A Low Point for the Peak Indebtedness Rule

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By Ariel Borland, Partner, Phoebe Pitt, Special Counsel and Nik Angelakis, Lawyer

Introduction

The decision in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 (Badenoch) handed down on 12 March 2021, is the first time an intermediate appellate court has considered the “peak indebtedness rule” since the decision of Timberworld Ltd v Levin[1] (Timberworld) which abolished the rule in New Zealand.

The Court in Badenoch followed Timberworld, and so held that the peak indebtedness rule does not form part of the law of corporate insolvency in Australia. The decision substantially changes the manner in which unfair preference claims will be quantified going forward and, accordingly, alters the commerciality of commencing an unfair preference claim where a “running account” is present.

Running Accounts and The Peak Indebtedness Rule

Section 588FA(3) of the Corporations Act 2001 (Cth) codifies the “running account” principle and provides that:

  • if a transaction is part of an integral part of a continuing business relationship or running account between a company or creditor; and
  • 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, “all the transactions forming part of the relationship [must be considered together] as if they together constituted a single transaction”; and
  • the “single transaction” will only be a preference if it results in the creditor receiving more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company.

Put another way, this “single transaction” will only be a preference if the payments made by the company exceed the value of the goods or services it received, such that the payments effected a reduction in the balance of the running account.[2]

The peak indebtedness rule arose from the decision of Barwick CJ in Rees v Bank of New South Wales, where his Honour said:[3]

In my opinion the liquidator can choose any point during the statutory period [i.e. the 6 month relation-back 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 peak indebtedness of the account during the six months period.”

Accordingly, the peak indebtedness rule permits a liquidator to calculate the value of the preference by subtracting the debt owing to the creditor from the debt owing at the point of peak indebtedness.

Background

Gunns Limited (in Liq) (Receivers and Managers Appointed) (Gunns) was a timber felling business located in Launceston, Tasmania, which operated sawmills and plantations across Tasmania, Victoria, South Australia and Western Australia. Following large losses and mounting debts, Gunns was placed in voluntary administration in September 2012 and liquidation in March 2013.

Badenoch Integrated Logging Pty Ltd (Badenoch) provided logging and transport services to Gunns. Over the period from 30 March 2012 to 24 September 2012, Badenoch received $3,360,876.16 from Gunns in 11 payments which the Court found were made whilst Gunns was insolvent. It was unlikely that other creditors of Gunns would receive a distribution in its winding up. The liquidators of Gunns sought to recoup these payments under sections 588FA and 588FF of the Act, on the basis that they were unfair preferences (as, in receiving those 11 payments, Badenoch would receive a better return than it otherwise would if it were to prove in the liquidation).

Badenoch maintained it had a running account with Gunns. The issues related to which of the 11 payments formed part of the running account, and then whether or not the Liquidators were entitled to quantify the single transaction comprising the running account by reference to the peak indebtedness rule.

At first instance, Davies J held that only two of the 11 payments (chronological payments 3 and 4) formed part of the running account.[4] The remainder were excluded as they were payments made towards “old debt rather than the provision of continuing services.”[5] Badenoch relied on Timberworld, however Davies J was not persuaded by that decision because, inter alia, section 588FA(3) was “aimed at embodying in legislation the principles reflected in the case of Queensland Bacon Pty Ltd v Rees [1967] 115 CLR 266 and Petagna Nominees Pty Ltd v AE Ledger 1 ACSR 547” which in turn cited numerous cases approving the peak indebtedness rule.[6]

Appeal Decision

An appeal and cross-appeal were filed concerning:

  • Badenoch’s contention that all 11 payments should have been found to form part of the running account; and
  • Badenoch’s contention that the trial judge erred in applying the peak indebtedness rule.

Continuing Business Relationship

The Full Court held that Davies J took an unduly narrow view to what comprises a “continuing business relationship” that founds a running account. The Court held where the “sole” purpose of a payment is to discharge an existing debt, it will cause the assumption of a continuing business relationship to cease.[7] However, it disagreed with earlier authority that this assumption will cease where the purpose of inducing supply of further goods or services is “subordinated to a predominant purpose of recovering past indebtedness.”[8] The Court said:[9]

“Indeed, it is surely a reality of continuing to do business with a company in financial distress … 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, such as where a creditor insists on payment of an ordinary invoice before continuing to supply on terms.”

Applying those principles, the Court held that the first two payments formed part of the running account. Around this time, Badenoch issued a letter of demand, implemented a 10 day “stop supply” and negotiated a payment plan for its two previous invoices in exchange for continued supply.[10] The Court described  that while these tactics were unprecedented, the intention was for Badenoch to receive payment for past services so that it could then “get deliveries back on track”.[11] The temporary cessation of supply did not destroy the mutual assumption of payment and reciprocal supply.[12]

However, the Court agreed with the reasons of her Honour with respect to payments 5 to 11. Badenoch insisted that Gunns enter into a payment plan for its past debt, the intention of which was “a gradual tapering off [of services] while another contractor gets up to speed”.[13]

Peak Indebtedness

The Court held that the peak indebtedness rule should no longer be applied to section 588FA of the Act. The Court held that section 588FA(3) requires the running account be taken as a “single transaction” which encompasses “all transactions forming part of the relationship”. Applying the peak indebtedness rule “would impermissibly sever the single transaction into two parts” and there is no room to imply it into the section.[14]

Likewise, when considering a preference, the Court must look to “the ultimate effect of the dealings between the parties”, being all payments and all supply forming part of the continuing business relationship (whether impugned or not), to ascertain whether there is a depletion of assets. Where there is no depletion, on the basis of payments that are not impugned, the doctrine of ultimate effect dictates that there is no preference. The Court agreed with Timberworld, in that it is impossible to reconcile the peak indebtedness rule with the doctrine of ultimate effect.[15]

Based on the Court’s guidance:

  • the starting point for the single transaction is either the date of the commencement of the continuing business relationship, or the start of the relation back period, whichever is later; and
  • the relevant end date for the single transaction is either the date of the cessation of the continuing business relationship or the date of liquidation, whichever is earlier.

