Just Like In Peaky Blinders - High Court Guns Down Peak Indebtedness Rule

In the recent case of Bryant & Ors v Badenoch Integrated Logging Pty Ltd,¹ the High Court has provided conclusive and critical guidance on the operation of the “running account principle” embodied in section 588FA(3) of the Corporations Act 2001 (Cth) (Act).

Following the decisions of the Full Court of the Federal Court of Australia which are analysed in our previous publications here and here, the High Court was called upon to answer two important questions: first, is the “peak indebtedness rule” excluded by section 588FA(3); and secondly, what is the proper approach for determining whether a payment forms part of a continuing business relationship.

The seven Judge bench of the High Court unanimously held that Part 5.7B of the Act does not incorporate the peak indebtedness rule, and confirmed that whether a payment or transaction is “an integral part of a continuing business relationship” under section 588FA(3)(a) requires an objective factual inquiry as to the ‘business character’ of the relevant payment or transaction.

Background

Gunns Limited (In Liquidation) (Receivers and Managers Appointed) (Gunns) previously carried on a timber processing business.  Gunns entered into an agreement with Badenoch Integrated Logging Pty Ltd (Badenoch) in 2003 for Badenoch to supply Gunns with timber, which was renewed in 2008 for the period up to June 2013.  The agreement required Badenoch to supply Gunns with specified quantities of timber per annum, with Badenoch to invoice Gunns at the end of each month, and Gunns to pay the invoices on the last working day of the following month.

Gunns suffered significant declines of revenue from 2010 and its parlous financial position was the subject of significant media coverage by late 2011.  Badenoch continued to supply timber to Gunns during 2011 and 2012 despite Gunns frequently being late in making payments or only making partial payments but took a number of steps to protect its position including by threatening to cease supply or by ceasing supply for short periods of time, issuing letters of demand, and negotiating a payment plan.  Ultimately, in August 2012, the parties agreed to terminate the agreement on the basis that Badenoch would continue to supply some services for a short period while a replacement contractor was found.

Gunns was subsequently placed into voluntary administration in September 2012 and liquidators were appointed to Gunns on 5 March 2013 (Liquidators).

The Liquidators subsequently commenced proceedings against Badenoch to recover 11 payments made by Gunns to Badenoch in the period between 30 March 2012 (the date on which Gunns became insolvent) and 25 September 2012 (the relation-back day) (the Relevant Period) as unfair preference payments under section 588FF(1) of the Act.

Badenoch argued (amongst other things) that the payments were part of a continuing business relationship (namely a running account) within the meaning of section 588FA(3) of the Act, and that the existence and amount of any unfair preference had to be assessed by reference to the single deemed transaction made up of all of the transactions forming part of the relationship.

The Liquidators argued that if there was a “continuing business relationship” for the purposes of section 588FA(3), then the Liquidators could rely on the peak indebtedness rule to select the point of highest indebtedness during the Relevant Period for the purposes of assessing the existence and value of any unfair preference obtained by Badenoch.

The Court at first instance held that:

• only two of the payments were part of a continuing business relationship, and the other nine payments were for the predominant purpose of paying past debts; and
• in assessing whether the deemed single transaction arising from the continuing business relationship had resulted in an unfair preference, the Liquidators were entitled to apply the peak indebtedness rule and to select the point of highest indebtedness as the ‘starting point’ for the assessment process.

The Full Court of the Federal Court then held that:

• the ‘predominant purpose’ test should be treated with caution, and where payments are made for multiple purposes the Court must look at the practical relationship between the payments and any subsequent supply of goods/services in assessing whether the payments are in fact part of a continuing business relationship;
• using this approach, the first four payments were part of a continuing business relationship but the remaining payments were not as by that time the relationship had changed and the payment plan agreed by the parties was with a view towards cessation (and not continuation) of future supply; and
• the peak indebtedness rule did not apply to section 588FA(3), although the Full Court ultimately did not make a finding as to the correct point to be used as the ‘starting point’ for assessing whether the single deemed transaction arising from the continuing business relationship gave rise to an unfair preference.

The matter was then appealed to the High Court.

The Decision

The High Court’s judgment was written by Jagot J (with whom Kiefel CJ and Gageler, Gordon, Edelman, Steward and Gleeson JJ agreed), and dealt separately with each of the matters raised for consideration by the High Court.

Issue 1 – Is the “peak indebtedness rule” part of or excluded by section 588FA(3)?

