in the relationship as the starting point. Therefore, leaving the issue open for another time and liquidators with uncertainty as to the calculation of unfair preference claims.
Background
Badenoch Integrated Logging Pty Ltd (Badenoch) provided harvesting and hauling services, it was an unsecured trade creditor of Gunns Limited (in liquidation) (receivers and managers appointed) and Auspine Limited (in liquidation) (receivers and managers appointed) (together, Gunns). Gunns’ liquidators were successful in the first instance in claiming that payments made by Gunns were unfair preference payments pursuant to section 588FA(1) of the Act.

This article focuses on the following issues considered by the Full Court on appeal by Badenoch and cross-appeal by Gunns’ liquidators in respect of section 588FA of the Act:
  • whether Badenoch was correct in its contention that the impugned payments were an integral part of a continuing business relationship within the meaning of section 588FA(3) of the Act, such that the series of transactions forming part of the relationship would be taken to constitute a single transaction for the purpose of determining whether there has been an unfair preference; and
  • whether the liquidators were correct in their contention that they were entitled to apply the peak indebtedness rule and choose any point in the relationship as the starting point of the single transaction for the purpose of section 588FA(3) of the Act.
1. Is there a continuing business relationship?
Section 588FA(3) of the Act governs the transactions that could amount to an unfair preference where there is a continuing business relationship between a company in liquidation and a creditor. Generally, such a relationship exists where there is continuous trading through the supply of goods and services to the company, payments are made by the company to the creditor and the company’s debt to the creditor increases and decreases over time. Where there is a continuing business relationship, section 588FA(3)(c) provides that all the transactions forming part of the relationship are to be treated as a single transaction for the purposes of determining whether there is an unfair preference under section 588FA(1) of the Act.

In Badenoch No. 1, the Court helpfully summarised the following principles and issues for determining whether a payment was part of a continuous business relationship, some of which we have extracted below:
  • there must be a mutual assumption of a continuing relationship of debtor and creditors, including that further debits and credits will be recorded;
  • whether each particular payment on a statement of account was connected with the subsequent provision of goods or services (as opposed to payment for prior goods or services); and
  • where the purpose of the payment was to induce the creditor to provide further goods or services, as well as to discharge an existing indebtedness, the payment received by the creditor will not be a preference unless that payment exceeded the value of the goods or services acquired by the company.
The Court opined that the often relied upon test of whether the purpose of inducing further supply is “subordinated to a predominant purpose of recovering past indebtedness” (first enunciated in Sutherland (as liquidator of Sydney Appliances Pty Ltd (in liq)) v Eurolinx Pty Ltd (2001) 37 ACSR 477), should be treated with caution in the context of considering whether there is a continuing business relationship under section 588FA(3) of the Act. Insisting on payment of an ordinary invoice before continuing to supply on terms does not necessarily mean that the continuing business relationship ceases to exist.

The Court found in favour of Badenoch that certain payments made in March and April 2012 formed part of the continuing business relationship, notwithstanding that Badenoch issued a letter of demand for outstanding invoices and ceased to supply for ten days, because there was a clear expectation that further debits and credits would be recorded and the parties would resume trading on different terms. However, with respect to payments made after 31 July 2012, the Court held that there was no longer a continuing business relationship as Badenoch insisted on Gunns entering into a payment plan for the repayment of approximately $1.36 million in outstanding debts and had proposed a gradual tapering off of services. Both of these factors indicated that Badenoch was inclined towards ceasing future supply.
2. The peak indebtedness rule was never meant to apply to section 588FA(3).
The peak indebtedness rule provides that a liquidator may choose the date during the continuing business relationship period where the debt owing to the creditor was at its peak as a starting point to calculate the quantum of the unfair preference claim. Liquidators will usually claim the difference between the peak debt amount during the relation-back period and the amount outstanding when the company is in liquidation as the unfair preference quantum against a creditor as this maximises the claim amount.    

The Court held that:
  • the peak indebtedness rule originated from Barwick CJ’s obiter dictum in Rees v Bank of New South Wales (1964) 111 CLR 210 (Rees) and therefore was not binding;
  • the decision in Olifent v Australian Wine Industries Pty Ltd (1996) 130 FLR 195 to adopt Barwick CJ’s comments in Rees and apply the peak indebtedness rule to section 588FA(3) of the Act was incorrect;
  • it was not Parliament’s intention to apply the peak indebtedness rule in the context of section 588FA(3) of the Act; and
  • the peak indebtedness rule is abolished.
The Court opined in Banedoch No. 1 that to abolish the peak indebtedness rule would be in the interests of doing fairness between unsecured creditors, in circumstances where the application of the rule can result in different unfair preference claim amounts against creditors who have provided the same value of supplies, received the same amount of payments and have the same unpaid debt amount remaining by the end of the business relationship, but have different credit and payment terms.

The effect of the decision is that liquidators can no longer simply pick the date, during the relation-back period, at which the debt was at its highest as the starting point to calculate their unfair preference claims. The proper starting point seems to be the debt level when the continuing business relationship commenced.

In Badenoch No. 2, the parties argued that the start date of the continuing business relationship was either the start of the relation-back period or the date of insolvency. The Court avoided deciding on this point as in this particular case the outcome would not change regardless of which date was picked.
3. The proper test is the doctrine of “ultimate effect”.
The Full Court was of the view that section 588FA(3) of the Act embodied the doctrine of ultimate effect as formulated by the High Court in Airservices Australia v Ferrier (1996) 185 CLR 483.

In considering whether there is an unfair preference payment in the context of a continuing business relationship, a Court is to look to the ultimate effect of the transaction, including by:
  • looking at the practical relationship between all of the payments and the past and future supply and the ultimate effect of the dealings; and
  • viewing the evidence as a whole, to ascertain whether the relevant transaction was undertaken to pay an old debt rather than for the purpose of continuing services or supply of goods.
What are the key takeaways?
The peak indebtedness rule has been abolished. Liquidators will need to wait for a Court decision to clarify the commencement date of a continuing business relationship in order to calculate the quantum of an unfair preference claim. 

A Court will need to look to the whole of the transactions and dealings between the parties to consider the existence and duration of a continuing business relationship. 

In considering section 588FA(3) of the Act, the ultimate effect of the transaction is the key consideration.

Hicksons’ insolvency team are experts in their field, and recognised in Best Lawyers Australia. We can assist creditors, debtors and insolvency practitioners in this complex and technical area of the law.

Post by Hicksons Partner, Marc Rossi, Senior Associate, Roxanna Lam, and Solicitor, Gumneet Mangat.

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