Defending an Unfair Preference Claim – Continuing Business Relationship Defence

Continuing on from my previous article in which I discussed the ‘Good Faith’ defence which may be available to creditors in the event of an ‘Unfair Preference’ claim, I will now look at the ‘Continuing Business Relationship’ defence and the effect of last year’s decision in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in Liquidation) (Receivers and Managers appointed) [2021] FCAFC 64 (‘Badenoch’).

Continuing Business Relationship Defence

Section 588FA(3) of the Corporations Act 2001 (Cth) states that:

where

a)  a transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company (including such a relationship to which other persons are parties); and

b)  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

c)  subsection (1) applies in relation to all the transactions forming part of the relationship as if they together constituted a single transaction; and

d)  the transaction referred to in paragraph (a) may only be taken to be an unfair preference given by the company to the creditor if, because of subsection (1) as applying because of paragraph (c) of this subsection, the single transaction referred to in the last-mentioned paragraph is taken to be such an unfair preference.

In simple terms, this means that, where transactions made during the six month relation back period, form an integral part of a ‘continuing business relationship’ between the company and a creditor, one must assess the net effect of all the transactions in the relation back period, rather than the effect of each individual transaction.

Any creditor seeking to rely on the ‘Continuing Business Relationship’ defence must ensure that the transactions in question did, in fact, form part of a ‘continuing business relationship’. Payments are likely to form part of a ‘continuing business relationship’ if the purpose of these payments to a creditor were to induce further supply of goods. If the payments did not have the purpose of inducing further supply of goods, the defence will not be available to the creditor.

Effect of Badenoch Decision

In 2021, the Full Court of the Federal Court of Australia, in Badenoch, handed down a decision which for all intents and purposes eliminated a rule, known as the ‘Peak Indebtedness Rule’, previously relied on by Liquidators to counter the ‘Continuing Business Relationship’ defence.

In Badenoch, the Court, in its decision, amongst other things, noted that:

• • The starting date for assessing the net effect of the ‘continuing business relationship’ is the later of either, the commencement of the ‘continuing business relationship’ or the start of the six month relation back period; and

• • The relevant end date for assessing the net effect of the ‘continuing business relationship’ is the earlier of either, the cessation of the ‘continuing business relationship’ or the date of liquidation of the company.

Prior to 2021, the ‘Peak Indebtedness Rule’ essentially enabled a Liquidator to select any date within the six month relation back period where there was the greatest level of indebtedness and calculate the net effect of the ‘continuing business relationship’ from that date.

For example, if at the start of the six month relation back period the indebtedness of a company to a creditor was $40,000, but during the six month relation back period reaches a peak indebtedness of $80,000 before reducing, as a result of several payments by the company, to $10,000 at the date of liquidation, the Liquidator, relying on the ‘Peak Indebtedness Rule’, would be able to pursue an ‘Unfair Preference’ claim of $70,000 (Peak Indebtedness of $80,000 less $10,000 indebtedness as at the date of liquidation).

However, in the same example, using the new guidance established by Badenoch, the Liquidator would only be able to pursue an ‘Unfair Preference’ claim of $30,000 ($40,000 indebtedness as the start of the relation back period less $10,000 indebtedness as at the date of liquidation). On that basis, it is feasible that an Unfair Preference may not in fact exist if the level of indebtedness at the beginning of the relation back period is less than the closing balance owed, despite significant transactions that may occur within the relation back period.  

As can be seen, by way of these examples, the decision in Badenoch has, at the very least, reduced the likely quantum of any ‘Unfair Preference’ claim which may available to a Liquidator.

The Future

The ‘Peak Indebtedness Rule’ might not be a relic of the insolvency regime just yet however, as the Full Court of the High Court, on 18 March 2022, granted the Liquidators of the Gunns Group, special leave to appeal the decision of the Full Federal Court in Badenoch on all grounds argued.

Future judgement resulting from this appeal will hopefully provide further clarity around this area of law to both Liquidators and creditors alike.

Conclusion

As it stands, following the 2021 Badenoch decision, creditors can not only rely on the ‘Continuing Business Relationship’ defence to reduce the quantum of any potential ‘Unfair Preference’ claim, but in some instances, a potential ‘Unfair Preference’ claim previously available to a Liquidator (prior to the Badenoch decision) may no longer even exist.

With the Badenoch High Court appeal on the horizon, this area of law is sure to remain a hot topic of conversation in the insolvency space for foreseeable future.

As a result of liquidation activity increasing over the last few months, should you or your client have any queries in relation to ‘Unfair Preference’ claims or insolvency more generally, please do not hesitate to contact Greg Quin office on 0402 943 091 or via email to gquin@hlbinsol.com.au for a confidential and obligation free discussion.