Farewell to the peak indebtedness rule… abolished by unanimous decision

Posted on May 11, 2021

In the recent decision of Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64,the Full Court of the Federal Court of Australia abolished the use of the peak indebtedness rule in Australia when calculating an unfair preference paid to a creditor. Scanlan Carroll acted for the appellant in the proceeding.

The parameters of an unfair preference which is susceptible to a claw back in the event of a liquidation can be found in s588FA of the Corporations Act 2001 (Cth) (the Act).

S588FA(3) of the Act provides that where a continuing business relationship (such as a running account) is established, all the transactions forming part of the relationship must be taken together as if they together constituted a single transaction. The application of this section has long been debated, and this latest decision confirms that the supply of goods or services during the relevant period must be accounted for as well as payments made.

For decades, the peak indebtedness rule has been applied, which allows a liquidator to choose any point in the relationship as the starting point of the single transaction for the purpose of s588FA(3). In Badenoch[1], the Liquidators nominated the peak of the liquidated company’s indebtedness to Badenoch in the relevant period, after a time when Badenoch had issued an invoice of $737,733.68 for further services provided during the relevant period.[2]

In the first instance, the primary judge upheld the application of the peak indebtedness rule, relying on statements in Rees[3] and Olifent[4], and reaffirmed that the introduction of regulations in the Corporations Act 1989 and the Corporate Law Reform Act 1992 had not been an intention to alter the law.[5]

On appeal, Badenoch argued that the specific change in the wording of the regulations to include the words all transactions forming part of the relationship, was in fact an intention to change the application of the defence, that the peak indebtedness rule was no longer relevant or applicable in Australia, and to ignore the wording of the legislation would be unjust to creditors who continued to supply the company in liquidation during the relevant period. In doing so, Badenoch relied on the interpretation of similar New Zealand legislative wording analysed in Timberworld.[6]

The Full Court unanimously agreed, relevantly citing paragraph [68] of Timberworld:

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.

Clarity was also provided as to the relevant period for “all transactions”. The Full Court held that to apply the literal interpretation of the entire relationship dating back to the commencement could lead to an absurd result, in that, trade creditors would effectively be made immune from the voidable preference regime.[7]  

Badenoch argued that in the absence of the peak indebtedness rule, the correct starting point for the single transaction is the latter of the relation-back date, which, in this case, was six months, or the start of the continuing business relationship.[8]

In making its ruling, the Full Court rejected the Liquidators’ reliance on and interpretation of Petagna[9], and in doing so, held that “the Liquidators’ reading overlooks the important qualification…that dealings prior to the chosen date should not be ignored.”[10]

The Full Court summarised its reasons as to why the peak indebtedness rule should no longer be applied to s588FA(3):

  1. [The Full Court did] not accept that there was any legislative intention to adopt the peak indebtedness rule when introducing the provision into the 1989 Act. The plain language of the statute and the legislative material both support Badenoch’s contention that the peak indebtedness rule was not intended to apply.[11]
  • To apply a peak indebtedness rule is to impermissibly sever the single transaction into two parts and to ignore the commands in both ss588FA(3)(c) and (d). There can be no room for the implication of a rule that is inconsistent with the express language of the statute.[12]
  • The Liquidators’ reliance on s588FF of the Act as authorising a company liquidator to elect which payments to avoid is no answer [to this]. While a liquidator may choose not to impugn particular payments, if they are an integral part of a continuing business relationship then s588FA plainly requires their effect to be considered by reference to the effect of all the transactions that form part of that relationship.[13]
  • S588FA(3) of the Act 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 of equal or greater value…This is consistent with the purpose behind Pt 5.7B of the Act…[14]
  • The Full Court could not reconcile the application of the peak indebtedness rule with the principle of ultimate effect in Airservices[15], and agreed with reasons of Timberworld that the peak indebtedness rule does violence to that principle.[16]
  • [The Full Court considered] that abolition of the peak indebtedness rule is consistent with the stated purpose of Pt 5.7B of the Act which is, in essence, to do fairness between unsecured creditors.[17]

This decision rectifies the long-standing application of an outdated rule and provides peace of mind to creditors that goods and services provided to a company during the relevant period cannot be ignored when calculating preference payments if there is a continuing business relationship.

[1] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713

[2] [2021] FCAFC 64, [31]

[3] Rees v Bank of New South Wales (1964) 111 CLR 210

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

[5] [2020] FCA 713, [102]

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

[7] [2021] FCAFC 64, [84]

[8] Ibid, [86]

[9] Petagna Nominees Pty Ltd & Anor v AE Ledger (1989) 1 ACSR 547

[10] [2021] FCAFC 64, [102]

[11] Ibid, [112]

[12] Ibid

[13] Ibid, [113]

[14] Ibid, [114]

[15] Airservices Australia v Ferrier (1996) 185 CLR 483

[16] Ibid, [118]; (2015) 3 NZLR 365 [81]