Full Court shoots down peak indebtedness rule in Gunns appeal

Summary

The application of a rule used by Australian liquidators for over 50 years in determining the amount able to be clawed back from creditors as unfair preferences is in doubt, following a recent decision of the Full Court of the Federal Court of Australia. We would not be surprised if this issue finds its way to the High Court of Australia.

The previously understood position

For the purpose of determining whether an unfair preference is given, section 588FA(3) of the Corporations Act 2001 (Cth) (Act) treats a series of transactions entered into during the relation-back period as part of a continuous business relationship, as a single transaction. This provision is directed to capturing running account transactions under which an insolvent debtor’s indebtedness to a creditor fluctuates from time to time as goods/services are supplied and payments made in the course of an ongoing business relationship.¹

The conventional wisdom in Australia has been that a liquidator could choose any point in the continuing business relationship during the relation back-period from which the single transaction would commence for the purpose of assessing the quantum of an unfair preference.² Although not required, this meant that in almost all cases the liquidator would choose the point of the company’s peak indebtedness as, when compared with the closing balance on the relation back day, the quantum of the preference was maximised. Hence, the “peak indebtedness rule”.

On 10 May 2021, the Full Court of the Federal Court handed down its decision in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed).³ The unanimous Full Court allowed the appellant creditor’s appeal and found that the peak indebtedness rule had no foundation in the text of section 588FA. This represents a significant change to the law and will, in many cases, significantly limit the quantum of preferences which would have otherwise been recoverable by liquidators applying the peak indebtedness rule.

Below is our summary of the decision in Gunns appeal so far as it concerns the peak indebtedness rule,⁴ and the developments leading up to it. While other issues are raised in the judgment, they are not considered in this article.

Unfairness between creditors caused by the peak indebtedness rule

The peak indebtedness rule is, by its simplicity, superficially attractive. However, the rule does not sit neatly with the “doctrine of ultimate effect” established in earlier case law and now codified in section 588FA(3) of the Act. The doctrine of ultimate effect recognises that there will be no preference where payments are made to induce trade creditors to supply goods of equal or greater value.⁵

The following example illustrates the potential inconsistency between the doctrine of ultimate effect and the peak indebtedness rule, and the anomalous and unfair outcomes as between unsecured creditors which can result from the application of the latter:

• Company X (in liq) owed $100 to each of Company Y and Company Z at both the commencement and the conclusion of the relation-back period, during which it remained in a continuing business relationship with each
• Company Y fulfilled a single order from Company X for $100 worth of goods during the relation back period. Company Y’s invoice remained unpaid for several months and, consequently, Company X’s indebtedness increased to $200. Company X then paid Company Y $100 in reduction of the amount owing before the conclusion of the relation back period. Applying the peak indebtedness rule, the quantum of the preference paid to Company Y is $100
• By contrast, Company Z fulfilled four orders from Company X for $25 worth of goods each during the relation back period. Company X paid off the amount owing in respect of each of the four invoices before the next fell due such that its indebtedness to Company Z never exceeded $125. Applying the peak indebtedness rule, the quantum of the preference received by Company Z is $25

In the above example, during the relation back period Company Y and Company Z both provided $100 worth of goods to Company X and received $100 payment in return. However, the quantum of the preferences liable to be unwound by Company X’s liquidator varies significantly based on the manner in which the transactions were structured.

Inconsistent (and arguably perverse) outcomes as between creditors as exemplified above have resulted in criticism of the peak indebtedness rule and calls for its express statutory abolition.⁶

The abolition of the rule across the ditch

In Timberworld Ltd v Levin⁷ the New Zealand Court of Appeal examined a number of Australian authorities and determined that the peak indebtedness rule did not apply in the context of an equivalent New Zealand statutory provision.

The Court found that the relevantly identical New Zealand provision required consideration of the net effect of all of the transactions comprising the continuous business relationship. In particular, the Court held:⁸

The effect of the section, taken on its face, is to require all payments and transactions within the continuing business relationship to be netted off against one another. This includes both payments to the creditor and the supply of goods to the debtor….The statutory wording does not permit a liquidator to disregard some of those transactions. There is also no basis on which the liquidator can commence with only the first payment, and disregard the first supply of goods. The plain meaning of “all transactions” is just that.

The peak indebtedness rule was accordingly abolished in in New Zealand.

