The ‘peak indebtedness rule’, a strategy which had been used by liquidators to maximise the recovery of unfair preference claims in the context of continuing business relationships, has been unanimously abolished by the High Court in Bryant v Badenoch Integrated Logging [2023] HCA 2 (Badenoch).[1]

The decision confirms the prior view of the full Federal Court,[2] that when assessing potential preference payments made in a continuing business relationship (for example, a running account), liquidators may no longer elect the date at which a debtor is maximally indebted to a creditor as the starting point from which to identify preferences, but must instead consider the broader relationship between the parties.

Background

Legislation

Under section 588FE(2) of the Corporations Act 2001 (Cth) (Act), an insolvent transaction is voidable if it is entered into in the period leading up to or after the ‘relation-back day’, usually being the date administrators are appointed (prescribed period).[3] Insolvent transactions include unfair preference payments, which exist where an insolvent company has made a payment to an unsecured creditor which results in that creditor receiving more than they would in a winding-up.[4]

Section 588FA(3) of the Act further provides that if multiple transactions between a company and a creditor are “for commercial purposes, an integral part of a continuing business relationship” (for example, a running account), those transactions are to be treated as a single transaction for determining if an unfair preference exists.[5]

The Peak Indebtedness Rule – as it was

The peak indebtedness rule was a strategy used by liquidators to maximise the amount recoverable in unfair preference claims in the context of continuing business relationships. When assessing mutual debits and credits, liquidators would strategically elect the date at which the debtor was maximally indebted to the creditor as the ‘commencement’ of the single transaction construed under section 588FA(3) of the Act, and claim any amount paid to offset of that peak indebtedness was an unfair preference.

While this approach was advantageous to liquidators: maximising the recovery available and providing an administratively simple time to elect as the commencement of a continuing relationship; it has also drawn criticism for effectively ignoring the true context of a continuing business relationship and the value that a creditor likely provided to the debtor prior to the point of peak indebtedness.

The Case

Badenoch Integrated Logging Pty Ltd (BIL), a family owned logging and transport service provider, was a creditor and former supplier of Gunns Limited (in liquidation) (receivers and managers appointed) (Gunns), a timber business. The parties had ongoing relations from 2003, and BIL continued to provide services to Gunns as the latter entered financial distress from 2010 through 2012. BIL was aware of this distress due to media coverage, Gunns’ consistently late or partial payments of their invoices, and the creation of payments plans and issuance of letters of demand.[6] In September 2012, liquidators were appointed to Gunns, who sought to recover a series of 11 payments made through the prescribed period, alleging those payments constituted voidable unfair preference payments. In seeking to set aside those payments, the liquidators argued that they were entitled to use the peak indebtedness rule to choose the starting date for their unfair preference claim.[7]

While the primary judge had originally allowed the rule to be employed when assessing the transactions, this was overturned by the full Federal Court. The liquidators of Gunns appealed the Federal Court decision.

In assessing the case, the key questions for the High Court to determine were:

1. whether the ‘peak indebtedness rule’ applies; and
2. how transactions in a ‘continuing business relationship’ are to be characterised in the context of unfair preference claims.[8]

Outcome & Analysis

The appeal was dismissed. The High Court agreed with the Federal Court, formally abolishing the peak indebtedness rule, and provided guidance on how to characterise transactions within a ‘continuing business relationship’.

Abolition of the Peak Indebtedness Rule

The peak indebtedness rule was set aside owing to its lack of statutory backing and the fact its operation ignores the connection between the alleged preference payments after the date of peak indebtedness and previous, mutual transactions which may have been made in a continuing business relationship.[9] In coming to its verdict, the court echoed the previous High Court decision of Airservices Australia v Ferrier:[10]

If, at the end of a series of dealings, the creditor has supplied goods to a greater value than the payments made to it during that period, the general body of creditors are not disadvantaged by the transaction – they may even be better off…

Although it remains open to a liquidator to determine which transactions are to be subject of a voidable transaction application,[11] a liquidator may not decide the first transaction forming part of the single transaction that arises in the context of a continuing business under section 588FA(3) of the Act.[12] Instead, the first transaction that can form part of the continuing business relationship from which any alleged unfair preference payment is to be assessed is the later of:

• the first transaction after the beginning of the prescribed period;
• the first transaction after the date of insolvency; or
• if the relationship started after the beginning of the prescribed period or the date of insolvency, the first transaction in the relationship.[13]

Characterising a ‘continuing business relationship’

In lieu of the peak indebtedness rule, liquidators may also recover potential preference payments made to a creditor if it can be established that those payments do not constitute ‘in a commercial sense, an integral part of the continuing business relationship’ contemplated by section 588FA(3) of the Act, but are instead standalone preference payments.[14] The Court stated that whether a transaction is an ‘integral part’ is a question of fact, with the intention of the parties relevant to, but not necessarily determinative of, that question.[15] “The actual business relationship, evaluated in its commercial context, is critical”.[16]

Broadly, where the primary impetus behind a payment is in furtherance of an ongoing business relationship, that payment will be construed as part of that ongoing business relationship and therefore treated as part of the ‘single transaction’. However, if the primary purpose of the payment is to greatly reduce to level of credit on account between parties, that payment is more likely to be an unfair preference.[17]

If the sole purpose of the payment is to discharge an existing debt, the effect of the payment is to give the creditor a preference over other creditors…

But if the purpose of the payment is to induce the creditor to provide further goods or services as well as to discharge an existing indebtedness, the payment will not be a preference unless the payment exceeds the value of the goods or services acquired.

