Looking back and thinking forward: the insolvency landscape in 2022 and beyond – part two

Part 1 of this two-part series explored potential legislative changes which could impact the Australian insolvency landscape in 2022 and beyond. Part 2 addresses the recent major developments in case law that have the potential to shape the insolvency landscape in Australia for many years to come. While most of these cases await final adjudication by the High Court (Australia’s highest court), they raise complex and nuanced issues with far-reaching implications for insolvency practitioners, creditors, insolvent companies, directors and investors.

Disruption to voidables

In the context of corporate insolvency, Australian law deems certain transactions as voidable. Such transactions have been a significant source of assets which liquidators have realised to populate the asset pool of companies in liquidation. The most well-known voidable transaction is an unfair preference payment – that is, a payment made to a creditor at the time the debtor-company was insolvent and therefore (subject to a number of other factors) can be clawed back by the liquidator.

Recent case law has developed in respect of unfair preference claims, which, on the one hand, could diminish the value of a claim and, on the other hand, could increase the value of a claim.

The “peak-indebtedness rule” – Badenoch v Gunns

In the recent cases of Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (recs and mgrs appointed) [2021] FCAFC 64 and Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (recs and mgrs appointed) [2021] FCAFC 111 (Badenoch No 1 and No 2, together Badenoch), the Full Court abolished the so-called ‘peak indebtedness rule’, which allowed a liquidator to pick the point of maximum indebtedness as the ‘commencement’ of a running account (from which subsequent credits and debits are netted) in order to maximise the quantum of any unfair preference payment. This decision will undoubtedly have a tremendous impact on the insolvency litigation landscape in Australia, given that the peak indebtedness rule has been universally applied by liquidators in calculating the recoverable quantum of preference claims for the last five decades.

In reaching its conclusion, the Full Court held that s 588FA of the Corporations Act 2001 (Cth) (Act) had abolished the common law peak indebtedness rule because it is irreconcilable with the legislation. The Full Court also held that the rule undermines the doctrine of ultimate effect, which is reflected in s 588FA(3) of the Act because the general body of creditors cannot be said to have been disadvantaged when payments are made to induce the supply of goods of equal or greater value to the payments. Lastly, maintenance of the rule would also result in a situation where two creditors who had provided equal supplies and received equal payments will nonetheless end up with two different preference calculations depending on their credit terms (eg the number of days credit under the payment terms and or the number and value of each invoice), which is inconsistent with the Act’s overall purpose of ensuring fairness between unsecured creditors.

Insight

The decision in Badenoch is significant in that it not only represents a major change in the law of unfair preferences as understood before this decision, but it also raises complex ancillary issues in relation to the final quantum recoverable by the liquidator – chiefly the questions of which payments are within the continuing business relationship and what is the start date of such relationship. There are various contenders for the start date, including the date of insolvency, the first day of the relation-back period, or the very start of the credit relationship (this option, in most cases, renders the value of any unfair preference claim in a continuing business relationship at zero). The problem is that none of these periods are addressed in the black-and-white letter of the relevant statutory provision.

There are two matters that will be resolved by the High Court. The first is whether the Full Court was correct in holding the ‘peak indebtedness’ rule was abolished by s 588FA of the Act. The second concerns the appropriate test for determining whether a payment was within or without a continuing business relationship. Determining this latter question will provide clarity as to when, if at all, a continuing business relationship has come to an end.

The traditional approach of the court, established in Sutherland v Eurolinx (2001) 37 ACSR 477, is that a continuing business relationship will cease where the payment in question was for the “predominant purpose of recovering past indebtedness” rather than inducing further supply. However, the Full Court, while stating that “a court will need to view the evidence as a whole to ascertain whether the relevant transaction was undertaken to effectively pay an old debt (in whole or in part) rather than being undertaken for the provision of continuing services or supply of goods”, also stated that the predominant purpose test “should be treated with some caution”. It will be up to the High Court to decide which of the two tests is correct or to fashion a new test altogether.

Depending on how the Court rules on these questions, the landscape of unfair preference recoveries may again be significantly altered.

On the one hand, if the High Court disagrees with the Full Court and upholds the peak indebtedness rule, the traditional understanding of the liquidator’s discretion in choosing the point of peak indebtedness from which to start a running account will be restored, leading to the largest potential unfair preference claim. On the other hand, if the High Court sides with the Full Court and rejects the peak indebtedness rule, the question of what constitutes the bounds of a continuing business relationship becomes relevant because the liquidator is no longer at liberty to choose the starting point of a running account. Although the Full Court avoided having to determine the proper start date for the single transaction by finding that there was no unfair preference (as the indebtedness at the end of the single transaction was higher than at the start), the Full Court explicitly left open the possibility that the start date of the single transaction is neither the start of the relation-back period (as was the liquidator’s position) nor the date of insolvency (as was Gunn’s position), but rather all the way back at the beginning of the running account itself. This position is probable because, as the Full Court itself noted while analysing the principles relevant to a continuing business relationship from the seminal High Court authority in Airservices Australia v Ferrier (1996) 185 CLR 483, there is no good reason why the continuing business relationship is restricted to the relation-back period or the date of insolvency and therefore cannot stretch as far back as the very start of the credit relationship. If this eventuates, its effect would be that the original balance may be zero, and therefore the running account computation will then subsume all transactions, except for those which have been made for the purpose of clawing back past indebtedness.

