On 8 February 2023, the High Court of Australia (being Australia’s highest court) simultaneously handed down two highly anticipated insolvency law decisions:
- Metal Manufactures Pty Limited v Morton [2023] HCA 1 (Morton), concerning the applicability of set-off in unfair preference claims (which might have broader application to other voidable transactions); and
- Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (Badenoch), concerning the so-called ‘peak indebtedness rule’, which was used to calculate the value of an unfair preference payment in the context of a running account.
The practical takeaways from these cases can be found at the end of this article.
MORTON: SET-OFF
The facts in Morton, as well as the previous judgment of the Full Federal Court (Full Court), can be found in our article of 4 January 2022.
By way of summary, Metal Manufactures (the creditor) was paid a total of $190,000 (Alleged Preference Payments) by MJ Woodman (the debtor, which subsequently went into liquidation) in the six-month period before the winding up commenced (the ‘relation-back period’).
The liquidator of MJ Woodman, Mr Morton, made an application under s 588FF(1)(a) of the Corporations Act 2001 (Cth) (Act) to recover the Alleged Preference Payments from Metal Manufactures as an unfair preference under s 588FA of the Act. This was contested by Metal Manufactures who argued that, under s 553C of the Act it should be entitled to set-off a debt of $194,727 owed to it by MJ Woodman against the alleged unfair preference. As the debt owed to Metal Manufactures exceeded the unfair preference claim, if set-off were available then an order under s 588FF requiring the Alleged Preference Payments to be paid to the liquidator could not be obtained.
While it was common practice for liquidators to allow the recipients of an unfair preference to set-off debts owed by the company in liquidation against the unfair preference and there was substantial case law offering support for that position, the direct question of its lawfulness came before the Full Court.
The decision of the Full Federal Court
The Full Court (Allsop CJ, Middleton and Derrington JJ) held that statutory set-off under s 553C was not available to Metal Manufactures against the liquidator’s attempt to recover the Alleged Preference Payments under s 588FA. In a lengthy and detailed judgment, the Full Court held that there was a lack of mutuality between the two debts (a key ingredient for statutory set-off). There were many reasons given by the Court as to why this was so. The main reason was that the right of a liquidator to claim the unfair preference arose only after he or she had brought an application under s 588FF, whereas the creditor’s claim arose long before that application such that there was no temporal mutual credit, debt or dealing as between the two parties. The Court also observed that allowing set-off in this case would render the voidable transaction regime under Div 2 of Pt 5.7B of the Act “out of kilter” with the entire statutory scheme of distribution in accordance with the pari passu principle under insolvency law more generally.
The High Court’s view
In a unanimous decision, the High Court reaffirmed all of the Full Court’s reasoning.
A restatement of the law
In its judgment, the majority of the High Court (Kiefel CJ, Gordon, Edelman and Steward JJ) undertook a systematic analysis of the various statutory schemes and attendant common law rules that were relevant in the case. In particular, they considered the provisions of the Act which concerned the liquidator’s duties and powers, proof and ranking of claims, set-off, and voidable transactions. In a paragraph that will undoubtedly be cited in future decisions, their Honours’ analysis was distilled into five key points, which deserve to be quoted in their entirety (even if trite to those in the insolvency community) (joint judgment at [31]):
“First, the liquidator is given power and responsibility to identify and gather in the assets of the company for distribution to creditors and contributories.
Secondly, the liquidator is obligated to distribute those assets through making priority payments and then on a pari passu basis by paying creditors and contributories.
Thirdly, a bright line is drawn to enable the liquidator to determine what debts are payable by the company and what claims must be met against it; here it is those arising from “circumstances” which existed “before” the date of winding up.
Fourthly, in aid of the duty to gather in the assets of the company, the liquidator may recover preference payments as a debt owed to the company.
Finally, in determining what debts are payable and what claims must be met, a setoff must take place between what is due as between the company and another person arising from “mutual credits, mutual debts or other mutual dealings”” (emphasis added, sentences separated for legibility.)
The above propositions stand as the most authoritative statement of the law in this area. However, despite their deceptively simple appearance, these propositions carry some very subtle yet crucial nuances, which ultimately proved to be fatal to Metal Manufactures.
The appellant’s arguments
The gist of appellant’s (Metal Manufactures) case in the High Court was that:
- the requirement for “mutual credits, mutual debts or other mutual dealings” must be read as widely as possible; and
- under this wide interpretation, it is sufficient that the liability which formed the basis of the set-off claim existed as a contingent liability before the date of the winding up. According to the appellant, the future liability arising from the unfair preference claim is ‘as good as certain’ – it is subject only to the liquidator actually bringing an action to seek the relevant order under s 588FF(1) and the court granting such an order, and that the facts necessary to make good these contingencies existed before the winding-up date.
