High Court's Landmark Decisions Clarify the Position for Creditors and Liquidators in Insolvency Proceedings

The High Court has had a busy start to the year, handing down two landmark decisions that have significant implications for insolvency practitioners. These decisions clarify the operation of important aspects of Australia’s insolvency regime and put to rest two questions long held by practitioners: whether liquidators are entitled to apply the peak indebtedness rule when assessing unfair preference claims and whether creditors are entitled to a right of set off against a liquidator’s claim to recover an unfair preference. Below, we take a closer look at both of those decisions and their implications.

Bryan v Badenoch Integrated Logging Pty Ltd [2023] HCA 2

On 8 February 2023, the High Court delivered a unanimous judgment settling the validity of a widely adopted principle commonly utilised by insolvency practitioners when assessing the value of unfair preference claims pursuant to section 588FA(3) of the Corporations Act 2001 (Cth) (the Act) – the “peak indebtedness rule”. This rule is based on a principle known as the “running account”; where the payments made from a company to a creditor are part of a “continuing business relationship” where the level of the company’s indebtedness to that creditor increases and decreases from time to time as a result of the existence of that relationship.

Until this time (or at least until May 2021), Australian insolvency practitioners had applied the peak indebtedness rule to calculate the effect of a creditor’s running account by providing that liquidators were entitled to value unfair preference claims by subtracting the debt owed to the creditor from the highest point of the indebtedness during the relevant period. This assessment enabled liquidators to seek to maximise the amount capable of recovery from a creditor and was often determinative of a liquidator’s assessment of whether to pursue a voidable transaction claim against a creditor.  

The Full Court of the Federal Court of Australia first cast significant doubt over the practice in its decision in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) [2021] FCAFC 64 when it held that liquidators could not use the peak indebtedness rule to assess unfair preference claims.  In their view, the Full Court found that the peak indebtedness rule was not a rule that applied under the Act and that creditors ought to be provided with the benefit of earlier dealings within a continuing business relationship when considering whether creditors have received an unfair preference.  

The Full Court’s decision has now been affirmed by the High Court confirming that insolvency practitioners have been wrong to apply the peak indebtedness rule to the assessment of unfair preference claims.  

Abolishing the peak indebtedness rule

In its second decision of 2023, the High Court in Bryan v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 held that insolvency practitioners and Australian courts had been wrong to assume that section 588FA(3) of the Act, although it incorporates the running account principle, also incorporates the peak indebtedness rule.

A key focus of the High Court’s reasoning was the statutory context surrounding section 588FA(3).  In short, the peak indebtedness rule cannot be applied given its inconsistency with other legislative requirements under Part 5.7B which sets out the claw-back regime for insolvent companies, which include:

• section 588FE(2) to (6B), which identifies the circumstances when a transaction is voidable.  For example, the circumstances can involve an “insolvent transaction”, an “uncommercial transaction”, an “unfair preference”, an “unfair loan”, or an “unreasonable director-related transaction” (see section 588FE(2), (2A), (2B), (2C) and (2D)).  In each circumstance, the transaction must have been entered into during a period of time prescribed by the relevant subsection. That period is identified as starting from or ending at the relation-back day or after that day but on or before the day the winding-up began; and  
• section 588FC, which provides that an insolvent transaction is only an unfair preference if, and only if, the transaction was entered into when a company is insolvent or the transaction had the effect of causing the company to become insolvent.  

The effect of the application of the peak indebtedness rule would allow a liquidator to select a starting date for the “continuing business relationship” that was outside of the period prescribed by section 588FE(2) to (6B) or a start date that was prior to the insolvency date.  It follows, the High Court found, that incorporating the peak indebtedness rule is not possible.

While the High Court accepted that limiting the relevant period in this way might be arbitrary, the effect of which might prevent the liquidator from maximising the potential claw-back from creditors, it reflects a policy choice made by Parliament as to the operation of section 588FA(3) of the Act.

