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On 27 May 2020, the Federal Court of Australia delivered three judgments in respect of unfair preference claims brought by the liquidators of Gunns Limited (‘Gunns’) against three of its creditors.

Judgments in all three proceedings were handed down simultaneously:

Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Badenoch Integrated Logging Pty Ltd [2020] FCA 713 (Badenoch);

Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Bluewood Industries Pty Ltd [2020] FCA 714 (Bluewood); and

Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed) v Edenborn Pty Ltd [2020] FCA 715 (Edenborn)

The liquidators were successful in all three proceedings.

The judgments are interesting because of the arguments that were raised by the creditors in order to try to defeat the liquidators’ claims.

The creditors sought to challenge the application and assessment of the following: 

  1. The determination and assessment of the start and end point of a continuing business relationship, or ‘running account’, between a company and creditor; 
  2. The ‘peak indebtedness rule’; and 
  3. The doctrine of ‘ultimate effect’.

 

One of the creditors also sought to argue that even if the Court was satisfied that it had received an unfair preference, the Court had a discretion under s588FF of the Corporations Act 2001 (the ‘Act’) to order that it was not required to repay the preferential payments to Gunns.

Many, if not all, of the arguments raised by the creditors to try to defeat the usual application of these principles will strike a chord with creditors who have similarly faced an unfair preference claim by a liquidator.

Each and every argument raised by the creditors was categorically unsuccessful.

The decisions serve to highlight that these principles are here to stay and their application is strongly established in precedent.

Background to the Gunns Preference Proceedings

Gunns was the parent company of the Gunns Group, a large scale corporation operating forest management, development and manufacturing. The Gunns Group was also responsible for the management of various forestry and horticultural managed investment schemes, ultimately taking over contracts from the Great Southern Scheme following its collapse.

Badenoch, Bluewood and Edenborn were each creditors of Gunns whom provided contracted harvesting, haulage and wood chipping goods and services to Gunns.

In separate Federal Court proceedings, the Court determined that Gunns was insolvent on and from 30 March 2012.

The Continuing Business Relationship or ‘Running Account’

Section 588FA(3) of the Act provides that where there is an ongoing supply of goods or services and payments made for those services during the relation back period, then all of the transactions forming part of the relationship should be taken into account as if they together constituted a single transaction for the purpose of determining whether a creditor has received an unfair preference.

However, relevant authorities have established that there will only be a continuous business relationship if the purpose of the payments is to induce further supply as well as to discharge past indebtedness. If there is no intention to induce further supply, then the continuing business relationship ceases and any payments received after that date will fall outside the running account and be discrete unfair preferences.

The liquidators accepted in all three matters that there was a continuing business relationship or running account between Gunns and each creditor.

At issue were the start and end dates of the running accounts during the relation back period.

As all creditors will know, the credits and debits that fall into and outside the running account can make a big difference to the amount of the preference and, in some cases, whether there is any unfair preference at all.

Each creditor contended that the running account ran uninterrupted from the start to the end of the relation back period.

Each creditor submitted that s588FA(3) of the Act applied to treat all the transactions within the relation back period as a single transaction for the purpose of s588FA(1) of the Act and that it was not appropriate for the liquidators to nominate alternative dates during the period.

The liquidators disputed in Badenoch and Edenborn that there was an uninterrupted continuing business relationship throughout the relation back period and alleged that it came to an end prior to the end of the relation back period.

In Badenoch, the liquidators submitted, and the Court accepted, that only two of the eleven payments under attack formed part of a continuing business relationship.

What was fatal to Badenoch’s case was that the nine payments made by Gunns followed payment plans negotiated after Badenoch had sent to it a solicitor’s demand threatening legal action unless certain debt was paid; had ceased to provide services to Gunns pending receipt of payment for prior services (albeit for 10 days only) and threatened to issue a creditor’s statutory demand for payment of debt.

Whilst Badenoch continued to provide limited services to Gunns even after such threats were made, the Court determined that the predominant purpose of the nine payments was to reduce past indebtedness in the face of threats of legal action rather than to secure the ongoing provision of services.

In Edenborn, the liquidators submitted, and the Court accepted that there were in fact two periods of a continuing business relationship and, in effect, two running accounts during the relation back period.

The liquidators submitted that the first running account commenced at the start of the relation back period and ended when Gunns suspended its operations as a result of a ‘force majeure’ event arising from contractual issues between Gunns and other entities not involving Edenborn. Edenborn could not provide its services to Gunns during this suspension period.

