The Death of the Peak Indebtedness Rule

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By Samuel Barber, Partner and Jack Chapman, Paralegal

Despite ruling in favour of the peak indebtedness rule’s existence only 12 months prior, on Monday, the Federal Court reversed its decision in Badenoch Integrated Logging Pty Ltd to revoke the rule’s operation in Australia.

Background

The liquidators of Gunns, a major forestry enterprise, commenced proceedings for an unfair preference claim under section 588FA of the Corporations Act 2001 (Cth) against Badenoch Integrated Logging Pty Ltd, a haulage and timber harvesting contractor.

In the previous judgments, a series of payments valued at approximately $3.6 million were found to be insolvent transactions which amounted to unfair preferences as they were deemed to result in Badenoch receiving more than would have received in Gunns’ winding up.

Badenoch subsequently appealed this ruling and the crux of the issue before the court was whether the previous authority had erred in law regarding the availability and scope of the Liquidators’ unfair preference claims. Under this, one of the key questions to be addressed was “whether the Liquidators were entitled to apply the peak indebtedness rule and choose any point in the relationship as the starting point of the single transaction for the purpose of s 588FA(3) of the Act” (‘peak indebtedness issue’).

The Decision

In a landmark decision, the Federal Court held that the Liquidators’ were not entitled to apply the peak indebtedness rule in order to claim that the single transaction was an unfair preference in respect of section 588FA of the Act.

The Court turned to Olifent as the only instance where the application of the peak indebtedness rule has been expressly considered.[1] In Olifent, the creditor made submissions that section 588FA(3) should be construed in a way which precludes a liquidator from utilising the peak indebtedness rule to pick the starting point for the impugned transaction in a continuing business relationship setting.[2] The Supreme Court of South Australia rejected this notion and held as per Master Burley at (202-203):

If the continuing business relationship commenced prior to the commencement of the six-month period, it does not necessarily follow that the opening balance for the purposes referred to should be taken as the balance as at the date of the commencement of the six-month period. This seems to me to be just as arbitrary a starting point as picking the point of peak indebtedness. In my opinion, the nature and ambit of the running account defence under the former provisions is essentially the same as the defence provided for under the current provisions. The absence of any provision in s 588FA(2) to alter or vary the situation which pertained under the former provisions indicates that the legislature did not intend to alter that position. I therefore consider that what was said by Barwick CJ in Rees v Bank of New South Wales applies with equal force to the current provisions of the Law…[3]

As a result, the peak indebtedness rule has been applied by Australia courts without question or further discussion, until now.

Ultimately, their Honours rejected the findings in Olifent, and the decisions that heeded it. Explicitly, they determined that the previous authorities were wrongly decided on the basis of their application of the peak indebtedness rule to section 588FA(3) of the Act for three key reasons.

Firstly, they rejected the idea that there was any legislative intention to adopt the peak indebtedness rule when the provision was introduced into the 1989 Act. They held that the plain language of the statute and legislation suggest that the peak indebtedness rule was not intended to apply in the context of s 588FA(3). The words of section 5888FA outline that where the test in s 588FA(3)(a) and (b) is satisfied, there is to be a single transaction encompassing all payments and supplies that are part of the continuing business relationship. This, as the Federal Court advocates, is to be the single transaction that is subject to the Court’s preference consideration under section 588FA(1) and section 588FA(3)(d). In other words, applying the peak indebtedness rule would impermissibly sever the single transaction into two fragments and ignore the instructions in both sub-ss 588FA(3)(c) and (d), and thus a rule cannot exist where it is inconsistent with the express language of the statute.

Secondly, section 588FA(3) of the Act exemplifies the doctrine of ‘ultimate effect’ which acknowledges that the general body of creditors are not disadvantaged by payments made to induce trade creditors to supply goods which are of equal or greater value. This view was deemed by the Court to be consistent with the purpose behind Pt 5.7B of the Act which aims to accommodate the interests of unsecured creditors with those of people who have engaged in fair transactions with the insolvent company. The effect of this is to separate trade creditors from the rest of the unsecured creditors and provide an incentive for creditors to continue providing value to companies in troubling financial situations. The Court looked to Airservices, which embraces the principle (at 509) where the High Court majority held:

“Once the doctrine of ultimate effect is applied, it follows that the payments to Airservices gave it no preference, priority or advantage over the general body of creditors. On the contrary, the general body of creditors benefited from the revenues that were generated as the result of the services provided by and at the expense of Airservices. The value of the services provided exceeded the amount of the payments during the relevant period by several million dollars.

