COVID-19 Updates: Read our blog for useful information about commercial, employment and family law issues.

Liquidation, Unfair Preferences & the abolishment of the ‘Peak Indebtedness Rule’

Maria Yum, James Ferguson

When a company is placed into liquidation, one of the purposes of the liquidation is for the liquidator to investigate the affairs of the company, in particular the circumstances that caused the winding up. Liquidators possess wide ranging powers of investigation and inquiry into the affairs and dealings of the company, including powers to recover, gather in and secure the company’s property. The liquidator must then realise the property and distribute any proceeds to the company’s creditors pursuant to the Corporations Act 2001 (Cth) (Act). As part of the liquidator’s investigations into the affairs of the company and in line with one of the purposes of insolvency law, one must ensure that the assets of the insolvent company are distributed equally among the creditors and that no single creditor receives preference over another creditor, unless permitted by law. If a creditor has received a preferential payment, then liquidators have power to recover the preferential payment from the creditor. Section 588FA of the Act deals with the unfair preferences.   

What is an Unfair Preference?

Pursuant to section 588FA(1) of the Act, a transaction is an unfair preference given by a company to a creditor of the company, if and only if:

  1. the company and the creditor are parties to the transaction (even if someone else is also a party); and,
  2. the transaction results in the creditor receiving from the company, an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the transaction were set aside and the creditor were to prove for the debt in a winding up of the company;

even if the transaction is entered into, is given effect to, or is required to be given effect to, because of an order made by an Australian court or by direction of an agency.

An unfair preference is a transaction that is voidable, within the meaning given by section 588FE of the Act.  However, such transaction will only be voidable if it is also an insolvent transaction (section 588FC of the Act).  What this means is that the insolvency of the company must be proved by the liquidator in order to set aside the transaction in question and claimed to be an unfair preference. Should a liquidator be successful in avoiding the pre-liquidation transaction, such as the unfair preference, then the Court may order the recipient of funds deemed a voidable transaction to repay those funds received from the company back to the company for distribution amongst creditors.

Timeframes and the unfair preference transactions

Generally, pre-liquidation transactions that occur within the following time periods could be subject to an unfair preference claim by a liquidator:

In circumstances where a liquidator was appointed pursuant to a Court order for the winding up of the company (where there is no prior administration or liquidation): the relation-back day is the date that the application to wind up the company was filed with the Court. 

Provided that a transaction occurred within the above mentioned timeframes, a liquidator can only make an application to the Court for an order that a transaction is voidable as an unfair preference during the period beginning on the relation-back day and ending:

whichever occurs later.

A liquidator may extend the time to bring a claim that a transaction is voidable as an unfair preference upon an application to the Court.

Defences and Recent Case Law

There are a number of possible defences that a party may raise to a liquidator’s unfair preference claim which protects the transactions with the company.  However, for the purposes of this article we will only consider the running account defence and a recent decision of the Full Federal Court which changes the lay of the land for liquidators claiming an unfair preference.

According to section 588FA(3) of the Act:

  1. where a particular transaction is part of a continuing business relationship (e.g. a running account) between the company and the creditor; and
  1. in the course of that relationship, the company’s indebtedness fluctuates from time to time as a result of a series of transactions;

then:

  1. for the purposes of section 588FA(1) of the Act, all transactions forming part of that relationship may be taken to constitute a “single transaction”; and
  1. a transaction referred to in sub-paragraph (a) above may only be taken to be an unfair preference given by the company to the creditor if the “single transaction” made by the company to the creditor is taken to be such an unfair preference.

In Badenoch Integrated Logging Pty Ltd v Bryant, in the matters of Gunns Limited (in liquidation) (receivers and managers appointed) [2021] FCAFC 64, the Full Federal Court of Australia considered, amongst other things, whether a liquidator is entitled to apply the peak indebtedness rule and choose any point of the continuing business relationship between a company and a creditor as the starting point of the single transaction for the purposes of s 588FA(3) of the Act in the context of an unfair preference claim brought by a liquidator. 

By way of brief background:

Amongst various issues, one of the issues the Court was required to determine was:

  1. whether any of the payments made by Gunns to Badenoch were an integral part of a continuing business relationship between the parties, such that the series of transactions would be taken to constitute a single transaction to determine whether there has been an unfair preference; and,
  2. if so, whether the liquidators were entitled to choose any point in the relationship as the starting point of the single transaction under the peak indebtedness rule.

In respect of these above issues, the Court determined:

  1. When assessing the preferential effect of a series of payments that are an integral part of a continuing business relationship between the company and a creditor as a single transaction, a liquidator must consider all transactions that form part of that relationship and cannot select the point of peak indebtedness as the relevant comparison to the indebtedness that remained at the point of the company being wound up.  This decision effectively abolishes the peak indebtedness rule.
  1. Section 588FA(3) of the Act exemplifies the doctrine of ‘ultimate effect’ – meaning that the general body of creditors are not disadvantaged by payments made by the company to induce trade creditors to supply goods of equal or greater value – liquidators, when assessing preferential payments, should have regard to the ‘ultimate effect of the dealings between the company and the creditor’ and if the effect results in the creditor giving the company valuable goods and services, there is no depletion of assets.

The effect of the decision in Badenoch is that liquidators will face greater difficulty (i.e., the amount likely to be recovered may not justify the time and expense involved) in pursuing unfair preference claims against trade creditors of companies in circumstances where there is a continuing business relationship, in light of the abolishment of the peak indebtedness rule

If you have any questions or concerns in relation to the above, please reach out to a member of Coleman Greig’s Litigation and Dispute Resolution team, who would be more than happy to assist you.