Unfair preferences: over the peak of the “peak indebtedness” rule?

Two recent judgments in the Full Federal Court make it harder for liquidators to recover unfair preferences payments from creditors under section 588FA of the Corporations Act 2001 (Cth). At the same time, they leave liquidators uncertain on how to calculate a preference, until another decision clarifies how that section works.

Under s 588FA(3), if a payment to a creditor forms “an integral part of a continuing business relationship” (for example, a “running account”), then all payments forming part of the relationship may be taken as a “single transaction”. That “single transaction” falls to be assessed under s 588FA(1) – that is, whether it prefers the creditor because that creditor receives more than it would have, had it proved in the winding up along with other creditors.

Prior to the Full Court’s latest ruling, liquidators could then apply the “peak indebtedness” rule to that “single transaction”. They could choose the within the statutory “relation back” period – usually 6 months – the date at which the amount owed by the company to the creditor was at its peak. This would be the ‘start date’ of the “single transaction”. They could then calculate the difference between the company’s indebtedness on the ‘start date’, and at the end of the “running account” to determine the amount of the preference. This would always maximise the recoverable preference amount.

Summary of the two judgments

On 10 May 2020, the Full Court, Middleton, Charlesworth and Jackson JJ, in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64:

• modified the test for identifying a “continuing business relationship”; and

• held that liquidators could no longer apply the “peak indebtedness rule”.

Their Honours invited submissions to give effect to this judgment. On 24 June 2021, in Badenoch (No 2) [2021] FCAFC 111, their Honours confirmed that the case was not the appropriate vehicle to determine what happens in the absence of the “peak indebtedness” rule, that is, how to identify the ‘start date’ of the “single transaction”.

The facts

Badenoch Integrated Logging Pty Ltd (Badenoch) provided logging services to Gunns Limited and its subsidiary (Gunns). Gunns was insolvent on 30 March 2012 and went into liquidation.

Within the statutory period, commencing on 26 March 2012, Gunns made 11 payments to Badenoch. The liquidators achieved partial success recovering these payments in the Federal Court. Badenoch appealed.

The “continuing business relationship”

Of the 11 payments made to Badenoch, the primary judge found that only the third and fourth payments formed part of a “continuing business relationship” for the purpose of 588FA(3).

Several single State and Federal Court judges had relied upon the principle that there will not be a continuing business relationship where the purpose of inducing further supply is “subordinated to a predominant purpose of recovering past indebtedness”: Sutherland v Eurolinx Pty Ltd (2001) 19 ACLC 633 at [148].

The Full Court doubted that test – it was unduly restrictive and inconsistent with the rationale underlying s 588FA(3) – saying at [54]:

… it is surely a reality of continuing to do business with a company in financial distress (as is contemplated by s 588FA(3)) that an unsecured creditor will often be concerned to ensure that payment is received for goods or services supplied. In 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.

The Full Court said that the correct test was whether the transaction was undertaken to effectively pay an old debt (in whole or in part) rather than for the provision of continuing services or supply of goods.

In applying this test, the Full Court held that the primary judge should have found that the first and second payments were also part of the “continuing business relationship”. Badenoch had applied pressure to have two invoices paid by temporarily ceasing supply, but there was a clear expectation that the parties would return to trading (albeit with a $1 million credit limit) – Badenoch was seeking assurance from Gunns that it would be paid for its services.

The Full Court agreed with the primary judge that the:

• third and fourth payments were part of the relationship – when Badenoch supplied services expecting to be paid, and Gunns continued to pay to secure those services;

• fifth to eleventh payments were not part of the relationship – a repayment plan was only agreed so that services could be tapered off while another contractor got “up to speed”. Any mutual assumption of a continuing business relationship had ceased.

The “peak indebtedness” rule

Badenoch argued that the primary judge erred in finding that the peak indebtedness rule applies to claims made in respect of s 588FA.

This issue concerned the date on which the “single transaction” commenced, noting that if applying the peak indebtedness rule, the liquidator can choose the start date as the date of peak indebtedness.

The Full Court said that the starting point was the words “all transactions forming part of the relationship” in s 588FA(3)(c). These words intend to give the creditor the benefit of all dealings between the parties. But read literally, they present difficulty. Where a company has gone into liquidation, inevitably, the closing balance of a running account would likely exceed the opening balance, meaning that a preferential payment would rarely occur.