The table below illustrates the difference between the calculation of a preference, on the basis of the payments made, and running account recognised, in Badenoch: [16]

Date Invoice Payment Balance
30 March 2012 $410,000.00 $410,965.07
31 March 2012 ($660,347.78) $1,071,312.85
13 (or 16) April 2012 $410,965.07 $660,347.78
30 April 2012 ($674,368.12) $1,334,715.90
30 April 2012 ($4,561.51) $1,339,277.41
1 (or 2) May 2012 $660,347.78 $678,929.63
31 May 2012 ($737,633.68) $1,416,563.31
7 (or 8) June 2012 $678,929.63 $737,633.68
30 June 2012 ($627,687.34) $1,365.321.02
  Start End Net Preference
Peak Indebtedness $1,416,563.31 $1,365.321.02 $51,242.29
No Peak Indebtedness $410,965.07 $1,365.321.02 No preference

Comment

Badenoch will have a significant impact on liquidators and unsecured creditors. The key takeaway points are as follows:

First, the Court will take a commercially realistic approach towards determining whether there is a mutual assumption of a continuing business relationship. Merely issuing a letter of demand to the debtor, or temporarily stopping supply in order to obtain payment for past debts, will not destroy that assumption so long there remains a mutual purpose to induce further supply following the receipt of payment or negotiation of terms. Conversely, arrangements which seek to settle past debt whilst “winding down” the relationship will generally be sufficient to cause the running account to cease.

Secondly, until the High Court is required to consider the issue, the Courts will not apply the peak indebtedness rule in calculating an unfair preference pursuant to section 588FA. Accordingly, a liquidator – well-advised – would refrain from issuing demands for payment on the basis of unfair preferences premised on the peak indebtedness rule. Given that liquidators can no longer rely on the peak indebtedness rule, we anticipate that preference claims in future will be run in such a way to bring as many payments as possible outside of the running account, so that the payments are considered in isolation, and the value of the potential claim is maximised. Future cases are likely to focus on whether the circumstances surrounding a payment evidenced a continuing business relationship or not.

Finally, and at a practical level, we often identify that the debt owing to a creditor in a running account will increase as the debtor reaches liquidation. If the liquidator cannot select a point in the account higher than the final balance, there can be no finding of a preference on that basis. Accordingly, we reasonably expect that the decision in Badenoch will result in fewer preference claims being commenced. This will have flow on effects as some claims made against recipient creditors are likely to now be significantly reduced, or entirely unavailable. Conversely, the constriction of circumstances in which preferential payments will be established will – in circumstances where preference claims relying either heavily or in full upon the peak indebtedness rule formed the only valuable asset – dilute the quantum of funds recoverable by liquidators, in turn reducing funds available to be distributed to other unsecured creditors.

Given the significant impact of this case, and its wide-ranging implications, we will be keenly watching to see whether the liquidators appeal the Court’s decision to the High Court.

[1] [2015] 3 NZLR 365.

[2] Airservices Australia v Ferrier (1996) 185 CLR 483, 501-2 per Dawson, Gaudron and McHugh JJ and Bryant, in the matter of Gunns Ltd (In Liq) (Recs and Mgrs Apptd) v Edenborn Pty Ltd (2020) 381 ALR 190 at 233 [171] per Davies J.

[3]  [1964] HCA 47.

[4] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713 (“Gunns (FCA)”) at [99] per Davies J.

[5] Badenoch (FCA) [2020] FCA 713 (“Badenoch (FCA)”) at [99] per Davies J.

[6] Explanatory Memorandum to the Corporate Law Reform Bill 1992 (Cth) at [1042].

[7] Badenoch [2021] FCAFC 64 at [56] per Middleton, Charlesworth and Jackson JJ.

[8] Badenoch [2021] FCAFC 64 at [49] to [50] and [54] per Middleton, Charlesworth and Jackson JJ referring to Sutherland (as liquidator of Sydney Appliances Pty Ltd (in Liq)) v Eurolinx Pty Ltd (2001) 37 ACSR 477 at [148] per Santow J.

[9] Badenoch [2021] FCAFC 64 at [54] per Middleton, Charlesworth and Jackson JJ.

[10] Badenoch [2021] FCAFC 64 at [60] per Middleton, Charlesworth and Jackson JJ).

[11] Badenoch [2021] FCAFC 64 at [65] to [68] per Middleton, Charlesworth and Jackson JJ).

[12] Badenoch [2021] FCAFC 64 at [68] per Middleton, Charlesworth and Jackson JJ).

[13] Badenoch [2021] FCAFC 64 at [76] to [78 per Middleton, Charlesworth and Jackson JJ).

[14] Badenoch [2021] FCAFC 64 at [82] and [112] per Middleton, Charlesworth and Jackson JJ) quoting Timberworld [2015] 3 NZLR 365 at [68].

[15] Badenoch [2021] FCAFC 64 at [117] to [118] per Middleton, Charlesworth and Jackson JJ) quoting Timberworld [2015] 3 NZLR 365 at [81] to [84].

[16] The Court identified two earlier payments on 26 March 2012 and 28 March 2012, pre-dating the insolvency of Gunns but which fell within the relation back period. The Court did not determine whether they fell within the running balance and have been excluded from this analysis.

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