Insights / June 28th, 2021

Creditors facing preference claims from liquidators to benefit from rejection of "peak indebtedness" rule

Creditors have long been at risk of claims by liquidators alleging they received payments, in relation to unsecured debts, that result in the creditor receiving more than it would through the winding up process if the funds were returned to the company. If the liquidator is successful, the creditor must repay those funds to the company (through the liquidator).

Where there was a continuing business relationship between the creditor and the company, with the company's debt fluctuating from time to time due to the various transactions, the liquidator must treat all the transactions (debits and credits) over the relevant period as one, with the net result being the amount of the unfair preference. This "running account" tends to reduce the amount the creditor could be required to pay back to the company as there will only be a preference if the payments made exceed the value of the goods and/or services supplied.

For many years, the accepted approach was that the liquidator could start at the highest point of company debt to the creditor, which was known as the "peak indebtedness rule". The effect of transactions after that date were then considered, until the end of the continuing relationship or the date the company went into external administration, whichever is the earlier. By taking the debt at its highest point, the amount of the "unfair preference", and how much the creditor could be required to repay, was higher.

This approach was rejected in May by the Full Federal Court in Badenoch Integrated Loggin Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64.

The Court instead held that the entirety of the continuing relationship must be considered (over the relevant period) when calculating an alleged preference. This includes all payments (whether challenged or not challenged) and all supply (both past and future) forming part of the continuing business relationship within the relevant period.

The effect of this decision is significant. It is likely that, in most cases, the amounts recoverable by liquidators will now be less when a running account applies. This decision not only affects potential claims by liquidators in the future, but also current claims being agitated. We expect that there will be an increased focus on the circumstances evidencing a continuing business relationship to determine if payments can be brought outside of the "running account" defence entirely.

Given the significant consequences for liquidations and the potential for lower recoveries, we do not think Badenoch will remain the last word on this subject for long.

Should you have any questions about this decision, or require advice in relation to insolvency matters generally, please do not hesitate to contact us.

This publication has been prepared for general guidance on matters of interest only and does not constitute professional legal advice. You should not act upon the information contained in this publication without obtaining specific professional legal advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication and to the extent permitted by law, Cowell Clarke does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting or refraining to act in relation on the information contained in this publication or for any decision based on it.

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