The Federal Court takes aim in Gunns – and extinguishes the Peak Indebtedness Rule in Australia

On 10 May 2021 in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq)(receivers and managers apptd)[i]  the Full Court of the Federal Court of Australia abolished the application of the Peak Indebtedness Rule to a running account ‘single transaction’ under section 588FA(3) of the Corporations Act 2001 (Cth) (the Act) in unfair preference claims.

The effect is that Liquidators can no longer maximise the return on such an unfair preference claim by valuing the section 588FA(3) ‘single transaction’ by reference to the highest point of indebtedness.

The Proceedings

The Liquidators of Gunns Limited (Gunns), a major forestry public company founded in 1875, commenced proceedings against Badenoch Integrated Logging Pty Ltd (Badenoch), a family-owned regional logging and haulage business, alleging eleven payments totalling approximately $3.6 million received from Gunns in the ‘relation-back period’ were unfair preference payments under section 588FA(1) of the Act.

Badenoch relied on the running account (section 588FA(3)), good faith (section 588FG) and set off (section 553(c)) defences under the Act. Further, Badenoch disputed the Liquidators’ application of the Peak Indebtedness Rule to the valuing of the running account ‘single transaction’ as an unfair preference payment.

The primary judge, Justice Davies, found in favour of the Liquidators, save that two of the eleven payments were held to be part of the ‘continuing business relationship’ between Gunns and Badenoch and, accordingly, were subject to the valuation of the ‘single transaction’ under section 588FA(3) of the Act.

On appeal, the Full Court re-considered:

1. 1. the running account defence and existence of a ‘continuing business relationship’;
   2. the ‘Peak Indebtedness Rule’;
   3. the good faith defence; and
   4. the set off defence.

The Full Court Decision

The Continuous Business Relationship Principles

The running account defence under section 588FA(3) provides that where:

1. 1. a company makes payments to a creditor that were an integral part of a continuous business relationship; and
   2. in the course of the relationship the level of the company’s net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship;

then all transactions forming part of the relationship are taken as one ‘single transaction’ for the purposes of valuing the amount of the unfair preference.

The Full Court provided clear guidance on eight factors to consider when determining whether a payment was part of a continuous business relationship:

1. 1. whether there was a mutual assumption of a continuing relationship of debtor and creditor;
   2. whether each particular payment was connected with the subsequent provision of goods or services;
   3. whether the purpose of the payment was to induce the creditor to provide further goods or services as well as to discharge an existing indebtedness (unless the payment exceeded the value of the goods or services acquired);
   4. whether there was an express agreement that one of the purposes of the payment was to permanently reduce the level of indebtedness below the level existing at the time of the agreement;
   5. knowledge/suspicion of insolvency or reasonable grounds to suspect insolvency will not necessarily destroy a continuing business relationship;
   6. a stop on an account will not necessarily destroy a continuing business relationship;
   7. the continuing business relationship does not need to exist for the entirety of the relation-back period; and
   8. the existence of a continuing business relationship is a question of substance, not form.

In its consideration of these eight principles, the Full Court determined the first four of the eleven payments made by Gunns were part of a continuing business relationship. Thereafter, following a letter of demand containing a proposal and subsequent variation to the agreement between the parties (which fundamentally changed the nature of the relationship), the mutual assumption of a continuous business relationship between the parties had ceased.

Peak Indebtedness Rule

The Court then considered how the value of the single transaction should be calculated.

Both parties agreed that the relevant end date for the single transaction was either (a) the cessation of the continuing business relationship or (b) date of liquidation, whichever was earlier.

The issue was when the single transaction was said to begin:

1. 1. Badenoch argued that it must be the relation-back day or the commencement of the continuing business relationship, whichever was latest; conversely
   2. the Liquidators argued that by applying the Peak Indebtedness Rule they should be free to choose any point in the continuing business relationship within the relation-back period (allowing them to choose the highest point for a maximum return on their unfair preference claim).

The Full Court: a) overturned the decision of the primary judge; b) rejected the decision of Olifent[ii]; c) determined previous authorities were wrongly decided; and d) agreed with the New Zealand Court of Appeal in Timberworld[iii] and abolished the application of the Peak Indebtedness Rule to section 588FA(3) for three reasons:

1. 1. The rule was inconsistent with the statute – the plain language of the statute and the legislative material outline a single transaction encompassing all payments and supplies that are part of the continuing business relationship.
   2. The section embodies the ‘doctrine of ultimate effect’ which recognises that the general body of creditors are not disadvantaged by payments made to induce trade creditors to supply goods which are of equal or greater value.
   3. Abolition of the rule was consistent with the purpose of Pt 5.7B of the Act which is ‘in essence to do fairness between unsecured creditors’.

The Full Court noted that the arbitrary timing of a single transaction in the absence of the Peak Indebtedness Rule may also result in unfairness, as liquidators may be less inclined to pursue preferences as the amount to be recovered may not justify the time and expense involved, resulting in a lower return to creditors.

Nonetheless, the Full Court concluded that there was a degree of arbitrariness or unfairness inherent in either approach but that the balance weighed in favour of not applying the Peak Indebtedness Rule.

Good Faith and Set Off Defences

The Full Court upheld the primary judge’s decisions that these defences were not made out on the facts and in doing so did not need to consider the issue of whether the right of set-off is available in unfair preference claims as a matter of law.

Conclusion

1. 1. As noted by the Full Court itself, the effect of the decision is potentially a significant reduction in the value of a Liquidator’s claim for unfair preferences.
   2. Liquidators will need to consider this decision, recalculate the value of unfair preference claims, and consider the effect when performing a cost/benefit analysis in deciding whether to pursue unfair preference claims.

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Authored by:

Scott Couper, Partner
Claudia Dennison, Senior Associate

[i] [2021] FCAFC 64.

[ii] Olifent v Australian Wine Industries Pty Ltd (1996) 130 FLR 195.

[iii] Timberworld Ltd v Levin (2015) 3 NZLR 365.