Thinking | 19 June 2020

Three of a kind: Federal Court provides clarification on key issues in determining unfair preference claims

By Hector West, Andrew Giorgi, Navar Amici and Emily So

In three related judgments delivered on 27 May 2020, Justice Davies found in favour of the liquidators of Gunns Limited (in liquidation) (Liquidators) against creditors Badenoch Integrated Logging Pty Ltd (Badenoch),[1] Bluewood Industries Pty Ltd (Bluewood),[2] and Edenborn Pty Ltd (Edenborn)[3] for various unfair preference claims.

Justice Davies provided some important clarification on key issues including:

  • the limitations of the running account defence under s 588FA(3)(a) of the Corporations Act 2001 (Cth) (the Act) (continuing business relationship issue);
  • whether the Court should have regard to the ultimate effect of transactions and consider their ‘downstream economic effect’ (the ultimate effect issue);
  • whether New Zealand Court of Appeal decision in Timberworld Ltd v Levin[4] should be referred to Australian authorities in abolishing the peak indebtedness rule (peak indebtedness issue).

The decision also provide a useful analysis of:

  • the circumstances in which a creditor will not be able to establish a good faith defence pursuant to s 588FG(2) of the Act (good faith defence);
  • whether the Court has a discretion under s 588FF to reduce the amount otherwise payable as a preference, and in what circumstances the Court’s discretion should be exercised (the discretion issue).

Unfortunately, the decisions also represent a lost opportunity to provide some clarity on the availability of set-off under section 553C of the Act to recipients of unfair preferences.

Continuing business relationship

Section 588FA(3)(a) of the Act creates an exception to an unfair preference claim, where certain transactions will not be voidable where they formed an integral part of a continuing business relationship of the creditor and debtor; this is often referred to as the ‘running account defence’.

In the Badenoch matter, Davies J considered two separate periods where the creditor raised the running account defence.  Both periods concerned payments directly referrable to invoices which were made pursuant to a payment plan negotiated after a letter of demand and threats of further action were made.

Justice Davies found that neither period met the definition of a running account.  Her Honour cited the High Court decision of Airservices Australia[5] in her reasoning, holding that in making a demand for payment of the outstanding debt the creditor was ‘looking backwards rather than forwards; looking to the partial payment of the old debt rather than the provision of continuing services’.

In the Edenborn matter, Davies J was required to determine whether a force majeure event giving rise to the suspension of operations, arising from contractual issues between the company and other entities, broke the contractual relations between the parties; and if so, whether that severed the continuing business relationship.

Importantly, in this period of suspension, the creditor requested a significant payment in order to recommence operations, and told the company that it intended to issue a letter of demand. Similarly with the Badenoch matter, Davies J held that those payments were made so as to reduce outstanding debt and not for the provision of continuing services, and therefore could not to be part of a running account.

Justice Davies acknowledged that it was ‘undoubted on the evidence’ that the company in making the payments was keen to ensure the continuation of the creditor’s services, but found that:

‘the fact that a small quantity of services (relative to the debt that was repaid) was provided … [that did] not negate a finding of a break in the continuing business relationship’.

Ultimately, the mutual purpose of inducing further supply was subordinated to a predominant purpose of recovering past debt.

Ultimate effect issue

Prior to the introduction of the current unfair preference provisions,[6] the doctrine of ultimate effect operated so that ‘a payment that induces the further supply of goods and services is evaluated by the ultimate effect that it has on the financial relationship of the parties… [if] the payment was made to induce the further supplies, the creditor is entitled to have the ultimate effect of the transaction examined’.[7]

However, the enactment of s 588FA of the Act has created some uncertainty as to whether the Courts would continue to apply earlier case law to determine an unfair preference in a running account scenario.

In the Edenborn matter, Davies J did not directly decide on this issue, but stated:

‘if it were necessary to form a view in this case … I would be disposed to hold that the doctrine still applied’, holding ‘there is nothing to suggest that the new provisions intended to alter the law’.

Justice Davies rejected the creditor’s submission that in order to making out an unfair preference claim, liquidators must allege and prove that the ultimate effect of the transaction was a reduction in the net assets available to creditors. Instead, Her Honour held that the doctrine ‘simply involves a comparison of the face value of the services provided as against the value of payments made’.

The creditor contended that for the purposes of the doctrine, the value of the services provided by the creditor[s] during the relation back period is to be measured by the “downstream” revenues and profits that the company made in that period as a direct consequence of the services provided.  Her Honour applied earlier authority in concluding that the doctrine of ultimate effect does not depend on an evaluation of the overall economic benefit of the impugned transaction, but rather whether the aggregate amount of the payments in the single transaction exceeds the aggregate value of the goods or services provided.

Peak indebtedness

The peak indebtedness rule provides that for the purposes of establishing a preferential payment, liquidators are entitled to nominate the point of the insolvent company’s peak indebtedness to the creditor during the period of the continuing business relationship within the relation back period as the starting point from which the dealings between the parties are to be treated as a single transaction.

In Timberworld Ltd v Levin[8] the New Zealand Court of Appeal decided not to apply the Australian peak indebtedness rule to the equivalent New Zealand law.[9]  In doing so, the Court considered the Australian High Court decision in Airservices Australia, and found that the decision was contrary to the peak indebtedness rule applying to s 588FA of the Act.

In each of the Badenoch, Bluewood and Edenborn matters, the creditors submitted that Timberworld Ltd v Levin should be adopted, as the Australian authorities had been incorrectly decided. Davies J explicitly disagreed with the New Zealand Court of Appeal that the peak indebtedness rule ‘does violence’ to the ultimate effect doctrine, and upheld the previous Australian authorities.[10]

Her Honour found that the peak indebtedness rule is reconcilable with the ultimate effect doctrine because the object of the doctrine is to ensure that the effect of a payment that induces the further supply of goods and services is evaluated by the ultimate effect that it has on the financial relationship of the parties.

Justice Davies rejected the position that the rule provides a windfall to the company in liquidation and held that the peak indebtedness rule does have application to s 588FA(3) of the Act.

Good faith defence

Davies J held that to establish the good faith defence it is not sufficient to show that the creditor genuinely held the belief that the financial difficulties of the company in liquidation were short term. The defence requires the creditor to prove it had no reasonable grounds for suspecting insolvency based on the factors and circumstances of which it was, or a reasonable business person in the creditor’s position would have been, aware at the time of the transactions.

In each of the three matters, Justice Davies found that the creditor had reason to suspect that the company was insolvent and could not rely on the good faith defence.  Her Honour found that the knowledge of the following factors were highly persuasive in reaching her determination against the establishment of the second and third limbs of the defence:[11]

  • the company was facing cash flow constraints and difficulties, which included payments not being made to creditors on time and some of which were made were in rounded amounts not linked to specific invoices;
  • the creditor was unable to secure the company’s agreement to pay its outstanding invoices within the timeframes prescribed by the letter of demand;
  • the company was selling assets in order to meet payments due to contractors;
  • the creditor was aware of a news article in which an analyst said that the company’s equity raising venture, was ‘the last throw of the dice’.
  • that the potential investor was not proceeding with its equity investment and that the company’s shares were in a trading halt;
  • the creditor wanted, but could not secure, a bank guarantee from the company for payment of its accounts; and
  • the creditor had ceased providing some of its services to the company and had threatened to suspend all services because of payment issues at that time.

Set off issue

The availability of a set-off under s553C as a defence to statutory recovery claims by a liquidator has become a hotly debated topic in recent years.  There remain difficult questions which the Courts have not adequately addressed or resolved, such as:

  • can there be mutuality where a creditor’s claim is against the company but recovery claims are claims in the hands of the liquidator;
  • do recovery claims qualify as being ‘due’ at the time of winding up despite the future need for a court to exercise its discretion in the liquidator’s favour;
  • at the ‘relevant date’, what claim available to the creditor existed which is available to set off against an amount it may owe to the insolvent debtor;
  • is it permissible for s 553C to operate alongside the running account defence in s 588FA(3) where this might mean credit transactions are counted twice towards a creditor’s defence; and
  • is allowing set-off against recovery claims contrary to the statutory purpose of the relevant recovery provisions?

Davies J mused that the law is not currently settled as to whether a set-off is available against a liquidator’s claim to recover unfair preference payments; but concluded that it was unnecessary to decide that issue because the creditor in each instance had notice of the fact that the company was insolvent and was therefore precluded from bringing a set-off claim by operation of s 553C(2) of the Act.

Davies J drew a distinction between the test for making out a good faith defence under s 588FG(2) and the test for the notice of a company’s insolvency under s 553C(2), noting that the latter test is a higher bar, being: actual notice of facts which disclosed that the company lacked the ability to pay its debts when they fell due.

Notwithstanding, Davies J held in the Bluewood and Badenoch matters that the following combination of factors were held to together constitute notice of insolvency for the purpose of s 553C(2) of the Act:

  • the company was facing cash flow constraints and any payments received were directly dependant on the sale of assets;
  • the company had not been paying creditors’ invoices on time or for the full amount, and was unable pay its outstanding invoices within the compromised timeframes prescribed by the creditor’s letter of demand;
  • the company’s equity raising had fallen through and its shares remained in a trading halt;
  • the company had “max’d out” its bank guarantees; and
  • in one instance, the company was willing to terminate, and had in fact agreed to terminate, the contract with the creditor;
  • the company’s lenders had called in an accounting firm to review its balance sheet prior to the relation back period;
  • the company had announced to the ASX that it predicted it would record a negative impairment in its financial assets for the ending financial year; and
  • the company announced to the ASX that a Voluntary Administrator had been appointed.

Discretion issue

  • In the Edenborn matter, Davies J found that the power of the Court under s 588FF in relation to the orders it can make where a creditor receives an unfair preference is a discretionary power. Davies J went on to qualify that the discretion must be exercised judicially, in light of the purpose and object of the preference provisions in Part 5.7B of the Corporations Act.
  • Davies J held that nothing in that case warranted the exercise of discretion that no repayment of the preference transactions should be ordered and accepted the liquidators’ submission that the laws protection against “unfairness” for the purposes of s 588FA is dealt with by the codification of the running account principle in s 588FA(3) and the doctrine of ultimate effect.

Key takeaways

  • A continuous business relationship between the parties will be severed by:
    • a creditor making a demand for payment of outstanding debt where the predominant intention of the parties is to repay old debt rather than to entice the provision of continuing services; and
    • the cessation of services or supply of goods by the creditor to the company; noting that the continuing provision of a small quantity of services relative to the debt that was repaid will not negate a finding of a break in the continuing business relationship.
  • Confirmation that it is appropriate for a liquidator to choose the peak indebtedness in the relation back period as the starting point for calculating an unfair preference.
  • The doctrine of ultimate effect continues to have relevance in unfair preference claims. It is not proper for a Court to consider the “downstream benefit” of payments when considering the doctrine of ultimate effect; rather, a high-level review of the debits and credits between the parties may be all that is required.
  • Establishing notice of insolvency as a defence to a set-off claim under s 553C(2) of the Act is a higher onus than demonstrating there were no reasonable grounds for suspecting insolvency as in the good faith defence in 588FG(2) of the Act.
  • Industry stakeholders will have a longer wait for a court to rule on the availability of set-off under section 553C against unfair preference claims.

[1] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713
[2] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Bluewood Industries Pty Ltd [2020] FCA 714 (27 May 2020)
[3] Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Edenborn Pty Ltd [2020] FCA 715
[4] [2015] 3 NZLR 365
[5] Airservices Australia v Canadian Airlines International Ltd (2000) 202 CLR 133, 510 (Air Services).
[6] Division 2 of Part 5.7B of the Act, introduced by the Corporate Law Reform Act 1992 (Cth).
[7] Airservices Australia, the plurality at 509
[8] [2015] 3 NZLR 365
[9] Section 292(4B) of the Companies Act 1993 (NZ) was enacted in 2007 and is materially the same terms as s 588FA(3) of the Corporations Act 2001 (Cth)
[10] CSR Ltd trading as the Readymix Group v Starkey (as liquidator) of Allan Fitzgerald Pty Ltd (in liq) (1994) 13 ACSR 321; Sutherland v Lofthouse [2007] VSCA 197; 214 FLR 157; Clifton (as liquidator of Adelaide Fibrous Plasterboard Linings Pty Ltd (in liq)) & Anor v CSR Building Products Pty Ltd [2011] SASC 103; In the matter of Employ (No 96) Pty Limited (in liquidation) [2013] NSWSC 61.
[11] Per section 588FG of the Act: that it had no reasonable grounds to suspect insolvency (the second limb); and a reasonable person, in its circumstances, would have had no reasonable grounds to suspect insolvency (third limb).

Contact

Hector West

Hector has extensive experience in commercial dispute resolution and insolvency matters for both corporates and individuals.

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