Past Its Peak: The High Court Of Australia Confirms The Abolition Of The Peak Indebtedness Rule For Unfair Preferences.

In the much-anticipated decision of Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (Badenoch (HCA)), the High Court of Australia (the HCA) has now confirmed that the peak indebtedness rule may not be used when assessing the quantum of an unfair preference claim arising from a continuing business relationship. While the decision is likely to benefit creditors with a continuing business relationship with a distressed company, liquidators will have a harder time pursuing unfair preference claims against trade creditors in the future.

Under s 588FA(3) of the Corporations Act 2001 (Cth) (the Act), all transactions that form an integral part of a continuing business relationship (such as where there is a running account) between the company and creditor must be treated as if they together formed a single transaction. Only if the ultimate net effect of all of those transactions results in a reduction of the indebtedness of the company to the creditor will there be a preference.^[1]

In Badenoch (HCA) the HCA examined the operation of s 588FA(3), confirming the previous decisions of the Full Federal Court (the Full Court) (discussed in our previous note here). In doing so, the HCA provided additional guidance as to when a continuing business relationship commences and ends, and which transactions arising from that relationship may form part of the single transaction for the purposes of the unfair preference regime under s 588FA(3) of the Act.

As a result of this decision, liquidators, when assessing unfair preference claims, will no longer be allowed to cherry-pick the starting point of a continuing business relationship so as to start the relationship at the point where the company has the greatest outstanding amount owing to that creditor. This approach benefited liquidators because it allowed them to demonstrate the largest aggregate net reduction in the amount owing to a creditor over the course of the continuing business relationship, and thereby the largest potential unfair preference claim that could be made by a liquidator against that creditor.

In this note we cover:

• A summary of the key points decided by the HCA
• Unfair preferences and running accounts – the legislative framework
• The peak indebtedness rule
• Issues arising in the Badenoch (HCA) decision
• Issue 1: the application of the peak indebtedness rule and the start of the continuing business relationship
• Issue 2: characterisation of the business relationship
• Issue 3: did specific payments by Gunns form an integral part of a continuing business relationship?
• Issue 4: the end of the continuing business relationship and the last invoice
• Our comments on the impact of the decision

Summary of the key points decided by the HCA

In the Badenoch (HCA) decision, the HCA determined the following key points:

• peak indebtedness rule abolished: the “peak indebtedness rule” does not form part of the unfair preference regime under s 588FA of the Act. Moreover, a liquidator may not utilise the peak indebtedness rule to select the first transaction that forms part of the continuing business relationship for the purposes of s 588FA(3);
• start of the continuing business relationship: the first transaction in a “continuing business relationship” for the purposes of s 588FA(3) is either:
  • the first transaction after the beginning of the prescribed period or after the date of insolvency, whichever is later (if the continuing business relationship started before that time); or
  • the first transaction after the beginning of the continuing business relationship (if the continuing business relationship started after the beginning of the prescribed period or date of insolvency);
• business relationship assessed objectively: whether “a transaction is, for commercial purposes, an integral part of a continuing business relationship” is to be determined via an objective factual inquiry into the business character of the transaction. While the subjective intention of the parties may be relevant, it is by no means determinative;
• application to payments: with respect to whether specific payments made from the debtor (Gunns) to the creditor (Badenoch) were made as an integral part of a continuing business relationship:
  • Payments 1 and 2: these payments were part of the continuing business relationship (despite Badenoch issuing a letter of demand, a temporary cessation of supply and entry into a payment plan) because on an objective assessment, the payments were made to induce further supply by Badenoch and the parties believed that all amounts would be paid and the relationship would continue; and
  • Payments 5-11: these payments were not part of the continuing business relationship as they were made after termination of the original supply agreement, and as part of new arrangements intended to facilitate the transition of Gunns to a new supplier and Badenoch ceasing supply; and
• end of the continuing business relationship and the last invoice: where a debt arises under an invoice issued after the end of the continuing business relationship, but the debt relates to work undertaken before the end of the continuing business relationship, such debt will be included within the single transaction arising from the continuing business relationship.

We explore the decision further in this note.

Unfair preferences and running accounts – the legislative framework

Unfair preferences

Where a company has entered liquidation, a liquidator may apply to the Court to set aside transactions occurring prior to the commencement of the liquidation that are “unfair preferences” and constitute “voidable transactions” under the Act.

Pursuant to s 588FA(1), a transaction is considered an “unfair preference” if it results in a creditor receiving more on its unsecured claim than it would have otherwise received in a winding up; that is, in a pari passu distribution of the company’s available assets to the unsecured creditors.

Unfair preferences can be set aside by the Court, on application by a company’s liquidator, where those unfair preferences satisfy the following conditions to constitute “voidable transactions”:

• the unfair preference must be an “insolvent transaction” in that the company was insolvent at the time of entering into the transaction or became insolvent as a result of entering into that transaction (s 588FC); and
• the unfair preference must have taken place during the 6 months (or, if the transaction involves a related entity, the 4 years) ending on the “relation-back day” (being the date the liquidation starts or is deemed to have started for these purposes) or after the relation-back day but before the day when the winding up actually began (s 588FE) (in this note we refer to this period of time as the prescribed period).

Running accounts and continuing business relationships

A significant feature of Australia’s unfair preference regime is the inclusion of the “running account principle”.

The principle was codified into statute by way of the Company Law Reform Act 1992 (Cth) (the Company Law Reform Act) which introduced s 588FA into the Corporations Act 1989 (Cth) (being the predecessor to the Act). Section 588FA has remained a feature of the corporations legislation since that time.

Currently embodied in s 588FA(3) of the Act, the running account principle allows all transactions that form an integral part of a “continuing business relationship” between a company and a creditor to be treated as a single transaction for the purposes of determining whether it is an unfair preference in accordance with s 588FA(1).

This requires the liquidator, when considering the amount of any payments received by the creditor during the relationship period, to factor in (i.e., deduct) the value of any additional services or products provided by the by the creditor to the company during that period. The liquidator must determine the overall effect of all of the transactions during the relevant period. This is referred to as the “doctrine of ultimate effect”.

The peak indebtedness rule

What is the peak indebtedness rule?

In addition to the running account principle, the Courts have also applied what is known as the “peak indebtedness rule” where there was a continuing business relationship.

The peak indebtedness rule enabled liquidators to choose any date during the prescribed period as the starting point of the continuing business relationship for the purposes of determining the single transaction. Being able to select the start date of the continuing business relationship is particularly important as the value of an unfair preference in a running account is generally calculated as the difference between the debt owing at the start of the relationship and the debt owing at the end of the relationship. By affording liquidators the discretion to select the point of peak indebtedness (i.e., the time at which the company was maximally indebted to the creditor) as the starting point of a continuing business relationship, the peak indebtedness rule would effectively allow liquidators to maximise the quantum of the unfair preference, and thereby maximise the potential amount that could be clawed back from the creditor on the basis that it should be set aside as a voidable transaction.

Rejection of the peak indebtedness rule by the Full Court

For many years, it was assumed that s 588FA(3) incorporated both the running account principle and the peak indebtedness rule. However, this assumption was rejected by the Full Court in Badenoch Integrated Logging Pty Ltd v Bryant [2021] FCAFC 64 (Badenoch 1 (FCAFC)), a decision which was further elaborated on by the Full Court in the subsequent decision of Badenoch Integrated Logging Pty Ltd v Bryant [No 2] [2021] FCAFC 111 (Badenoch 2 (FCAFC)). In Badenoch 1 (FCAFC), the Full Court held that the “peak indebtedness rule” should not be applied when determining the quantum of the “single transaction” resulting from a continuing business relationship under s 588FA(3). This was decided on the basis that:

• there was no legislative intention to adopt the peak indebtedness rule when the predecessor of s 588FA(3) was first enacted;
• s 588FA(3) embodies the doctrine of ultimate effect which cannot be reconciled with the peak indebtedness rule; and
• the abolition of the peak indebtedness rule is consistent with the purpose of Pt 5.7B which is “to do fairness between unsecured creditors”.

For a more detailed analysis of Badenoch 1 (FCAFC) and Badenoch 2 (FCAFC) (together, Badenoch (FCAFC)) , please see our previous blog post here.

