Background and summary

What is a voidable transaction and what is the peak indebtedness rule?

The voidable transactions framework is set out in Part 5.7B of the Corporations Act 2001 (Cth). These provisions enable a liquidator to apply to the Court to grant orders that certain transactions entered into with creditors of a company in liquidation are 'void.' If such an order is granted, it often means the creditor will also be required to repay the company an amount equal to or part of the money it had been paid by the company.

One type of 'voidable transaction' is an unfair preference. A transaction is an unfair preference if:

• the company and the creditor are parties to the transaction which the liquidator is able to prove in hindsight was entered into at the time the company was insolvent at law, and
• the transaction results in the creditor receiving from the company, in relation to an unsecured debt owed to the creditor, a greater amount than it would have received in relation to the debt in a winding up of the company.

A key way of defending of an unfair preference claim by a creditor is to rely on 'the continuing business relationship' or 'running account' defence. A continuous business relationship arises when multiple individual transactions form a running account in which the debtor and the creditor adopt a mutual assumption that payments are made to induce ongoing supply rather than to solely discharge existing indebtedness.

The peak indebtedness rule has its genesis in case law. The courts have said that it is open to a liquidator in a preference proceeding to choose the highest point of indebtedness in a running account during the relevant period as the "starting point" rather than the balance as at the start of the relevant period. Since then, liquidators have applied the peak indebtedness rule in calculating whether a preference payment has been made to a creditor in a liquidation.

The difference in the two alternate approaches can be material. In the Gunns decision, applying the 'peak indebtedness' rule would mean taking the 'peak debt' during the relevant period of $1,416,563.31 and comparing it to the debt at the end of the relevant period of $1,365,31.02. This equates to a reduction in the company's indebtedness to the creditor and therefore a preference of $51,200. On the other hand, taking the 'net effect' of the running account would mean taking the balance of the account at the start of the relevant period, being $410.965.07 and comparing it to the balance at the end of the relevant period, being $1,365,321.02, which would mean a net increase in the company's debt to the creditor and therefore no preference.

Background to the Gunns decision

Gunns Limited (in liquidation) (receivers and managers appointed and its wholly owned subsidiary Auspine Limited (in liquidation (receivers and managers appointed (Auspine) (together, Gunns) conducted a timber felling business located in Tasmania, Australia which operated sawmills and plantations across several states in Australia . Badenoch Integrated Logging Pty Limited (Badenoch) provided logging and transport services to Gunns. In or around 2003, Auspine and Badenoch entered into agreement whereby Badenoch would supply the Gunns group with timber. Under the terms of the agreement, Badenoch was required to provide a specified quantity of timber annually and would invoice Auspine on a monthly basis for the provision of its services. The payment arrangement required Auspine to pay the invoice on the last working day of the following month.

Between the period of 2010 – late 2012, the Gunns group suffered poor financial performance and Badenoch continued to provide services to the group throughout this period.

On 25 September 2012 (the relation back day), Gunns appointed Mr Daniel Bryant, Mr Ian Cason and Mr Craig Crosbie as joint and several administrators to the company and its wholly owned subsidiary Auspine. The administrators were subsequently appointed as liquidators to the companies.

Upon their appointment, the liquidators, applied to the Court to have a series of 11 payments made from 26 March to 25 September 2012 (relation back period) by Gunns (on behalf of Auspine) to Badenoch declared void under section 588F(1) of the Act. In a separate contested judgment, Davies J found that Gunns was deemed insolvent from 30 March 2012.

A summary of the various invoices issued by Badenoch, the payments made by Gunns and the balance of the running account relied on by Badenoch was referred to in the judgments of both the Full Court and the High Court judgment. It is copied below to assist in the illustration of the relevant concepts:

The liquidators then argued that:

1. All payments made between the period from 30 March to 25 September 2012 were unfair preferences and voidable in accordance with the Act; and

2. If there was "a continuing business relationship" between Gunns and Badenoch:

a. it came to end when Gunns temporarily ceased to provide services to Badenboch by 30 June 2012, or alternatively, upon the mutually agreed termination of the contract on or about 2 August 2012; and

b. they were entitled to apply the peak indebtedness rule and choose the starting date within the relation back period to prove the existence of an unfair preference. The liquidators argued that 31 May 2012, being Badenoch's highest level of indebtedness to Gunns should be the starting point of the "single transaction".

Accordingly, on the liquidators' case either:

1. all of the 11 payments in the total amount of $3,360,876.16 were unfair preferences on application of section 588FA (1) and subject to claw back; or

2. if a continuous business relationship was found to be in place and that relationship ended at the end of June or early August 2012, the preference would be:

a. the difference between the amount owing by Badenboch as at 31 May 2012 being $1,416,563.41; and

b. the amount owing as at the end of the continuous business relationship, which the liquidators contended was 30 June 2012, being $1,365.321.02.

On this basis, Gunn's indebtedness to Badenoch decreased in the amount approximately $51,200 being the amount of the unfair preference received by Badenboch and the amount subject to clawback. To this amount, the total of payments 5 to 11 would be added being the total amount of $1,200,000, bringing the total preference amount to approximately $1,251,000.

Badenoch on the other hand, contended that:

1. Gunns and it had a continuous business relationship or running account for the entirety of the relation back period (or from 30 March) to 25 September 2012 and that each of the payments in issue was an integral part of that continuing business relationship; and

2. As a result and pursuant to section 588FA(3), all the transactions should be treated as a single transaction by calculating their net effect, in determining whether an unfair preference was given to it.

On this basis, Gunn's indebtedness to Badenoch increased in the amount approximately $158,000 and therefore there was no unfair preference.

First instance decision

At first instance, Justice Davies held that a continuous business relationship existed between the parties (subject to the qualification below). He said that the "peak indebtedness rule" continued to apply under section 588FA(3) and as such, allowed the liquidators to choose the date of the first transaction in the relevant commercial relationship for the purposes of the netting process required in order to determine if the transaction constituted an unfair preference under section 588FA(1)(b) of the Act.

However, His Honour found that only two payments, being payments 3 & 4 referred to in the table above, were key to the continuing business relationship between the parties. The remainder of the payments being payments 1 and 2 and 5 to 11, were made in discharge of previous debts (that is, past invoices) rather than the provision of continuing services in support of the Gunns business. Therefore, these payments did not constitute integral transactions as part of a continuing business relationship.

The result of this decision was that:

• the continuing business relationship existed between 17 April 2012 and 30 June 2012 (thus creating one single transaction);
• the point of peak indebtedness which could be relied upon by the liquidators for that period was 31 May 2012, at which time Gunns owed Badenoch $1,416,563.31. At the conclusion of the continuing business relationship on 30 June 2012, Gunns owed Badenoch $1,365,321.012, representing a reduction in the debt owed to Badenoch and an unfair preference in the amount of approximately $51,200;
• otherwise, payments 1 and 2 and 5 to 11 were each held to be unfair preferences and subject to claw back, the value of which was $2,020,000. As a result, on this reasoning, the total claw back amount was approximately $2,071,200.

Full Court decision

The first instance decision was then appealed to the Full Court of Australia where Justices Middleton, Charlesworth and Jackson disagreed with the first instance judge on all material points. In this note, we do not set out the Full Court's reasoning and instead focus on the High Court's decision.

The High Court’s decision on the 'peak indebtedness' rule

On appeal, their Honours, Kiefel CH, Gageler, Gordon, Edelman, Steward, Gleeson and Jagot JJ were asked to answer the following questions:

• Whether the peak indebtedness rule is incorporated into section 588FA(3) of the Act;
• What is the proper approach for determining whether a "transaction is, for commercial purposes, an integral part of a continuing business relationship"; and
• Were certain payments from Gunns to Badenoch for commercial purposes, an integral part of a continuing business relationship" within the meaning of section 588FA(3) of the Act.

In answering the first of these questions, the High Court unanimously dismissed the appeal and in doing so, held that the 'peak indebtedness rule' does not coexist with the principle of a 'running account' and the plain language of section 588FA(3) of the Act. In coming to this decision, the High Court considered both the language within the Act and the relevant Explanatory Memorandum, and determined that section 588FA(3) did not establish an intention by the legislature to create a 'peak indebtedness rule' in respect of unfair preference claims. Rather, it was the legislature's intention to give effect to the 'running account' principle'.

Second, the High Court held that in circumstances where it is established that a running account exists between the company in liquidation and the creditor, the question of an unfair preference is to be determined by reference to the 'ultimate effect' of the transactions during the relevant period. The 'ultimate effect' of the transactions is the net effect of all payments made and all services or goods supplied during the entire period of the running account.

Third, the High Court disagreed with the primary judge's finding that the payments and 1 and 2 in the table above did not form part of the continuous business relationship. The primary judge had, as we explain above, formed this view relying on the fact that the creditor had at the time put in place a short, 10 day 'supply stop" and negotiated a repayment plan in respect of the outstanding debt. The Full Court had disagreed with the primary judge on this point and had expressed caution in drawing the conclusion that a continuous business relationship does not exist where the purpose of inducing further supply is subordinated to a predominant purpose of recovering past indebtedness".

The High Court agreed with the Full Court's reasoning. It held that a liquidator must determine whether a payment made to a creditor within the relation back date was for the purpose of paying an existing or past debt (a type of payment which was characterised as looking backwards) or whether the purpose or a purpose of the payment was to induce the continued commercial relationship between the parties (a type of payment which was characterised as forward looking). If the latter, then the payment would be part of any continuous business relationship for purposes of calculating whether a preference was given to the creditor. We consider the High Court's reasoning is sensible and reflects commercial reality.

In response to the final question, the High Court agreed with the Full Court:

• that payments 1 to 4 were an integral part of the continuing business relationship between the parties;
• in concluding that the business relationship ceased to exist after around 10 July 2012. As a result, payments 5 to 11 did not from part of the running account;
• that, to be an unfair preference, the deemed single transaction under section 588FA(3), being all of the transactions forming part of the relationship during the relevant period, was required to reduce the indebtedness of Gunns to Badenoch in that period. However, given the net indebtedness of Gunns to Badenoch increased over the relevant period of the continuous business relationship, there was no unfair preference;
• only payments 5 to 11 were unfair preferences and subject to claw back being the total amount of $1,200,000.