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UNFAIR PREFERENCES AND THE END OF THE PEAK INDEBTEDNESS RULE

Newsletter

by James Shaw08.06.21

The Quick View

  • Grounds of an appeal and cross appeal upheld in Full Federal Court on May 10, 2021 will have the effect of abolishing the peak indebtedness rule.
  • The case, Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64, appealed a judgement delivered in the same court 12 months earlier, in which the Liquidators sought to claw back preference payments.
  • The outcome of the appeal means that liquidators must now consider the nature and entirety of the business relationship to determine the net outcome of transactions, and whether or not the creditor gained a benefit (an unfair preference) over the benefit it has supplied to the company during the relation-back period.

Background of the appeal

Gunns Limited was an Australian forestry enterprise that was placed into administration on 25 September 2012 and eventually into liquidation in March 2013, owing over $780 million to creditors at the time.

The Liquidators alleged that 11 payments (imputed payments) made to a supplier, Badenoch, after the insolvency date and during the 6-month relation-back period, were insolvent transactions and unfair preference payments that should be repaid to Gunns.

Badenoch Integrated Logging Pty Ltd, a local family-owned business, and the appellant in the most recent case, provided logging and transport services to Gunns, their sole client.

The primary judge[i] found in favour of the Liquidators that 9 of the 11 imputed payments were preference payments and held that Badenoch must repay over $2 million of the payments received during the relation-back period[ii].

Badenoch appealed the findings. Two key questions for the Court were:

  • Whether any of the payments in question from Gunns to Badenoch were part of a continuing business relationship where, under s588FA(3) of the Corporations Act 2001 (Cth) (the Act)[iii], payments and services rendered would be considered as a net single transaction for the purposes of determining if the creditor had received an unfair preference, and
  • Whether the Liquidators were entitled to choose the point of peak indebtedness in the relation-back period as the starting point of the single transaction to maximise recovery for creditors.

What is the peak indebtedness rule?

Liquidators must establish the beginning and end dates of a continuing business relationship to determine the net result of transactions between the creditor and the debtor. But it is difficult to establish the date of commencement of a continuing business relationship that predates a relation-back period.

So, liquidators have used the peak indebtedness rule. The rule applies during the relation-back period where there is preference payment, and where the creditor and debtor have a running balance account. It allows the liquidator to calculate the value of the preference claim as the difference between the highest point of indebtedness during the relation back period from the value of the debt due to the company on the relation back day (usually the commencement date of the external administration – see s91 of the Corporations Act).

The findings on appeal

The Court held with the primary judge in part in that they agreed that:

  • Payments 5 to 11 were not part of a continuing business relationship for the purpose of s588FA(3) of the Act.
  • Badenoch had not established that they had no reasonable grounds for suspecting that Gunns were, or would become, insolvent (Good Faith Defence).
  • Badenoch had received notice of Gunns’ insolvency and therefore were not entitled to set off the $568,321.81 still owed by Gunns against the amount the Court found Badenoch liable to pay the Liquidators.

The Court differed from the primary judge’s reasoning as follows:

  • The primary judge found that only payments 3 and 4 of the imputed payments were related directly to invoices for supply and were therefore part of a continuing business relationship. The remainder of the payments were to repay existing debts and therefore preferential payment of these debts disadvantaged other creditors on winding up.
  • On appeal, however, the Court found that at the time of imputed payments 1 and 2, Badenoch had been in negotiations with Gunns for past debts with the full expectation of continuing supply of their logging and transport services. Therefore, payments 1 and 2 were found to be part of the running account of a continuing business relationship and to be considered part of a single transaction with payments 3 and 4 as described in s588FA(3) of the Act[iv]
  • This raised the issue of whether the Liquidators were entitled to apply the peak indebtedness rule in calculating the value of the unfair preference. The Court found that the peak indebtedness rule should be abolished.

Reasons for the abolishment of the peak indebtedness rule

  • The Court found that, though the peak indebtedness rule had become practice through common law, that it was not the intention that it be permissible once s588FA(3) was inserted into the Act. The application of the peak indebtedness rule was in fact, contrary to the express language of subsection 588FA(3)(c) and (d), in that it severed the single transaction allowed for in the statute[v].
  • Further, the Court found that inducing trade creditors to continue to trade with debtors in distress will advantage all creditors where it may enable it to trade out of difficulties and maintain value in the company, particularly where the net of transactions is such that the creditor has provided goods or services equal to, or less than, payments received (the doctrine of ‘ultimate effect’). Allowing liquidators to sever select payments from the net effect in fact may disadvantage the group of trade creditors in comparison to the general body of creditors.
  • In further consideration of fairness between unsecured creditors, the Court referred to the sometimes-perverse outcomes of the application of the peak indebtedness rule shown by the Australian Credit Forum in a submission to the Parliamentary Joint Committee on Corporations and Financial services in its 2003 insolvency law inquiry.

Implications

  • The peak indebtedness rule has no continued application and when a liquidator is now calculating the quantum of a preference and in the context of a continuing business relationship they must now: -
  • Determine the balance owing to the creditor who is the alleged recipient of a preferential transaction at the beginning the relation back period or the commencement of the continuing business relationship, whichever is the later

And deduct this from,

  • The balance owing to the creditor who is the alleged recipient of a preferential transaction from the balance owing on the relation back day, or at the end of the continuing business relationship, whichever is the earlier.
  • The Federal Government is continuing to tinker with the insolvency regime in an attempt to reduce costs for SMEs being wound up.
  • The unavailability of the peak indebtedness rule will, in some circumstances, result in lengthier investigations and greater costs where liquidators need to determine the net effect of transactions to prove and claw back unfair preference payments for the benefit of creditors.

[i] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713

[ii] ibid

[iii] Corporations Act 2001 (Cth) (the Act)

[iv] Ibid s 588FA(3)(c)

[v] Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 [112] per Middleton, Charlesworth and Jackson JJ.