Insolvency: Reaching its peak – unfair preference claims

7 APRIL 2021 BY JASON GEISKER & GEORGINA OVEREND

Snapshot

• Three recent judgments by Davies J provide clarity on a number of key issues in unfair preference claims.
• The judgments have provided the first opportunity for an Australian court to consider the application of the peak indebtedness rule following the New Zealand Court of Appeal’s decision in Timberworld.
• Badenoch’s recent appeal to the Full Court will provide a further opportunity for the peak indebtedness rule to be considered, as well as the ability to rely on set-off pursuant to s553C of the Corporations Act 2001 (Cth).

Three trials in the Federal Court provide clarity on key issues in unfair preference claims.

Three trials in the Federal Court of Australia arising from the Gunns Ltd liquidation have provided the first opportunity¹ for an Australian court to consider the peak indebtedness rule following the New Zealand Court of Appeal’s landmark decision in Timberworld Ltd v Levin [2015] 3 NZLR 365 (Timberworld). Fortunately for the liquidators, the Federal Court confirmed the peak indebtedness rule remains and rejected the New Zealand approach.

Background 

In 2015, Daniel Bryant, Ian Carson and Craig Crosbie (Liquidators) in their capacity as joint and several liquidators of Gunns Limited (in liq) (Gunns) and its wholly owned subsidiary, Auspine Ltd (in liq) commenced unfair preference proceedings against:

• Badenoch Integrated Logging Pty Ltd (Badenoch) 
• Bluewood Industries Pty Ltd (Bluewood) 
• Edenborn Pty Ltd (Edenborn). 

All three defendants had provided timber harvesting services to Gunns during the six-month period prior to the Liquidators’ appointment as joint and several administrators of Gunns (relation back period). The Liquidators alleged that during the relation back period Gunns had made a series of payments to each of the defendants which were unfair preferences as they had resulted in the defendants receiving more than they would have had they proved their unsecured debts in the winding up of the company. 

In determining the claims, Davies J was asked to consider the application of the peak indebtedness rule in light of the New Zealand Court of Appeal’s decision in Timberworld, the ultimate effect doctrine and the availability of set-off, under s553C of the Corporations Act 2001 (Cth) (Act), to unfair preference claims. 

On 27 May 2020, Davies J delivered three separate judgments² all in favour of the Liquidators, finding that the payments were unfair preferences pursuant to s588FA of the Act.

The peak indebtedness rule

At general law, where a payment forms part of a broader series of transactions, its effect as a preference involves a consideration of the whole transaction and whether the payment is integral to the continuation of a business relationship.³ On the basis that the transaction is integral to the continuation of a business relationship, the amount of any recovery can be limited to the difference between the highest point of indebtedness during the relation back period and the level of the debt on the last day of that period. This is known as the peak indebtedness rule. 

The peak indebtedness rule can be traced back to the High Court’s decision in Rees v Bank of New South Wales [1964] HCA 47 (Rees) in which Barwick CJ remarked:

“In my opinion the liquidator can choose any point during the statutory period in his endeavour to show that from that point on there was a preferential payment and I see no reason why he should not choose, as he did here, the point of peak indebtedness of the account during the six months period”.

Following Rees, the peak indebtedness rule has been applied by various Australian courts when considering the application of running account. However, following the introduction of Part 5.7B of the Act,⁴ questions have been raised as to the continued application of the peak indebtedness rule in the context of a running account. Consequently, one of the live issues to be determined by the Court was whether the peak indebtedness rule continued to apply in Australia following the introduction of Part 5.7B. 

In all three cases the defendants argued that s588FA(3) did not codify the peak indebtedness rule. They submitted that it was reasonable to infer the wording of s588FA(3) was intended to alter the law as it related to the peak indebtedness rule. This argument relied on the New Zealand Court of Appeal’s decision in Timberworld, which had held that the peak indebtedness rule did not apply to s292(4B) of the Companies Act 1993 (NZ) (NZ Act), as that had been introduced in materially the same terms as s588FA(3) of the Act. 

In Timberworld, the Court relevantly held that s292(4B) did not give the liquidator any right to disregard transactions which formed part of the continuing business relationship but, rather, the plain wording of s292(4B) required all transactions forming part of the relationship to be treated as amounting to a single transaction, with the only limitation being that only transactions occurring in the relation back period could be considered. With this in mind, it had been suggested that arriving at some “artificial point during the course of the relevant transaction and to select the date of peak indebtedness would be to ignore the express wording used by Parliament”.⁵

However, having considered the Court’s reasons in Timberworld, Davies J was not persuaded the peak indebtedness rule no longer applied in Australia. Davies J noted that the explanatory memorandum to the Corporate Law Reform Bill 1992 (Cth) clearly states that the proposed sub-s588FA(2) (which became sub-s(3)) “is aimed at embodying in legislation the principles reflected in the case of Queensland Bacon Pty Ltd v Rees [1967] 115 CLR 266 and Petagna Nominees Pty Ltd v AE Ledger 1 ACSR 547” (Petagna).⁶ To this end, Petagna cited various cases with approval concerning the application of the peak indebtedness rule, noting that “the liquidator can choose any point during the statutory period in his endeavour to show that from that point on there was a preferential payment”.⁷

Davies J also concluded there was no reason to depart from the clear weight of authority, supporting that the current provisions of the Act were not intended to substantively change the law with respect to unfair preferences.