In such a case a court … looks to the ultimate effect of the transaction…

In Badenoch, a number of the alleged preference payments were made primarily to “induce further supply”, with the necessary reduction of past indebtedness ancillary to that primary purpose.[18] Those payments, therefore, were not a discrete unfair preference, but instead a component of the continuing business relationship.

However, creditors should be aware that the existence of ongoing dealings between parties will not inherently give rise to a presumption of a ‘continuing business relationship’. In Badenoch, although the parties had mutually dealt with one another for a lengthy period, certain transactions were excluded from ambit of the continuing relationship, as they were provided at a time when Gunns had been advised they would need to procure a different contractor and their dealings with BIL were drawing to a close.[19] Although BIL continued to provide services to Gunns throughout this ‘transition period’, “the pre-existing business relationship between Gunns and [BIL] had ceased”.[20]

While the Court did not provide extensive guidance on what may constitute the cessation of one continuing business relationship and the commencement of another, changes goods provided, services rendered, payment terms, contractual arrangements or frequency of dealings between parties are likely to be indicia of a ‘break’ in the relationship.

Example

The changes wrought by the Badenoch decision may be best illustrated with an example. Consider the below hypothetical, in which a continuing business relationship exists between a Debtor and Creditor for the supply of products:

If the Debtor was insolvent throughout this period, the peak indebtedness rule would have allowed its administrators to identify the point of maximum indebtedness as the ‘commencement’ of  continuing business relations, and claim the amounts paid to offset this amount are unfair preference payments:

While this approach maximises the preference claim (in turn expanding the pool of assets distributable among the general class of creditors), it disregards the business transactions that occurred prior to the point of peak indebtedness. This is punitive to the Creditor, who has actually added value to the debtor (through the provision of products) prior to the point of peak indebtedness.

Contrast the same scenario post-Badenoch, where the entirety of the continuing relationship throughout the prescribed period is construed as one transaction under section 588FA(3) of the Act:

The preference claim is substantially lower, but more reflective of the true relationship. However, this is contingent on all transactions (including the substantial payment to offset the normal debt and resume ‘normal service’) throughout being an ‘integral part’ of that relationship. If it could be shown that the primary purpose for any payment is simply to reduce indebtedness without regard to the continuing business relationship, an unfair preference payment may still exist.

Comment

The Badenoch decision closes the door on a strategy which had been effective in Australia for over half a century,[21] and aligns Australia’s approach to assessing unfair preferences with that of New Zealand.[22]

Insolvency practitioners should be aware that the quantum of recovery for unfair preference claims, particularly those against unsecured creditors who have ongoing relations with a company, may be drastically reduced. Applying to have such transactions voided may now include greater analysis of transactions over a longer stretch of time and involve more detailed consideration of the nature of the business relationship existing between the company and the creditor throughout the prescribed period.

By contrast, the position of unsecured creditors who are the beneficiaries of alleged preference payments is improved: they are likely to retain more than previously and are under less pressure to closely monitor the position of those who are indebted to them. However, creditors should take care to ensure that any transactions on running account can be characterised as an integral part of one continuous relationship.

Speculatively, an unintended consequence of Badenoch (particularly given the emphasis it places on continuing relationships) may be to reduce the impetus for regular suppliers of distressed companies to change payment terms to being cash on demand.

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Notes

[1] Bryant v Badenoch Integrated Logging [2023] HCA 2 (‘Badenoch’).
[2] See Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 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.
[3] Corporations Act 2001 (Cth) (‘Corporations Act’) s 588FE.
[4] Corporations Act ss 588FA, 588FC, 588FE(2A).
[5] Corporations Act s 588FA(3).
[6] Badenoch at [30]–[31].
[7] Badenoch at [35].
[8] Badenoch at [9]–[10].
[9] Badenoch at [45], [53].
[10] Airservices Australia v Ferrier (1996) 185 CLR 483 (‘Airservices‘) at 503-504; Badenoch at [71].
[11] Corporations Act s 588FF(1).
[12] Badenoch at [68].
[13] Badenoch at [13] and [74].
[14] Corporations Act s 588FA(3)(a).
[15] Badenoch at [14] and [79]–[81].
[16] Badenoch at [90].
[17] Airservices at 501-502; Badenoch at [41].
[18] Badenoch at [91].
[19] Badenoch at [81], [93]–[96].
[20] Badenoch at [96].
[21] Rees v Bank of New South Wales (1964) 111 CLR 210 per Barwick CJ.
[22] See Timberworld Ltd v Levin [2015] NZLR 365 at 382; Companies Act 1993 (NZ) s 295.