The peak indebtedness rule employed by liquidators to maximise recovery of unfair preference claims is abolished
In the recent Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed)  FCAFC 64 (Badenoch) and Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed)  FCAFC 111 (Badenoch No 2) cases, the full Federal Court abolished the ‘peak indebtedness rule’, a longstanding strategy employed by company liquidators to maximise recovery of unfair preference payments. This article will explain what the peak indebtedness rule was, the reasons given in Badenoch to support its abolition as well as an exploration of what a post-peak-indebtedness landscape will look like for liquidators and creditors.
‘Peak Indebtedness’ Pre-Badenoch
Background – Unfair Preferences & Continuing Business Relationships
Section 588FA of the Corporations Act 2001 (Cth) (Act) defines an unfair preference as a transaction (usually a cash payment) by an insolvent company to an unsecured creditor in the 6 months preceding administration or liquidation, which results in that creditor receiving more than they would in a winding-up. Section 588FA(3) further specifies that a series of transactions that occur in a “continuing business relationship”, where the level of indebtedness fluctuates (such as in a running account), are deemed to collectively constitute a single transaction. This means an alleged ‘preference’ is assessed based on the net position of parties arising from mutual debits and credits rather than by exclusively counting payments made by the debtor to the creditor. Unfair preferences are recoverable by liquidators as voidable transactions under s 588FE of the Act.
The Peak Indebtedness Rule
The peak indebtedness rule was used to determine the quantum of preference claims by assessing the ‘single transaction’ in continuing business relationships. Under the rule, liquidators could select a time in the 6 months preceding insolvency as the ‘commencement’ of the transaction, from which subsequent debits and credits are netted. Tactically (and for practical ease), liquidators would generally select the time in which the debtor was maximally indebted to the creditor (ie the time of ‘peak indebtedness’) since any amount paid to offset this debt could be assessed as an unfair preference. This unfair preference claim would therefore be the largest possible.
For clarity, let us imagine a simple continuing business relationship with a running account between A (the debtor) and B (the creditor), which occurs exclusively in the 6 months preceding A’s insolvency. After the first transaction (eg where B provides supplies to A), A is indebted to B $50,000. A does not pay this amount back at this stage. B again supplies A, with another charge of $50,000, for a total indebtedness of $100,000. Eventually, A makes a payment of $70,000toward this amount, leaving the debt outstanding at $30,000 at the time of A’s insolvency. A’s liquidator would identify the point of “peak indebtedness” to B as $100,000. Since this debt is reduced to $30,000 by the relation-back day (usually the date administrators are appointed), the net reduction in debt is $70,000, an amount for which A’s liquidators can attempt to recover as an unfair preference.
In essence, the rule allowed a liquidator to cherry-pick the day that most benefits the insolvent estate. While this approach maximises the liquidator’s claim (and thus payout [if any] to the general class of creditors), it disregards earlier related transactions before the point of peak indebtedness where the creditor likely provided value to the debtor. Regardless, the rule has been operative in Australia for five decades, initially arising from Chief Justice Barwick’s judgment in Rees v Bank of NSW (1964) CLR 210.
The Badenoch Decision
The cases were between the liquidators of Gunns, a timber business, and Badenoch, a family-owned logging and transport service provider which had an ongoing continuing business relationship with Gunns in the lead-up to its insolvency. The liquidators of Gunns launched recovery proceedings against Badenoch on the basis that 11 payments made in the 6 months preceding the relation-back day (26 March 2012 to 25 September 2012) constituted unfair preferences recoverable under s 588FE. The court concluded that the payments made by Gunns to Badenoch constituted a single transaction within the meaning of s 588FA(3), but that the liquidators were unable to use the peak indebtedness rule to calculate the scale of any unfair preference. While the cases also involved discussions as to set-off rights under s 553C of the Act, and a methodology for determining whether payments constitute part of a continuing business relationship – this article will focus on the abolition of the peak indebtedness rule.
The full Federal Court abolished the peak indebtedness rule in Badenoch for 3 reasons:
First, the lack of legislative backing to support the existence of the rule. In particular, the court noted (at ) that where s 588FA(3)(a) applies (ie in the context of a continuing business relationship), s 588FA(3)(c) and (d) require all transactions in that continuing relationship to constitute one transaction for the purposes of assessing unfair preference claims. Allowing a liquidator to identify a specified point of indebtedness in what should be a single transaction is to necessarily and “impermissibly sever the single transaction”.