This is where the difference between the predominant purpose and the sole purpose test becomes important: a payment would be more likely to be considered to have been made outside a continuing business relationship under the predominant purpose test compared to the sole purpose test and, as such, be more beneficial to liquidators, whereas the sole purpose test would benefit creditors instead. Generally, the combined effect of these principles would likely decrease the quantum recoverable by the liquidator. All this said, the High Court decision on the matter should provide some finality on these contentious issues and will hopefully also provide useful guidance on the law of unfair preferences as a whole.

Availability of set-off in unfair preference claims – MJ Woodman v Metal Manufacturers

The recent case of Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited [2021] FCAFC 228  (MJ Woodman) found that set-off under s 553C of the Act is not available to unsecured creditors of an insolvent company in respect of unfair preference claims, effectively ending several decades of uncertainty (and perhaps misapplication of the law) surrounding the section. Whilst it remains to be seen whether this decision will be overturned on appeal, it will likely expand the value of claims available to the liquidator.

Insight

Although the decision explicitly limits the unavailability of set-off to unfair preference claims and not other voidable transactions (eg uncommercial transactions), it is possible that the decision will impact the availability of set-off in those other situations. As such, liquidators might be more inclined to pursue other voidable transaction claims that they would not have previously pursued for fear of set-off being available.

Further, some transactions are not strictly voidable transactions but are capable of being characterised as such and therefore may be affected by the impending High Court decision (for example, a director loan from the company in lieu of receiving a formal salary – a common practice amongst SMEs to minimise income tax obligations). Depending on the circumstances (such as amount and timing), such a transaction could be considered an unfair preference or an uncommercial transaction capable of being clawed back by a liquidator – set-off may no longer be available in such claims. Finally, the removal of set-off as a defence means that depending on the final quantum, it may be financially viable to pursue some claims notwithstanding the abolition of the peak indebtedness rule (although, as previously mentioned, that case is also subject to a final High Court decision).

MJ Woodman has recently been granted special leave to be heard in the High Court, and a final decision from that court is expected sometime later this year. Although it remains unclear what the submissions are and what questions the High Court has in fact been asked to answer, it is widely expected that the decision would be upheld – although, as ever, there are cogent arguments in both directions.

Powerful powers of investigation might fuel litigation

When a company is under external administration, certain persons (most commonly liquidators) are able to examine persons (such as the directors and accountants) and obtain orders the for production of documents, aimed at investigating the affairs of the insolvent company. This is a very powerful tool because, traditionally, it has been used to explore claims which might be available to the liquidator or the company and issues of recoverability.

Historically, there was an understanding that the use of the power had to be exercised for the benefit of the creditors of the insolvent company – rather than some third-party interest (such as a non-creditor investor). That has changed.

Mandatory public examinations – Walton v Arrium

The ground-breaking case of Walton v ACN 004 410 833 Limited (formerly Arrium Limited) (in liquidation) [2022] HCA 3 has clarified the purpose and scope of mandatory public examinations under s 596A of the Act. In the light of this decision, the test for abuse of process in mandatory public examinations has been altered such that eligible applicants are only barred from bringing public examinations where it would obstruct the public interest regardless of the ultimate motive behind such an act (ie to obtain information in support of a private claim). In other words, it need not be used for the benefit of creditors of the insolvent company.

Insight

This decision creates a substantial advantage for plaintiffs seeking to publicly examine directors, as they can now do so if they have obtained ‘eligible applicant’ status and the other requirements of s 596A are satisfied.

We expect to see investor plaintiffs applying to ASIC (who has the power to grant the necessary ‘eligible applicant’ status) to use the public examination process to investigate claims against and recoverability from directors and their insurers on matters such as pre-investment representations. As ever in a financial downturn, investors who want to exit an investment or wish to recoup a loss are more inclined to look to litigation.

As such, there may be a significant increase in applications for public examination summonses, especially as a putative plaintiff can get their hands on relevant documentary evidence and hear from witnesses well before starting any actual claim (which has potential adverse cost consequences) and the process of discovery occurs much later.

On the other hand, the ruling has been seen in some quarters as weakening the liquidator’s special role, as the examination process can now be utilised by a broader range of interested parties who are not necessarily creditors and may be acting in their own self-interest rather than that of the body of creditors as a whole.

A further significant impact of the decision is likely to be in the scope of ASIC’s powers, who has become a gatekeeper figure in deciding whether a mandatory public examination will go forward. This is because, as a result of this decision, the only practical obstacle to a public examinations summons is the conferral of ‘eligible applicant’ status by ASIC. As such, it is arguable that ASIC now has too much power over this process, particularly in the light of the fact that it has neither an obligation to afford procedural fairness in considering whether to grant ‘eligible applicant’ status, nor is its decisions subject to merits review by the Australian Administrative Tribunal. Whilst it remains to be seen, this might eventually result in ASIC’s powers being curtailed by Parliament through an amendment of s 596A itself.

Further developments

The three abovementioned cases represent the biggest changes in the insolvency landscape within the last year, and their impact is already starting to be seen in courts all around Australia. For instance, in Re Jewel of India Holdings Pty Ltd (in liq) [2022] NSWSC 356, the Supreme Court of New South Wales has recently dismissed an application to set aside summonses issued by a former owner of a business to the liquidators because the summonses were not held to be an abuse of process under the wider interpretation of s 596A by the High Court in Walton. The decision has essentially flipped the ordinary examination regime on its head since it is normally the liquidator who would conduct examinations rather than be examined. Such a decision would likely not have happened had it not been for the new precedent in Walton.

On the other hand, there has been relative inaction in relation to unfair preference claims because of the likely absence of unfair preference payments due to COVID-19 government support and creditor leniency. Regardless, it is likely that there will be major changes in the way courts will interpret the law in relation to unfair preferences as a result of these pending High Court decisions, so stay tuned.