The Abolishment of the Peak Indebtedness Rule

On 10 May 2021, in a historical Australian decision, the Full Federal Court handed down a decision which abolished the peak indebtedness rule and found that a liquidator cannot apply the peak indebtedness rule in unfair preference claims involving running accounts.

The Full Court held that if there is a continuing business relationship involving multiple transactions from a company to a creditor (during the relation back period), in assessing whether the transactions (considered a single transaction) are preferential, a liquidator cannot select the highest point of indebtedness in that period. Ultimately, a liquidator must take into account all supplies provided by a company to the creditor, and all payments made by the creditor to the company during the relation-back period. This follows the Timberworld Ltd v Levin decision made in the New Zealand Court of Appeal in 2015 which also abolished the long-standing rule.[1]

Continuing business relationship

Pursuant to section 588FA of the Corporations Act 2001 (Cth) (the Act), an unfair preference is a transaction to which a company and the creditor/s are parties and which results in the creditor receiving in respect of the debt that the company owes to the creditor, more than the creditor would receive in respect of that debt if the transaction had been set aside and the creditor had to prove for the debt in the winding up of the company.

Section 588FA (3) of the Act treats a series of transactions entered into during the relation-back period as part of a continuous business relationship, as a “single transaction”.

Pursuant to the section:

a transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company (including such a relationship to which other persons are parties); and

in the course of the relationship, the level of the company‘s net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship;

then: all the transactions forming part of the relationship [must be considered together] as if they together constituted a single transaction.

Put simply; in determining whether there is an unfair preference pursuant to section 588FA(3) of the Act, the “single transaction” will be considered a preference if the payments made by the company to the creditor ultimately exceed the value of the goods or services it received, in a way that the payments caused a reduction in the balance of the running account.[2]

What is the peak indebtedness rule?

Traditionally, the peak indebtedness rule enables the liquidator to choose the “highest point” of indebtedness in the running account during the relation-back period as the point at which the net reduction indebtedness is to be measured. Ultimately, the liquidator can calculate the value of the preference by subtracting the debt owing to the creditor from the debt owing at the point of “peak indebtedness”.

The peak indebtedness rule first came about in the decision of Barwick CJ in Rees v Bank of New South Wales, where his Honour said:

“In my opinion the liquidator can choose any point during the statutory period [i.e. the 6 month relation-back period] in his endeavour to show that from that point on there was a preferential payment and I see no reason why he should not choose, as he did here, the point of peak indebtedness of the account during the six months period.”[3]

Background to the first Gunns Decision

Gunns Limited (Gunns) was placed into liquidation in 2013 at which time, it owed over $780 million to creditors. The liquidators of Gunns commenced various proceedings against creditors, including Badenoch Integrated Logging Pty Ltd (Badenoch). The liquidators claimed that 11 payments made by Gunns to Badenoch during the relation-back period were insolvent transactions and voidable under the Act. It was submitted by the liquidators that the peak indebtedness rule was the correct starting point to determine the quantum of the preferences.

Davies J held that the peak indebtedness rule was consistent with earlier authorities and that Badenoch was to repay over $2 million of the payments received from Gunns in the relation-back period.

Appeal of the Gunns Decision

An appeal was lodged on the basis that that the 11 payments should have been found to form part of the running account and the trial judge erred in applying the peak indebtedness rule.

The main issues to be considered were:

whether any of the payments were part of a ‘continuing business relationship’ within the meaning of section 588FA(3) of the Act; and

whether the liquidators were entitled to apply the peak indebtedness rule by choosing any point of the Gunns’ indebtedness within the relation-back period as the starting point for the single transaction.

The Full Court held that the peak indebtedness rule ought to be abolished and that it did not apply under the Act. The Court found that creditors should be provided with the benefit of earlier dealings with the continuing business relationship to be considered in determining whether or not an unfair preference exists.

Further, the Court found that section 588FA(3) should be applied so that a running account is taken as a “single transaction” encompassing “all transactions forming part of the relationship”.[4]

Takeaway

It goes without saying this decision will have a significant impact on liquidators and unsecured creditors moving forward.

Some argue that the abolishment of the peak indebtedness rule will ensure fairness between unsecured creditors, which is one of the main focuses of Part 5.7B of the Act. Further, the decision is likely to be viewed unfavourably by liquidators as the quantum of preferences recoverable in running account relationships is likely to be significantly limited.

How we can help you

At JHK Legal we regularly act for administrators, liquidators, and recipients of unfair preference payments. If you require any advice or assistance in relation to voidable transactions, or any other insolvency matters, please do not hesitate to contact us.

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Written by, Anna Hendriks, Associate

[1] (2015) 3 NZLR 365 (Timberworld)

[2] Airservices Australia v Ferrier (1996) 185 CLR 483, 501-2 per Dawson, Gaudron and McHugh JJ and Bryant, in the matter of Gunns Ltd (In Liq) (Recs and Mgrs Apptd) v Edenborn Pty Ltd (2020) 381 ALR 190 at 233 [171] per Davies J.

[3] [1964] HCA 47.

[4] Badenoch [2021] FCAFC 64 at [82] and [112] per Middleton, Charlesworth and Jackson JJ) quoting Timberworld [2015] 3 NZLR 365 at [68].