With interest rates climbing above 4%, corporate debt having risen over a sustained period of low interest rates and the cost of living ever increasing, Australia’s economy is set to face increased rates of insolvency – as demonstrated by the recent collapses of home-building and construction companies. Accordingly, we look back at two landmark decisions from the High Court in February which will no doubt change the strategic approach of both liquidators and creditors facing unfair preference claims going forward[1].

In Metal Manufacturers Pty Ltd v Morton[2] (‘Metal Manufacturers v Morton’) the High Court dismissed an appeal which concerned whether a creditor is entitled to set-off an amount equivalent to that received as an unfair preference against a separate and distinct debt owed by the company in liquidation. In the same month, Bryant v Badenoch Integrated Logging Pty Ltd[3] (‘Bryant v Badenoch’) saw the High Court banish the peak indebtedness rule, rejecting its incorporation in the Corporations Act 2001 (Cth) (the Act).

Creditors can no longer hide behind set-off against a liquidator’s unfair preference claim

What is the set-off scheme?

Where there have been mutual credits, mutual debts or other mutual dealings between an insolvent company and its creditor, the payments are generally set-off against one another pursuant to s 553C of the Corporations Act. Consequently, only the remaining balance can be claimed either by or against the insolvent company.

Over the past few decades however there have been many cases where creditors have sought to set-off debts owed by the insolvent company to the creditor against the creditor’s preference payment obligation to the liquidator. There has been ongoing contention surrounding the availability of set-off in these circumstances.[4]

Following the High Court’s unanimous decision in Metal Manufacturers v Morton, a creditor is not entitled to deduct any outstanding debt against an insolvent company from its liability to repay an unfair preference.

Background of Metal Manufacturers Pty Ltd v Morton 

MJ Woodman Electrical Contractors Pty Ltd (MJ Woodman) was wound up with Mr Morton (Morton)  appointed  liquidator. Metal Manufacturers Pty Ltd (Metal Manufacturers) was paid $50,000 and $140,000 by MJ Woodman, within the six-month period prior to the winding up of MJ Woodman (known as the ‘relation-back period’). Subsequently, Morton sought to have these payments clawed back as voidable transactions, on the basis that these payments represented unfair preferences under s 588FA of the Corporations Act.

Metal Manufacturers asserted it had the right to set off the potential liability to repay these “unfair preferences” against a separate debt owed to it by MJ Woodman, being $194,727.23, pursuant to s 553C of the Act.

Upon referral by the trial judge, the Full Court of the Federal Court held that set off was not available, a decision that Metal Manufacturers sought to appeal before the High Court for the following reasons:

• Metal Manufacturers submitted it was entitled to set off its potential liability against amounts owing to it by MJ Woodman because there had been a mutual dealing between it and that company; and
• the future liability to repay unfair preferences of Metal Manufacturers at the commencement of the liquidation was no different to any other claim owed to MJ Woodman because MJ Woodman would be entitled to receive the amount beneficially.

High Court Decision

In dismissing the appeal, the High Court held:

1. Set-off, pursuant to s 553C(1) of the Act, requires that the ‘mutual credits, mutual debts or other mutual dealings be credits, debts or dealings arising from circumstances that subsisted in some way, before the commencement of the winding up’.[5]

Immediately before the winding up commenced there was nothing to set-off between Metal Manufacturers and MJ Woodman., MJ Woodman owed money to Metal Manufacturers, but Metal Manufacturers did not owe money to MJ Woodman because the liquidator’s claim of a preferential payment did not exist before the winding up commenced. The preferential payment was therefore not eligible to be set-off against the pre-existing amount owed by MJ Woodman.[6]

2. There was no dealing between the same persons, and therefore the dealings were not mutual.[7]

The liquidator’s right to recover a priority payment cannot be comparable to a trading transaction whereby goods or services have been previously supplied by a creditor to a company. The interest Metal Manufacturers had in being paid by MJ Woodman is the same as  the interest the liquidator and company had in recovering the preferential payment.[8]

The High Court held that the cases of Re Parker[9], Buzzle Operations Pty Ltd v Apple Computer Australia Pty Ltd[10], Hall v Poolman[11] and Stone v Melrose Cranes & Rigging Pty Ltd [No 2][12] were wrongly decided to the extent that they are inconsistent with the above analysis[13].

Commentary

The High Court decision provides some much-needed clarification, ending decades of uncertainty regarding the issue. The decision is bad news for those creditors who will now be unable to use set-off as a standard response to unfair preference claims. The decision, however, will maximise the distribution pool of assets available for priority payments and rateable distribution, achieving the primary objective of voidable transaction provisions to ‘secure equality of distribution amongst creditors of the same class’.[14]  Creditors will now be forced to reassess their strategic approach and seek alternative defences, where available, in responding to an unfair preference claim.

 

The death of the peak indebtedness rule in unfair preference cases

Explaining voidable transactions and unfair preferences

Under Part 5.7B of the Corporations Act, liquidators can seek orders that certain transactions between a company and its creditors are void[15].

One kind of voidable transaction is where the transaction gives an ‘unfair preference’ to an unsecured creditor of a company. To be an unfair preference, the payment to the unsecured creditor must have occurred when the company was insolvent and within the ‘relation-back period’ (which is usually the date starting when an application for winding up the company is made).[16] The transaction must have the result of the creditor receiving more than it would have if the company had paid all the unsecured creditors a dividend. If it has that result, a liquidator can ‘claw back’ an unfairly preferential payment and distribute those funds amongst all the creditors.

However, if there are multiple individual transactions that show the creditor supplied goods on credit to the company, which would in turn make payments, the transactions forming part of the continuing relationship are regarded as a ‘running account’. Under the Act, all transactions within the running account will thus be treated as a single transaction; the transactions will only be an unfair preference if that single transaction can be taken to be an unfair preference[17].

What is the peak indebtedness rule?

In determining whether there is an unfair preference, the ‘peak indebtedness rule’ allows a liquidator to claw-back the difference between the lowest level of indebtedness and the highest (‘peak’) level of indebtedness. Therefore, if a company owes $50,000 as its ‘peak’ level of indebtedness, and $10,000 at the end of the period, a liquidator would be able to claim for the difference between  the two numbers (i.e. $40,000).

However, if the rule cannot be applied, then the liquidator’s claim is determined by the difference between the levels of indebtedness at the beginning and end of the relevant period. The difference in amounts between these two periods will often be lower than the difference between the amount at end of the period and the peak indebtedness.

The peak indebtedness rule arose from High Court decisions that were concerned with the determination of a preference to a creditor where there was a running account between the debtor and a creditor, prior to the introduction of the running account principle in s588FA in the predecessor legislation of the Act[18]. In Bryant v Badenoch, the High Court considered whether in incorporating the running account principle in s588FA of the Act, the legislature also incorporated the peak indebtedness rule.

Background of Bryant v Badenoch

Bryant, along with Mr Ian Cason and Mr Craig Crosbie, were liquidators of the company Gunns. The respondent company, Badenoch, previously entered into an agreement with Gunns to supply Gunns services for harvesting and hauling timber.  Gunns had poor financial performance between 2010 and 2012, but Badenoch continued to provide services until Gunns was unable to pay for its services, and the agreement was terminated by both parties in August 2012.

On 25 September 2012, Gunns appointed liquidators. The liquidators applied for a series of eleven payments to be declared to be voidable transactions as unfair preferences. Badenoch argued that Gunns had a continuing business relationship or running account with Badenoch; therefore, under the Act, the transactions would be considered as a single transaction. The liquidators argued that in such a case they were entitled to apply the peak indebtedness rule to a running account and choose the date on which the single transaction begins as being the date of peak indebtedness.

At first instance, Justice Davies in the Federal Court held that the “peak indebtedness rule” did apply under s 588FA (3). It was later appealed to the Full Federal Court, and then the High Court.

High Court Decision

The High Court, on appeal, unanimously held that the rule did not apply for the following reasons:

1. The language of s 588FA of the Act, and the relevant Explanatory Memorandum[19] , reveal that the section is intended to give effect to the running account principle, but there is no evident intention that it seeks to give effect to the peak indebtedness rule[20].
2. Moreover, it could not be said that s588FA, in giving effect to the running account principle, sought to incorporate the peak indebtedness rule. The purpose of the running account principle is to allow a company to continue to trade for ‘the likely benefit of all creditors’, not to maximise the potential for claw-back of assets, as the peak indebtedness rule does[21].
3. The running account principle exists to ensure that the question of whether there has been an unfair preference, despite a continuous business relationship, is determined by reference to the “ultimate effect” of the transactions in the whole period; allowing a liquidator to make such a claim by starting at the point of peak indebtedness would subvert this purpose[22].

Commentary

As the High Court also noted, while the peak indebtedness rule can be reconciled with the running account principle, it is clear that the rule maximises the potential to find an unfair preference claim within the relevant period, and this was not the intention of Parliament[23]. In the case of a running account, a liquidator is not able to choose the date of peak indebtedness as the starting point in order to maximise the amount of an unfair preference claim. Unsurprisingly, this may deter some liquidators from bringing unfair preference claims.

David Hing, Nicola Nygh, Hugo Hosie, Matthew Dutaillis and David Stano

Notes:

[1] Jeremy Hill and Lucca De Paoli (2023), ‘A $700b corporate-debt storm is building over the global economy’ Sydney Morning Herald (19 July 2023), accessed: https://www.smh.com.au/business/the-economy/a-700b-corporate-debt-storm-is-building-over-the-global-economy-20230719-p5dpf9.html

[2] [2023] HCA 1 (‘Metal Manufacturers v Morton’).

[3] [2023] HCA 2(‘Bryant v Badenoch’).

[4] Note that historically authorities have held the right to statutory set-off is unavailable for claims of unfair preference, see Re a Debtor [1927] 1 Ch 410; Re Clements; Ex parte Trustee; Golsbrough Mort & Co Ltd (1931) 7 ABC 225; Re Smith (1933) 6 ABC 49; Calzaturuficio Zenith Pty Ltd v NSW Leather & Trading Co Pty Ltd [1970] VR 605; Painter v Charles Whiting & Chambers Ltd (1932) 4 ABC 203; Re Buchanan Enterprises Pty Ltd (No 2) (1982) 7 ACLR 407. Competing authorities, however, have developed suggesting otherwise, See Re Parker (1997) 80 FCR 1, Buzzle Operations Pty Ltd (In liq) v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47, Hall v Poolman (2007) 65 ACSR 123 and Stone v Melrose Cranes & Rigging Pty Ltd [No 2] (2018) 125 ACSR 406.

[5] Metal Manufacturers v Morton at [45].

[6] Ibid at [46].

[7] Ibid, 52.

[8] Ibid, 54; cf Gye v McIntyre (1991) 171 CLR 609, 623 per Mason CJ, Brennan, Deane, Dawson, Toohey, Gaudron and McHugh JJ.

[9] (1997) 80 FCR 1.

[10] (2011) 81 NSWLR 47.

[11] (2007) 65 ACSR 123.

[12] (2018) 125 ACSR 406.

[13] Metal Manufacturers v Morton at [56].

[14] G & M Aldridge Pty Ltd v Walsh (2001) 203 CLR 662, [30] per Gleeson CJ, Gaudron, Gummow, Hayne and Callinan JJ.

[15] Corporations Act 2001 (Cth) s 588FF

[16] Bryant v Badenoch Integrated Logging Pty Ltd (2023) HCA 2 A10/2022 at [35] (Bryant v Badenoch) and Corporations Act s588FE(2)

[17] Corporations Act s 588FA(3)

[18] see Rees v Bank of New South Wales (1964) 111 CLR 210 being the original source of the peak indebtedness rule and Bryant v Badenoch at [49]

[19] Explanatory Memorandum to the Corporate Law Reform Bill 1992 (Cth)

[20] Bryant v Badenoch at 45-54

[21] Bryant v Badenoch at 70

[22] Bryant v Badenoch at 60

[23] Bryant v Badenoch at 77

 

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