Federal Court of Appeal Gunns down peak indebtedness rule


Federal Court of Appeal Gunns down peak indebtedness rule

Introduction

In a major blow to liquidators, on 10 May 2021 the Federal Court Appeal in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) [2021] FCAFC 64 (“Gunns Appeal”) held that liquidators are not entitled to apply the “peak indebtedness rule” when calculating the quantum of an unfair preference claim in the context of a continuing business relationship.

Instead, liquidators will now have to compare the company’s indebtedness to the relevant creditor at the commencement of the relation back period (or the beginning of the continuing business relationship, whichever is the later), with the closing balance.  In most instances this will mean there is no unfair preference to recover.

Additionally, the Court’s decision raises the threshold that liquidators will have to meet to show the termination of a continuing business relationship.

What is the peak indebtedness rule?

The “peak indebtedness rule” allows a liquidator to choose the highest point of indebtedness during the relation-back period when assessing the quantum of an unfair preference in the context of a continuing business relationship. The rule had its genesis in the High Court decision of Rees v Bank of New South Wales (1964) 111 CLR 210 (which applied previous legislation). The operation of the rule under s588FA(3) of the Corporations Act 2001 (Cth)(“Act“) was confirmed in Olifent v Australian Wine Industries Pty Ltd (1996) 130 FLR 195. Since then, the rule has been applied by all Australian courts without question.

The decision at first instance

At first instance, Badenoch Integrated Logging Pty Ltd (“Badenoch”) argued that each of the 11 payments made to it by Gunns Limited (“Gunns“) formed part of a continuing business relationship. Badenoch asserted the peak indebtedness rule should not apply, and that previous Australian cases which applied the rule had been wrongly decided, having regard to the reasoning of the New Zealand Court of Appeal in Timberworld v Levin [2015] 3 NZLR 365 (“Timberworld“) when considering an equivalent provision.

Davies J rejected Badenoch’s arguments, and held that only 2 of the impugned payments (payments 3 and 4) formed part of a continuing business relationship.  Davies J also confirmed the continued operation of the “peak indebtedness rule” in Australia.

The Appeal decision

Continuing business relationship

On appeal, the Full Court of the Federal Court disagreed with Davies J in respect of the first 2 payments. The Court was not persuaded that the tactics employed by Badenoch terminated the running account. Those ‘tactics’ included implementing a stop supply, issuing a demand for payment which threatened legal action, and insisting on a payment plan.

Significantly, the Court stated that, so long as ongoing supply is genuinely intended (which was the case at the relevant time in respect of Badenoch), a continuing business relationship will not necessarily end when a creditor’s predominant purpose in receiving a payment is to recover past indebtedness.  Rather, the mutual assumption will cease when the creditor’s real purpose is the recovery of old debt, and not ongoing supply.

Peak indebtedness

The Federal Court of Appeal also disagreed with Davies J in respect of the “peak indebtedness rule”.  The Court held that the rule has no application in Australia because:-

  • There was no legislative intention to adopt the “peak indebtedness rule” when section 588FA of the Act was enacted. In particular, the Court found the plain language of section 588FA(3) requires all transactions forming part of the continuing business relationship to be considered as a single transaction.  The “peak indebtedness rule,” which allows the liquidator to sever this single transaction into multiple parts, is inconsistent with the express language of the statute.
  • Section 588FA(3) of the Act embodies the doctrine of “ultimate effect,” which requires all payments and all supply forming part of the continuing business relationship to be considered. The Court agreed with the New Zealand Court of Appeal in Timberworld that the “peak indebtedness rule” is irreconcilable with the doctrine of “ultimate effect”.
  • The “peak indebtedness ruleis incompatible with the purpose of Part 5.7B of the Act, which is to ensure that there is fairness between unsecured creditors. This is because the application of the rule may lead to arbitrary results, depending on the different credit terms of creditors.

Conclusion

Insofar as the “peak indebtedness rule” is concerned, the Gunns Appeal represents a major departure from what was regarded as settled law in Australia.  The decision also raises the threshold that liquidators will have to meet to show the termination of a continuing business relationship.

In practice, the decision will significantly limit a liquidator’s ability to pursue an unfair preference claim in the context of a continuing business relationship.

It will be interesting to see how the Victorian courts approach the “peak indebtedness rule” following the Gunns Appeal.  In particular, the decision is inconsistent with the Victorian Court of Appeal decision in Sutherland v Lofthouse (2007) 213 FLR 157 (“Sutherland”), where  Nettle JA (with whom Neave and Redlich JJA agreed) stated:

“… a liquidator faced with the prospect of having to treat the account as a notional single transaction is entitled to pick the peak indebtedness during the relation back period as the beginning of the arrangement, in order to maximise recovery” (emphasis added).

While the Gunns Appeal is not, strictly speaking, binding in Victoria, it will no doubt be highly persuasive. For now, we will have to wait to see if there is an appeal to the High Court to clarify the application of a rule that has been applied without much thought for a long time.

Please contact our insolvency team if you have any questions.

 


~ with Christian Mennilli, Lawyer and Alice Rudaya, Lawyer