To ignore the practical relationship between the payments and the subsequent supply of services and the ultimate effect of the dealings between the parties would not advance the purpose for which s 122 was enacted. That purpose is to strike down those payments by a debtor during the six-month period prior to bankruptcy that have the effect of depleting the assets available to the general body of creditors. But it is no purpose of s 122 to prevent a debtor from making payments – even payments to existing creditors – if the purpose of the payments is to acquire goods or services equal to or of greater value than the payment.” [4]

Accordingly, they ruled that when one is assessing the “the ultimate effect of the dealings between the parties”, they are required to look to all payments both impugned and non-impugned, and all supply both in the past and future which forms part of the continuing business relationship within the statutory period as required by section 588FA(3).

For that reason, they saw no avenue to reconcile the doctrine of ‘ultimate effect’ with the peak indebtedness rule. This lead them to agree with the reasoning of the New Zealand Court of Appeal in Timberworld as follows:

[81]     If the principle in Airservices Australia is that the ultimate effect must be considered in ascertaining the results of a running account, there is no doubt the peak indebtedness rule does violence to that principle. As earlier discussed, the liquidators contend this conclusion has been misused in New Zealand, incorrectly forming a “complete answer” to voidable claims. They submit preferences in the case of a running account should be assessed by looking to the first payment, rather than supply. That would ensure the “net preferential receipt” is considered, rather than using a running account to constitute in effect a complete defence to a preference claim.

[82]    The problem with this analysis is that it disregards the first advancement of supply, which would fall within the concept of “all transactions” in the running account as per s 292(4B), with no compelling explanation. Commencing with “payment” still requires the liquidator to select a payment, in the middle of the “single transaction” and assess preference only from that point onwards. The relevant question still remains: why should this be the starting point, in light of the clear statutory wording? The liquidators’ position assumes an answer to this question, without justifying it. It goes no further in offering a principled reason why the supplies prior to the first payment should be ignored in the “entire transaction”.

[…]

[84]    It is correct Airservices Australia was not a “peak indebtedness” case, but that was because there was no question the creditor had not been preferred. Whether or not a running account existed, Airservices Australia had clearly provided services in excess of any payment it had received. The key issue concerned the application of the running account on the facts. The central determination of the High Court was the relevance of the doctrine of “ultimate effect” to that quantum assessment. Peak indebtedness did not apply on the facts but Airservices Australia was still a running account case.[5]

Finally, the Court considered that the abolition of the peak indebtedness rule would be consistent with the stated purpose of Pt 5.7B of the Act, which principally, was to achieve fairness between unsecured creditors. Here, they agreed with the illustration of this resulting unfairness in submissions from the Australian Credit Forum to the Parliamentary Joint Committee on Corporations and Financial Services in its 2003 insolvency law inquiry, as set out in Timberworld:

[87]    The Australian Credit Forum gave some examples to demonstrate the problems with the peak indebtedness rule. It posits three creditors, Creditor 1, 2 and 3. Each has provided Company X with a $10,000 credit limit. At the beginning of the specified period, the debtor’s level of indebtedness to each creditor is $60,000. At the end of the specified period, the debtor owes each creditor $10,000 once more. In each case, the creditor has provided $60,000 worth of supplies to the debtor, and has been paid $50,000. Assuming for present purposes these are correctly classified as running accounts, and the principle in s 292(4B) (or s 588FA(3) as the case may be) applies, there would be no net preference. Taking the running accounts as single transactions, in respect of Creditors 1, 2 and 3, payments did not exceed supply.

[88]    The Credit Forum demonstrates, however, if each creditor adopts different credit terms, the peak indebtedness results in a different preference calculation, despite, in substance, their having offered equal supplies and received equal payments. Creditor 1 may not require payment on any specific terms; Company X receives the goods advanced, and advances payments after the full advancement of goods to the value of $60,000. The point of peak indebtedness will be $60,000 and the preference will be as much (the previous supplies being disregarded prior to this point).

[89]    Creditor 2 imposes credit terms keeping to the credit limit, therefore advances goods to the value of $10,000 and receiving payment of as much each month. The point of peak indebtedness will only ever reach $20,000, and the preference received after that point will be $10,000. Creditor 3 on the other hand, may impose credit terms requiring payment after three months. It advances supplies to the value of $30,000, after which Company X advances $20,000 and returns to within the credit limit, thereafter receiving goods and paying in $10,000 instalments. In that case, peak indebtedness is $30,000 and the creditor received a preference of $20,000.

[90]     These illustrate the arbitrariness of peak indebtedness in operation. Despite each creditor advancing the same value of goods to Company X and receiving the same payments in return, the peak indebtedness rule can operate to produce vastly different outcomes, merely on the basis of the particular credit arrangements in each case. Contrary to the arguments advanced by the liquidators there is no connection between the “preference” received by one creditor, and the entitlement of another. Each creditor is a trade creditor in precisely the same ultimate circumstances, but is treated differently.[6]

Implications

At present, the peak indebtedness rule forms an integral part of any liquidator’s assessment of the commercial viability of commencing unfair preference proceedings, and thus this recent decision will pose significant implications for liquidators moving forward.

For example, with respect to the claim against Badenoch Integrated Logging Pty Ltd (“Badenoch”)[7], the liquidators endeavoured to value the unfair preference from 31 July 2012, the date at which Gunns’ indebtedness was at its peak point at $1,559,594.08. This was permissible by utilising the peak indebtedness rule despite the continuous business relationship having commenced on the 26th March 2012. Consequently, this provided the liquidators with the most favourable result when measuring the value of the net reduction in indebtedness. Upon the conclusion of the continuous business relationship on the 25th of September 2012, the liquidators owed Badenoch $569,321.81. The value of the unfair preference was therefore $990,272.27, being the gross reduction in indebtedness.

Conversely, if the net reduction in indebtedness was to be measured from the commencement of the 6-month relation-back period such to give ‘ultimate effect’ to the dealings between parties (i.e. $1,143,940.82 on the 26th March 2012), the value of the unfair preference is only $415,653.26. This reduction is a direct by-product of the value of the goods and services provided by Badenoch exceeding the payments they had received. Accordingly, creditors often prefer to use this earlier date as the initial comparison point so that any later reductions in indebtedness are offset by earlier transactions with which the creditor may have supplied the company with net value.

The inability of liquidators to enforce the operation of the peak indebtedness rule will undoubtedly benefit creditors extensively by reducing the value of unfair preference claims and, in some instances, extinguishing them altogether. Their Honours respectfully acknowledge this at (121) noting, “it is true that the arbitrary timing of a single transaction in the absence of the peak indebtedness rule may also result in unfairness, as liquidators may be less inclined to pursue preferences as the amount likely to be recovered may not justify the time and expense involved, and this may result in a lower return to creditors.”[8]

In dealing with this, it was conceded that “there is a certain degree of arbitrariness or unfairness that is inherent in either approach”, however, it was their Honours’ view that, “the balance weighs in favour of not applying the peak indebtedness rule”. [9] In their opinion, “any unfairness appears to be a foreseeable consequence of the statutory regime”.[10]

These concessions suggest that the Court is astutely aware of the challenges that its findings may present for liquidators however, at this stage, it remains to be seen what actions will be taken to address the grievances of liquidators when they inevitably arise.

[1] Olifent v Australian Wine Industries Pty Ltd (1996) 19 ACSR 285 (SASC).

[2] Ibid at 290.

[3] Ibid at (202-203).

[4] Airservices Australia v Ferrier (1996) 185 CLR 483 at 509.

[5] Timberworld Ltd v Levin (2015) 3 NZLR 365 at (81-82) and 84.

[6] Timberworld Ltd v Levin (2015) 3 NZLR 365 at (87-90).

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

[8] Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 at [121]; see also McAloon, D ‘“Ultimate Effect” or maximum recovery? – should liquidators be able to apply the “peak indebtedness rule” to running accounts when pursuing unfair preference claims?’ (2006) 14 Insolv LJ 90 at 96.

[9] Ibid.

[10] Ibid.

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