The second running account commenced when Gunns’ operations resumed, approximately 3 months later, which then continued until the date the liquidators (then as Administrators) were appointed to Gunns.

During the approximate three month period that Gunns’ operations were suspended, Gunns made three significant payments to Edenborn, which resulted in substantially reducing the overdue debt. The liquidators contended that these payments were separate and discrete payments and fell outside the running account.

Edenborn submitted the running account between it and Gunns continued during the suspension period because the ‘force majeure’ event was unconnected to Edenborn and its contract with Gunns remained on foot during the suspension period so there was no cessation of the continuing business relationship between them.

What was fatal to Edenborn’s case was that there was evidence that during the suspension period Edenborn’s demands for payment from Gunns escalated from an initial threat to issue a letter of demand unless the debt was reduced below a certain amount, rising to a threat to issue a statutory demand and demands for full payment as a condition of recommencing services for Gunns. This evidence established that the payments made by Gunns during the suspension period were clearly not for the purpose of inducing further supply, rather, were to reduce past indebtedness in the face of threats of legal action and threats to withhold future services.

The Court placed little weight on the fact that Edenborn provided a small amount of services (relative to the debt that was repaid) just after the suspension period and said that this did not negate a finding of a break in the continuing business relationship.

Point of Peak Indebtedness

Satisfied that there was a continuing business relationship between Gunns and each of the three creditors, the liquidators then submitted that the continuous business relationship should be taken to have started not from the start of the relation-back period but from the date of the highest point of indebtedness of each creditor to Gunns during the relation back period.

The ‘peak indebtedness rule’ has its genesis in Rees v Bank of New South Wales [1964] HCA 47 in which it was held that it is open to a liquidator in a preference proceeding to choose the highest point of indebtedness in a running account as the “starting point”, rather than the balance of the debt at the start of the relation back period, for the purpose of calculating the quantum of the preference.

Each of Badenoch and Bluewood contended that that the peak indebtedness rule established by Rees had no further application following the introduction of s588FA(3) into the Act in 1993.

These creditors submitted that s588FA(3) of the Act makes plain that when there is a running account, all transactions in the running account must be treated as a single transaction for the purpose of determining whether the creditor has received an unfair preference. To permit the liquidator to pick one point during the relevant period directly conflicts with the plain language meaning of s588FA(3) of the Act. Further, the failure by the Parliament to enshrine the ‘peak indebtedness rule’ when it introduced this provision into the Act in 1993, signaled that the peak indebtedness rule no longer applied.

The creditors went so far as to submit the Court should not follow the authorities that have applied the peak indebtedness rule as they have been wrongly decided.

In support of their submissions, the creditors relied on the New Zealand Court of Appeal decision of Timberworld v Levin [2015] 3 NZLR 365. In Timberworld, the Court considered whether the Australian peak indebtedness rule applied to the New Zealand equivalent of s588FA(3) and determined that it did not. The Court of Appeal stated that:

to arrive at some artificial point during the course of all the relevant transactions and to select the point of peak indebtedness (resulting in transactions prior to this point being disregarded) would be to ignore the express wording used by the Parliament” (at 386) [69].

This was the first occasion on which an Australian court was asked to consider the Timberworld decision. 

Justice Davies considered the reasons given by the New Zealand Court of Appeal and conducted a thorough review of the relevant authorities, including relevant extrinsic material to the bills that introduced s588FA into the Act.

Her Honour disagreed with the New Zealand Court of Appeal’s reasoning and observed that the weight of Australian authority indicated that the current provisions of the Act were not intended to substantively change the law with respect to unfair preferences and that there was nothing in the extrinsic material which indicated that the peak indebtedness rule was not intended to continue to have operation. She rejected Badenoch and Bluewood’s submission that the peak indebtedness rule has no application to s588FA(3) of the Act.

Bluewood made a further alternative submission that the application of the peak-indebtedness rule to the circumstances of its running account was grossly unfair. In its case, the liquidator had picked the date on which Gunns had suspended its operations as a result of a ‘force-majeure’ event. You will recall that Gunns made a series of significant payments to Bluewood during the suspension period. Bluewood submitted that the application of the peak indebtedness rule in this instance was grossly unfair because Bluewood did not provide services to Gunns during this period, not because it did not wish to do so, but because it was prevented from doing so due to circumstances outside of its control. Meanwhile, Gunns’ obligations to make payments to Bluewood were not similarly suspended.

Justice Davies disposed of this argument swiftly. Her Honour observed that the value of the subsequent services that Bluewood had provided to Gunns, once operations resumed, were to a lesser value than the payments received, so even if the suspension period was disregarded, it would not change the outcome. The ultimate effect of the course of dealing was that Bluewood received an advantage over other creditors by reason of the payments. In the circumstances, her Honour was satisfied that there was nothing unfair about the application of the peak indebtedness rule in this circumstance.

Doctrine of Ultimate Effect

Where a payment is part of a running account between a debtor and creditor, the task of the Court is not to look at the effect of each payment in isolation, but to determine the ultimate effect of course of dealings between the parties. In the case of payments made to induce further supply, those payments will not be preferences unless the “ultimate effect” of those payments is that their value exceeds the value of the goods supplied. In so doing, the Court evaluates the effect of the course of dealing between the parties on their financial relationship.

In Edenborn, the Court received competing submissions from liquidators and the creditor as to the manner in which the “ultimate effect” of the payments received by Edenborn from Gunns is to be assessed and determined.

The liquidators contended that all that is required is a comparison of the face value of the services provided by Edenborn to Gunns as against the value of the payments made by Gunns to Edenborn.

Edenborn contended that what is required is an enquiry into the actual effect on the net assets of Gunns of the services provided and payments received by Edenborn.

Edenborn submitted that the ultimate effect of its dealings with Gunns was to increase the net assets of Gunns available to meet the demands of other creditors. It submitted that the services that it provided enabled Gunns to convert its timber assets into woodchips for export so the value of the services that it supplied to Gunns should be measured by the “downstream” revenues and profits that Gunns enjoyed in that period as a direct result of its services. Edenborn cited no legal authority for the proposition.

Justice Davies reviewed the relevant authorities and concluded that the approach advocated for by Edenborne misconceived those authorities. Her Honour dismissed the proposition that a liquidator is required to establish that value of the downstream services that a creditor provides exceeds the quantum of the payments made. She affirmed that all that is required is a comparison of the face value of the services provided by Edenborn to Gunns as against the value of the payments made by Gunns to Edenborn.

Discretion

Edenborn argued that the powers given to the Court by s588FF(1)(a) of the Act are discretionary because the provision provides that the Court ‘may’ make an order directing the creditor to repay the preferential payments to the company.

It submitted that Gunns directly benefitted from the services that it provided to it during the relation back period and adduced expert accounting evidence to quantify the amount of profit that Gunns enjoyed as a direct benefit of its services. It further submitted that an order for payment would provide a windfall to the liquidators.

The liquidators contended that s588FF(1) of the Act confers jurisdiction and power on the Court, not a discretion. The liquidators further submitted that the contention that they would enjoy a “windfall’ gain as a result of the payment was completely misconceived as the preferential amount is determined by the application of the running account principle in s588FA(3) of the Act and the doctrine of ultimate effect. This rule and doctrine is designed to ensure that all unsecured creditors are treated equally in the period leading up to the liquidation and that where there is a running account between a creditor and a company, the creditor receives the benefit of the services supplied in return for the payments.

Justice Davies considered the relevant authorities and concluded that the power of the Court under s588FF is a discretionary power. However, it must be exercised judicially in light of the purpose and object of the preference provisions in the Act.

Her Honour considered the matters submitted by Edenborn and stated that she was not satisfied that they justified the Court exercising its discretion not to order the repayment of the preferential payments. She also accepted the liquidators’ submissions that the running account principle and doctrine of ultimate effect militates against any “unfairness” of the kind contended for by Edenborn.

Final Comments

At the heart of the ‘running account’, ‘peak indebtedness rule’ and doctrine of ‘ultimate effect’ is a desire to ensure that all unsecured creditors are treated equally in the period leading up to the appointment of a liquidator. These decisions clearly establish that the courts hold a strong faith in the operation of these rules and that in practice they operate as intended.

It is fair to say that creditors faced with a claim to repay significant sums to a liquidator as preferences will find it difficult to accept that there is any fairness in having to repay preferential payments. It is a bitter pill to swallow. These three decisions highlight that it is a fools’ errand to try to resist an unfair preference claim on the grounds that the unfair preference regime operates unfairly to the targeted creditor.