Therefore, the appellant essentially contended that, in layman’s terms, whatever state of affairs as at the date of the winding up, the unfair preference debt was as good as a real liability and therefore should be treated as such.
It would follow that the elements of mutuality required by Gye v McIntyre (1991) 171 CLR 609 would be met because (1) the relevant transactions were between the same parties, (2) the benefit or burden of these dealings “laid in the same interests” because the company and the creditor are owed monies which will be received beneficially, and (3) both the ordinary trade liability by MJ Woodman and that by Metal Manufactures under s 588FF sound in money.
Lastly, the appellant also noted that the Harmer Report, which introduced the set-off provision, expressly recommended the enactment of an exception which would have the effect of excluding a right of set-off in unfair preference situations. The appellant argued the fact that this recommendation did not make it into the original enactment of the set-off provision (and is not in the wording of s 553C), ought to be construed as a deliberate choice of Parliament to permit a right of set-off in unfair preference claims.
The High Court’s reasoning
The High Court rejected all of the appellant’s arguments. Even if “mutual dealings” were to be given a wide meaning and contingent liabilities could in some cases give rise to a right of set-off, the facts of Morton nevertheless did not give rise to a “mutual dealing” under the Act. This is because, unlike in those cases where there existed some sort of subsisting right or obligation before the liquidation (eg under a guarantee or claim against the company in liquidation), the Court held that not only did the liquidator’s right to sue under s 588FF not exist before the winding up, it could not have existed at that point at all (at [46]). The statutory right held by the liquidator for the purposes of gathering in the assets sprang into existence only at the point of the winding up and not before. When one looks at the state of affairs immediately before the winding up, there was nothing to set-off as between the two companies (Metal Manufactures and MJ Woodman, as personified and distinct legal entities) because although MJ Woodman owed the appellant money, the appellant did not owe MJ Woodman anything.
Further, the Court also reaffirmed the Full Court’s judgment that notwithstanding the fact that the an ability to sue for an order under s 588FF is not supported by any right or obligation which pre-existed the liquidation, the fact that this ability is “conditioned … on both the liquidator’s decision to sue and the court’s satisfaction” means that it constitutes a “mere possibility without more”, and certainly not amounting to anything close to a “right” or “obligation” that would help the appellant’s claim (at [49]). As such, there was no “mutual dealing” between the two parties and therefore the trade transactions (which occurred before winding up) and the s 588FF liability (which arose after the winding up) could not be set off against each other under s 553C, which “correctly construed, does not address dealings which straddle the period before and after the commencement of the winding up” (at [47]).
The Court also held that contrary to the appellant’s contention, the other requirements of “mutuality” under Gye v McIntyre were not satisfied. First, there were no dealings between the same persons because, although the trade transactions were between the appellant and the company (MJ Woodman), the unfair preference was as between the appellant and the liquidator in his or her own right as an officer of the court rather than as an agent of the company (at [52]). Secondly, it could not be said that the interests behind a trading transaction involving goods and services are the same as the interests behind the recovery of an unfair preference payment – the latter being a “unique statutory ability to recover the proceeds of a voidable transaction” (at [54]).
Aside from a consideration of the technical legal tests, the Court also noted the fundamental “gross distortion” resulting from the appellant’s argument in this case – namely, that “a creditor could, in effect, avoid the consequences of having received a preferential payment by the happenstance that it was also owed money by the company in liquidation” (at [51]). This would violate the cardinal rule in insolvency, the pari passu principle, because allowing a preferred creditor to set off liability arising from receiving an unfair preference dollar-for-dollar would result in the pool of available assets available for rateable distribution being greatly diminished. Finally, Parliament’s failure to include the Harmer Report’s recommendation to expressly exclude a right of set-off for unfair did not support the appellant’s approach. Rather, the correct view as expounded by the Court, as to the exclusion of express wording, is that set-off was never available in these situations.
Justice Gageler’s concurrence
Justice Gageler, although agreeing with the majority in full, wrote a short concurrence to address a separate aspect of mutuality – specifically the requirement that the burden of the debt and the benefit of the credit must lie in the same “equitable or beneficial interests” under the second limb of Gye v McIntyre. His Honour emphasised that the interests that must be considered here are not constrained to only those enforceable in equity; but rather that “legislation can impose restrictions on dealings with property for the benefit of persons other than the legal owner without occasion arising for any intervention of equity at all” (at [71]).” Although not particularly significant for practical purposes, this is nonetheless interesting from a theoretical perspective in that it represents another blow (since Commissioner of Stamp Duties (Qld) v Livingston [1965] AC 694) to the traditional dualist view that proprietary interests must always exist in two dimensions – legal and equitable. It may be the case that there will emerge a fully-fledged third category of “beneficial” interests distinct from legal and equitable with its own body of authority – that would indeed represent a tremendous change to property law as we know it.
