The peak indebtedness rule rejected: new uncertainty for unfair preference claims against trade suppliers

Until the recent decisions of 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) and 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 use of the “peak indebtedness rule” had been applied in unfair preference recovery actions to determine the quantum recoverable for the benefit of an insolvent estate.

In Badenoch the Full Court held that the peak indebtedness rule should not be applied when determining the quantum of the “single transaction” resulting from a continuing business relationship under section 588FA(3) of the Corporations Act 2001 (Cth) (the Corporations Act). In Badenoch No 2, the Full Court considered how the start and end dates of the single transaction should be determined (in the absence of the peak indebtedness rule).

As a result, the Full Court determined that a number of payments by Gunns Limited (Gunns) to Badenoch Integrated Logging Pty Ltd (Badenoch) and supplies of services from Badenoch to Gunns together comprised a single transaction under section 588FA(3), that this single transaction did not give rise to any reduction in Gunns’ total indebtedness to Badenoch and therefore the single transaction did not amount to an unfair preference.

This note focuses on issues relating to the continuing business relationship and the peak indebtedness rule considered in the Badenoch decisions. These decisions have important ramifications for liquidators and trade creditors because they signify a departure from the, until now, accepted approach to calculating unfair preference claims in the context of ongoing supply of goods or services by a creditor. Furthermore, the Full Court made a number of observations as to how the continuing business relationship, and resultant single transaction, should be assessed. This gives rise to some uncertainty as to the ambit of section 588FA, and has the potential to further narrow the scope for liquidators to claim unfair preferences in cases involving ongoing supply.

The Full Court’s decision to abandon the peak indebtedness rule may have benefits to creditors with a continuing relationship with a distressed company, but will make the job of seeking to recover unfair preference payments by liquidators more challenging.

An application for special leave to have the matter heard by the High Court of Australia has recently been filed by the liquidator of Gunns to challenge the decisions of the Full Court.

Unfair preferences and the peak indebtedness rule

Unfair preferences

In Australia, transactions (including payments) in the period leading up to the liquidation (or administration) of a company that result in a creditor receiving more on its unsecured claim than it would in a liquidation are referred to as “unfair preferences”. Unfair preferences can be set aside by the Court, on the application of a company’s liquidator, where those unfair preferences satisfy the various Corporations Act requirements to constitute “voidable transactions”.

Continuing business relationships

Section 588FA(3) of the Corporations Act provides that, when assessing whether a transaction is preferential, if the transaction is an integral part of a “continuing business relationship” between the company and a creditor, all transactions forming part of that relationship must be treated as constituting a single transaction. This means that any preferential effect will be measured by reference to the net result of the credits and debits between the parties during this period (rather than simply looking at the gross payments received in a series of individual payments to the creditor). This benefits the creditor who therefore gets to take into account the value of goods or services supplied by the creditor to the company during the period of the continuing business relationship.

The peak indebtedness rule

The peak indebtedness rule has been applied in the context of assessing the single transaction formed from a continuing business relationship. Courts have held that the peak indebtedness rule allows a liquidator to select any point in time during the continuing business relationship as the ‘starting point’ for measuring the single transaction. The practical effect is that a liquidator could choose the point of peak indebtedness of the company to the creditor as the starting point of the single transaction,  – being the point where the most was outstanding to the creditor, as this would result in the largest reduction in debt by the single transaction and therefore the largest potential unfair preference claim.

The peak indebtedness rule had its origins in the decision of Barwick CJ in Rees v Bank of New South Wales (1964) 111 CLR 210 which considered the wording of a similar provisions in the Bankruptcy Act 1924 (Cth).[1] The peak indebtedness rule approach was applied in the context of the Corporations Act by a number of subsequent decisions, although (in most cases, at least) the rule was applied without full consideration of the statutory language in section 588FA(3).

It was noted by the New Zealand Court of Appeal in Timberworld Ltd v Levin (2015) 3 NZLR 365 (Timberworld), that “[t]he Australian courts seem to have assumed the [peak indebtedness] rule had the weight of authority and sufficient pedigree to warrant its direct application. We have located no Australian authorities offering a considered analysis of the rule.”[2] The position in New Zealand for preference claims (under section 292 of the Companies Act 1993 (NZ), which for these purposes is similarly worded to the Corporations Act provisions), is that the peak indebtedness rule does not apply.

Background to Badenoch decisions

Gunns was a timber business which entered administration on 25 September 2012 (which was the relation-back day for the purposes of voidable transaction claims) and was subsequently placed into liquidation. Badenoch supplied logging and transport services to Gunns over an extended period. Gunns’ liquidators commenced recovery proceedings against Badenoch claiming that 11 payments made in the six month period from 26 March to 25 September 2012 (being the relation-back period) were recoverable as unfair preferences.

At first instance, the Federal Court held that only two of the 11 payments, were part of a continuing business relationship and the remaining payments were not.

On appeal to the Full Court of the Federal Court, the key issues were:

• whether some or all of the payments were part of a continuing business relationship pursuant to section 588FA(3) and therefore treated as a single transaction (or potentially as more than one single transaction) for the purposes of determining whether there had been an unfair preference;
• if yes, whether the liquidators could apply the peak indebtedness rule to determine the amount of the preference in respect of that single transaction;
• whether Badenoch could establish a good faith defence under section 588FG(2); and
• whether any set-off was available to Badenoch under section 553C.

The Full Court concluded that:

• four of the payments should be assessed as part of a single transaction under the continuing business relationship between Badenoch and Gunns; and
• the peak indebtedness rule should not apply to determine the quantum of any preference under that single transaction.

Further, the Full Court determined that Badenoch could not establish a good faith defence nor could it make a set-off claim due to its notice of and knowledge of the likelihood that Gunns was or would become insolvent during the relation-back period, including at the time of the impugned payments.

Was there a continuing business relationship?

Section 588FA(3) of the Corporations Act provides:

Where:

(a) a transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company…; and

(b) in the course of the relationship, the level of the company’s net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship;

then:

(c) subsection (1) [which defines unfair preferences] applies in relation to all the transactions forming part of the relationship as if they together constituted a single transaction; and

(d) the transaction referred to in paragraph (a) may only be taken to be an unfair preference given by the company to the creditor if, because of subsection (1) as applying because of paragraph (c) of this subsection, the single transaction referred to in the last-mentioned paragraph is taken to be such an unfair preference.

In effect, this section provides that where there is a ‘continuing business relationship’, all transactions that form an integral part of the relationship will be considered as a single transaction for the purposes of determining whether there is an unfair preference.

Therefore, the relevant transactions (that form the single transaction) will only be preferential if the overall effect of all of the transactions comprised in the single transaction (including any supplies by the creditor) result in a net reduction in the indebtedness of the company to the creditor.

Accordingly, a key issue will be the period within which a continuing business relationship should be recognised - this will impact which payments and supplies between the parties are included in the assessment of the single transaction.

Continuing business relationship: key principles

In Airservices Australia v Ferrier (1996) 185 CLR 483 (Airservices), the High Court of Australia emphasised the need to consider the “purpose for which the payment was made and received”, and that the Court in determining whether a transaction is an unfair preference under section 588FA(3) should not “ignore the practical relationship between the payments and the subsequent supply of services and the ultimate effect of the dealings between the parties”.[3]

The Full Court in Badenoch adopted the approach in Airservices, and set out (at [48]) the following further principles, derived from that case and subsequent decisions, for determining whether the payments are part of a continuing business relationship:

• there must be a “mutual assumption of a continuing relationship of debtor and creditor”;
• whether “each payment was connected with the subsequent provision of goods or services”;
• whether the purpose was to “induce the creditor to provide further goods or services as well as discharge an existing indebtedness”: if yes, it is not a preference “unless the payment exceeds the value of the goods or services acquired”;
• assuming there is a continuing debtor-creditor relationship, payment towards a past debt is not a preference unless there is an express agreement that the purpose “is to permanently reduce the level of indebtedness below the level existing at the time of the agreement”;
• any level of knowledge of insolvency does not necessarily mean it is not part of a continuing business relationship, nor does a stop on an account;
• “the continuing business relationship does not need to exist for the entirety of the relation-back period”; and
• it is a “question of substance, not form”.

“Predominant” purpose of the payment

Since the Airservices judgment there have been a number of single-judge decisions which considered that the crucial element of the test for a continuing business relationship was to assess the “predominant purpose” of the payment – that is, was the purpose for the continued supply or for paying past debts?[4]

However, the Full Court in Badenoch considered that approach to be “unduly restrictive” and noted that, practically, an unsecured creditor dealing with a company in financial distress would be concerned with receiving payment for goods or services supplied:

“[i]n such circumstances, it would be wrong to say that a mutual assumption of a continuing business relationship ceases whenever the balance tips ever so slightly in favour of recovering past indebtedness, such as where a creditor insists on payment of an ordinary invoice before continuing supply on terms”[5] but “[a]t the other end of the scale a creditor will not be permitted to hide behind the façade of a continuing business relationship where the true nature of what he or she is doing is seeking to recover past indebtedness in priority to other unsecured creditors.”[6]

Were the payments to Badenoch part of a continuing business relationship?

In Badenoch, the Full Court held, contrary to the Federal Court, that the first two payments received by Badenoch were part of a continuing business relationship. This was despite Badenoch issuing a letter of demand for the amounts owed under two previous invoices and ceasing to supply services to Gunns for a 10 day period, and negotiating a payment plan for the payment of the outstanding invoices. Notwithstanding the liquidators’ argument that Badenoch had reservations about Gunns’ ability to pay, the Court found that Badenoch had a genuine belief that it would eventually be paid and the behaviour and communications of the parties evidenced an intention that the relationship would continue. In respect of the third and fourth payments, the Full Court upheld the primary judge’s findings that they were also part of the continuing business relationship.

However, for the balance of the payments, the Full Court held (agreeing with the primary judge’s findings) that these were not part of a continuing business relationship. Prior to these payments being made, Badenoch had insisted that Gunns enter into a payment plan for repayment of all past debts as a precondition to supply of any further services, and then proposed a transition towards a termination of the supply agreement over three to four months. This indicated that the later payments were made with a view to cessation rather than continuation of the relationship.

Does the peak indebtedness rule apply?

In relation to the four payments in Badenoch that were found to be part of a continuing business relationship, the next question was to determine the time frame within which transactions could be considered part of the single transaction for the purposes of section 588FA(3).

The Full Court noted section 588FA(3) requires “all transactions forming part of the relationship” to be included in the single transaction. On its face there is no ability for a liquidator to disregard some of the transactions by selecting a start date after the relationship began.

However, this does give rise to a practical difficulty in that, taken literally, the continuing business relationship under section 588FA(3) could go back to the very outset of trade between the parties, when there was nil balance owing, or at least a balance significantly lower than that outstanding at the date of liquidation. The Full Court acknowledged that such an interpretation would lead to an “absurd result” that would make trade creditors effectively immune from the unfair preference regime.

In Badenoch, the parties had agreed that the relevant end date for the single transaction was the earlier of the date of cessation of the business relationship or the relation-back date.[7] It was also common ground that the single transaction must begin within the relation-back period (in this case the 6 month period prior to the relation-back date), but otherwise disputed the start date.

The liquidator submitted that the peak indebtedness rule applied and accordingly the liquidator could choose whichever start date in the relation-back period it considered produced the best outcome. Badenoch submitted that the start date must be the latest of the start of the relation-back period or the commencement of the continuing business relationship. [8]

The Full Court considered that the authorities relied upon by the liquidators, particularly Petagna Nominees Pty Ltd v Ledger (1989) 1 ACSR 547 and Queensland Bacon v Rees (1967) 115 CLR 266, as well as the Victorian Court of Appeal decision in Sutherland t/as Southern Livestock Nutrition v Lofthouse (2007) 213 FLR 157,[9] did not provide support for the application of the peak indebtedness rule. The Full Court instead effectively agreed with the New Zealand Court of Appeal’s assessment in Timberworld that the application of the peak indebtedness rule was not well founded by in the Australian authorities.

The Full Court held that the peak indebtedness rule did not apply to section 588FA(3) for three reasons:

• There was no legislative intention to adopt the rule (in regards to the Corporations Act at least), considering the language of the statute, legislative material, and the context of the provision. “To apply a peak indebtedness rule is to impermissibly sever the single transaction into two parts and to ignore the commands in both sub-ss 588FA(3)(c) and (d). There can be no room for the implication of a rule that is inconsistent with the express language of the statute.”[10]
• The Court found that section 588FA(3) entrenches 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 or greater value.[11] The Court considered that the ultimate effect doctrine could not be reconciled with the peak indebtedness rule.
• Abolition of the peak indebtedness rule was consistent with the purpose of Pt 5.7B which is “to do fairness between unsecured creditors.”[12]

When is the start and end of the continuing business relationship?

In Badenoch No 2, the Full Court considered when the single transaction should start and end, in the absence of the application of the peak indebtedness rule.

Whilst the Full Court had settled which payments by Gunns to Badenoch should be included in the single transaction in the Badenoch decision, the Full Court had not expressly considered which supplies by Badenoch by Gunns would be included in that single transaction.

The parties were in dispute as to the relevant start and end dates of the single transaction:

• start date: Badenoch argued that the relevant start date was 30 March (when the company became insolvent). The liquidator argued it was 26 March (at the start of the relation back period).
• end date: Badenoch submitted that the relevant end date was 31 July (when Badenoch sent Gunns a letter proposing the termination of their agreement and a payment plan for outstanding debts). The liquidators argued it was 30 June (based on the primary judge’s findings that that was the end date of the relationship, on the basis that the final payment that was part of the continuing business relationship was made in June).

On the facts established at first instance, the continuing business relationship had, as a matter of practical reality, commenced long before either date proposed by the parties.

The impact of the start and end dates was critical to the determination of whether an unfair preference could be established:

• If the starting date for the single transaction was at the start of the relation-back period, as the liquidators argued, the transactions would have resulted in a net reduction in Gunns’ indebtedness to Badenoch, and therefore an unfair preference.
• If, however, the starting date was the date that Gunns became insolvent, as Badenoch argued, the transactions would have results in a net increase in Gunns’ indebtedness to Badenoch, and therefore there would be no unfair preference.

This difference in result, depending on the dates selected for the single transaction, is common in preferences cases involving a continuing business relationship and illustrates the importance of this analysis.

In Badenoch No 2 the Full Court found that the continuing business relationship ended on 10 July when Badenoch stopped providing services to Gunns. However, the invoice issued by Badenoch on 31 July related to the provision of services by Badenoch in the period up to 10 July. Therefore the supplies provided were part of the continuing business relationship, and the increased indebtedness relating from that supply, as recorded in the 31 July invoice, needed to be factored into the single transaction.

The inclusion of the amounts referred to in the 31 July invoice in the single transaction meant that, regardless of which of the proposed start dates in March 2012 was used, the indebtedness at the end of the single transaction was higher than at the start of the single transaction, meaning there was no unfair preference.

The Full Court therefore avoided needing to determine the appropriate start date for the single transaction, which had not been part of the matters originally addressed as part of the appeal. However, the Full Court left open the possibility that the single transaction might in fact stretch back even before the relation back period, stating:[13]

“It may also be observed that if the continuing business relationship commenced at the beginning of the running account (some years prior to 2012), questions may arise as to whether Badenoch received anything in relation to its unsecured debt at all. Expressed another way, if the single transaction is that evidenced by the whole of the running account, Badenoch appears to have supplied more than it received, such that there could be no unfair preference. Whether that is the intended operation of the Act is a question that may be deferred to a case where the outcome depends upon it.”

Comment

The Badenoch decisions represent a significant change to the interpretation and assessment of continuing business relationships in the context of unfair preference claims.

The Full Court has held that peak indebtedness rule is no longer applicable to section 588FA(3), and therefore liquidators are no longer free to choose the date of “peak” indebtedness in the relation-back period at the start of the single transaction, so as to result in the maximum reduction of debt as a result of the single transaction, and therefore the largest potential quantum of unfair preference claim to seek to recover for the insolvent estate.

The practical impact of these decisions is significant and include:

• For liquidators, assessing whether there are any available unfair preference claims will be a more challenging task, and in many cases the quantum of potential claims will be smaller (or entirely offset by creditor supplies during the period).
• For creditors, the continuing business relationship will be applied more broadly and will therefore provide more protection against preference claims by liquidators.

In addition, whilst the Full Court did not rule on this issue, based on the observations made by the Full Court, particularly in Badenoch No 2, it is now appears potentially arguable, as a legal matter, that a single transaction, for the purposes of section 588FA, could start prior to the relation-back period. It will of course depend on the facts in any individual case whether the relationship can actually be demonstrated to have continued for that period, or whether assessing the single transaction over such longer period would change the overall effect of that transaction.

