High Court abolishes the Peak Indebtedness Rule in Bryant & Ors v Badenoch Logging Pty Ltd [2023] HCA 2

ABSTRACT

In the highly anticipated decision of Bryant & Ors v Badenoch Logging Pty Ltd [2023] HCA 2 (Bryant), the High Court of Australia confirmed that the “peak indebtedness rule” has now been abolished and the decision provides long awaited clarity to the interpretation of the unfair preferences regime in the context of continuing business relationships.

In Bryant, the High Court examined the operation of s 588FA(3) of the Corporations Act 2001 (Cth) (Act) and affirmed the Full Federal Court’s finding that the continuing business relationship defence to unfair preferences claims does not incorporate the peak indebtedness rule. The High Court’s decision provides additional guidance as to what constitutes a continuing business relationship, and which transactions form part of the defence. Therefore, Bryant has important implications for liquidators, creditors and companies, as it will reduce the value of unfair preferences claims and potentially disincentivise them from being pursued by liquidators altogether.

UNFAIR PREFERNECES – THE LEGISLATIVE FRAMEWORK

Where a company has gone into liquidation, a liquidator may apply to the Court to set aside certain payments to creditors of the company as “void” under s 588FE of the Act. If the court makes such an order, the creditor is generally required to repay money or hand back property, which increases the pool of assets for general distribution among creditors.

A transaction is voidable under ss 588FE(2) and 588FC if:

• it was entered into while the company was insolvent, or if the company becomes insolvent because of the transaction; and
• it was entered into:
  • within 6 months before the date the liquidation commenced or is deemed to have commenced (relation-back period). The date the liquidation commences is called the relation-back day; or
  • after the relation-back day, but before the day the winding up actually began.

The relevant type of voidable transaction in Bryant was an “unfair preference”. Under s 588FA of the Act, an unfair preference is a transaction that results in the creditor receiving from the company, in respect of an unsecured debt, more than the creditor would receive in a liquidation.

A creditor can defend an unfair preference claim by relying on the “continuing business relationship” defence, also known as the “running account principle”. Under s 588FA(3) of the Act, the defence applies to transactions between a company and a creditor that: (1) form an integral part of a “continuing business relationship”, such as a running account; and (2) result in the company’s net indebtedness to the creditor during the relationship to increase and reduce over time. In such circumstances, the multiple transactions constitute one single transaction for the assessment of an unfair preference, which is based on the mutual assumption that payments are made to induce ongoing supply rather than to solely discharge existing indebtedness. The purpose of this principle is to recognise that creditors who supply a company on a running account in circumstances of potential or suspected insolvency, enables the company to continue to trade to the benefit of all creditors.

PEAK INDEBTEDNESS RULE

Before Bryant, there were two alternate tests for assessing the preferential effect of an insolvent transaction in a continuing business relationship: (1) the peak indebtedness rule; and (2) the doctrine of ultimate effect. The peak indebtedness rule originated from case law and entitled a liquidator to choose the highest point of indebtedness to the creditor during the relation-back period as the starting point, rather than the balance at the start of the relation-back period. In doing so, the rule allowed liquidators to maximise the likeliness of ascertaining an unfair preference and its quantum, which in turn increases the pool of assets for general distribution among creditors.

On the other hand, the doctrine of ultimate effect provides that if the payment results in the company being in a better asset position and receiving a greater benefit than the value of the payment, the ultimate effect has not been to decrease the net value of the company’s assets. Importantly, the tests can result in materially different outcomes including whether or not there was an unfair preference. Therefore, liquidators have benefitted from the court’s continued application and approval of the peak indebtedness rule since 1996.[1]

LITIGATION BACKGROUND

The unfair preferences regime under s 588FA of the Act has been the subject of considerable commentary since its enactment, involving questions as to whether it was intended to alter the previous regime, the uncertainty as to whether the “ultimate effect doctrine” or the “peak indebtedness rule” is the appropriate test, and the resultant inconsistent case law that arose in this area. For many years, it was assumed that s 588FA(3) incorporated both the running account principle and the peak indebtedness rule.

However, the High Court’s decision in Bryant provides long-awaited high court authority and clarification as to the appropriate interpretation of s 588FA by confirming the peak indebtedness rule has now been abolished, and that the provision instead embodies the ultimate effect doctrine, which is the appropriate test for assessing the preferential effect in a continuing business relationship.

Facts

In 2003, Gunns Limited (Gunns) entered into an agreement for with Badenoch Integrated Logging Pty Ltd (Badenoch) for Badenoch to supply timber to Gunns, which continued for 10 years. Gunns experienced significant declines in revenue from 2010 onwards. Despite Gunns’ financial difficulties and frequently making late or only partial payments, Badenoch continued to provide services to Gunns. In August 2012, the parties agreed to terminate the agreement on the basis that Badenoch would continue to supply some services for a further short period to enable another contractor to get up to speed. While Badenoch was continuing to supply some services, Gunns appointed liquidators on 25 September 2012 (relation-back day), therefore, the relation-back period was from 25 March 2012 to 25 September 2012. Further, it was agreed that that the parties’ continuing business relationship ended by 30 June 2012.

Federal Court of Australia

In 2020, the liquidators of Gunns (liquidators) applied to the Federal Court of Australia to have a series of payments made by Gunns to Badenoch from the date of insolvency (30 March 2012) to the relation-back day, declared as voidable transactions. The liquidators contended that if there was a continuing relationship between the parties, they were entitled by the peak indebtedness rule to choose the starting date within the relation-back period to prove the existence of an unfair preference. As such, the liquidators chose the date of 31 May 2012, when Gunns’ indebtedness to Badenoch peaked at $1,416,563.31. The indebtedness decreased to $1,365,321.02 by 30 June 2012, and the $51,242.29 difference was claimed to be the unfair preference.

