The Full Federal Court affirms the abolition of the indebtedness rule

On 10 May 2021, the Full Federal Court of Australia handed down its 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 v Bryant). The Full Court affirmed the abolition of the “peak indebtedness” rule with the Court preferring the approach of treating the payments as a single transaction to determine the ultimate effect of the transaction pursuant to section 588FA(3) of the Corporations Act 2001 (Cth) (Act).

In other words, the liquidator can no longer seek to maximise the preference claim based on the peak indebtedness of the company and must look at the overall effect of the payments in the context of a continuing business relationship.

This is a significant shift in the interpretation and quantification of an unfair preference.

Key takeaways

• The “peak indebtedness” rule no longer applies in Australia.
• Liquidators are no longer entitled to calculate the value of the preference claim by subtracting the debt due to the unsecured creditor at the relation back day from the debt due to the creditor at the highest point of indebtedness during the relation back period.
• The value of a preference must now be calculated from the start of the relation back period, or the start of the continuing business relationship.

Preference Claims & Continuing Business Relationships

Section 588FA(1) of the Act provides that a transaction is an unfair preference given to a creditor of the company if:

• the company and the creditor are parties to the transaction; and
• the transaction results in the creditor receiving from the company, in relation to an unsecured debt that the company owes to the creditor, a greater amount than it would have received in relation to the debt in a winding up of the company.

Pursuant to section 588FA(3) of the Act, a liquidator’s unfair preference claim can be defended or limited on the basis that the transactions are not voidable as they formed an integral part of a continuing business relationship between the company in liquidation and the creditor (often referred to as the “running account defence”).

In Badenoch v Bryant the Full Court considered the notion of a “continuing business relationship” in detail.

Badenoch v Bryant

Background

The liquidators of Gunns Group (Gunns) brought an unfair preference claim under section 588FA of the Act against Badenoch Integrated Logging Pty Ltd (Badenoch).[1]

In the six months prior to the appointment of liquidators in September 2012 (being the “relation back period” under the Act), Gunns made a series of payments to Badenoch which the liquidators alleged to be insolvent transactions and voidable under section 588FE of the Act, on the basis that they were made after the date of Gunns’ insolvency.

At first instance, the Federal Court upheld the operation of the peak indebtedness rule in Australia.

The Full Court decision

On appeal, the Full Court held that the peak indebtedness rule is inconsistent with the language of section 588FA(3), and rather than choosing the peak indebtedness, the liquidator is required to take into account the whole of the continuing business relationship. The Full Court was persuaded by the New Zealand Court of Appeal reasoning in Timberworld Ltd v Levin (2015) 3 NZLR 365 concerning the equivalent New Zealand statutory provision to section 588FA(3) of the Act, that the plain wording in the Act requires “all of the transactions” within a continuing business relationship to be taken into account as if they together constituted a single transaction.

Continuing Business Relationship

Usefully, the Full Court provided a summary of the factors indicating a continuing business relationship (and therefore where section 588FA(3) should apply), including:

• There must be a mutual understanding that there is a continuing business relationship;
• Whether or not each payment made in connection to further supply? If so,
  • Was the payment made to discharge past indebtedness or to induce further supply, or both?
  • Notably, the Full Court held the view that even if the payment is made for the predominant purpose of discharging past indebtedness, it does not mean that there has been a cessation of the on continuing business relationship;
• A stop on account will not necessarily cease the continuing business relationship and the parties must assess the totality of the circumstances;
• Knowledge or suspicion of insolvency does not automatically stop the continuing business relationship.
• Importantly, it is critical that the ongoing business relationship is genuine and the overall effect of the relationship must be assessed to consider if there has been a net disadvantage to the insolvent company.

Implications

The decision in Badenoch v Bryant will significantly reduce the value of potential preference claims made by liquidators. The Full Court acknowledged that the absence of the peak indebtedness rule may deter liquidators from pursuing preferences “as the amount likely to be recovered may not justify the time and expense involved”,[2] particularly if a liquidator does not have access to creditor or third-party litigation funding support.

The decision may be favourable for individual creditors who receive unfair preference as part of a continuing business relationship. However, the absence of the rule is likely to result in a lower recovery of preference payments by liquidators and, in turn, return to the general body of creditors. 

Need help?

For more information on how we can help you in your insolvency legal enquiries or for further questions, please contact our Insolvency team.

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

[2] Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64, the Full Court (Middleton, Charlesworth and Jackson JJ) at para 121.