A win and a loss for liquidators in pursuing unfair preferences

On 8 February 2023, the High Court handed down two important decisions regarding unfair preference claims and in so doing settled, once and for all, the law relating to two provisions in the Corporations Act 2001 (Act) that had been the subject of significant uncertainty.  In short, the decisions mean that:

• A creditor cannot rely on a debt owing to it by the company in liquidation to set-off a liquidator’s unfair preference claim.
• The peak-indebtedness rule used by liquidators has been abolished.   Liquidators had adopted the peak indebtedness rule to select the “highest point” of indebtedness in a running account between the company and a creditor during the relation-back period as the point at which the net reduction indebtedness is to be measured. The quantum of the preference claim is calculated by subtracting the debt owing to the creditor by the company at the time of liquidation from the point of “peak indebtedness”.

Statutory set-off not unavailable to creditors as a defence against an unfair preference claim

Pursuant to s 553C of the Act, where there have been mutual debts, claims or dealings between a company in liquidation and a creditor, these are set off against one another, and only the balance can be claimed by the company or against the company (as the case may be).  

What has been unclear over the past decade or so is whether that right of set off applied to voidable transaction claims available to a liquidator (preference claims, for example) such that a creditor can deduct their claim against the company from their liability to the liquidator.

The High Court decision in Metal Manufactures Pty Limited v Morton [2023] HCA 1 (Metal Manufactures) settles the position that set off against a liquidator’s unfair preference claim is not permitted and that the authorities over the past decade deciding to the contrary, were wrong.

The question answered by the High Court was:

Is statutory set-off, under s 553C(1) of the [Act], available to the [appellant] in this proceeding against the [first respondent's] claim as liquidator for the recovery of an unfair preference under s 588FA of the Act?

The simple answer was “no”.

The High Court agreed with the Full Court of the Federal Court that there was no mutuality between the debt owed by the company to the appellant creditor and the liquidator’s claim for an unfair preference.  The Court reasoned that:

• At the time of winding up, the liquidator and the company had no claim against the creditor that could be set off. The liquidator’s right to pursue an unfair preference claim against the creditor was not a contingent claim at the time of winding up capable of any set-off rather, it was an obligation that arose only after liquidation.
• There was no mutuality in the dealings sought to be set off.  The debt owed to the creditor arose out of a dealing between the creditor and the company and the claim for an unfair preference arose as between the liquidator (who acts as an officer of the court, not an agent of the company) and the creditor.

The High Court, having regard for the statutory scheme of liquidation, reasoned at [51] that:

It would be a gross distortion of the statutory scheme of liquidation if a creditor could, in effect, avoid the consequences of having received a preferential payment by the happenstance that it was also owed money by the company in liquidation. Such an outcome would diminish the pool of assets available for priority payments and rateable distribution. It would permit a preferred creditor to use each dollar owed to it by the company to set off in full each dollar of liability arising from receipt of an unfair preference.

Whilst the High Court did not go as far to express that the s 553C set-off provision is not applicable to all voidable transaction and insolvent trading claims in a liquidator’s arsenal, the reasoning and principles in Metal Manufacturers would be equally applicable in the context of other forms of voidable transactions such as uncommercial transactions (s 588FB), insolvent transactions (s 588FC) and creditor-defeating dispositions (s 588FDB). 

“Peak indebtedness” has no place in a liquidator’s calculation of a running account for recovery of an unfair preference claim

The effect of s 588FA(3) of the Act is that, where there was a “continuing business relationship” between a company in liquidation and a creditor such that the level of the company's net indebtedness to the creditor increased and decreased from time to time as a result of a series of transactions forming part of the relationship (such as a trading account), the continuing business relationship is assessed as a whole and only the net preferential effect can be clawed back by a liquidator.  The legislative intent of the section is to limit the amount of a liquidator’s preference claim in circumstances where a debtor is making payments to a creditor who is supplying goods or services as part of a continuing business relationship.

In the past, liquidators have relied on the “peak indebtedness rule” to choose the highest point of indebtedness in the running account during the relation-back period and subtracting from that amount, the sum owing on the relation back day.  The “peak indebtedness rule”, in practice, maximised both the likelihood of proving an unfair preference and the quantum of any unfair preference claim.

The High Court has, in its decision in Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (Badenoch), made clear that the peak indebtedness rule is no longer available to a liquidator in establishing and quantifying an unfair preference claim under s 588FA of the Act. 

The High Court unanimously held that:

1. Section 588FA(3) of the Act does not incorporate the peak indebtedness rule. A liquidator should not be allowed to choose the “start date” of a continuing business relationship. The relevant period is either the period within the six months from when the continuing business relationship started or when the company became insolvent, whichever is later.[1]
2. It is not unusual for companies to trade on a continuing basis for a period but for that relationship to end and another to start again over time or for odd jobs to appear in the interim outside of the continuing relationship. In those circumstances, the two groups of transactions would be separate running accounts rather than one single continuing transaction and any ‘odd job’ would be excluded from the single transaction. To determine whether a transaction is an integral part of a continuing business relationship, the whole of the evidence of the ‘actual business’ relationship between the parties must be objectively considered. What the parties intended is a relevant, but not the only, factor.
3. The Full Federal Court was correct in excluding the payments made after the relationship between the company and the creditor ceased.

Without the peak indebtedness rule, the Badenoch decision will likely reduce the quantum recoverable by liquidators in unfair preference claims where there has been a running account.

[1] Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 at [13].