In a significant decision delivered on 10 May 2021, in which JWS acts for the plaintiff liquidators of the Gunns Group, the Full Federal Court in Badenoch v Bryant has declined to follow over five decades of case law in holding that the peak indebtedness rule does not apply in Australia. The decision, if it stands, will have a serious impact on the quantum of future preference claims in the context of transactions as part of a running account.
The decision also raises doubt as to the proper test for determining when payments will form part of a continuing business relationship.
The rule of peak indebtedness allows a liquidator to calculate the value of a preference claim by subtracting the debt due to the creditor on the relation-back day from the debt due to the creditor at the highest point of indebtedness in the running account during the relation-back period. The rule has its genesis in the decision of Barwick CJ in Rees v Bank of New South Wales and has since been held to apply in the context of s588FA(3) by a number of superior and appellate courts in Australia.
The Full Court declined to follow these authorities and held that they were wrongly decided on the basis that:
- Contrary to the reasoning in Olifent v Australian Wine Industries, there was no legislative intention to adopt the peak indebtedness rule formulated in Rees when introducing s588FA(3) into the Corporations Law. In this regard, the Court engaged in an analysis of the Explanatory Memorandum to the Bill introducing the section and the authorities cited therein.
- The peak indebtedness rule cannot be reconciled with the doctrine of ultimate effect, which recognises that the general body of creditors are not disadvantaged by payments made to induce creditors to supply goods of equal or greater value.
- The abolition of the peak indebtedness rule is consistent with Part 5.7B’s purpose to do fairness between unsecured creditors. To that end, the Court noted that while this new approach may cause unfairness, that unfairness is a foreseeable consequence of the statutory regime.
While the Full Court denied that the liquidator could choose the date when the single transaction for the purposes of s588FA(3)(c) begins, the judgment does not identify clearly what the relevant date should be. Implicitly, the Court might be seen as accepting Badenoch’s submission that the relevant date must be either the relation-back day or the commencement of the continuing business relationship.
If that is the case, in circumstances where the start date is the commencement of the continuing business relationship, the balance of starting indebtedness will always be zero (or alternatively, the quantum of the first supply of credit on that date). As was noted in Olifent, such an approach effectively rules out most preference claims involving a running account.
Indeed, such an approach will, as the Full Court acknowledges, lead to a decrease in the number of preference claims pursued and ultimately the return to creditors.
The judgment also does not provide clarity for liquidators where a continuing business relationship exists for the whole six month relation back period, but the company is only insolvent for part of the relation back period, for example, the final three months. It is not clear in that scenario whether the liquidator will be able to prove that the company was insolvent at the time of the single transaction calculated pursuant to s588FA(3).
Continuing business relationship
Another significant aspect of the decision is the Court’s approach to determining when payments will form part of a continuing business relationship. Previously, it had been thought that there will be no mutual assumption of a continuing business relationship where the purpose of inducing further supply is ‘subordinated to a predominant purpose of recovering past indebtedness’.
The Full Court noted that this approach should be treated with some caution and instead, at least on the face of the judgment, prefers a sole purpose test. That is, a payment will not be made as part of a continuing business relationship in circumstances where the payment’s sole purpose is to discharge past indebtedness.
On one view, the Court’s reasoning means that provided that an ongoing supply of goods or services is not a ‘façade’ and the creditor genuinely intends to continue a business relationship with the company, the fact that the creditor’s primary motive in receiving payments was to get outstanding bills paid will not be sufficient to break the continuing business relationship. Instead, it will be necessary to examine the relationship between the payments, the subsequent supply of services to the company and the ultimate effect of the parties’ dealings in order to determine whether the payment gave the creditor a preference.
This represents a significant shift in the current approach to considering the existence of a continuing business relationship and leaves some doubt as to the circumstances in which a continuing business relationship will (or will not) be found to have ceased.
The Full Court’s decision is significant in its dramatic departure from more than five decades of accepted legal principle, a departure which will have profound implications for the ongoing viability of a large number of preference claims.
Accordingly, there will undoubtedly be significant public interest in a further appeal to the High Court, to which the plaintiff liquidators are presently giving active consideration.