Jagot J considered the key Australian authorities in relation to the peak indebtedness rule as well as the relevant passages in the Explanatory Memorandum for the introduction of what is now section 588FA(3) in making the following key findings:

• it is clear that Parliament intended to embody the concept of a running account in section 588FA(3) in that where there is a continuing business relationship, Parliament expressly intended that all of the transactions forming that relationship should be taken into account in assessing the existence and amount of any unfair preference.  This is reflected in both the Explanatory Memorandum as well as the language used in section 588FA(3);
• in contrast, the “peak indebtedness rule” has its origins in the judgment of Barwick CJ in Rees v Bank of New South Wales (1964) 111 CLR 20 and reflects the fact that liquidators would naturally want to select a starting point of the moment of peak indebtedness when assessing whether a continuing business relationship gave rise to an unfair preference as doing so would maximise both chances of establishing an unfair preference as well as the amount of the unfair preference.  However, this “rule” is not reflected anywhere in the language of section 588FA(3) and there is no, or alternatively no sufficient, indication in the Explanatory Memorandum that Parliament intended to incorporate this “rule” into the Act;
• on its proper construction, section 588FA(3) requires that all of the transactions forming a continuous business relationship (subject to the timing issue below) should be taken into account in assessing the existence and amount of any unfair preference.  This construction gives the language of the provision its natural and ordinary meaning without reading in additional words, and accords with the policy choice underlying the statutory embodiment of the “running account” principle evidenced by the Explanatory Memorandum; and
• the cases which concluded that the “peak indebtedness rule” is to be read into section 588FA(3) either wrongly assumed that the “running account principle” included the “peak indebtedness rule”, did not involve full argument or reasoning about the issue, or must now be considered to be wrong in that respect.

As to the start and end points for the transactions to be included in the assessment of the single deemed transaction, Jagot J held that:

• section 588FA(3) exists and operates in the context of and as part of the voidable transactions provisions in the Act;
• as a result, the relevant transactions for the purposes of the assessment must be the transactions which are within the relevant period prescribed by sections 588FE(2) to (6B); and
• in a standard case, this will be the six-month period ending on the relation-back day (assuming that the company was insolvent and that the continuing business relationship was in existence for the whole of this period).

Issue 2 – What is the proper approach for determining whether a transaction is, for commercial purposes, an integral part of a continuing business relationship as referred to in section 588FA(3)?

In relation to this issue, Jagot J held that:

• section 588FA(3) expressly mandates and requires an assessment of whether a “transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company”;
• this is a question of objectively ascertained fact.  The language used in previous decisions merely describes how those Courts approached the exercise of assessing this objectively ascertained fact;
• in answering the question, it is necessary to consider the whole of the evidence of the “actual business relationship” between the parties;
• the test is whether, on the whole of the evidence, the objectively inferred character of a payment is to reduce past indebtedness and not to induce the continuation of supply; and
• it therefore follows that it is not the case that a continuing business relationship necessarily continues unless and until it can be inferred that the sole mutual assumption or purpose of the creditor and debtor is the reduction of indebtedness.

Overall disposition of the appeal

The High Court held that once the above principles are applied, the findings of the Full Court of the Federal Court were correct in that the first four payments by Gunns to Badenoch in the period between 30 March 2012 and 25 September 2012 were part of a continuing business relationship but the remaining payments were not as by that time the relationship had changed and the objectively inferred character of the remaining payments was to reduce past indebtedness and not to induce the continuation of supply.

Lavan comments

This important decision is not necessarily an easy read, but sets out a very clear basis for the conclusion that the “peak indebtedness rule” is not available to liquidators when combatting a running account “defence” under section 588FA(3).  The decision also makes it very clear as to which transactions are to be included in the single deemed transaction.  While this will inevitably reduce the number and value of recoverable unfair preference claims in cases of continuing business relationships/running accounts, the additional certainty will benefit liquidators and creditors (and lawyers and funders) in the long run.

The position in relation to the assessment of whether a transaction forms part of a continuing business relationship is slightly less clear.  On one view, Jagot J’s findings simply confirm the existing position that there has to be an objective assessment on the facts of the case.  However, on another view, the reference to the “whole of the evidence of the actual business relationship” could threaten to expand the scope of what has to be considered and therefore the potential for more (and more costly) disputes.

If you have any questions about this important decision, or about unfair preferences or section 588FA(3) in general, the experienced Lavan team is here to help.