Where to from here – determining the commencement of the “continuing business relationship”

In light of its finding, the High Court has sought to avoid any ambiguity as to the commencement of the “continuing business relationship” for the purposes of section 588FA(3) of the Act.  At paragraph [74] of its judgment, the High Court has held that the “continuing business relationship” begins from the later of:

• the beginning of the period prescribed by one or more of the requirements under section 588FE(2) to (6B); or
• the date of insolvency, as required by section 588FC; or
• if the continuing business relationship started after the prescribed period or date of insolvency, the beginning of the continuing business relationship.

From there, whether a particular transaction is “for commercial purposes, an integral part of” this continuing business relationship (and therefore part of the single transaction required for the assessment of an unfair preference claim) is an objective factual inquiry.  The High Court commented that concepts such as mutual assumption or the common business purpose of the parties to a transaction might be useful, but not conclusive.  Rather, the statutory task remains one of characterisation of the facts involving an objective ascertainment, on the whole of the evidence, of the business character (for commercial purposes) of the transaction in issue.

Excluding the peak indebtedness rule – good or bad policy?

In the respective decisions of both the High Court and the Full Federal Court in the Bryan v Badenoch decisions, the Court said nothing about whether the peak indebtedness rule was, in practice, good or bad policy.  The High Court undertook a surgical analysis of the statutory language and found that Parliament made a policy decision to exclude the peak indebtedness rule from the application of the unfair preference regime, leaving open the scope for the peak indebtedness rule to be specifically legislated for under the Act in the future.  This might make sense from a policy perspective having regard to Australia’s insolvency regime, which has always promoted measures that support liquidators to maximise the return to creditors as a whole.  

Currently, the Federal Government is undertaking a major review of corporate insolvency for the first time in 30 years (the last major review being the Harmer Report, published in 1988).  It remains to be seen whether, in light of the High Court’s interpretation of section 588FA(3) of the Act, a review of the peak indebtedness rule will be included in the terms of reference. We will follow any such developments with interest.

Metal Manufactures Pty Limited v Morton [2023] HCA 1

Introduction

Australian insolvency practitioners have long considered whether a defendant to a liquidator’s claim to recover unfair preferences was entitled to rely on a right of set-off under section 553C of the Corporations Act 2001 (Cth) ("the Act"). In Metal Manufactures Pty Limited v Morton [2023] HCA 1 (Morton), the High Court has finally settled the issue, finding  that a liquidator’s claim to recover an unfair preference is not subject to a right of set-off under section 553C.

What is the right of set-off?

Pursuant to section 553C of the Act, a company’s creditors will be automatically entitled to a right of set-off where there have been mutual credits, debts or other dealings between an insolvent company that is being wound up and a person seeking to have a debt or claim admitted against that company.

The purpose of section 553C is to ascertain what funds are available for distribution to each of the company’s creditors.  Where a right of set-off applies, it is only the balance of that set-off that is admissible to proof against the company. Section 553C prevents a creditor of an insolvent company who is also a debtor of that company being required to pay the full amount of the debt owed to the company and being entitled to receive only a portion of the credit owed by the company.

Which debts can be set-off?

The courts have held that the following claims are capable of being set-off:

• liquidated damages
• unliquidated damages
• secured debts
• contingent debts
• future debts

Section 553 creates a cut-off date for the determination of the debts and claims that can be proved in the winding up. In order for debts to be admissible to proof against the company, the rights of both the company and the creditor must arise out of circumstances that occurred before the “relevant date”, which is defined in section 9 of the Act as the day on which the winding up is taken to have commenced. Relevantly, in order for a debt or claim to be capable of set-off, it must have existed before the relevant date (i.e., the commencement of the winding up).

The “relevant date” will depend on the circumstances of the liquidation.  If the winding up is ordered by the Court, the relevant date is generally the day when the winding up order was made. Where the company resolves by special resolution that it be wound up voluntarily, the relevant day is generally the day on which the resolution was passed. If the company is under a deed of company arrangement at the time the debt is incurred or the claim arises, the relevant date is the date on which the deed terminates.

