Full Federal Court brings an end to the peak indebtedness rule

18 JULY 2022 BY GEORGINA OVEREND (ORIGINALLY PUBLISHED ON 1 JULY 2021)
 

Snapshot

• A recent judgment of the Full Court has rung the death knell on 50 years of case law applying the peak indebtedness rule.
• The Full Court formed the view that the abolition of the peak indebtedness rule reflected the objective of part 5.7B of the Corporations Act, being fairness among unsecured creditors.
• Subject to any grant of special leave to appeal to the High Court, the decision is expected to have far reaching ramifications and may result in liquidators being less inclined to pursue unfair preference claims.
• On 18 March 2022, the High Court of Australia granted special leave to appeal the Full Court’s decision. A High Court decision on 1) the “peak indebtedness” rule and 2) the test to apply when determining whether a continuing business relationship has ceased is expected later in 2022.

In the landmark decision of Badenoch Integrated Logging P/L v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64, the Full Court of the Federal Court of Australia has rung the death knell on the peak indebtedness rule for unfair preference claims.

At law, where a payment by an insolvent company to a creditor forms part of a broader series of transactions, determining whether it is an unfair preference involves consideration of the whole transaction and whether the payment is integral to the continuation of a business relationship. On the basis that the transaction is integral to the continuation of a business relationship, the peak indebtedness rule previously provided that the amount of any recovery can be ascertained by the difference between the highest point of indebtedness during the relation back period and the level of the debt on the last day of that period.

Background 

In 2015, Bryant, Carson, and Crosbie (‘Liquidators’) in their capacity as joint and several liquidators of Gunns Limited (in liq) (‘Gunns’) and its wholly owned subsidiary, Auspine Ltd (in liq) commenced proceedings against Badenoch Integrated Logging Pty Ltd (‘Badenoch’). The Liquidators alleged a number of payments made by Gunns to Badenoch were unfair preferences pursuant to s 588FA of the Corporations Act 2001 (Cth) (‘Act’), and were therefore voidable pursuant to s 588FE(2).

In May 2020, Justice Davies delivered judgment in favour of the Liquidators, finding the payments were unfair preferences (Bryant, in the matter of Gunns Ltd (in liq) (receivers and managers appointed) v Badenoch Integrated Logging P/L [2020] FCA 713). In determining the claim, Davies J was asked to consider whether s 588FA(3) codified the peak indebtedness rule having regard to the New Zealand Court of Appeal’s decision in Timberworld Ltd v Levin [2015] 3 NZLR 365 (‘Timberworld’).

In Timberworld, the Court relevantly held that s 292(4B) of the Companies Act 1993 (NZ) (substantially the same form as s 588FA) did not entitle the liquidator to apply the peak indebtedness rule in a way that disregarded transactions which formed part of the continuing business relationship. Instead, the plain wording of s 292(4B) required ‘all transactions’ occurring in the relation back period and forming part of the relationship to be treated as amounting to a single transaction.

However, having considered the Court’s reasons in Timberworld, Davies J was not persuaded the peak indebtedness rule no longer applied in Australia following the introduction of part 5.7B of the Act. Her Honour noted (at [108]) the explanatory memorandum to Corporate Law Reform Bill 1992 (Cth) (‘Explanatory Memorandum’) clearly stated the proposed s 588FA(2) (which became s (3)) of part 5.7B ‘is aimed at embodying in legislation the principles reflected in … Queensland Bacon Pty Ltd v Rees (1967) 115 CLR 266 and Petagna Nominees Pty Ltd v A E Ledger 1 (1989) ACSR 547’ (‘Petagna’). In Justice Davies’ view there was no reason to depart from the clear weight of authority that the current provisions of the Act were not intended to substantively change the law with respect to unfair preferences.

The appeal

On appeal, the Full Court overturned the decision of Justice Davies on this issue, finding the peak indebtedness rule does not apply in respect of unfair preference claims under s 588FA.

In construing s 588FA, the Court agreed with the NZ Court of Appeal in Timberworld, to the effect that all transactions within the continuing business relationship must be considered and the ordinary language of s 588FA(3) does not contemplate the liquidator looking at only part of the transactions (at [82]-[83]).

Despite this, the Full Court accepted that a wholly literal interpretation of s 588FA(3) would lead to an absurd result as a running account would often commence with a nil balance so, if the entire relationship was considered together, a preferential payment would rarely occur (at [84]). Accordingly, the Court had regard to Petagna, referred to in the Explanatory Memorandum. In considering Petagna, the Court noted the reference to a liquidator’s freedom to ‘choose any point during the statutory period in his endeavour to show that from that point on there was a preferential payment’ was concerned with the cessation of the continuing business relationship rather than the commencement of it, with the effect that it did not provide support for the peak indebtedness rule (at [101]). The Court found the reference to Petagna supported the conclusion that it was Parliament’s intention to allow creditors to have the benefit of earlier dealings within a continuing business relationship (at [104]).

The Court turned to consider the case of Olifent v Australian Wine Industries P/L (1996) 130 FLR 195, being the only case where the application of the peak indebtedness rule had been expressly considered and applied following the introduction of s 588FA(3). However, in the Court’s view, Olifent and all cases applying it have been wrongly decided for the following reasons:

1. There was no legislative intention to adopt the peak indebtedness rule when introducing part 5.7B (at [112]).
2. Section 588FA(3) embodies the doctrine of ultimate effect, which recognises that the general body of creditors are not disadvantaged by payments made to induce trade creditors to supply goods of equal or greater value. The effect is to set apart certain trade creditors from the general pool of unsecured creditors and provide an incentive to continue trading with companies in financial distress (at [114]). In light of this, the Court was unable to reconcile the doctrine of ultimate effect with the peak indebtedness rule, accepting the NZ Court of Appeal’s comment in Timberworld that the peak indebtedness rule does violence to that principle (at [118]).
3. The abolition of the peak indebtedness rule is consistent with the purpose of part 5.7B which is to do fairness between unsecured creditors (at [119]).

In reaching this conclusion, the Full Court accepted the absence of the peak indebtedness rule may result in unfairness as liquidators may be less inclined to pursue unfair preference claims which in turn may result in a lower return to creditors. However, the Court considered the balance weighs against applying the peak indebtedness rule to unfair preference claims (at [121]).

Looking ahead

The decision is expected to have far reaching ramifications for insolvency practitioners. Certainly, the Court acknowledged the likely reduction in value to unfair preference claims as a result of its decision. Abolition of the peak indebtedness rule may result in liquidators not being able to justify the time and expense involved in pursuing preference claims that might previously have been pursued. It remains to be seen what broader impacts these developments will have on a liquidator’s ability to fund investigations and to pursue other claims for the benefit of creditors.

Before these broader impacts can be considered further, the High Court has granted special leave to appeal the Full Court’s decision. A High Court decision on 1) the “peak indebtedness” rule and 2) the test to apply when determining whether a continuing business relationship has ceased is expected later this year.

Article originally published in the LSJ Online.

Georgina Overend is an Associate at Maurice Blackburn Lawyers, legal advisers to Claims Funding Australia.