Consistent with previous case law, the primary judge held that the peak indebtedness rule continued to apply and that the liquidators were entitled to choose the date of peak indebtedness as the starting point. The primary judge also held that payments do not form part of a continuing business relationship if they were made towards existing debts, and not for the continued provision of services. Therefore, only 2 out of the 11 payments were found to form part of the running account, with the remainder being excluded as they were payments towards old debts.

Full Court of the Federal Court of Australia

In 2021, Badenoch and the liquidators both appealed to the Full Court of the Federal Court (Full Court). Badenoch argued that the primary judge erred in applying the peak indebtedness rule, and that all 11 payments should have formed part of the running account. On the other hand, the liquidators argued that the primary judge erred in finding that the 2 payments were part of the running account. The Full Court held for the first time that the peak indebtedness rule is inconsistent with s 588FA(3) on the basis that there was no legislative intention to adopt the rule when introducing this provision, and that there is nothing in the plain language of the statute which suggests the rule applies. Instead, the Full Court endorsed the reasoning of Airservices[2] and held that the doctrine of ultimate effect is the correct test for unfair preferences.

The Full Court also held that if a payment is made to induce the continued provision of goods or services and to discharge an existing debt, it will not be an unfair preference unless the payment exceeds the value of the goods or services. As such, the Full Court found that the first 4 payments formed part of the continuing business relationship, which was an additional 2 payments than the primary judge found. The remaining 7 payments did not form part of the relationship because they were made after the mutual assumption of a continuing relationship had ceased.

High Court of Australia

The liquidators appealed to the High Court, and Badenoch cross-appealed. The High Court unanimously dismissed the appeal and cross-appeal, upheld the decision of the Full Court, and ordered that the parties each pay the other’s costs of the proceedings. Badenoch was granted special leave to appeal the High Court’s decision regarding whether certain payments formed an integral part of the continuing business relationship.

The appeal raised three questions about the operation of s 588FA(3): (1) does the peak indebtedness rule apply; (2) how do courts determine whether a transaction is, for commercial purposes, an integral part of a continuing business relationship; and (3) whether the payments made by Gunns to Badenoch were, for commercial purposes, an integral part of a continuing business relationship?

Does the peak indebtedness rule apply?

The High Court confirmed the Full Court’s rejection of the peak indebtedness rule and stated that although “there is no doubt that s 588FA(3) is a statutory embodiment of the ‘running account principle’, the same conclusion cannot be drawn from the statutory context in respect of the ‘peak indebtedness rule’” as there was no legislative intention to incorporate the rule within this provision. Instead, the provision embodies the ultimate effect doctrine, which cannot be reconciled with the peak indebtedness rule. The High Court further stated the previous cases which approved the peak indebtedness rule wrongly assumed that the running account principle included the peak indebtedness rule, did not involve full argument on or reasoning about the issue, or must now be considered to be wrong in that respect.

Therefore, liquidators are not entitled to choose the highest point of indebtedness as the starting point to maximise the likelihood of ascertaining an unfair preference and its quantum. Rather, the first transaction that can form part of the continuing business relationship is either: (1) the first transaction after the beginning of the relation-back period; (2) after the date of insolvency; or (3) if the relationship started after the beginning of the relation-back period, the first transaction of the continuing business relationship – whichever is the later. In this case, the High Court concluded that the starting point in the relationship between Gunns and Badenoch in accordance with s 588FA(3) of the Act was 30 March 2012.

Is a transaction an integral part of a continuing business relationship?

The High Court clarified that this question involves an objective factual assessment of the “business character” of the relevant transactions and whether they can be treated as an integral part of the continuing business relationship, or “as so unconnected from the subsequent debits to the account to enable treating them as having produced an immediate effect to be considered independently of what followed”. The High Court warned against relying on judges’ reasonings from previous cases concerning different facts, as “to do so would be to substitute words of judicial explanation for the language of the statute”.

Therefore, it is necessary to consider the whole of the evidence of the actual business relationship between the parties, and the intention of the parties may be relevant but not determinative of this statutory question. The High Court gave the example that if, on the whole of the evidence, the objectively inferred character of the payment was to reduce past indebtedness only and not to induce the continuation of supply, the transaction would be characterised as an unfair preference.

Were the relevant transactions part of a continuing business relationship?

The High Court upheld the Full Court’s finding that the first 4 out of 11 transactions formed part of the continuing business relationship between the parties, and that the remaining 7 transactions did not as the relationship had ceased before they were entered into.

COMMENT

The High Court’s rejection of the peak indebtedness rule in Bryant is a significant departure from the previous case law’s interpretation of the unfair preferences regime, which was once considered settled law in Australia. The decision will come as a disappointment to liquidators, as they can no longer arbitrarily choose a date within the relation-back period so as to maximise their claims against a creditor for unfair preferences.

Understandably, the decision will benefit creditors as it is easier for them to defend unfair preferences claims by arguing that any payments they received from a debtor company during the relation-back period formed an integral part of their continuing business relationship. Notably, this is the opposite outcome to Metal Manufacturers v Morton, which was good news for liquidators and bad news for creditors.

Nevertheless, the decision in Bryant benefits both liquidators and creditors in that it clarifies that the doctrine of ultimate effect is the correct test for assessing unfair preferences claims, which had been subject to debate and uncertainty for years. In addition, the decision beneficially provides guidance as to what constitutes an “integral part” of a continuing business relationship. Further, the abolishment of the peak indebtedness rule will incentivise creditors to continue trading with distressed companies, which not only benefits the company but the general creditors as a whole.

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

[2] Airservices Australia v Ferrier (1996) 185 CLR 483.