Insolvency Update: Federal Court clarifies quantification of preference claims in Australia

There is a long line of cases in Australia which set out how to quantify claimed preference payments made by an insolvent company to a creditor where there was a continuing business relationship between them. The approach has been commonly referred to as the peak indebtedness rule.

In the recent decision of Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 (Badenoch), the Full Court of the Federal Court of Australia has held that the peak indebtedness rule should not be applied Australia. 

In this article, after setting out what a preference payment is in the context of a company in liquidation and possible defences to a preference claim, we will explore the peak indebtedness rule and why the Federal Court of Australia has decided to find against the application of the rule after so many years.

What is a preference payment?

Under section 588FA of the Corporations Acts 2001 (the Act) a liquidator is entitled in certain circumstances to seek repayment of any sum paid to an unsecured creditor during the six-month period ending on the relation back day (being the day the liquidator was appointed to wind up the company) (Relation Back Period) on the basis that it is an unfair preference payment.  

An unfair preference is a voidable transaction that occurs during the Relation Back Period at a time when the company was insolvent that results in a creditor receiving more on its unsecured claim than it would in the liquidation. 

Defences

There are a number of arguments that can be raised in defence of unfair preference claims. One of them is that the impugned payments were made in good faith and in circumstances that the creditor was not reasonably aware that that the company was insolvent or likely to become insolvent.

Another defence requires analysis of the continuing business relationship between the creditor and the company, and determination of the appropriate amount that can properly be considered voidable on the basis it was an unfair preference.

This defence, often referred to as the ‘running account defence’, is the subject of this article.

Continuing Business Relationship and Running Account Defence

Section 588FA(3) of the Act provides that, when assessing whether a transaction is preferential, if the transaction is an essential part of a ‘continuing business relationship’ between the company and creditor, all transactions forming part of that relationship will constitute a single transaction. A continuing business relationship is often evidenced by a running account.

This means that determining the preferential effect will be measured by reference to the net results of the credits and debits between the parties during this period, as opposed to looking at the gross payments received in a series of individual payments to the creditor.

A running account defence can be used as a defence (although not a complete one) to an unfair preference claim, where there are multiple transactions (an active account) between the debtor and creditor over the Relation Back Period (s 588FA(3) of the Act).

For a running account defence to be available to a creditor facing an unfair preference claim, the payments must have been made as part of a continuing business relationship.

So, what is the Peak Indebtedness Rule?

The “peak indebtedness rule” permits a liquidator to choose the highest point of indebtedness during the Relation Back Period and compare that to the indebtedness at the end of the Relation Back Period when assessing the quantum of an unfair preference in the context of a continuing business relationship.

The practical effect of this rule is demonstrated in the following example:

• at the start of the Relation Back Period a creditor was owed $30,000,

• the company enticed further provision of goods valued at $20,000 so that three months into the Relation Back Period, the company was indebted to the creditor for $50,000, and

• at the end of the Relation Back Period the creditor is owed $10,000.

In a factual scenario such as this one, assuming the creditor can establish a continuing business relationship throughout the Relation Back Period, the court would likely compare the peak indebtedness of $50,000 to the amount owed to the creditor at the end of the period ($10,000), and determine the liquidator’s unfair preference claim in the amount of $40,000.

Quantifying preference payments using the Badenoch method

In Badenoch, the Federal Court stated that if the creditor proves there is a continuing business relationship and that it was induced to continue to supply goods or services of equal or greater value to a debtor, there is no unfairness to be remedied unless there is a net gain to the creditor overall during the Relation Back Period.

The court will look at the flow of goods or services from the creditor to the company and then the flow of money from the company to the creditor to determine the difference between the two during the period and whether there has been a net benefit to the creditor, or not. 

Applying the Badenoch principle, a liquidator would take the indebtedness at the start of the Relation Back Period less the indebtedness on the relation back day.

Applying this to the above example, the potential preference claim would be calculated by comparing the $20,000 worth of goods/services supplied to the company by the creditor, less the $40,000 paid by the company in the same period, giving rise to the amount of $20,000.

Practical implications of the Badenoch principle

The practical implications of Badenoch are significant, and parties involved in unfair preference cases will need to be ready and able to deal with the different arguments now available, and the ramifications of them in each instance.

Whilst Badenoch was delivered by the Full Court of the Federal Court of Australia, the judgment is not necessarily binding on State Supreme Courts around the country, and this unfortunately introduces a high degree of uncertainty into consideration of claims in this area. Liquidators may be inclined to look to pursue claims in jurisdictions that are not bound by the Badenoch decision to apply the peak indebtedness rule where there is upside for them in increasing the risk for creditors by doing so.

We understand that Badenoch is subject to a special leave application to the High Court of Australia. It is hoped that the High Court decides to hear the matter as uniformity and certainty around these types of claims is highly desirable.

If you need help with any aspect of preference claims or insolvency generally, contact Bartier Perry today.

Authors: Gavin Stuart, Emma Boyce & Gabriella Porcu