In Short

The Situation: The High Court of Australia has confirmed in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 that the "peak indebtedness rule" is no longer available to liquidators when assessing the value of running accounts in unfair preference claims.

The Development: The court upheld the decision of the Full Court of the Federal Court, which found that the language of the Corporations Act requires that any preference made as part of a "continuous business relationship" must be valued as the difference in the amount owing to a creditor at the beginning and end of the ongoing relationship.

Looking Ahead: The peak indebtedness rule has now been abolished once and for all. As a result, liquidators are less likely to pursue unfair preference claims where a running account defence may apply as the potential recovery will be diminished. The decision may also give creditors more confidence in continuing business relationships with debtors in potential distress given there is now greater certainty in the application of the running account defence.

Full Federal Court Proceedings

The findings of the appeal to the Full Court of the Federal Court were set out in our previous Commentary, "After a Peak Comes the Fall: Australian Federal Court Rejects "Peak Indebtedness Rule". In short, Badenoch claimed that the primary judge erred in finding that only two of the 11 impugned payments formed part of the running account, and that the peak indebtedness rule applied to claims made in respect of section 588FA(3) (which contains the running account defence, a key means of rebutting an unfair preference claim).

The Full Federal Court held that a continuous business relationship could exist where the measures adopted by a creditor were directed towards allowing or inducing the creditor to provide ongoing goods or services, even if they also had the purpose of encouraging the debtor to discharge an existing indebtedness.

In relation to the application of the peak indebtedness rule, the Full Federal Court held that the common law doctrine was not incorporated within section 588FA(3). This was because the incorporation of the peak indebtedness rule did not accord with the plain language of section 588FA(3) and offended the doctrine of "ultimate effect", which requires consideration of the net effect of all payments and supplies that form part of the running account in determining whether a preference is "unfair". The liquidator appealed against this decision and Badenoch cross-appealed.

High Court Decision

The High Court unanimously dismissed the liquidator's appeal against the Full Federal Court's decision rejecting the peak indebtedness rule.

The court considered that the proceedings raised three questions about the operation of section 588FA(3):

• Whether the peak indebtedness rule is encompassed within the statutory language of section 588FA(3);
• What the proper approach is to determining whether a transaction is part of a "continuing business relationship" for the purposes of section 588FA(3)(a); and
• In light of the above, whether certain payments made by Gunns to Badenoch were, for commercial purposes, an integral part of a "continuing business relationship" between them.

The court held that, properly construed, Part 5.7B of the Act does not incorporate the peak indebtedness rule, the insertion of the rule not being open on the language of section 588FA. In reaching this conclusion, the court looked to the context of section 588FA(3). It held that while Parliament intended to introduce the running account principle when enacting section 588FA(3), the assumption that the peak indebtedness rule was also embodied in that introduction was "fraught". Any cases that assumed that the running account principle included the peak indebtedness rule can now be considered wrongly decided.

The court also clarified that the first transaction that can form part of the continuing business relationship contemplated by section 588FA(3) is the first transaction of either the period within six months from when the continuing business relationship began or when the company became insolvent, whichever is later. This contrasts to the previous ability under the peak indebtedness rule for the liquidator to select a date to act as the date of the first transaction forming part of the voidable "single transaction", which the court deemed to be an arbitrary choice.

Section 588FA(3)(a) also requires consideration of whether a transaction is, for commercial purposes, an "integral part of a continuing business relationship" between a company and a creditor. The court observed that the proper approach to determining whether a transaction is part of a "continuing business relationship" involves an objective factual inquiry. This necessitates consideration of the whole of the evidence of the actual business relationship between the parties. In this case, after conducting the objective factual inquiry, the court upheld the Full Federal Court's decisions as to whether certain payments were transactions forming an integral part of the continuing business relationship between Gunns and Badenoch.

Three Key Takeaways

1. The peak indebtedness rule will no longer apply to the valuation of running accounts. This provides clarity to the application of a rule which has been criticised for being arbitrary.
2. Liquidators can no longer cherry-pick the starting date that maximises the quantum of recovery to prove the existence of an unfair preference. Liquidators will need to take this into account when considering whether to pursue an unfair preference claim.
3. Where a creditor and debtor are parties to a continuing business relationship, and share a mutual assumption that payments are made to induce ongoing supply, the running account defence may apply to rebut unfair preference claims, even if the payments also had the effect of discharging indebtedness. This may provide comfort to creditors that continue to trade with distressed companies.