Up until recently, liquidators have been able to claim for unfair preferences by applying the peak indebtedness rule.
However, on 8 February, the High Court of Australia (Bryant vs Badenoch—Gunns decision) determined that the so-called peak indebtedness rule can no longer be used when assessing the amount of an unfair preference claim arising from a ‘continuing business relationship’.
If you’re unfamiliar with the peak indebtedness rule and what this means in practice, let’s explore it in more detail.
Understanding unfair preference claims
Unfair preference claims are set out under S588FA of the Corporations Act 2001.
They refer to a situation where a debtor company, which later becomes insolvent, makes a payment or transfers an asset to an unsecured creditor, putting that creditor in a more favourable position than other creditors.
If the liquidator determines that a payment or transfer made by the debtor company qualifies as an unfair preference, they may seek to recover that amount for the benefit of all creditors.
To establish an unfair preference claim, certain criteria must generally be met:
- The company must have been insolvent when making the payment or transfer or became insolvent due to the transaction
- The payment or transfer must be made to a creditor
- The payment or transfer must put the creditor in a better position than other creditors in the liquidation
The continuing relationship defence
Under S588FA, all transactions that form an integral part of a ‘continuing business relationship’ between a company and a creditor must be treated as a single transaction.
The continuing relationship rule recognises that in certain ongoing commercial relationships, it may be common for payments or transfers to occur regularly between the debtor company and a creditor.
The continuing relationship rule can provide a defence against an unfair preference payments claim by showing that the transactions were part of an ordinary course of business or a typical ongoing commercial relationship.
In such cases, even if the payments or transfers occurred during the vulnerable period, they may not be considered preferential.
Peak indebtedness explained
To claim an unfair preference, liquidators could previously apply the peak indebtedness rule to determine the priority of claims in a liquidation scenario.
According to this principle, the value of a creditor's claim is calculated based on the highest point of indebtedness to the company during a specific period. This period is typically within the six months leading up to the appointment of a liquidator, although it is extended to four years where the creditor is a related party.
The peak indebtedness rule was used to ensure creditors are treated fairly by considering the highest level of debt owed to them by the insolvent company.
It was intended to help prevent situations where a company intentionally reduces its debt just before liquidation to benefit certain creditors over others.
The Bryant vs Badenoch ruling
In the recent Bryant vs Badenoch case, it was determined that the ‘continuous relationship’ defence to an unfair preference claim does not include the peak indebtedness rule. Therefore it can no longer be used.
Now, while a liquidator can decide which transaction they want to void, they are not allowed to determine the first transaction forming part of that relationship.
Instead, the first transaction is the first one that happens after the relationship has begun. However, to be deemed a single transaction, the association must have either started:
- At the beginning of the prescribed period
- At the date of insolvency
- At the beginning of the ‘continuing relationship’ (If the relationship started after the beginning of a prescribed period)
Whichever is later.
Instead of working out the amount of the unfair preference starting at its highest peak, it must now be worked out by taking the net effect of the running account.
In the Bryant vs Badenoch case, applying the peak indebtedness rule would mean taking the ‘peak debt’ during the relevant period ($1,416,563.31) and comparing it to the debt at the end of the relevant period ($1,365,31.02)
This would equal $51,200 in unfair preferences that could be clawed back.
By comparison, taking the net effect would mean taking the balance at the start of the relevant period ($410.925.07) and comparing it to the balance at the end ($1,365,31.02)
This would mean a net increase in the company’s debt to the creditor and, therefore, no unfair preference payment.
Harder for claims, better for creditors
While this ruling will make it harder for liquidators to pursue unfair preference claims against unsecured creditors, it will likely benefit creditors with a continuing relationship with a distressed company, as they will get a better return.
There is also merit in incentivising trade creditors to keep trading with and providing value to distressed companies. This increases the distressed company’s chance of successful restructuring, benefiting both parties, the wider supply chain, and the economy.
Is your company struggling financially and considering liquidation?
Contact our experts at Shaw Gidley today on (02) 4908 4444 or (02) 6580 0400 for free initial advice. Please be assured that all discussions are confidential.