In a highly anticipated decision, the High Court of Australia has unanimously determined in Bryant & Ors v Badenoch Logging Pty Ltd  HCA 2 that the peak indebtedness rule is not part of the unfair preference provisions in the Corporations Act 2001 (Cth) (Act).
The decision means liquidators will no longer be able to select the most optimal time period over which to calculate the net preferential effect of payments made, where a continuing business relationship and a running account is in place between a company and a creditor. This will make it more difficult for a liquidator to recover an unfair preference payment in future and will also impact on the quantum of the recovery.
Under an agreement first entered into in 2003, Badenoch Integrated Logging Pty Ltd supplied timber to Gunns Limited. Badenoch would invoice for the supply at the end of each month as a running account and Gunns was to pay the invoice on the last working day of the following calendar month.
Gunns’ revenue started to decline in 2010, but Badenoch continued to supply timber until August 2012, when the parties agreed to terminate the agreement and create a new agreement where Badenoch would supply limited services while Gunns rectified its finances.
On 25 September 2012, while Badenoch was continuing to supply services, Gunns entered voluntary administration.
Over the relation back period (the six month period before the commencement of Gunns’ administration) from 30 March 2012 to 24 September 2012, Badenoch received over AUD $3.3 million in payments from Gunns. The liquidators claimed that the entirety of the payments constituted an unfair preference under section 588FA of the Act.
In its defence, Badenoch relied on the “running account” defence under section 588FA(3) of the Act. – This provides that when a company and a creditor are in a continuing business relationship, and a series of payments are made to the creditor in return for the ongoing supply of goods or services as an integral part of that relationship over a period of time, all of the payments are to be considered together in assessing whether there has been a net unfair preference during the relation back period.
The liquidators argued that they were entitled to select, as the starting point of the assessment, the point of “peak indebtedness” of the outstanding debts owed to Badenoch during the relation back period, and compare that figure to the remaining debt owing at the time of the voluntary administration. This approach would have the effect of maximising the value of the unfair preference claim, and was argued to be the accepted practice in calculating the quantum of unfair preference claims, following a series of lower court decisions over nearly three decades. The Full Federal Court, however, disagreed. For further details on the background to this case, and the determination made by the Full Federal Court (the decision of which was upheld by the High Court), see our previous case alert here. It was this decision that was appealed to the High Court.
Issues for the High Court
Two critical questions were raised about the operation of section 588FA(3):
- Does the “peak indebtedness” rule apply?
- What is the proper approach to determining whether a “transaction is, for commercial purposes, an integral part of a continuing business relationship”?
Does the peak indebtedness rule apply?
The High Court unanimously upheld the Full Federal Court’s finding that the peak indebtedness rule is not part of section 588FA(3) of the Act.
The High Court held that the peak indebtedness rule cannot be grounded in the express terms of the Act, and there is no reason to allow liquidators to arbitrarily determine the first transaction within a continuing business relationship in assessing whether there has been a net preferential effect under the running account principle.
The High Court further held that the running account principle is not intended to maximise the potential for the claw back of money and assets from a creditor, as the peak indebtedness rule so often does. Rather, the running account principle is intended for the benefit of creditors who continue to supply a potentially insolvent company so the company can continue trading for the benefit of all other creditors.
What is the proper approach to determining whether a “transaction is, for commercial purposes, an integral part of a continuing business relationship”?
The High Court also took the opportunity to clarify the proper approach to determine when a continuing business relationship exists between a creditor and a debtor. The Court held that this is an objective factual inquiry – with the task being to ascertain the “business character” of a transaction said to have been made as part of a continuing business relationship, and determine whether the transaction is an integral part of the relationship that commercially benefits both parties. In doing so, it is necessary to consider the whole of the evidence of the actual business relationship.
The peak indebtedness rule has no continued application as a matter of Australian law. Its abolition means liquidators cannot arbitrarily choose a date within the relevant relation back period so as to maximise their claims against a creditor and potentially recover an unfair preference.
This will have a significant impact on liquidators’ ability to pursue unfair preference claims, and the scope of the recovery available. Previously, the availability of the peak indebtedness rule made many preference claims financially viable to pursue, increasing the assets available to satisfy creditor claims. In circumstances where the company and a creditor are in a continuing business relationship, preference claims will now be less common and, when made, will be for a lesser amount.
Liquidators’ focus is now likely to turn to establishing that any continuing business relationship has ended and that the objective circumstances indicate that payments to a creditor are motivated by securing the discharge of past indebtedness, rather than inducing ongoing supply.
Outside of a continuing business relationship, liquidators will be able to rely on the unavailability of set-off as a defence for creditors, to enhance the scope of their recoveries following the decision in Metal Manufactures Pty Ltd v Morton  HCA 1. You can read our summary of that decision here: