Badenoch fires the final Gunn shot!

In a historical first female majority High Court Judgment, Bryant v Badenoch Integrated Logging Pty Ltd [1] saw all seven Judges unanimously uphold the decision to abolish the Peak Indebtedness Rule, and set in place the starting point for calculation of “all transactions” in a “running account”.

Scanlan Carroll acted on behalf of Badenoch Integrated Logging Pty Ltd, a trade creditor of Gunns Limited, and defendant in a claim for preference payments made by the liquidators.

As a result of Badenoch’s persistence regarding the unfairness of the law, creditors can now take some comfort in the application of the Ultimate Effect doctrine which after the High Court’s decision will continue to apply.

For those unfamiliar with the regime, you can read our previous summary published after Badenoch’s success in the lower Court. In summary, where a liquidator claims that a preference payment has been made to a creditor, the “running account” defence is available, and under certain circumstances, the creditor can offset the value of goods and services provided from preference payments claimed back.

The theory behind the regime is that funds paid unfairly to one creditor are clawed back to evenly distribute to all creditors. Despite this, small to medium businesses who typically make up the pool of unsecured creditors will rarely see any benefit of the funds clawed back. As is the case in the Gunns matter, where tens of millions of dollars in preferences have been clawed back from a portion of the unsecured trade creditors, many of whom were providing goods or services for such payments, the unsecured creditor pool as a whole will not receive any of the funds called in. Rather, the funds will be distributed across the secured creditors including banks, litigation funders, and the liquidators and advisors. 92% of all liquidations see no return at all to unsecured creditors, including where there are preference claims pursued.[2]

Lower Court’s decision

The High Court has upheld the lower Court’s finding that there has never been legislative intention to adopt the Peak Indebtedness Rule, and that to apply this Rule is to impermissibly sever the single transaction into two parts and to ignore both ss588FA(3)(c) and (d) of the Corporations Act 2001.[3]

The overall fairness of the regime is rectified by the application of the Ultimate Effect doctrine, which recognises that the general body of creditors are not disadvantaged by payments made to induce trade creditors to supply goods of equal or greater value.

Benefit to businesses Australia wide

This decision positively impacts each and every business across the country.

The removal of the Peak Indebtedness Rule levels the playing field and protects creditors from unfair treatment where they have continued to provide goods and services to the company in financial trouble, and the creditor has received payment of a lesser value.

For decades, wrongly, the Peak Indebtedness Rule has been applied[4], which has allowed liquidators to claim all payments made to creditors of the company in the relevant period, while simultaneously ignoring the goods or services provided in return. This decision will assist to prevent double dipping, where the company holds the goods provided and has the benefit of its value, and the liquidators also claim back the payment made for the goods, which are not returned to the creditor.

Does this impact the ability for a liquidator to make a claim for unfair preference?

Contrary to previous commentary, the removal of the Peak Indebtedness Rule does not prevent unfair preference claims from being made. The defence is available only to a certain category of creditors faced with a preference claim. Further, unfair preference claims are still available where the doctrine of Ultimate Effect applies, and taking the Badenoch matter as an example, even when accounting for the services provided by Badenoch under the running account, there is still a preference claim for over $1 million available to, and being pursued by the liquidators.

It simply means that liquidators must take a fairer approach and offset the value received by the company when calculating the portion of the payment which was ‘unfair’.

The calculation for the preference and a claim available will now be the actual benefit received by the relevant creditor, being the amount received in excess of the goods and services provided, rather than an arbitrary number which sees the highest amount of payments clawed back without accounting for the value received by the company in return.

This notion goes back to 1983 in the Judgment of M & R Jones[5], referenced again in the High Court Judgment:

“The mere fact that a payment is made on a running account does not protect it from scrutiny and if a point comes where payments are made with a view to terminating the running account, or greatly reducing the level of credit granted on the account, the effect of these payments may be a preference.”[6]

It should be noted that there are other defences available to creditors facing an unfair preference claim, such as the good faith receipt defence. This defence operated in circumstances where there is a lack of knowledge or suspicion that the company is insolvent. This defence is not available to those creditors who make a choice to continue to provide services despite knowledge of financial difficulty, and rightfully expect that such services will be accounted for when calculating the benefit they received for payments. The protection of such creditors is vital for small business as a whole, and why the correct application of the running account is so significant.

What about “dodgy” directors and related parties?

The Judgment does not affect the ability to pursue directors or related entities who strip assets from the company. The Peak Indebtedness Rule and its application is all but irrelevant to directors, with the running account defence only available to those who demonstrate a continuing business relationship with a running account balance that increases and decreases over time as a result of the provision of services, and which provides value to the company.

Uncommercial Transactions, and Voidable Transactions of directors operate under a different sub-section of the legislation. In the event that a director can demonstrate that they have provided market value for the payment, then it would never have constituted a voidable transaction to begin with, nor should it.

Related parties will also have to show a provision of goods or services if they want to prevent a preference claim. Any amount received in excess of the value given to the company is still available for claw back, and liquidators are still required to assess each transfer of funds or assets to a related entity to ensure that market value has been received in return.

To say otherwise, or to say that preference claims are no longer available is misconstrued.

How does this help small and medium businesses?

Trade creditors should be immune to a claw back when they demonstrate that they have provided goods and services in the equivalent amount. Otherwise, a situation arises where creditors are providing millions of dollars of services, only to have to return all payments received, regardless of whether the payments were less than what was provided. The Peak Indebtedness Rule allowed liquidators to choose the highest point of indebtedness in the relevant period, and calculate the payments from that date, while ignoring the fact that services were provided for the creditor balance to have increased to that level.

This decision assures that where there is a continuing business relationship, and a creditor continues to supply goods and services even in times of financial difficulty, the value of these goods or services must be accounted for in any consideration for a claim for a preference payment.

Lawyers can now practically advise small to medium business clients to defend and reduce preference claims to the value provided by that client.

It will also impact the advice given to clients who may suspect that a company is in financial difficulty, and still want to provide goods and services to that company in good faith in an effort to assist the company to continue to trade and avoid insolvency.

This change of law came about because Badenoch took exception to the unfairness of the perceived benefit received and the payments considered to be unfair, in circumstances where Badenoch was providing services even on the day Gunns entered into administration. The company could not reconcile the negative result of the application of the Peak Indebtedness Rule, and the perceived benefit of payments which did account for the continued services it was providing, which allowed Gunns to continue to trade and pay other creditors for a longer period of time.

Many small businesses who are creditors of liquidated companies also subsequently enter into administration as a result of the unfair preference regime and more specifically, the application of the Peak Indebtedness Rule. In the Gunns liquidation, on preliminary numbers it is estimated that approximately 10% of creditors have entered into administration or liquidation as a result of preference claims and the liquidation in general. This is due to the companies continuing to supply goods and services to Gunns in a time of financial difficulty, and until now, the liquidators were able to ignore the value of such goods and services when claiming payments back which were made in the same period. The new application means that any benefit received by a company must be accounted for when calculating the actual preference received by the creditor, and this will result in fewer creditors being negatively affected.

When does time start for the purpose of “all transactions” to be accounted for?

The High Court has also confirmed that insofar as it relates to unfair preference payments claimed from third party creditors, the relevant starting point is the later of:

The relation back period, being 6 months;
The actual date of insolvency; and
The commencement of the continuing business relationship. [7]

This clarifies the absurd notion that that taking “all transactions” means all transactions between the parties for the entirety of the relationship even if decades long, which would correctly result in no preference being claimable. The High Court has correctly confirmed that the time period in which the transactions are captured must be read in context of the other sections of the legislation under which the defence operates and is linked to, and within which time frame the claims for preference payments are available.[8]

Are “all transactions” really included?

The narrow application of continuing business relationship is still troublesome as a creditor can supply goods and services, and such value will not be accounted for in the running account calculation under certain circumstances. If liquidators can show that a relationship was not “continuing”, the running account will not apply across the entire period, and liquidators can compartmentalise the various transactions in the running account, and disregard goods and services provided by the creditor when calculating the preference received.

The total payments received by Badenoch in the relevant period was substantially similar to the $3.1 million of services provided, and services were still being provided up until the administration of Gunns. Despite this, due to the technicalities involved in what is deemed a continuing business relationship, the running account was only applicable to half of the transactions in that period, and services to the value of approximately $1 million were not available to offset the remaining preference claim of over $1 million.

Despite this shortfall, the benefit of the correct application of the running account will be seen by creditors, especially unsecured small to medium business creditors in future liquidations.

Take away

The application of this regime will now be pursuant to the wording of the Corporations Act 2001 and not in accordance with outdated and impractical case law.

This will result in fewer liquidations and administrations, as creditors will no longer be required to return payment when they can demonstrate that they have provided equivalent goods or services.

The value of goods and services provided cannot be ignored when a running account applies, and creditors will no longer be required to return payments received while also wearing the loss of the goods or services provided.

This Judgment creates fairness amongst creditors who have continued to trade with the company in good faith.

[1] Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2

[2] Australian Small Business and Family Enterprise Ombudsman, ‘Insolvency Inquiry Report’ July 2020, 16

[3] Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 [13]; [2023] HCA 2 [58]

[4] [2023] HCA 2 [76]

[5] M & R jones Shoplifting Co Pty Ltd (in Liq) v The National Bank of Australasia Ltd;

[6] [2023] HCA 2 [52]

[7] [2023] HCA 2 [13]

[8] [2023] HCA 2 [64]