Gunns at 10 paces: Full Court of the Federal Court blows away peak indebtedness rule

In the decision in 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 considered (amongst other things) the test for establishing the ‘running account’ defence under section 588FA(3) of the Corporations Act 2001 (Cth) (the Act), as well as the validity of the peak indebtedness rule as it has previously been applied to unfair preference claims.

Background

Badenoch Integrated Logging Pty Ltd (Badenoch) is a family owned business that provides logging and transport services, and that contracted with and received payments from Gunns Limited (in liquidation) (receivers and managers appointed) (Gunns) before Gunns was placed into administration on 25 September 2012.

The liquidators of Gunns (Liquidators) subsequently claimed against Badenoch for 11 payments made by Gunns to Badenoch between 30 March 2012 (being the date that the Liquidators said that Gunns became insolvent) and 25 September 2012.  Badenoch raised the ‘running account’ defence, claiming that all of the payments were made in the context of a continuing business relationship and that all of the transactions forming part of the relationship should be assessed as a single transaction in accordance with section 588FA(3) of the Act.

The Court in the first instance judgment held that:

  • only 2 of the payments could be said to have formed part of a continuing business relationship in that they were referrable to a “mutual assumption of a continuing business relationship”;
  • the other 9 payments were made in circumstances where the “predominant purpose” of the payments was to reduce past indebtedness and therefore did not form part of any relevant continuing business relationship; and
  • in assessing the preference resulting from the single transaction arising from the period of the continuing business relationship, the Liquidators were entitled to apply the peak indebtedness rule – i.e. to select the point of highest indebtedness during the relevant period as the ‘starting point’ for assessing the existence and value of the preference received by Badenoch for the deemed single transaction.

The matter was then appealed to the Full Court of the Federal Court.

Continuing business relationship

The Full Court undertook a review of the authorities on what constitutes a continuing business relationship for section 588FA(3) and usefully summarised the Full Court’s view of the applicable principles as follows:

  • the payment must be made in circumstances where there is a mutual assumption of a continuing relationship of debtor and creditor, with an expectation that  further debits and credits will be recorded;
  • it will usually be relevant to consider whether (from a business point of view) each payment was connected with subsequent provision of goods or services;
  • if the purpose of a payment is to induce the creditor to provide further goods or services as well as to discharge existing indebtedness, then the payment will not be a preference unless the payment exceeds the value of the goods or services acquired;
  • where the relationship contemplates further debits and credits, the appropriation of a payment to a past debt is not unusual and has no significance unless the parties expressly agree that one of the purposes of the payment is to permanently reduce the level of indebtedness below the level existing at the time of the agreement;
  • knowledge, suspicion or reasonable grounds to suspect insolvency will not necessarily destroy a continuing business relationship, nor does a stop on an account;
  • the continuing business relationship does not need to exist for the entirety of the relation-back period; and
  • the existence of a continuing business relationship is a question of substance, not form.

However, the Full Court then went on to consider the principle that has arisen from the decision in Sutherland (as liquidator of Sydney Appliances Pty Ltd (in liq)) v Eurolynx Pty Ltd (2001) 37 ACSR 477, which provides that there will be no mutual assumption of a continuing business relationship where the purpose of inducing further supply “is subordinated to a predominant purpose of recovering past indebtedness”.

The Full Court did not expressly overturn Sutherland, but noted that the principle in Sutherland should be treated with caution.  The Full Court observed that it would not be consistent with the rationale behind section 588FA(3) to take an unduly restrictive approach to assessing the existence of a continuing business relationship, and emphasised that where there are multiple purposes for a payment the Court must look at the practical relationship between the payments and the subsequent supply of goods/services in assessing whether the parties were in reality looking backwards to the payment of an old debt and not to the provision of continuing goods and services.

In going on to dispose of this aspect of the appeal, the Full Court carefully considered the findings at trial as to the state of mind and motivations of the directors of Badenoch in finding that:

  • the first 4 payments were part of a continuing business relationship, despite the fact that Badenoch issued a letter of demand, implemented a 10 day ‘stop supply’ and negotiated a repayment of the January and February 2012 invoices in exchange for continued supply albeit subject to a $1m credit limit.  This was because during the time of these payments, there was still a genuine belief, intention and expectation by Badenoch that Gunns could meet Badenoch’s terms and that it would continue to supply services to Gunns;
  • however, the last 6 payments did not form part of a continuing business relationship because the relationship had changed and the payment plan agreed between the parties at this time was clearly with a view towards cessation (and not continuation) of future supply.  

Peak indebtedness rule

The parties agreed that the end date of the single transaction within the meaning of section 588FA(3) is the earlier of the end date of the continuing business relationship or the date on which the company went into external administration.

However, the issue was when the single transaction should be said to begin.

Badenoch claimed that the start date should be the later of the relation-back date or the start date of the continuing business relationship.  The Liquidators claimed that in accordance with the peak indebtedness rule, they should be free to choose any point in the continuing business relationship within the relation-back period.

The Full Court undertook a detailed review of the history of section 588FA(3) and the emergence of the peak indebtedness rule, and found that there was no reference to the peak indebtedness rule in the legislation or the explanatory memorandum, and that the only decision where the peak indebtedness rule appears to have been considered is the decision of Master Burley in the Supreme Court of South Australia in the case of Olifent v Australian Wine Industries Pty Ltd (1996) 130 FLR 195.

The Full Court went on to find that Olifent and the decisions that followed it were wrongly decided insofar as they applied the ‘peak indebtedness rule’ to section 588FA(3) on the following grounds:

  • first, the peak indebtedness rule is inconsistent with the express words of section 588FA(3), and there is no evidence of any legislative intention to adopt such a rule or approach when the provision was introduced into law.  The words of section 588FA(3) clearly require all transactions in the continuing business relationship to be included in the single deemed transaction.  Allowing a liquidator to select a start date and therefore exclude the transactions before that point is inconsistent with the express language of the statute;
  • secondly, section 588FA(3) embodies the doctrine of “ultimate effect” which recognises that the general body of creditors are not disadvantaged by payments made to induce trader creditors to supply goods or services of equal or greater value.  As a result, it is necessary to assess all payments and supplies in the continuing business relationship falling within the relevant statutory period; and
  • thirdly, abolishing the peak indebtedness rule is consistent with the purpose of Part 5.7B of the Act, which is to do fairness between unsecured creditors.  

Lavan comment

This is a very significant decision by the Full Court of the Federal Court, both in relation to the abolition of the peak indebtedness rule and the caution issued regarding the principle in Sutherland where there are multiple reasons for a payment.   

It is clear that this decision will make it easier for creditors to raise the running account defence, and will likely reduce the assessable preference arising from deemed single transactions available for recovery by a liquidator in most if not all cases.

The implications of Badenoch are complex for both creditors and insolvency practitioners involved in existing or pending unfair preference disputes, and Lavan’s experienced insolvency team would be happy to discuss any queries about this decision.