Issues arising in the Badenoch (HCA) decision

The Badenoch (FCAFC) decisions became the subject of an appeal to the HCA, raising four key questions about the operation of s 588FA(3):

• Does s 588FA(3) incorporate or exclude the peak indebtedness rule (and if not, how is the first transaction in the continuing business relationship determined)?
• What is the proper approach to determining whether a “transaction is, for commercial purposes, an integral part of a continuing business relationship” for the purposes of s 588FA(3)?
• Were certain payments from Gunns as the debtor to Badenoch as the creditor, for commercial purposes, an integral part of a “continuing business relationship” between them within the meaning of s 588FA(3)?
• When did the continuing business relationship end, and were debts payable under an invoice issued after that date included in the single transaction?^[2]

The HCA’s approach to each of these issues is examined in the following sections.

Issue 1: the application of the peak indebtedness rule and the start of the continuing business relationship

Does the peak indebtedness rule apply?

The HCA unanimously held that the peak indebtedness rule should not be applied when determining unfair preference claims under s 588FA(3).

In arriving at this conclusion, the HCA considered the Explanatory Memorandum to the Company Law Reform Bill 1992 (Cth) and the context to the enactment of s 588FA in the Company Law Reform Act. The HCA considered that s 588FA(3) was intended to embody the running account principle as had been reflected in the cases of Queensland Bacon Pty Ltd v Rees (1967) 115 CLR 266 and Petagna Nominees Pty Ltd & Anor v A E Ledger 1 ACSR 547 (and its associated requirement to determine the question of an unfair preference by reference to the ultimate effect of the transactions during the relevant prescribed period in the running account as a whole).^[3] However it could neither be assumed nor inferred that the legislature also intended to incorporate the peak indebtedness rule into s 588FA(3).^[4]

The HCA contrasted the effect of the peak indebtedness rule, which was “to maximise the claw back of money and assets from a creditor” with the purpose of the running account principle. Jagot J noted in this regard:^[5]

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.

Furthermore, the HCA noted that whilst the liquidator was entitled under s 588FF to determine which transaction it was seeking to set aside as a voidable transaction, this did not allow the liquidator to determine which was the first transaction forming part of the continuing business relationship.^[6] The first transaction forming part of any continuing business relationship was determined by s 588FA(3).

What is the first transaction in a continuing business relationship?

Accordingly, the first transaction that can form part of the “continuing business relationship” contemplated by s 588FA(3) is not selected by the liquidator, but is instead the first transaction occurring after the continuing business relationship begins.

However, in Badenoch 2 (FCAFC) a further question arose: when is the first transaction where the continuing business relationship began before the prescribed period or the date of insolvency? Does the single transaction include transactions occurring before that time? If so, how far back in time does one look?

The question arises because an unfair preference will only constitute a voidable transaction, and therefore be capable of being set aside by a Court, where the transaction (or an act or omission for the purpose of effecting the transaction) occurs:

• while the company is insolvent (or if the company becomes insolvent because of that transaction, act or omission). In other words, there must be an “insolvent transaction” under s 588FC; and
• during the prescribed period (as determined under s 588FE).

Justice Jagot, with whom the rest of the HCA bench agreed, explained that s 588FA(3)(c) could not possibly mean that the single transaction should encompass all the transactions forming part of the continuing business relationship from the first transaction which started the relationship, in circumstances where the relationship started before the prescribed period or the time of insolvency.

This is because:^[7]

• s 588(1) contains the definition of an “unfair preference”;
• the purpose of s 588FA(3)(c) is to dictate how the concept of an unfair preference in s 588FA(1) applies where there is a continuing business relationship; and
• the operation of s 588FA(1) (and the concept of an unfair preference) is necessarily confined to insolvent transactions under s 588FC occurring within the prescribed period specified under s 588FE. This context was important as s 588FA “pre-supposed” the existence of ss 588FC and 588FE.

As a result, the HCA held that: ^[8]

“all the transactions forming part of the relationship” for the purpose of the deemed “single transaction” in s 588FA(3)(c) must mean “the relationship” starting at the beginning of the prescribed 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 the later.

Issue 2: characterisation of the business relationship

The HCA also provided further guidance on the proper approach to determining whether “a transaction is, for commercial purposes, an integral part of a continuing business relationship”.

Various previous decisions had referred to identifying the “common business purpose” or “mutual assumption” of the parties.^[9] It had been suggested (in Sutherland v Eurolinx Pty Ltd (2001) 37 ACSR 477 (Eurolinx)) that there would be no mutual assumption of a continuing business relationship where the purpose of inducing further supply is “subordinated to a predominant purpose of recovering past indebtedness”.^[10]

This led to some debate before the HCA in Badenoch HCA as to the assumptions or purposes of the debtor and creditor and whether the “sole” or “dominant” assumption or purpose of one or both of the parties in making and receiving an impugned payment was to continue the business relationship between them.

However, the HCA considered this approach was misconceived, and appeared to reject the “predominant purpose” test suggested in Eurolinx.^[11] The HCA instead focused on the statutory wording, and characterised the test as follows:^[12]

The statutory task remains one of characterisation of the facts involving an objective ascertainment, on the whole of the evidence, of the business character (for commercial purposes) of the transaction in issue.

Therefore, while the subjective intention of the parties may be relevant, at least insofar as it sheds light on the objective “business character” of the transaction, it should not be treated as the determining factor.^[13]

Accordingly, the HCA considered that:^[14]

it is not the case that a continuing business relationship necessarily continues unless and until it can be inferred that the sole mutual assumption or purpose of the creditor and debtor in respect of the transaction is the reduction of indebtedness.

Issue 3: did specific payments by Gunns form an integral part of a continuing business relationship?

Payments 1 and 2

The HCA upheld the Full Court’s finding that the two payments made by Gunns to Bandenoch on 30 March 2012 and 13 April 2012 (Payments 1 and 2) were an integral part of the continuing business relationship between them.^[15] Relevantly, these payments were made in circumstances where Badenoch had issued Gunns a letter of demand, ceased supply for 10 days, and entered into a progressive payment plan with Gunns.

The HCA found that the mutual assumption or purpose as between Gunns and Badenoch, inferred as a matter of objective fact from all of the circumstances, was that Payments 1 and 2 were made to induce further supply.^[16] This was because:^[17]

• the controlling minds of Badenoch believed that Gunns would ultimately be in a position to pay all outstanding invoices;
• the temporary cessation of supply and negotiation of additional credit terms in the lead up to Payments 1 and 2 did not cause either party to consider that their business relationship was coming to an end; and
• the parties were working towards continuing their business relationship and believed it would continue.

Importantly, there was a continuing business relationship notwithstanding that Badenoch and Gunns intended the payments to reduce Gunns’ past indebtedness (in addition to their intention that such payments would induce further supply of services from Badenoch).

Payments 5 to 11

The HCA also agreed with the Full Court’s conclusion that Payments 5 to 11 (being further payments made between 6 August 2012 and 21 September 2012) did not form part of the continuing business relationship.^[18] These payments were made in circumstances where Badenoch:

• had terminated the agreement for supply between it and Gunns; and
• had agreed, under a new agreement dated 2 August 2012, to continue to supply services to Gunns for a short period of time pending the engagement of a new contractor. Payment 5 was the first payment under and in accordance with this new arrangement.

Badenoch sought to argue that because it had continued to supply its services to Gunns until September 2012, Payments 5 to 11 still formed part of its continuing business relationship with Gunns. This argument was rejected by the HCA on the basis that:^[19]

• the parties had agreed that their agreement would cease and entered into a transition plan towards the cessation of supply;
• in a practical “business sense”, the pre-existing business relationship between Gunns and Badenoch had ceased by no later than 2 August 2012 in virtue of the new supply arrangement; and
• Badenoch’s continued supply following the termination of the original agreement was for the purpose of minimising Gunns’ debt to it before the handover to another contractor.

Issue 4: the end of the continuing business relationship and the last invoice

This left the question of when the continuing business relationship actually ended, and whether the net indebtedness of Gunns at the end of that relationship should reflect the amounts payable by Gunns under an invoice issued by Badenoch dated 31 July 2012.

