After a Peak Comes the Fall: Australian Federal Court Rejects "Peak Indebtedness Rule"

In Short

The Situation: The Full Court of the Federal Court has changed industry practice in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 by holding that the "peak indebtedness rule" is not available to liquidators when assessing the value of running accounts in unfair preference claims. 

The Development: The Full Court has clarified the application of the peak indebtedness rule by focussing attention on the language of the Corporations Act 2001 (Cth) ("Corporations Act"). Any preference made as part of a "continuous business relationship" must be valued as the difference in the amount owing to a creditor at the beginning and end of the ongoing relationship. This is in contrast with the previously accepted approach, where liquidators could choose the point of highest indebtedness as the relevant starting point. 

Looking Ahead: Subject to any future consideration of the issue by the High Court of Australia, the peak indebtedness rule can be considered to be abolished for the purposes of unfair preference claims. As a result, liquidators are less likely to pursue unfair preference claims where a running account defence may apply as the potential recovery will be diminished. The decision may also give creditors more confidence in continuing business relationships with debtors in potential distress given there is now greater certainty in the application of the running account defence.

A Refresher: Running Account Defence and Peak Indebtedness Rule

The Full Court's decision was an appeal from a first instance judgment, in which the liquidators for Gunns Limited ("Gunns") successfully argued that 11 payments made to Badenoch Integrated Logging Pty Ltd ("Badenoch") after Gunns' insolvency were recoverable as unfair preferences. 

In our previous Commentary on the first instance decision, "Australian Court Affirms Peak Indebtedness Rule", we discussed the operation of Part 5.7B of the Corporations Act, which prescribes that liquidators may commence an action to set aside and recover unfair preferences made to creditors during the six-month "relation-back period" from the date of liquidation. 

A key means of rebutting an unfair preference claim is the "running account defence", which is set out in section 588FA(3) of the Corporations Act. The defence arises when multiple individual transactions form "an integral part of a continuing business relationship". This will occur when the debtor and creditor share a mutual assumption that payments are made to induce ongoing supply rather than solely discharge existing indebtedness. 

Where there is a continuing business relationship that overlaps with the relation back period, individual payments within the period are treated as a single transaction for the purposes of valuing the unfair preference. The defence operates by comparing the aggregated value of the individual payments with the aggregate value of the goods or services supplied as part of the continuing business relationship. The value of the unfair preference, if any, is the amount by which payments exceed the supply value. 

While the running account defence can function as a complete or partial defence to an unfair preference claim, its utility has previously been diminished by the application of the common law "peak indebtedness rule". As opposed to measuring the unfair preference from the date the single transaction commenced in the relation back period, the Courts had permitted liquidators to apply the doctrine to choose the highest point of indebtedness during the continuing business relationship from which the net reduction in indebtedness was measured. 

 The First Instance Decision 

The factual background and findings of the primary judgment are set out in our previous Commentary.  In short, Badenoch successfully raised a running account defence, with the primary judge finding that two impugned payments made between May and June 2012 formed part of a continuous business relationship. 

Notwithstanding submissions by Badenoch that the codification of the running account defence in section 588FA(3) excluded the continued application of the peak indebtedness rule, the primary judge agreed with the liquidators that the rule continued to have force. 

This meant the liquidators were entitled to nominate the peak of Gunns' indebtedness to Badenoch for the two impugned payments. By contrast, if the running account had been measured from the beginning of the continuous business relationship, there would have been no unfair preference. This is because total indebtedness at the end of the relationship exceeded the opening indebtedness, suggesting that Gunns received a net benefit. 

The Appeal 

On appeal, Badenoch claimed (among other things) that the primary judge had erred in finding that:  

  • Only two of the 11 impugned payments formed part of the running account; and 
  • The peak indebtedness rule applied to claims made in respect of section 588FA(3).

In considering the scope of the running account defence, the Full Court disagreed with the primary judge's finding that two payments made in March 2012 had not formed part of the continuous business relationship. The primary judge reached this conclusion after considering evidence that the mutual assumption of continuing supply had been subordinated after Badenoch implemented a 10‑day "supply stop" and negotiated a repayment plan. 

The Full Court disagreed with this reasoning and advised caution towards earlier authorities that suggested there could be no continuous business relationship where the purpose of inducing further supply is "subordinated to a predominant purpose of recovering past indebtedness". While the measures adopted by Badenoch were designed to encourage Gunns to pay existing debts, they were still ultimately directed towards allowing future supplies to continue. 

Turning to the application of the peak indebtedness rule, the Full Court agreed with Badenoch that the common law doctrine had no application in the context of the statutory regime established by section 588FA(3). This was because: 

  • The continued application of the rule is not reconcilable with the plain language of section 588FA(3), which requires all transactions forming part of the relationship to be treated as a single transaction. It would be inconsistent for a liquidator to be permitted to choose an arbitrary point in the single transaction and disregard transactions that occurred before it; 
  • Relatedly, the peak indebtedness rule offends the doctrine of "ultimate effect" embodied by section 588FA(3), which requires consideration of the net effect of all payments and supplies that form part of the running account in determining whether a preference is "unfair"; and 
  • The peak indebtedness rule is inconsistent with the broader purpose of Part 5.7B of the Corporations Act, which is to ensure fairness between unsecured creditors. 

Holding that previous Australian decisions applying the peak indebtedness rule had been wrongly decided, the Full Court adopted the approach of the New Zealand Court of Appeal in Timberworld v Levin (2015) 3 NZLR 365, which had abolished the rule in the context of a relevantly identical provision of the New Zealand corporations legislation.

Two Key Takeaways

  1. Where a creditor and debtor share a mutual assumption that payments are made to induce ongoing supply rather than solely discharge existing indebtedness, the running account defence may apply to rebut an unfair preference claim. Even though a creditor's focus may inevitably turn to the payment of existing debt in scenarios involving distressed debtors, the defence will be available so long as there remains a mutual assumption of continuing supply. 
  2. The peak indebtedness rule will no longer apply to the valuation of running accounts. Liquidators will need to take this into account when considering whether to pursue unfair preference claims. While the general pool of creditors in liquidations may find themselves with smaller distributions as a result, defendants to unfair preference claims can be reassured that the doctrine, which has previously attracted criticism as being artificial and logically unsound, has fallen from its perch.
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