The Gunns first instance decisions

In three concurrently heard preference proceedings commenced by the liquidators in the Federal Court⁹, the liquidators submitted that the peak indebtedness rule was the appropriate starting point by which to determine the quantum of the preferences they sought to recover from the three creditor defendants. In contradistinction, the defendant creditors each submitted that the Court ought to follow Timberworld.

Davies J declined to follow Timberworld and instead accepted that the liquidators were entitled to nominate the point of peak indebtedness as the starting point for the purposes of establishing a preferential payment. Her Honour emphasised that the peak indebtedness rule was consistent with earlier authorities which had considered the predecessor of section 588FA.¹⁰ Her Honour also placed significant reliance of the statement of Ormiston JA (with whom Winneke P and Tadgell JA agreed) in VR Dye¹¹ that “no change was intended to be made to the nature of a preference under the new legislation, whatever other alterations were made to the law”.¹²

The Gunns appeal

One of the creditors then appealed to the Full Court.

The appeal grounds included, among others, that the trial judge erred in finding that the liquidators were entitled to apply the peak indebtedness rule and to choose any point in the relationship as the starting point of the single transaction for the purposes of section 588FA(3) of the Act.

The unanimous Full Court found that the peak indebtedness rule ought to be abolished for the following reasons:

• First, the plain language of the statute and the legislative material both supported the creditor’s contention that the peak indebtedness rule was not intended to apply in the context of s 588FA(3);¹³
• Secondly, the peak indebtedness rule cannot be reconciled with the doctrine of ultimate effect which requires one to look at the net effect of all payments forming part of the continuing business relationship;¹⁴ and
• Thirdly, the abolition of the peak indebtedness rule is consistent with the purpose of Pt 5.7B of the Act which is, in essence, to do fairness between unsecured creditors.¹⁵

The Court identified that although Ormiston JA had stated in VR Dye that section 588FA should be construed in the same way as its predecessor (which statement was relied upon by the trial judge), this was subject to the express caveat “except to the extent that the language of s 588FA clearly points to a contrary conclusion.”¹⁶ The Court held that the language in section 588FA(3)(c) pointed clearly against the application of the peak indebtedness rule and, accordingly, found that VR Dye added little to the analysis.¹⁷

Against this background the Full Court allowed the appellant’s appeal and held that previous Australian decisions applying the peak indebtedness rule were wrongly decided.¹⁸

Consistency of Gunns with earlier appellate decisions construing section 588FA

Much was made of Ormiston JA’s judgment in VR Dye in both Gunns at first instance and in the appeal. As indicated above, Davies J found that the ratio for which VR Dye stands is the unqualified proposition that no change was intended to be made to the existing law by the introduction of the current unfair preferences regime in Part 5.7B of the Act. It followed, for her Honour, that earlier High Court authority in which the peak indebtedness rule has its genesis¹⁹ continued to apply notwithstanding it (and the decisions which followed) was decided in respect of the predecessor provisions. In contradistinction, the Full Court found that Ormiston JA had decided that principles from cases considering the earlier provisions continued to apply unless the express language of the new provisions required otherwise.

The decision in VR Dye was subsequently affirmed by the NSW Court of Appeal in Beveridge v Whitton²⁰ and the Victorian Court of Appeal in McKern v Minister Administering the Mining Act 1978²¹. However, it is not entirely clear whether the respective appeal courts accepted, on the one hand, the unqualified proposition that section 588FA ought to be construed entirely consistently its predecessor or, on the other, the limited proposition that only the principles from Airservices as to the application of the doctrine of ultimate effect continued to apply under the new provisions. To the extent that the latter is correct, the Full Court’s decision is Gunns consistent with these authorities. That said, there may be room for debate.

The Gunns decision is however directly at odds with the Victorian Court of Appeal in Sutherland v Lofthouse²² in which Nettle JA (with whom Neave and Redlich JJA agreed) held:

Where the balance of a continuing account fluctuates over the relation back period, a liquidator faced with the prospect of having to treat the account as a notional single transaction is entitled to pick the peak indebtedness during the relation back period as the beginning of the arrangement, in order to maximise recovery: Rees v Bank of New South Wales (1964) 111 CLR 210 at 221; Austin and Ramsay, Ford’s Principles of Corporations Law, 13th ed, Butterworths, Sydney, 2007 at [28.370]…

The Full Court in Gunns was critical of the application of the peak indebtedness rule in Sutherland without any meaningful consideration²³ and thereafter found (at least by implication) that Sutherland was wrongly decided on this point.²⁴ The apparent conflict between appellate court authorities makes Gunns a likely candidate for an appeal to the High Court.