The Full Court had held that the continuing business relationship ended on 10 July 2012 (being the date that Badenoch ceased supply the second time). The HCA considered that this was correct, as up 3 July 2012 the parties:^[20]

were still contemplating supply being continued under the agreement as modified in March if the non-payment was rectified. Further, at that time, Badenoch was merely contemplating termination of the agreement if Gunns did not rectify the non-payment. This is sufficient to conclude that the continuing business relationship did not cease before 10 July 2012 when Badenoch ceased supply.

The HCA held (agreeing with the Full Court in Badenoch 2 (FCAFC)) that the debts payable by Gunns under the 31 July 2012 invoice should be included when calculating the net indebtedness at the end of the single transaction even though the continuing business relationship ended on 10 July 2012. The issuance of the invoice gave rise to the obligation on Gunns to make payment, and was therefore a “transaction”. However, because the invoice related to work carried out by Badenoch before 10 July 2012, the obligation to pay which arose pursuant to the invoice on 31 July 2012 was nevertheless an integral part of the continuing business relationship that existed prior to 10 July 2012.^[21]

Our comments on the impact of the decision

Ending the uncertainty

The decision in Badenoch (HCA) brings to a close a period of uncertainty regarding the assessment of unfair preferences in the context of continuing business relationships.

This uncertainty was highlighted by the case of Timberworld Ltd v Levin [2015] 3 NZLR 365 (Timberworld), where the New Zealand Court of Appeal (NZCA) observed, in respect of the peak indebtedness rule, that the Australian courts “seem to have assumed the rule had the weight of authority and sufficient pedigree to warrant its direct application.”^[22] The NZCA went on to decide that there was no authority justifying the application of the peak indebtedness rule under the corresponding New Zealand statutory provisions.

The HCA has agreed with the NZCA in Timberworld (in this regard at least)[23] and similarly abolished the peak indebtedness rule in Australia. Furthermore, the HCA’s decision has also brought welcome clarity as to when the continuing business relationship, and the single transaction arising from it, starts and ends (and which transactions are to be included within that single transaction).

Encouraging trading on

Liquidators may be disappointed to lose their ability to rely on the peak indebtedness rule as a means of maximising recoveries in unfair preference claims. However, there is also some merit in incentivising trade creditors to keep trading with, and providing value to, a distressed company, as this has the potential to benefit not only the distressed company itself, but also its broader creditor group. As the HCA identified, the running account principle incorporated into s 588FA(3) reflects a policy decision by Parliament.

The (fairly) recently enacted insolvent trading safe harbour also encourages companies to continue trading despite being insolvent (where this is part of a ‘course of action’ that is reasonably likely to result in a better outcome than administration or liquidation). Indeed, the safe harbour has given rise to concerns that creditors are at increased risk of payments being clawed back as unfair preferences (see for example the discussion in section 7.2(a) of the Safe Harbour Panel’s Review of the Insolvent Trading Safe Harbour Report).

In this context, the HCA’s approach to the continuing business relationship will offer trading counterparties some degree of relief. Whether or not a creditor has received a preference on a running account will be determined on the basis of all transactions falling within the prescribed period while the company is insolvent (or if the continuing business relationship commences after this point, at the time of the first transaction). This means that where the balance of a running account between a debtor and creditor remains relatively static over the relevant period, the amount recoverable by the liquidator will be significantly reduced or may even be extinguished entirely.

“A true relationship is two imperfect people refusing to give up on each other”

Finally, as to the establishment of a “continuing business relationship” (and whether it continues to apply to any given transaction), creditors and liquidators will need to keep in mind that what matters is not the subjective intention of the parties as to the purpose of the transaction, but the overall business character of the transaction objectively ascertained from the whole of the evidence – is it one that has the character of reducing past indebtedness or inducing continued supply?

Suppliers and service providers should therefore consider carefully how they frame negotiations and arrangements with delinquent customers. For example, taking steps to transition customers to another provider, even if there is still some period of further trading before this occurs, is likely to indicate an end to the continuing business relationship. However, moving to tighter credit terms, or even temporarily halting supply, is not necessarily enough to end a business relationship – seeking to reduce past indebtedness can potentially co-exist with an ongoing business relationship. The key is whether the evidence objectively demonstrates that the parties intend that, despite some ‘bumps in the road’, they are working to remedy the situation and expect to continue trading together over the longer term.

For further information, please contact:

Paul Apathy, Partner, Herbert Smith Freehills

paul.apathy@hsf.com

[1] This is referred to as the “doctrine of ultimate effect”.

[2] In their summary, the HCA referred to the first three issues and described the fourth issue as a “subsidiary question” arising in connection with issue 3.

[3] Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 at [45]-[54] (Badenoch (HCA)).

[4] Ibid [45].

[5] Ibid [70].

[6] Ibid [77].

[7] Ibid [61]-[64]. Interestingly, the HCA did not put significant emphasis on the issue raised by the Full Court in Badenoch 2 (FCAFC) with a construction that could extend the continuing business relationship back before the start of the prescribed period to the outset of the relationship (that this may result in there being no preference at all). The Full Court said in that decision at [22]: “It may be also observed that if the continuing business relationship commenced at the beginning of the running account (some years prior to 2012), questions may arise as to whether Badenoch “received” anything in relation to an unsecured debt at all. Expressed another way, if the single transaction is that evidenced by the whole of the running account, Badenoch appears to have supplied more than it has received, such that there could be no unfair preference. Whether that is the intended operation of the Act is a question that may be deferred to a case where the outcome depends upon it.” In this regard, Jagot J stated in Badenoch (HCA) at [58]: “The rule also remains unexplained in the decisions which embody it, other than that it is obvious that if the relevant “relationship” between debtor and creditor is taken to start at the first transaction between them, there could never be an unfair preference because the account will stand at zero at that time. It may be inferred that it is for this reason that, in Rees v Bank of New South Wales, Barwick CJ conceived of the possible starting points for the relevant “relationship” to be either the date on which the prescribed period ending on the relation-back day commenced or the date selected by the liquidator.”

[8] Badenoch (HCA) at [74].

[9] See e.g., Richardson v The Commercial Banking Co of Sydney Ltd (1952) 85 CLR 110 at 133; Queensland Bacon Pty Ltd v Rees (1966) 115 CLR 266 at 286; Airservices Australia v Ferrier (1996) 185 CLR 483 at 502-506 (Airservices); Sutherland v Eurolinx Pty Ltd (2001) 37 ACSR 477, 504 at [148] (Eurolinx).

[10] Eurolinx at [148].

[11] Whilst it is not stated explicitly, Jagot J appears to regard the “predominant purpose” test arising from Eurolinx as a misunderstanding of the decision in Airservices. His honour states in Badenoch (HCA) at [84]: “The different conclusion in respect of the last payment in Airservices Australia v Ferrier resulted from the fact that, although the creditor believed it would continue to supply services to the debtor and in fact did so after the last payment, that payment was made “looking backwards rather than forwards; looking to the partial payment of the old debt rather than the provision of continuing services”. In so concluding, Dawson, Gaudron and McHugh JJ were not suggesting that a subjective intention of a creditor to reduce past indebtedness meant that the continuing business relationship would cease (clearly not, given the treatment of the earlier eight payments). They were saying that, on the whole of the evidence, the objectively inferred character of the payment was to reduce past indebtedness, and not to induce the continuation of supply. On this basis, the whole of the last payment was to be characterised as an unfair preference.”

[12] Badenoch (HCA) at [85].

[13] Ibid [81].

[14] Ibid [85].

[15] Ibid [15]; [90]-[92].

[16] Ibid.

[17] Ibid.

[18] Ibid [15]; [95]-[97].

[19] Ibid.

[20] Ibid [102].

[21] Ibid.

[22] Timberworld Ltd v Levin [2015] 3 NZLR 365 at [41] (Timberworld).

[23] The HCA appears to have disagreed with the NZCA’s suggestion in Timberworld (at [80]) that “the running account doctrine is difficult to reconcile with the concept of peak indebtedness.” Instead, the HCA appears to have seen the starting point of the continuing business relationship (and single transaction) as simply reflecting a policy choice – see Badenoch (HCA) at [77]. This also appears to be a point of departure of the HCA from the Full Court, which stated in Badenoch 1 (FCAFC) at [118] “we cannot see any way to reconcile the doctrine of ‘ultimate effect’ and the decision in Airservices with the peak indebtedness rule.”