Nevertheless, the Full Court held that cases applying the peak indebtedness rule were wrong:

• First, the implication of the rule would be inconsistent with the express language of s 588FA(3), as it would “impermissibly sever the single transaction into two parts…”.

• Secondly, the peak indebtedness rule cannot be reconciled with the “ultimate effect” doctrine recognised by the High Court in Airservices Australia v Ferrier (1996) 185 CLR 483. That doctrine recognises that a company’s creditors suffer no disadvantage by payments made to induce the company’s trade creditors to supply goods of equal or greater value.

On this point, the Full Court agreed with the New Zealand Court of Appeal in Timberworld Ltd v Levin (2015) 3 NZLR 365 regarding the equivalent NZ provision.

The Full Court said that s 588FA(3), consistent with Airservices, requires consideration of all payments (both impugned and non-impugned) and all supply (both past and future) forming part of the continuing business relationship falling within the relevant statutory period. Their Honours said at [117]:

“If value provided to the company and a subsequent payment against accrued debt are viewed as part of an arrangement which has the effect of giving the company valuable goods and services, there is no depletion of assets. If s 588FA(3) applies then it expressly requires them to be viewed that way.”

• Thirdly, abolishing the peak indebtedness rule is consistent with the purpose of Pt 5.7B of the Corporations Act, to do fairness between unsecured creditors. Submissions to a 2003 insolvency law inquiry illustrated how the peak indebtedness rule can produce different outcomes between unsecured creditors who adopt different credit terms – some allowing the level of peak indebtedness to rise higher than others – even if they each advance the same value to the company and receive the same payments in return.

The Full Court accepted that “the arbitrary timing of a single transaction in the absence of the peak indebtedness rule may also result in unfairness” if liquidators may be less inclined to pursue preferences. But their Honours held that the balance weighs in favour of abolishing the rule, saying that any unfairness appears to be a foreseeable consequence of the statutory regime.

Defences and set-off

The Full Court held that the primary judge was correct to find that Badenoch:

• had not made out a defence under s 588FG (good faith; no reasonable grounds to suspect insolvency); and

• could not set-off the preference under s 533C because it had notice of Gunns’ insolvency throughout the statutory period. It was not the opportunity to determine whether set-off was, as a matter of law, available to reduce a creditor’s liability to repay a preference.

Judgment (No.2)

The Full Court noted that the parties disagreed on what the Full Court actually found in its first judgment as to the start date and the end date of the “single transaction”.

Depending on the dates, there would be, either, a net reduction in Gunns’ indebtedness to Badenoch, in which case the liquidators would say there was a preference; or a net increase, in which case Badenoch would say there was no preference.

It was common ground that the end date of the “single transaction” was the earlier of either, the end date of the continuing business relationship or the liquidation date (26 September 2021). The Full Court held that the continuing business relationship ended on 10 July 2012 when Badenoch ceased providing services for a time, and that the “single transaction” ended on 31 July 2012 when Badenoch issued an invoice referrable to those services.

As to the start date of the “single transaction”, the liquidators contended it should be 26 March 2012 (the start date of the statutory period). Badenoch contended it should be 30 March 2012 (the date of insolvency). Gunns’ indebtedness was higher on the liquidators’ preferred date.

The Full Court said it was unnecessary to determine the start date. Given its finding that the “single transaction” ended on 31 July 2012, on the calculations, whether the start date was 26 or 30 March 2012, there would be no preference.

More importantly, the Full Court observed, as the primary judge found, the relevant continuing business relationship commenced long before 26 or 30 March 2012. No party had addressed the Full Court on the consequences of fixing the commencement date of the single transaction as either the start of the continuing business relationship, the start of the statutory period, or any other date.

Their Honours said at [22]:

… 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 an unsecured debt at all. … if the single transaction is that evidenced by the whole of the running account, Badenoch appears to have supplied more than it has 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.

Costs

Each party was to bear its own costs of the appeal. Badenoch was only partly successful. Of the 11 payments, the fifth to eleventh payments were not part of the single transaction, and so Badenoch was still required to return preference payments totalling over $1.2 million.

What’s the upshot?

One wonders how the result could have been different if Badenoch had put into play the transactions spanning its entire running account / continuing business relationship with Gunns.

Creditors will now almost certainly attempt to do so, arguably increasing the burden on liquidators to investigate transactions within a larger span of time than the statutory period.

The issue of the intended operation of s 588FA and the start date of the “single transaction” may ultimately need to find its way to the High Court.