Nevertheless, when the transactions of a company in liquidation and a creditor are aggregated over a long enough period the result inevitably becomes that the indebtedness of the company to the creditor has increased, rather than decreased. Therefore, if the “start” date for a continuing business relationship is determined, on the facts of a particular case, to be sufficiently early, the practical effect in many cases may be to completely inoculate the creditor against any liability for an unfair preference.

Should this be the how unfair preference law operates? The Badenoch has come at a time of growing debate and discussion among practitioners, academics and commentators as to the underlying policy rationale for unfair preference recoveries, whether the regime achieves those goals and indeed whether there sufficient benefit to justify unfair preference recoveries at all.[14]

There is some merit in the suggestion that the regime should provide an incentive (or at least not a disincentive) for trade creditors to continue providing value to companies in financial distress (as envisaged by the doctrine of ultimate effect). It is unclear however that section 588FA(3), as currently formulated, achieves this goal in a sensible manner.

In this regard, it is interesting to note that the United States Bankruptcy Code takes a somewhat different approach to the same issue. Rather than having a concept of a continuing business relationship, section 547(c)(4) of the Bankruptcy Code contains the “subsequent new value defence”. This provides a creditor who has received a preferential payment with a defence to the extent of any “new value” the creditor provided to the company after receiving the preferential payment.[15] This formulation therefore only looks forwards from the time of the individual impugned payment, rather than looking both forwards and backwards as contemplated by the concept of the continuing business relationship. The Bankruptcy Code also contains a defence in respect of transactions in the ordinary course of business.

The liquidator of Gunns has sought special leave to appeal the Badenoch decisions of the Full Court before the High Court. Assuming such leave is granted, it would appear that the Full Court decision is not the final say on this matter. We will see whether the High Court will resuscitate the peak indebtedness rule, or confirm the analysis of the Full Court.

Endnotes

[1] Barwick CJ, at 220-221, stated: “It was also said in argument for the bank that it was not permissible for the liquidator to choose a date within the period of six months and to make a comparison of the state of the overdrawn account at that date and its state at the date of the commencement of the winding up. It was submitted that the proper comparison was between the debit in the account at the commencement of the statutory period of six months and the debit at the commencement of the liquidation - a comparison which in this case would result in a materially lesser figure than that reached by taking the liquidator's comparison. In my opinion the liquidator can choose any point during the statutory period in his endeavour to show that from that point on there was a preferential payment and I see no reason why he should not choose, as he did here, the point of the peak indebtedness of the account during the six months period.” (emphasis added)

[2] Timberworld at [41].

[3] Quoted in Badenoch at [47], emphasis added.

[4] See especially Sutherland as liquidator of Sydney Appliances Pty Ltd (in liq) v Eurolinx Pty Ltd (2001) 37 ACSR 477, applying Airservices.

[5] Badenoch at [54].

[6] Badenoch at [55].

[7] The decision actually says the “liquidation date” rather than the relation-back date, but in this case an administration preceded the liquidation and therefore the date the relation-back period ended (i.e. the relation-back date) was the date the administrators (rather than the liquidators) were appointed.

[8] The decision actually says Badenoch argued for the later of the relation-back day or the commencement of the continuing business relationship, but this is clearly an error, as this would mean the continuing business relationship would not apply to any of the transactions.

[9] In which Nettle JA (as his Honour then was) applied the peak indebtedness rule with Neave and Redlich JJA agreeing.

[10] Badenoch at [112].

[11] See Airservices at 509, quoted in Badenoch at [115].

[12] Badenoch at [119]. In this regard the Court noted some examples provided by the Australian Credit Forum illustrating the potential for differing outcomes for unsecured creditors based on their credit terms as a result of application of the peak indebtedness rule.

[13] Badenoch No 2 at [22].

[14] See for example Michael Murray’s discussion in “Why do we have preference recoveries in insolvency?” (27 June 2021).

[15] Such new value must be: (i) not secured by an otherwise unavoidable security interest and may be credit or goods; and (ii) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor. “New value” means money or money’s worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee in a transaction that is neither void nor voidable by the debtor or the trustee under any applicable law, including proceeds of such property, but does not include an obligation substituted for an existing obligation.