- Secondly, the explanatory memorandum of s 588FA(3) embodies the ‘ultimate effect’ doctrine, which “recognises that the general body of creditors is not disadvantaged by payments made to induce trade creditors to supply goods of greater or equal value” . That is, the alleged preference payments made from Gunns to Badenoch to pay off its debts did not give Badenoch any priority or advantage over the general body of creditors. Rather, the ultimate effect of Badenoch’s logging and transport services was financially beneficial to Gunns (and therefore the general body of creditors). The court concluded (at ) that the peak indebtedness rule was inconsistent with the ultimate effect doctrine, drawing on principles from the previous High Court case of Airservices Australia v Ferrier (1996) 185 CLR 483 and the reasoning of the New Zealand Court of Appeal Timberworld v Levin  NZLR 365 (who had previously rejected the peak indebtedness rule).
- Thirdly, the peak indebtedness rule is inconsistent with the general purpose of Part 5.7 of the Corporations Act, which is “to do fairness between unsecured creditors” . Upholding the peak indebtedness rule would be unfair, both due to it allowing liquidators to select an otherwise arbitrary day at which indebtedness is at its highest and where an unsecured creditor has provided goods or services of greater value than the impugned preference payment.
Regardless of one’s thoughts on the reasoning, the impact is clear: the Peak Indebtedness Rule is no more. Two questions naturally follow:
- If liquidators can no longer use the date of peak indebtedness to determine the quantum of an unfair preference claim, what date is to be used instead?
- More generally, what impact will this decision have on liquidators and creditors going forward?
The new date of assessment? – Frustratingly unclear
The commencement date of a deemed ‘single transaction’ in a continuing business relationship from which net reductions in debts for the purposes of unfair preferences was a focus of Badenoch No 2. Unfortunately, there was less clarity on this matter than would be desired, with no determinative statement as to what liquidators should use instead of the date of peak indebtedness. Utilising the level of indebtedness at the beginning of a continuing business relationship, or the level as it exists 6 months before the relation-back date (whichever comes later) is likely to be an uncontroversial marker from which unfair preference recovery should be calculated.
Impact of the decision going forward
Impact on liquidators
The straightforward consequence of the abolition of the peak indebtedness rule is a reduction in the quantum of preference claims. This is illustrated by returning to the example earlier in this article. Previously, the peak indebtedness rule allowed A’s liquidators to claim $70,000 as an unfair preference (reflecting their $100,000 peak indebtedness netted against their $30,000 closing indebtedness against B). However, without this rule, since A’s running account with B opens with a debt of $50,000 and closes with a debt of $30,000, the liquidator’s preference claim would be just $20,000. Although the precise recovery amount is of course contingent on the existence of a continuing business relationship that should be classified as a single transaction and the ultimate effect of that single transaction, the example nonetheless demonstrates the significantly lower claim liquidators may now pursue.
Relatedly, the job of liquidators is likely to become more difficult, as they will need to be more contemplative in assessing whether pursuing reduced preference claims is worth the hassle. Further, liquidators may have difficulty identifying the precise timing or amount a preference claim should be for, particularly if the continuing business relationship and ‘single transaction’ involves significant fluctuations or commences well before the 6 months prior to the relation-back day.
Impact on defendants of preference claims
The Badenoch decisions will be welcome news to unsecured creditors defending preference claims for several reasons.
- The abolition of peak indebtedness significantly diminishes the value of recoverable preference claims, meaning unsecured creditors with ongoing business relations with a company in distress can retain more than they would have been able to were the old rule to apply.
- The burden on creditors to monitor the precise financial position of a distressed debtor is eased, as temporary fluctuations in running account indebtedness are less likely to dramatically increase liquidator preference claims.
- The value of goods or services rendered by a creditor to the debtor during the relationship is more straightforwardly accounted for.
- A renewed focus on the ultimate effect doctrine in unfair preference claims will offer greater protection to defendants if they can prove the goods or services they provided to a distressed debtor were ultimately advantageous to the business.
Notably, Gunns’ liquidators have filed an application for special leave to appeal the Badenoch decision to the High Court. If that leave is granted, the final status of the peak indebtedness rule may soon be known.
For more information about this case or assistance in any aspect of insolvency, contact Trevor Withane: