Insolvency – ‘Peak Indebtedness’

Earlier this year, the High Court handed down judgment in two important decisions concerning the controversial ‘peak indebtedness’ rule and the previously unresolved question as to whether a creditor could rely on the statutory set-off in section 553C of the Corporations Act 2001 (Cth) (the Act) as a defence to an ‘unfair preference’ claim.

In Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2, the High Court unanimously held that the Act does not incorporate the ‘peak indebtedness’ rule and further clarified that the approach to determining whether a transaction falls within a ‘continuing business relationship’ is to objectively ascertain, on the whole of the evidence, the “business character” of the transaction.

In Metal Manufactures Pty Limited v Morton [2023] HCA 1, the High Court unanimously held that the statutory right to set-off could not be used by a creditor as a defence to an unfair preference claim brought by a liquidator.

Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2

What was the case about?

1. Gunns and Badenoch entered into an agreement in 2003 for Badenoch to supply Gunns with timber. Under the agreement, Badenoch provided timber in a specified quantity per annum. Badenoch was to provide an invoice at the end of each calendar month and payment was due from Gunns on the last working day of the following month. They renewed their agreement in 2008 for the period from 1 January 2008 to June 2013.
2. Badenoch continued to provide services to Gunns despite its revenue starting to decline in 2010 and it frequently being late in making payments or only being able to make partial payments. After numerous attempts to reduce the indebtedness, the parties agreed to terminate the agreement in August 2012 on the basis that Badenoch would supply limited services for a short period while Gunns found another contractor. Shortly after, Gunns entered voluntary administration on 25 September 2012.
3. Liquidators later commenced proceedings against Badenoch seeking declarations that a series of payments totalling approximately $3.3 million made by Gunns to Badenoch between 30 March 2012 and 25 September 2012 were voidable transactions, pursuant to section 588FF(1) of the Act, and liable to be repaid.
4. Badenoch argued there was a “continuing business relationship” and all of the payments should be considered together to determine the net (not total) unfair preference.
5. In response, the liquidators argued that, if there was a “continuing business relationship”, they were entitled to apply the so-called ‘peak indebtedness’ rule and thereby choose the starting date within the period to prove the unfair preference Badenoch received (with the effect of maximising the value of the unfair preference). The liquidators argued that the transactions of the relevant relationship should be assessed from 31 May 2012, rather than 30 March 2012 (the date Gunns was determined by the Court to have become insolvent).

The Relevant Provisions of the Act

1. Section 588FF of the Act allows a court to make certain orders in relation to ‘voidable transactions’ including orders directing a person to repay to the company some or all of the money that was paid under the transaction.[1] A transaction is voidable if it is an “insolvent transaction” of the company being wound up and such transaction was entered into during the six months ending on the “relation-back day”[2] (in this case, the date the winding up commenced). 
2. An ‘insolvent transaction’ includes an ‘unfair preference’ between the company and creditor which results in the creditor receiving from the company more than the creditor would receive in respect of an unsecured debt if the transaction were set aside and the creditor “were to prove for the debt in a winding up of the company”.[3]
3. Section 588FA(3) provides that when a company and a creditor are in a continuing business relationship (for example, a running account), all transactions forming an integral part of that relationship are to be considered together, by reference to the overall indebtedness of the creditor during the period, to assess the net value of any unfair preference during the relation back period.

Does the ‘peak indebtedness rule’ apply to a ‘continuing business relationship’?

1. The High Court unanimously upheld the Full Federal Court’s finding that the peak indebtedness rule is not incorporated in the Act. Their Honours found the rule is not open on the express words of the Act and there is no reason why a liquidator should be able to arbitrarily choose the first transaction within the relevant continuing business relationship to determine the highest net value for the unfair preference. Jagot J, with whom Kiefel CJ, Gageler, Gordon, Edelman and Steward JJ agreed, said at [70]:

The purpose of the “running account principle” is not to maximise the potential for the claw-back of money and assets from a creditor, but that is the effect of the “peak indebtedness rule”. The “running account principle” recognises that a creditor who continues to supply a company on a running account in circumstances of suspected or potential insolvency enables the company to continue to trade to the likely benefit of all creditors.

2. As to whether a transaction forms an ‘integral part of a continuing business relationship’, the Court held it is a question of objectively ascertained fact.  The Court said at [81]:

What one or both of the parties intended (if ascertainable) may be relevant to, but is not determinative of, the statutory question. There must be a continuing business relationship and the transaction must, for commercial purposes, be an integral part of that continuing business relationship. In objectively characterising those matters – whether, on all the facts, there is a continuing business relationship (and the transaction is, for commercial purposes, an integral part of that continuing business relationship), there is no longer such a relationship, or that relationship has ended and been replaced by another (as occurred in this case) – it is necessary to consider the whole of the evidence of the “actual business” relationship between the parties.

3. The Court then looked at each of the payments made during the relevant period in light of the business relationship including, for example, whether payments were made for the purpose of inducing further supply[4] or whether they were made after Gunns and Badenoch agreed that Badenoch would cease providing services (and the ongoing business relationship had therefore ended)[5].

Metal Manufactures Pty Limited v Morton [2023] HCA 1

What was the case about?

1. The Appellant, Metal Manufacturers, was paid a total of $190,000 by the respondent, MJ Woodman, within the six-month period prior to the winding up of MJ Woodman. The liquidator of MJ Woodman sought to recover that amount from the Appellant under section 588FF(1)(a) of the Act on the basis that such amount was an ‘unfair preference’ payment. In addition to that amount already paid to the Appellant, MJ Woodman owed further amounts to the Appellant in the sum of approximately $194,000. The Appellant sought to set-off, pursuant to section 553C of the Act, the additional outstanding debt against any liability it had in respect of the ‘preference payment’ action.
2. The Full Court of the Federal Court dismissed the claim, finding that the statutory set-off was not available to the Appellant in seeking to set-off a liquidator’s claim for the recovery of the unfair preference under 588FA of the Act.[6]

The Relevant Provisions of the Act

1. Like Badenach, Metal Manufacturers also concerned voidable transactions and in particular, unfair preferences.  Metal Manufacturers also concerned the application of the set-off regime in section 553C of the Act.  That section provides for a mutual credit and set-off regime by which mutual credits, debts or other dealings are accounted for and balanced as between the insolvent company and a creditor for the purposes of any claim made by the creditor who wishes to have a debt or claim admitted against the company. 

Mutual Credits, Mutual Debts and Mutual Dealings

1. In dismissing the appeal and upholding the decision of the Federal Court, the High Court considered:

(a) mutual credits, mutual debts or other mutual dealings must arise from circumstances that subsisted in some way or form before the commencement of the winding up;[7]

(b) immediately before the commencement of the winding up there was nothing to set off as between the appellant and MJ Woodman, and the inchoate or contingent capacity held by the liquidator to sue for an unfair preference could not and did not exist before then;[8]

(c) it would be a gross distortion of the statutory scheme of liquidation if a creditor could, in effect, avoid the consequences of having received a preferential payment by reason that it was also owed money by the company in liquidation.[9]

2. The Hight Court also considered that any liability for an unfair preference could not constitute a mutual credit, mutual debt or mutual dealing with the pre-existing amount owed by the company because:

(a) Firstly, the dealings are between different persons. In this regard, the liability created by section 588FF(1)(a) to repay an unfair preference is one which arises on an application by the liquidator, who does so in his or her own right, rather than as an agent of the company.[10] Whereas the pre-existing debt exists only as between the company in liquidation and the appellant creditor; and

(b) Secondly, there is no mutuality of interest. Any money recovered by the liquidator must be made available, amongst other things, for the making of priority payments and for distribution to creditors in accordance with the pari passu principle. That unique statutory interest is not comparable to a trading transaction whereby goods or services have been previously supplied to (and for the benefit of) the company.[11]

7. Key Takeaways from Badenach and from Metal Manufacturers

1. The ‘peak indebtedness’ rule, no longer has any application in Australian Law.  Liquidators cannot arbitrarily choose a date within the relation back period to maximise the net amount of an unfair preference.  Liquidators should now focus on carefully identifying when the ‘continuing business relationship’ ended and the ‘business character’ of each transaction.
2. Although liquidators’ claims might now be reduced by the abolition of the ‘peak indebtedness’ rule, creditors will not be able to set-off outstanding debts against unfair preference claims.

[1] Corporations Act 2001 (Cth), s588FF(1)(a).

[2] Corporations Act 2001 (Cth), s588FE(2).

[3] Corporations Act 2001 (Cth), s588FA(1).

[4]  At [91].

[5]  At [96]

[6] Morton v Metal Manufactures Pty Ltd (2021) 289 FCR 556 at 560 [5] per Allsop CJ (Middleton and Derrington JJ agreeing).

[7] At [45].

[8] At [46]

[9] At [51].

[10] At [52].

[11] At [54].