Ultimate effect

The ultimate effect doctrine emanates from a number of cases in the 1960s where it was stated that the doctrine was designed to “ensure that the effect of a payment that induces the further supply of goods and services is evaluated by the ultimate effect that it has on the financial relationship of the parties . . . [if] the payment was made to induce the further supplies, the creditor is entitled to have the ultimate effect of the transaction examined”.⁸

In this regard, payments made to induce further supplies were not preferences unless the “ultimate effect” was that the value of the payments exceeded the value of the goods or services provided.

In the Edenborn decision, it was common ground between the parties that the doctrine of ultimate effect continued to apply in determining whether a creditor had received an unfair preference in a running account scenario following the introduction of Part 5.7B. However, despite the parties’ agreement that the doctrine applied, the parties differed as to why that was so. Neither party was able to point to any binding authority on the Court on the question of ultimate effect. 

The Liquidators contended that s588FA(3) codified the ultimate effect doctrine such that there was no work for the earlier authorities to do. The effect of this was that the doctrine simply involved a comparison of the face value of the services provided against the value of the payments made. 

In contrast, Edenborn asserted that the cases preceding the introduction of s588FA(3) remained relevant to its interpretation and that the Liquidators were required to allege and prove that the transaction resulted in an overall reduction in the net assets available to other creditors.

Notwithstanding the uncertainty surrounding the continued application of the ultimate effect doctrine, Davies J acknowledged that it was not necessary to form any conclusive view on the matter as the Liquidators had established, as a matter of fact, that the payments were preferential. However, her Honour did observe that: 

“If it were necessary to form a view in this case . . . I would be disposed to hold that the doctrine still applied”.⁹

Davies J’s conclusion relied on the fact that s588FA(3) undoubtedly codified the running account principles and that as a matter of construction s588FA(1)(b), read with s588FA(3), codified the ultimate effect doctrine in s588FA(1)(b). 

Davies J also rejected Edenborn’s argument that the Liquidators’ claim must fail because the Liquidators did not allege and prove that the ultimate effect of the single transaction was a reduction in the net assets available to creditors. In her Honour’s view, this argument was based on the incorrect proposition that s588FA(1) incorporated a requirement that a single transaction must result in a decrease in the net value of other assets available to creditors.¹⁰

Availability of set-off under s553C of the Act

Bluewood and Badenoch also sought to set-off, under s553C of the Act, any amounts said to be still owing by Gunns to them against any amounts that the Court found Bluewood and Badenoch liable to pay as an unfair preference and therefore voidable transaction. 

While a number of cases commencing with the UK decision in Re A Debtor [1927] 1 Ch 410 have held that set-off under s553C and other equivalent provisions is not available in unfair preference claims, in recent years there have been other cases which have held or suggested that set-off for a claim for recovery by a liquidator should be extended to s588FF. 

Ultimately, Davies J considered that it was unnecessary to decide the set-off issue because both Bluewood and Badenoch had notice at the relevant times that Gunns was insolvent and therefore were caught by s553C(2) of the Act. Accordingly, debate as to the availability of set-off under s553C of the Act in unfair preference claims remains.

Takeaway points

The trio of Gunns judgments confirms that the peak indebtedness rule continues to apply following the introduction of Part 5.7B. 

Although Davies J’s decision did not determine the availability of s553C of the Act to unfair preference claims, an appeal lodged by Badenoch, and heard on 10 February 2021, asked the Full Federal Court to consider this issue.

The Full Court’s decision on this issue, as well as Davies J’s acceptance of the application of the peak indebtedness rule, will have a significant impact on liquidators and creditors alike. If the Full Federal Court overturns Davies J’s decision and follows the New Zealand Court of Appeal in Timberworld, the repercussions will be enormous. Likewise, any appeal finding that the peak indebtedness rule should no longer apply to running account, or that s553C of the Act should allow for set-off in unfair preference claims, could vastly reduce the value of preference claims brought by liquidators in the future. Such an outcome might well also have broader ramifications on a liquidator’s ability to fund investigations and bring other potential claims, absent access to creditor or third-party litigation funding support. 

Article originally published in the April 2021 Law Institute Journal.

Jason Geisker is a Principal Lawyer at Maurice Blackburn and Head of Claims Funding Australia, the litigation funding arm of Maurice Blackburn.

Georgina Overend is an associate at Maurice Blackburn Lawyers, legal advisers to Claims Funding Australia.

1. Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713 (Badenoch decision) at [105].
2. Badenoch decision, Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Bluewood Industries Pty Ltd [2020] FCA 714 and Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Edenborn Pty Ltd [2020] FCA 715 (Edenborn decision).
3. Richardson v Commercial Banking Co of Sydney Ltd [1952] 85 CLR 110 at 129; Re Employ (No 96) Pty Ltd (in liq) [2013] 93 ACSR 48 at [37].
4. Section 588FA was part of a raft of new legislative provisions for recovery of property for the benefit of creditors comprised in a new part 5.7B of the Corporations Law introduced by the amending Corporate Law Reform Act 1992 (Cth), The relevant provisions of part 5.7B were adopted into the Act in 2001.
5. Timberworld at [386].
6. Explanatory Memorandum to the Corporate Law Reform Bill 1992 (Cth) at [1042].
7. Petagna at 564.
8. Airservices Australia v Ferrier [1966] HCA 54 at [509].
9. Edenborn decision at [165].
10. Note 9 above, at [167].