The Peak Indebtedness Rule Plumbing the Depths

Introduction

Business people who deal with regular suppliers of goods and services will be familiar with the concept of the running account.  So far as concerns insolvency law, it has particular relevance when a consumer of those goods and services is wound up and its liquidator pursues a preference claim against a supplier. 

Until the decision in Badenoch Integrated Logging Pty Limited v Brant, in the matter of Gunns Limited (in liq) [2021] FCAFC 64 ("Gunns") it was taken to be the case, generally speaking, that, for the purpose of computing the amount of a preference claim in respect of a running account, the liquidator could identify the peak indebtedness of the account during the relation-back period and sue for the difference between that amount and the balance of the account owing when the company was wound up.  That approach was informed by the decision of Barwick CJ in Rees v Bank of New South Wales [1964] HCA 47.  

Gunns deals with two important issues for liquidators when pursuing preference claims in respect of payments made on a running account:

(a) how is the amount of the preference claim on a running account to be calculated?; and

(b) during what period will there be a running account?

Calculating the preference claim on a running account

The approach to quantifying a preference claim on a running account is determined by the proper construction of Section 588 FA(3), Corporations Act, which reads:

"Where:

1. a transaction is, for commercial purposes, an integral part of a continuing business relationship … between a company and a creditor … ; and
2. in the course of the relationship, the level of the company's net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship:
   
   then:
3. subsection (1) applies in relation to all the transactions forming part of the relationship as if they together constituted a single transaction
   
   … " 

As to the proper construction of that subsection, the court in Gunns said (at [114]):

"[the subsection] embodies the doctrine of 'ultimate effect' which recognises that the general body of creditors are not disadvantaged by payments made to induce trade creditors to supply goods of equal or greater value … "

and concluded (at [117]):

"So in saying one should have regard to 'the ultimate effect of the dealings between the parties' … [one looks] to all payments (both impugned and non-impugned) and all supplied (both past and future) forming part of the continuing business relationship and otherwise falling within the relevant statutory period.  If value provided to the company and a subsequent payment against accrued debt are viewed as part of an arrangement which has the effect of giving the company valuable goods and services, there is no depletion of assets.  If section 588 FA(3) applies then it expressly requires them to be viewed that way."

All of this is to say that, for the purpose of computing the amount of a preference claim on a running account, it is the net amount received by the creditor when allowance is made for all of the transactions between the creditor and the company in liquidation.  That calculation is made over the time, within the relation-back period, when there is a "continuing business relationship" between the creditor and the company.  

When does a "continuing business relationship" exist?

A determination of the period during which there was a continuing business relationship between a company and one of its creditors is an essential prerequisite to deciding whether the ultimate effect of the transactions between them resulted in the creditor getting a preference.  It is only the transactions during that period which are relevant to that computation.

The court in Gunns (at [48]) summarised the principles for determining whether there was a continuing business relationship as follows: 

1. "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;
2. it will usually be relevant to consider a statement of account in determining whether, from a business point of view, each particular payment was connected with the subsequent provision of goods or services;
3. if the purpose of the payment is to induce the creditor to provide further goods or services as well as to discharge an existing indebtedness, the payment will not be a preference unless the payment exceeds the value of the goods or services acquired;
4. 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;
5. knowledge of insolvency, suspicion of insolvency, or reasonable grounds to suspect insolvency will not necessarily destroy a continuing business relationship;
6. a stop on an account will not necessarily destroy a continuing business relationship;
7. the continuing business relationship does not need to exist for the entirely of the relation-back period; and
8. the existence of a continuing business relationship is a question of substance, not of form."

The court (at [49]) noted that there was a number of decisions which; "relied upon the principle that there will be no mutual assumption of a continuing business relationship where the purpose of inducing further supply is 'subordinated to a predominate purpose of recovering past indebtedness'".

Whilst the court did not express a concluded view as to the formulas to be applied when testing whether there was a continuing business relationship between the company and one of its creditors, it is our opinion that it is reasonable to distil from the judgement the proposition that it is sufficient to test whether there was a continuing business relationship by asking whether each payment made to the creditor was made for, amongst other purposes, the purpose of securing the ongoing supply of goods and services by the company.  That purpose need not be the dominant purpose of making the payment.

In any event, the decision in Gunns provides a useful example of the application of the relevant principles not least because there were two periods of time when it was relevant to do so.  In respect of the first period it was held that there was a continuing business relationship notwithstanding that the creditor had threatened debt collecting proceedings.  In the second period, however, the court found that such proceedings and other relevant circumstances were clear evidence that the creditor did not wish to continue in a business relationship with the company. The application of the relevant principles in those two periods and the reasoning which identifies why there were divergent conclusions as between them is best summarised by the following passage from the judgment (at [54] and [55]):

“..it is surely a reality of continuing to do business with a company in financial distress…that an unsecured creditor will often be concerned to ensure that payment is received for goods or services supplied. In such circumstances, it would be wrong to say that a mutual assumption of a continuing business relationship ceases whenever the balance tips ever so slightly in favour of recovering past indebtedness, such as where a creditor insists on payment of an ordinary invoice before continuing supply on terms.

At the other end of the scale, a creditor will not be permitted to hide behind the façade of a continuing business relationship when the true nature of what he or she is trying to do is seeking to recover past indebtedness in priority to other unsecured creditors.  A mutual assumption of a continuing business relationship will cease in circumstances where the real purpose is the recovery of past indebtedness, so if it becomes clear on the evidence that there is a looking backwards to the payment of an old debt (and not the provision of continuing services or goods) then there will be a preference.”

Authors: Richard Fisher (Consultant)