TGIF 14 May 2021 – ’Peak indebtedness’ rule abolished: Federal Court allows appeal by Gunns creditor

This week’s TGIF considers the most recent case involving Gunns Limited where the Full Federal Court confirmed that the ‘peak indebtedness’ rule has been abolished in a partial win for Gunns creditor.

Key takeaways 

• The Full Court has held that a liquidator cannot apply the ‘peak indebtedness’ rule in unfair preference claims involving running accounts. Liquidators will no longer be permitted to rely on this rule to maximise the result for creditors in recovering money from trade creditors who received payments for goods and services from the company during the relation-back period.
  
  
• Liquidators must now assess the net result of all dealings between the creditor and company in a continuous business relationship throughout the relation-back period, including both payments made and goods and services received.
  
  
• In assessing whether a creditor and company were in a continuous business relationship, the Court must not take an unduly restrictive approach against creditors who seek to recover past indebtedness in the course of providing further goods and services, and must instead look to the practical relationship between payments made and services rendered.

Gunns Limited (Gunns) was a major forestry enterprise with Australia-wide operations when it was placed into liquidation in March 2013. At the time of its collapse, Gunns owed over $780 million to creditors.

The appellant, Badenoch Integrated Logging Pty Ltd (Badenoch), is a family-owned business that provided logging and transport services to Gunns in South Australia prior to its liquidation. The respondents are the liquidators of Gunns.

The liquidators alleged that 11 payments made by Gunns to Badenoch in the six-month period prior to Gunns’ liquidation in 2012 (relation-back period) are insolvent transactions and voidable under section 588FE of the Corporations Act 2001 (Cth) (the Act).  

Under the Act, the Court may order that monies be paid to a company in liquidation if satisfied that a transaction is a voidable transaction, including because it is an unfair preference given to a creditor.

The primary judge held that Badenoch must repay over $2 million of the payments received from Gunns in the relation-back period in 2012, and rejected that Badenoch had established a good faith defence or that set-off was available under the Act.

On appeal, the key issues included:

• whether any of the impugned payments were part of a ‘continuing business relationship’ within the meaning of section 588FA(3) of the Act, such that the series of transactions forming part of the relationship (including both payments and services rendered) would be considered as a net single transaction in determining whether there had been an unfair preference; and
  
  
• if so, whether the liquidators were entitle to apply the ‘peak indebtedness rule’ and choose any point in time within the relation-back period as the starting point of the single transaction for the purpose of section 588FA(3) of the Act in order to maximise recovery for creditors generally.

Continuing business relationship

Under section 588FB(3) of the Act, where a payment forms an inseparable part of an entire transaction, whether or not it is an unfair preference must be assessed in the context of the parties continuous business relationship.  

If the net result of dealings, including payments made and services rendered, is that the creditor has provided goods or services of a greater value than payments made to it, the creditors are not disadvantaged and there has been no unfair preference.

The Full Court cautioned against adopting an unduly restrictive approach against creditors who seek to recover past indebtedness in the course of continuing dealings. To do so is not consistent with the rationale of the statutory regime, which recognises that payments made by an insolvent company to induce creditors to provide further supply do not cause any disadvantage to creditors generally unless the total payments exceed the total value of goods or services acquired.

On the other hand, the Full Court held that a creditor will not be permitted to hide behind a façade of a continuing business relationship when the true intention is to recover past indebtedness in priority to other unsecured creditors.  

In balancing these countervailing factors, the Court must look at the practical relationship between payments made and the subsequent supply of services.

In a partial win for Badenoch, the Full Court found that several of the earlier payments were made within a continuous business relationship with Gunns. However, as Badenoch was seeking primarily to recover past debts by mid-2012 and not to continue the supply of services, that business relationship was at an end from that point for the purpose of section 588FB(3).

Peak indebtedness rule

It is necessary to identify the beginning and end date of relevant dealings within a continuous business relationship for the purpose of determining the net result of those dealings. The Court acknowledged that, in the context of a commercial relationship that predates a relation-back period, identifying a beginning date presents practical difficulties.

Badenoch submitted that the beginning date must be the relation-back day or later commencement of the continuing business relationship whereas the liquidators submitted that the peak indebtedness rule applies, which allows them to choose any point in time in the continuing business relationship within the relation-back period. This rule allows a liquidator to choose the point of the company’s peak indebtedness to lead to the maximum net result in claiming a preference.

The Full Court examined the statutory context of section 588FA(3) and relevant authorities in concluding that the peak indebtedness rule does not apply under the Act.

Rather, the Full Court held that the Act requires that creditors be given the benefit of all earlier dealings within a continuing business relationship when determining whether there has been an unfair preference. This, the Court commented, is consistent with the stated purpose of Part 5.7B of the Act, which is to do fairness between unsecured creditors.

In reaching this decision, the Full Court found that Olifent v Australian Wine Industries Pty Ltd (1996) 130 FLR 195 and the decisions that followed it were wrongly decided to the extent that they applied the peak indebtedness rule to section 588FA(3) of the Act. In doing so, the Full Court followed the New Zealand Court of Appeal in Timberworld Ltd v Levin (2015) 3 NZLR 365.

Takeaway 

In assessing whether to take steps against creditors of insolvent companies who have received payments from that company, liquidators must carefully assess the entirety of the business dealings between the creditor and the company to identify:

• the nature of their relationship; and
• the practical net outcome of their dealings.  

Liquidators will need to consider whether there is cogent evidence to support that the creditor and company were in a continuous business relationship. If so, and if the creditor has not gained a material benefit over and above the benefit that it has supplied throughout the relation-back period, the creditor may be able to resist an order to pay monies to the company.  

As the Full Court has confirmed that the peak indebtedness rule does not apply, liquidators will no longer be permitted to rely on that rule to maximise the result for creditors generally.