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Corporations Law Noticeboard July 2021 – Full Federal Court rules that “peak indebtedness” rule is history

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In Badenoch Integrated Logging Pty Ltd v Bryant [2021] FCAFC 64, the Full Court of the Federal Court of Australia (Middleton, Charlesworth and Jackson JJ) effectively put paid to the peak indebtedness rule, which had been used to enable a liquidator to choose the time of an insolvent company’s peak indebtedness to maximise claims for preference payments to creditors, rather than the commencement of the unfair preference recovery period.

Section 588FA of the Corporations Act 2001 (Cth) determines whether a transaction by an insolvent company is an unfair preference. Some commercial transactions that would otherwise be preferential are exempt under s 588FA(3) if they form part of a continuing business relationship or running account.

The Badenoch decision arises from unfair preference claims brought by the liquidators of the Gunns Group of companies. Badenoch Integrated Logging Pty Ltd, a timber harvesting and haulage contractor, was a creditor of Gunns.

The Gunns liquidators sought to recover potential unfair preference payments made by Gunns to its creditors while it was insolvent, resulting in the judgments in Bryant v Badenoch Integrated Logging Pty Ltd [2020] FCA 713 (which was appealed to the Full Court of the Federal Court), Bryant v Bluewood Industries Pty Ltd [2020] FCA 714 and Bryant v Edenborn Pty Ltd [2020] FCA 715. In those judgments, Davies J accepted that the liquidators were entitled to use the time of peak indebtedness as the starting point from which to ascertain the amount of preferences that they could claw back from each of the creditors. As a result, a series of payments totalling $3.36 million over and above what Badenoch would have received in the winding up were received by Badenoch while Gunns was insolvent.

However, Badenoch appealed arguing that all 11 payments should have been found to form the running account and that the peak indebtedness rule should not have applied. The Full Federal Court found that the Explanatory Memorandum to the Corporate Law Reform Act 1992 (Cth), which introduced s 588FA(3), indicated that Parliament intended to allow creditors the benefit of earlier dealings in a continuing business relationship when determining if there had been an unfair preference (thus ousting the peak indebtedness rule).

The Court held that s 588FA(3) embodies the doctrine of “ultimate effect” which recognises that the general body of creditors should not be disadvantaged by payments made to induce trade creditors to supply goods of equal or greater value.

Before this decision, a liquidator could isolate “peak indebtedness” under a running account to accentuate the extent of an unfair preference where, for instance, there had been a sharp decline in the state of the running account resulting from significant payments despite there being a continuing business relationship.

The Full Federal Court found that s 588FA(3)(c) excluded the application of the peak indebtedness rule, which could be traced by to Rees v Bank of New South Wales (1964) 111 CLR 210. The Court found that the abolition of the peak indebtedness rule is consistent with the purpose of Pt 5.7B of the Act which is to do fairness between unsecured creditors.

The judgment also brings Australian case law into line with that in New Zealand which abolished the peak indebtedness rule in Timberworld Ltd v Levin [2015] 3 NZLR 365.

With the abolition of the peak indebtedness rule, liquidators seeking to recover unfair preference payments where a running account or a continuing business relationship exists, must now determine the preferential effect of mutual dealings from the start of the unfair preference avoidance period until liquidation.  The reduction in the state of the account will be the amount of any unfair preference recovery (subject to defences the creditor may invoke under s 588FG(2)).  However, if the running account or continuing business relationship ceases, individual payments may not be protected by s 588FA(3).

Section 588FA is in Part 5.7B (Recovering property or compensation for the benefit of creditors of insolvent company) of Chapter 5 (External administration) of the Corporations Act. Matthew Broderick, Partner, HWL Ebsworth has revised annotations to Part 5.7B in Robson’s Annotated Corporations Legislation. They will be published in July 2021.

The Badenoch appeal judgment will also be discussed in a forthcoming update of Company Receivers and Administrators by Professor James O’Donovan, University of Western Australia.

By Nick Jewlachow
Senior Content Manager, Analytical Law

Nick has over 20 years’ worth of experience in publishing, commissioning and editing experts’ contributions on corporate and tax law in Australia.

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