Lingering questions: what about other voidables?
One of the most important questions left unanswered by the Full Court’s decision was whether set-off remained available in respect of other voidable transactions. It seems as though the answer to this question is likely to be ‘no’, as the Court appeared to have overruled all of the previous authority on this question (at [56]). But the devil is in the detail – these cases are only overruled insofar as they “are inconsistent with the above analysis”. In the Full Court below, Allsop CJ, perhaps out of an abundance of caution, carefully distinguished these cases and went to great pains to explain the reason why the situation is different with respect to other voidable transactions, most importantly the fact that the purpose between statutory scheme was different across the sections (eg the insolvent trading provisions are directed towards protecting the company, whereas the unfair preference provisions are all about ensuring a fair distribution in the interests of the general body of creditors). These differences, in conjunction with the fact that the High Court was only concerned with specifically unfair preferences, may mean that they are not “inconsistent with the above analysis”; in fact, it is likely that these other cases remain good authority for the availability of set-off in respect of other voidable transactions. Whether set-off does lawfully apply to other voidable transactions, will ultimately be a matter to be resolved in future cases. That said, no doubt the High Court’s pronouncement in Morton will have a tremendous impact in deciding any such cases going forward. A well-funded liquidator or defendant will have to lead the charge to the superior courts to clarify the uncertainty.
BADENOCH: PEAK INDEBTEDNESS
The facts in Badenoch, as well as the previous judgment of the Full Court, were set out in our article of 28 January 2021.
To summarise, the respondent, Badenoch, supplied Gunns (the company in liquidation) with services in relation to harvesting and hauling timber. Due to a decline in revenue, from about 2010, Gunns struggled to pay debts owed to Badenoch, frequently making late or only partial payments. By August 2012, Badenoch agreed with Gunns to terminate the supply agreement contingent on further supply of some services for a short period afterwards. The liquidators (including Mr Bryant) were appointed on 25 September 2012, and promptly applied under s 588FF(1) to recover a series of payments made within the six-month relation-back period as unfair preferences. The liquidators argued that there was a “continuing business relationship” within the meaning of s 588FA(3) of the Act, and, since this was the case, they were entitled to use the long-established “peak indebtedness rule” to identify the start date of the continuing business relationship (within the six-month relation-back period) as a means of calculating the unfair preference transaction. Mathematically, by applying the date of peak indebtedness as the start of the continuing business relationship, liquidators were able to claim the highest value of the unfair preference. This is because, within a continuing business relationship in the relation-back period, liquidators could take the debt at its highest point less the debt at the end of the relationship to determine the value of the unfair preference.
The decision of the Full Court
The Full Court held that out of the 11 payments which the liquidators sought to impugn, there was a continuing business relationship only between payments 1 to 4 (inclusive). However, they also held that the peak indebtedness rule did not apply by operation of s 588FA(3), and endorsed an alternative calculation (first propounded in the New Zealand case of Timberworld Ltd v Levin [2015] NZCA 111). Under this alternative calculation, all payments forming part of the running account are netted against each other in determining the value of the preference (ie not just the transaction from the date of peak indebtedness). In doing so, the Full Court held that because the net indebtedness of Gunns to Badenoch actually increased over this relevant period, there was accordingly no unfair preference.
However, the Full Court left open the question as to the start date of the continuing business relationship, with several possible contenders including (1) the start date of the credit-trading relationship; (2) the first day of the relation-back period, and (3) the date of insolvency, among other possibilities.
The High Court’s view
Three questions were in issue for the High Court to determine:
- Whether, as a matter of statutory construction, the “peak indebtedness rule” is part of, or is excluded by, s 588FA(3)? If not, what is the proper start date of the continuing business relationship?
- What is the proper approach to determining whether a particular transaction forms part of the continuing business relationship under s 588FA(3)(a)?
- Which payments made by Gunns to Badenoch formed part of the continuing business relationship and what was ultimately the amount of the unfair preference received by Badenoch (if any)?
In a unanimous decision, the High Court held that the “peak indebtedness rule” is not part of s 588FA(3) and adopted an objective approach in determining whether a transaction falls within the continuing business relationship. In doing so, the High Court also provided some useful guidance as to how the relevant provisions under the Act are to be interpreted, which will be of valuable assistance to practitioners in future cases.
Is the peak indebtedness rule still valid?
In respect of this first question, the High Court first noted that there is a distinction between the “running account principle” and the “peak indebtedness rule”. The Court reaffirmed the proposition that the running account principle exists as a pillar of Australian insolvency law, but stressed that it “does not follow from the running account principle that a liquidator may choose the point during the prescribed period from which to identify a preference” (at [53]). One of the main reasons for this is that the practical effect of the peak indebtedness rule would be to compel a court to adopt the liquidator’s choice as to the first transaction of the “single transaction” under s 588FA(3)(c), something that the Court found there to be no basis for in the statutory text. As a result, the Court approved the Full Court’s conclusion that the peak indebtedness rule was excluded by the inclusion of s 588FA(3) by Parliament, and also approved of the approach involving the “netting off” between all payments received and all further amounts supplied as propounded by the Full Court (at [70]).
What is the start date of the continuing relationship?
As an alternative to the peak indebtedness rule, the High Court found that the proper method for selecting the start date of the continuing business relationship constituting the “single transaction” must be either:
- the beginning of the prescribed period [being the first day of the relation-back period]; or
- the date of insolvency; or
- if the relationship started after the beginning of the prescribed period or the date of insolvency, the beginning of the continuing business relationship, whichever is later,
(at [74]).
In other words, the start date of the continuing relationship would be “the first transaction capable of being a voidable transaction”, and that choice, though in some sense arbitrary, was made by Parliament in enacting Div 2 of Pt 5.7B of the Act (at [70], [77]).
What is the proper approach to determining whether a transaction falls within or without the continuing business relationship?
In the Full Court, the test for whether or not a transaction fell within the continuing business relationship was held to be whether the dominant (as opposed to sole) purpose of the parties behind that particular transaction was to continue the business relationship between them (simplistically, the question could be answered by determining whether the dominant purpose of making the payment was to induce future supply or to retire old debt).
This distinction between dominant and sole purpose was considered to have “reflect[ed] a misunderstanding, and misapplication” of the law, and that mentions of “purpose” in this case is no more than “a characterisation of the facts, involving an objective ascertainment of the business character of the relevant transaction” (at [80]). Therefore, quite apart from the subjective intentions of the parties (which may still, to some degree, be relevant), the true test is whether on the whole of the evidence objectively viewed, there was “a continuing business relationship, … there is no longer such a relationship, or that relationship has ended and been replaced with another” (at [81]).
The importance of this new objective test becomes apparent when one considers how the High Court has applied it to the facts of Badenoch in upholding the decision of the Full Court below. The High Court held that although payments 1 and 2 were made with the mutual intention to reduce Gunn’s past indebtedness, looking at the entire business character of the transaction it could not be said that those payments were made to “reduce past indebtedness rather than to induce the continuation of supply” (emphasis original) (at [91]). Thus, although it is true on the facts that both Gunns and Badenoch demonstrated a desire to reduce indebtedness during this time, this was of itself not determinative of a conclusion that the continuing business relationship has ceased (at [90]). Importantly, the High Court also held that the “temporary cessation of supply and negotiation of additional credit terms” in the relevant period did not cause the continuing business relationship to end. This is because during this time, the “controlling minds” of Badenoch still held a firm belief that Gunns would ultimately be in a position to pay all of Badenoch’s debts and both parties were actively working towards continuing this relationship (at [90]).
On the contrary, payments 5 to 11 were made in circumstances where, objectively assessed in a practical “business sense”, the pre-existing business relationship had ceased. This is because, by this time, there was an agreement that the previous agreement was to cease, with a transition plan towards winding down supply before handing over to another contractor also in place, and that any further supply from Badenoch from that point on was clearly for the purpose of maximising the reduction of indebtedness before the handover (at [96]). As a result, the Court held that the Full Court below was correct in concluding that payments 1-4 were part of the continuing business relationship, whereas the remaining payments 5-11 were not (at [97]).
When does the continuing business relationship end?
The last piece of the puzzle was the issue of when the continuing business relationship ended, such that each payment thereafter could be treated as a single voidable transaction rather than being subject to netting. The High Court affirmed the Full Court’s decision that the continuing business relationship ended on 10 July 2012, when Badenoch stopped supplying Gunns for the second time (at [102]). This was because prior to 10 July 2012, Gunns and Badenoch were still contemplating the continuation of supply subject to the non-payment situation being rectified, and Badenoch was also merely contemplating termination of the agreement if the non-payment situation persisted rather than having made any concrete decision to that effect. Applying the objective test analysed above, one can clearly see how the High Court arrived at this conclusion.
There was also a dispute as to whether an invoice rendered on 31 July 2012 also formed part of the continuing business relationship, notwithstanding that the relationship was held to have ceased on 10 July 2012. The High Court held that the invoice did form part of the continuing business relationship – even though the invoice was rendered after the relationship ended, it related to supply that took place before the date and therefore was a part of the continuing business relationship (at [101]-[102]). Taking into account this final invoice, the net indebtedness of Gunns to Badenoch increased throughout the course of the continuing business relationship – from $410,965.07 on 30 March 2012 to $1,559,594.08 on 31 July 2012 (relating to services provided before the end of the continuing business relationship on 10 July 2012) (at [102]). As a result, because there was a clear increase in net indebtedness, there was accordingly no unfair preference in relation to this single transaction.
Lingering questions: inconsistent applications?
Although the High Court’s judgment might be accepted as having provided a satisfactory resolution of all outstanding issues in relation to the particular facts of Badenoch, some larger questions remain as to the viability of the High Court’s approach to the insolvency space at large.
For example, consider the position of (an unsecured) creditor A whose continuing business relationship starts within the relation-back period. As paragraph 58 of the decision made clear, in the vast majority of these cases the creditor will be shielded from all unfair preference claims because the start of the relationship will be taken to be the beginning of the relationship itself, and the balance at that point will almost always be zero. On the other hand, (an unsecured) creditor B who engaged in one transaction with the company in liquidation and was paid an amount in (partial) satisfaction of that transaction would have to disgorge that amount as an unfair preference, since the very fact that there is only one transaction would cause this “relationship” to fall outside the scope of s 588FA(3) (there is no supply debt which can be netted). This discrepancy might be viewed as unfair, particularly in the light of the fact that the two creditors, A and B, are virtually in the same position, except for the fact that one engaged in more transactions than the other – which does not appear to be a logical ground for a difference in treatment. It might be that such inconsistencies are inevitably going to arise when dealing with bright-line rules and temporal cut-offs.
Further, although the High Court stressed that this approach is the best at harmonising the application of all the relevant sections of the Act, there remain sections whose operation remains unclear as a result of the judgment. For instance, there is not yet an answer to the question of how the continuing business relationship under s 588FA(3) will operate in conjunction with 588FA(2) (which provides that “a secured debt is taken to be unsecured to the extent of so much of it (if any) as is not reflected in the value of the security”) despite both sections being necessary ingredients of an unfair preference claim. The question is now also whether this “security analysis” mandated by s 588FA(2) must be determined before the payments are netted-off as part of the running account under s 588FA(3). The fact that 588FA(2) appears before s 588FA(3) in the legislative scheme lends credence to this chronological approach, but at present there is no judicial authority on this point.
Practical takeaways
- Liquidators should review their files as to whether there remain unfair preference claims which are not time-barred and are now commercial to pursue given set-off does not apply. Similarly, liquidators should consider, in respect of existing files and new ones, whether to challenge the availability of set-off in respect of other voidable transactions.
- Although it is generally clear that Morton is good for liquidators and bad for creditors, while the opposite is true for Badenoch, the clarity that the decisions bring will no doubt simplify the settlement process between both parties and help them avoid costly litigation. In addition, this would also have a positive ‘spillover’ effect on other creditors, as the available pool of funds for distribution will be significantly enlarged if legal fees incurred by the liquidator in litigating these claims can be minimised.
- By enacting s 588FA(3), Parliament had abolished the peak indebtedness rule. Instead, the start of a continuing business relationship under s 588FA(3) will be the first transaction that is capable of being a voidable transaction.
- The new emphasis on objectivity in determining whether a transaction forms part of a continuing business relationship will be of great benefit to all trade creditors operating on a running account basis. In particular, the fact that a mutual intention to reduce past indebtedness will not in and of itself be fatal to the continuing business relationship (provided other factors are established) will be very good news for SME trade creditors, whose interests in reducing past indebtedness are often (and one might even say inextricably) linked to their continued participation in any business relationship.
- Another significant impact of this objective approach in determining the existence of a continuing business relationship is the paramountcy of evidence that exists at the relevant time between the parties. As such, it is vital for the parties to keep all records pertaining to the business relationship, especially any such records which show a change in the position of either party.
- By highlighting the complexity of the whole unfair preference regime, the decisions serve as a powerful reminder of a clear alternative which would help trade creditors avoid the hassle entirely – by becoming secured creditors through the use of a simple retention of title clause in their agreement (properly registered).
Further Information
For more information about unfair preferences, litigation or insolvency, contact Trevor Withane: