Back on Top: Australian Court Affirms the "Peak Indebtedness Rule" in Unfair Preference Claims
The Situation: When determining and quantifying unfair preference claims in Australia, does the Corporations Act permit liquidators to value transactions forming part of a single "continuous business relationship" (such as a running account) from the point of peak indebtedness, even if doing so disregards earlier transactions that might act to reduce the value of the claim against the creditor?
The Result: Notwithstanding recent New Zealand authority that held the "peak indebtedness rule" is not permitted under similar legislation, the Federal Court of Australia affirmed that in cases of continuous business relationships, it is open for liquidators to pick the highest point of indebtedness as the beginning of the "transaction" in order to maximise recovery from a creditor.
Looking Ahead: The Federal Court has put to rest the growing suggestion that creditors could rely on the developments in New Zealand when defending unfair preference claims. While other defenses may be available, it will remain difficult to establish a "running account" defense on that basis that the value of goods and/or services provided as part of a continuous business relationship exceeds the value of payments received in return.
After the Gunns Group ("Gunns") went into liquidation in 2013, the liquidators commenced proceedings against various creditors alleging unfair preferences had been made to them after the date Gunns became insolvent.
The Federal Court recently handed down separate judgments against three of these creditors, finding that payments made to each of them were voidable as insolvent transactions. In doing so, the Court affirmed the continued role of the "peak indebtedness rule" contrary to recent suggestions in the industry that it no longer applied.
The liquidators of Gunns brought unfair preference claims under section 588FA of the Corporations Act 2001 (Cth) ("Corporations Act") against the following defendants:
- Badenoch Integrated Logging Pty Ltd (see Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd  FCA 713);
- Bluewood Industries Pty Ltd (see Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Bluewood Industries Pty Ltd  FCA 714); and
- Edenborn Pty Ltd (see Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Edenborn Pty Ltd  FCA 715).
Each of the defendants were timber-harvesting and haulage contractors. In the six months prior to the appointment of liquidators in September 2012 (being the "relation back period" under the Corporations Act), Gunns made a series of payments to each of the defendants valued at roughly $3.6 million, $1.3 million and $2.5 million respectively.
In a previous judgment, Gunns was found to have been insolvent on and from 30 March 2012. Therefore, the impugned payments constituted insolvent transactions. The primary issue before the Court was whether these payments amounted to unfair preferences.
In all three cases, the Federal Court held that the impugned payments were unfair preferences as they resulted in the defendants receiving more than they would have, had they proved their unsecured debts in the winding up.
Relevant to each of the claims was whether the "running account" defense applied. Section 588FA(3) of the Corporations Act provides that where there are multiple transactions forming a "continuing business relationship" and payments are made in the course of this relationship to ensure the ongoing supply of goods and/or services (rather than to discharge any particular past debt), then these forward-looking payments are to be treated as a single transaction when determining whether there has been an unfair preference.
The running account defense operates by aggregating the value of the various payments comprising the single transaction. This is compared with the aggregate value of all goods and/or services provided by the creditor over the same period. The value of an unfair preference, if any, is the amount by which the payments exceed the value of the goods and/or services provided. In other words, to constitute a preference, the ultimate effect of the payments must result in an overall reduction in the company's net indebtedness.
In each decision, the Federal Court held that some or all of the impugned payments were made under a continuing business relationship. Further, in each case, the unfair preference claim was made out as the value of the payments exceeded the value of the goods and/or services received.
In quantifying these unfair preferences, the liquidators relied on the "peak indebtedness" rule, which allows a liquidator to choose the highest point of indebtedness in the running account during the relation back period as the point from which the net reduction in indebtedness is to be measured. For example, in the claim against Bluewood Industries Pty Ltd ("Bluewood"), the liquidators sought to value the unfair preference from 15 May 2012, the date on which Gunns' indebtedness was at its highest ($989,800.30) notwithstanding that the continuous business relationship (for the purpose of the relation back period) actually commenced on 26 March 2012. At the conclusion of the continuous business relationship on 25 September 2012 (the date the liquidators were appointed), Gunns owed Bluewood $211,499.69. The value of the unfair preference was the overall reduction in indebtedness, being $778,355.61.
While in practice, the peak indebtedness rule is often a key factor in making unfair preference proceedings commercially worthwhile for liquidators, the rule has been questioned as logically unsound. The rule often operates against creditors who would prefer to use an earlier date as the starting point of the comparison so that any subsequent reductions in indebtedness are offset by earlier transactions by which the creditor may have supplied net value to the debtor company.
Using the Bluewood example, if the net reduction in indebtedness was instead measured from the commencement of the single transaction comprising the continuous business relationship ($494,247.32 on 26 March 2012), the unfair preference is only $282.797.68. This reduction is because during the period leading up to the point of peak indebtedness, the value of the goods and/or services provided to Gunns exceeded the value of any payments Bluewood received.
Questions have also been raised as to the continued application of the rule as a matter of law. Although it is an established principle in common law, there has been debate as to whether the codification of the running account defense in section 588FA(3) excluded the peak indebtedness rule.
Each of the defendants touched on these issues and submitted that the peak indebtedness rule was inconsistent with the provisions of section 588FA and should no longer apply. In doing so, the defendants relied on the New Zealand Court of Appeal decision in Timberworld v Levin  3 NZLR 365 ("Timberworld"), in which it was held that the peak indebtedness rule did not apply to a materially identical provision of New Zealand's corporations legislation.
In Timberworld, the Court of Appeal unanimously held that selecting an artificial point during the course of the continuing business relationship, and disregarding any transactions that came before it, ignored the express wording of the legislation that all transactions forming part of the relationship be treated as a single transaction. Provided they occur within the relation back period, "the effect of the section, taken on its face, is to require all payments and transactions within the continuing business relationship to be netted off against one another … The statutory wording does not permit a liquidator to disregard some of those transactions".
The recent judgments of the Federal Court of Australia provided the first occasion in which an Australian Court was able to consider the persuasiveness of Timberworld with respect to section 588FA(3).
In affirming the operation of the peak indebtedness rule in Australia, the Federal Court was unpersuaded by the approach taken in New Zealand. After considering the explanatory memorandum that proposed section 588FA(3), the Federal Court concluded that the legislature had not sought to alter, but merely embody in statute, the existing common law principles as they relate to preferences, including the peak indebtedness rule. The Court held there was no reason or justification to disturb the clear weight of authority that the current provisions of the Corporations Act in relation to unfair preferences were not intended to substantively change the law.
It remains to be seen whether these recent judgments will finally answer whether the peak indebtedness rule continues to apply. Although the Federal Court was guided by precedent, it can be said that the criticisms of the doctrine made in Timberland have not yet been conclusively addressed.
Three Key Takeaways
- In Australia, the peak indebtedness rule has been held to apply for unfair preference claims under section 588FA(3) of the Corporations Act. This differs from the position in New Zealand.
- Where a liquidator can demonstrate that multiple impugned payments formed part of a continuous business relationship and those payments were made to ensure an ongoing supply of goods and/or services, these payments are to be treated as a single transaction. A creditor may then enliven the running account defense (potentially in addition to good faith and set-off defenses).
- Generally, the circumstances in which the running account defense applies will be limited. It is necessary to establish that the value of goods and/or services provided exceed the value of payments received in return, measured from the point of time at which the insolvent company's indebtedness was highest against the creditor.