What is mutuality?

In order for the right of set-off to be available, the requisite mutuality must be established. The High Court of Australia in Gye v McIntyre (1991) 171 CLR 609 identified three key aspects of mutuality:

1. the credits, debts or claims arising from other dealings must be between the same parties;
2. the benefit or burden of the credits, debts or claims must lie in the same interests – this means that each party must hold the credit, debt or claim in the same capacity as that party is liable under the other claim; and
3. the credits, debts or claims arising from other dealings must be commensurable for the purposes of set-off – that is, they must be sound in money. However, they may also be contingent.

The characteristics of the claims themselves and how they arose do not matter. Whether mutuality exists is determined by reference to the characteristics of the parties.

The Morton decision

Facts

Metal Manufactures Pty Ltd (‘the appellant’) was paid $50,000 and $140,000 by MJ Woodman Electrical Contractors Pty Ltd (‘MJ Woodman’), which was subsequently placed into liquidation. The payments were both made by MJ Woodman within the six-month period prior to winding up of MJ Woodman (‘the relation-back period’).

MJ Woodman’s liquidator (‘the liquidator’) sought to recover both payments from Metal Manufactures pursuant to section 588FF(1)(a) on the basis that each was an unfair preference under section 588FA. However, the appellant contended that it had a right to set off its potential liability to repay the alleged unfair preferences against the separate debt owed to it pursuant to section 553C.

First instance and Federal Court

Derrington J, after hearing the matter at first instance, referred the question of whether the appellant was entitled to set off the payments against the debt it proved for in the winding up to the Full Court of the Federal Court.

Following a construction of the relevant statutory provisions, the Full Court unanimously held that set off under section 553C was not available to the appellant because the requirement of mutuality was not met. In particular, the creditor’s debt arose from ‘historical events in the ordinary course of business’ while the creditor’s obligation to pay the unfair preference payments arose from a court order obtained by the liquidator in the exercise of their statutory duties after the ‘relevant date’.

The appellant subsequently appealed the decision to the High Court by special leave.

High Court’s decision

The High Court unanimously held that any liability arising from the Court making an order under section 588FF(1)(a) in relation to voidable transactions was not eligible to be set off against the debt owed to the appellant. It held that section 553C(1) requires that the ‘mutual credits, mutual debts or other mutual dealings” be credits, debts or dealings arising from circumstances that subsisted in some way or form before the commencement of the winding up’ [at 45].

Immediately before the commencement of the winding up, there was nothing that could be set off as between the appellant and MJ Woodman. There was no mutuality of interest as required by section 553C(1). This was because the company owed money to the appellant, but the appellant owed nothing to the company immediately before the winding up commenced.

The High Court relevantly held:

[47] It follows that the appellant could not identify a relevant mutual dealing. Contrary to its contentions, neither the trade transactions which were undischarged by MJ Woodman during the relation-back period nor, for the reasons already expressed, the discharged trade transactions (giving rise to the liabilities of $50,000 and $140,000), together with the liability which may arise under s 588FF(1)(a), were mutual dealings. Section 553C(1), correctly construed, does not address dealings which straddle the period before and after the commencement of the winding up.

…

[50] … under the statutory scheme of liquidation, any liability arising from the making of an order by a court under s 588FF(1)(a) cannot form part of the process for the identification of provable debts and claims for the purposes of s 553, and thus cannot be the subject of a valid set-off against pre-existing amounts owed by the company to the preferred creditor for the purposes of s 553C.

Their Honours concluded that there had been no dealing between the same persons because, while the liability created under section 588FF(1)(a) was owed to the company, it only arose on the application of the liquidator and not MJ Woodman itself. Further, there was no mutuality of interest because the amount the liquidator would recover from the unfair preference claim could not be seen as being for the benefit of the liquidator. Rather, it was to be made available, amongst other things, for the making of priority payments and for distribution to the company’s creditors in accordance with the pari passu principle.