Insolvency's Very Own "Mandela Effect"

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Metal Manufacturers and Bryant | Insolvency’s Very Own “Mandela Effect”

05 APRIL 2023 | by Seamus Brand and Travis Shueard | published in the April edition of The Bulletin

Metal Manufacturers Pty Ltd v Morton as Liquidator of MJ Woodman Electrical Contractors (in liq) [2023] HCA 1 (Metal Manufacturers) provides liquidators clarity by confirming that set-off under section 553C of the Act is not available as a defence for liability for unfair preference payments; and Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 (Bryant) has cast light on the “peak indebtedness rule”, holding that the rule has no place in the analysis of a running account under section 588FA(3) of the Act.

A Quick Summary: Unfair Preference Payments, Running Account and Set Off

The Act provides for certain transactions to be considered “voidable transactions”, transactions that can be wound-back by a court with the beneficiary of the transaction required to repay the proceeds of the transaction to a company.¹

Unfair preference payments are one form of voidable transaction, defined by section 588FA of the Act to be a transaction that:

1. is between a company and a creditor;
2. concerns an unsecured debt the company owes to that creditor; and
3. results in the creditor receiving more than the creditor would receive in respect of that debt if the transaction was set aside and the creditor was to prove for the debt in a winding up of the company.

“Transaction”, per section 9 of the Act, includes a conveyance, transfer or other disposition of property, the granting of a security interest, the giving of a guarantee, the making of a payment, the incurrence of an obligation, the giving of a release or waiver, and/or the giving of a loan to the body.² Importantly, section 588FA contemplates that an opportunistic creditor may attempt to legitimise the receiving of an unfair preference by obtaining payment of its debt by court judgment and provides that a transaction includes those occurring because of an order of an Australian court or agency.

A key defence to unfair preference claims is the “running account” – effectively, the insolvent business had a “continuing business relationship” with the creditor, which was made for the ongoing supply of goods or services rather than to reduce indebtedness.³ All transactions forming part of that “continuing business relationship” are, per section 588FA (3), to be treated together as if they are one, single transaction in determining if the transaction is an unfair preference.⁴

Section 553C of the Act allows a right of set off where there have been “mutual credits, mutual debts or other mutual dealings” between the insolvent company and a person who would have a debt or claim admitted against the company,  provided that the creditor did not have notice of the company’s insolvency at the time it extended credit to the company.⁶ A company may be owed debts by (or have claims against) creditors who seek to prove debts against the company in its liquidation. Section 553C operates in such circumstances to set off sums due by the creditor against sums due to the creditor and to set off sums due from the company against sums due to the company.

Metal Manufacturers, Set Off and the “Mutuality” Principle

Metal Manufacturers Pty Ltd (Metal) was paid $50,000 and $140,000 by MJ Woodman Electrical Contractors Pty Ltd (MJ Woodman) during the 6-month period prior to MJ Woodman’s winding up. MJ Woodman also owed Metal an amount of $194,727.23 at the time of liquidation.

The liquidator of MJ Woodman tried to recover both payments from Metal pursuant to section 588FF(1)(a) of the Act as unfair preference payments. Metal claimed that the amount owed to it by MJ Woodman would eclipse that of the unfair preference claims and that this constituted a “mutual dealing” for the purposes of section 553C of the Act, despite Metal’s potential liability under section 588FF(1)(a) being a future liability. Accordingly, Metal submitted, Metal’s liability for the unfair preference claims should be set off against the amount owed to it by MJ Woodman, preventing MJ Woodman’s liquidator from obtaining an order under section 588FF(1)(a) of the Act.

The purpose of section 553C, as the High Court found,⁷ is to ascertain what is available in a liquidation for distribution on the pari passu basis. It is only the balance of any set off which is then admissible to prove against the company for the purposes of section 553.⁸ It is this “mutuality”, per se, on which the provision hinges.
This “mutuality” was absent in Metal Manufacturers. While Metal was owed $194,727.23 by MJ Woodman, it did not owe MJ Woodman any debt. The only reason that a cause of action lay against Metal was due to the liquidator utilising statutory provisions to claw back unfair preferences. This arose after the liquidation, as noted by the High Court:

“Here, immediately before the commencement of the winding up there was nothing to set off as between the appellant and MJ Woodman; the company owed money to the appellant, but the appellant owed nothing to the company. Moreover, the inchoate or contingent capacity held by the liquidator to sue under s 588FF could not and did not exist before then. It could only be made following the commencement of the winding up. It was wholly "new" in the sense described by Dixon J in Hiley. It sprang into existence as a specific statutory right held by the liquidator for the purposes of recovering preference payments to secure the equitable distribution of assets amongst creditors. As such, it was not eligible to be set off against the pre-existing amount owed to the appellant.”⁹
Accordingly, the High Court dismissed the appeal.

Bryant and the “Peak Indebtedness Rule”

Gunns Limited (in liq) (Gunns) was a timber felling business which was placed into voluntary administration in September 2012, followed by liquidation in March 2013. Badenoch Integrated Logging Pty Ltd (Badenoch) was a creditor and former supplier of services to Gunns, having provided harvesting and timber hauling services.¹⁰

Gunns and Badenoch entered into a supply agreement in 2003, whereby Badenoch would supply Gunns with timber in a specified quantity per annum.¹¹ Badenoch would invoice Gunns at the end of each calendar month, with payment due from Gunns on the last working day of the following month.  This agreement was renewed in 2008 to June 2013.

Despite Gunns’ declining financial situation, Badenoch continued to provide its agreed services, although at times it would issue letters of demand for unpaid amounts, threaten cessation of supply, negotiate payment plans and require a bank guarantee. This agreement was terminated in August 2012, although Badenoch continued to supply some services for a further period until a future contractor had begun service.¹²

On 25 September 2012, Gunns appointed administrators, which served as the “relation back day” for the purpose of section 588FE of the Act. Soon thereafter, the liquidators applied under section 588FF for payments made to Badenoch between 26 March and 25 September 2012 to be declared voidable transactions.¹³ This totalled an amount of $3,360,876.16 and the liquidators claimed this constituted an unfair preference.

“Peak Indebtedness Rule” No Longer

Badenoch claimed that this arrangement had been a “running account” and defended the claim on that basis.
The liquidators argued that:

• any “continuing business relationship” ended either on 30 June 2012 when services were temporarily ceased or the termination date of 2 August 2012; and
• they were entitled to apply the “peak indebtedness rule.”

The “peak indebtedness rule” allowed a liquidator to choose the point at which a company was most indebted to a creditor as the starting date of the single transaction constituting a “continuing business relationship” for the purposes of section 588FA (3). The rule itself is not enshrined in the Act but instead stems from the decision of Rees v Bank of New South Wales¹⁴ and the presumption that the rule forms part of the “running account principle”, which itself is plainly codified by the Act.

In Justice Jagot’s judgment, with which the remainder of the Court unanimously agreed, her Honour held that the “peak indebtedness rule” is not found in section 588FA. Her Honour determined that section 588FA codifies the “running account principle” only, and wrote that the cases that read the “peak indebtedness rule”¹⁵ into section 588FA (3)

“wrongly assumed that the “running account principle” included the “peak indebtedness rule”, [and] did not involve full argument or reasoning about the issue, or must now be considered to be wrong in that respect.”¹⁶
Her Honour therefore reasoned it is the purpose of the “running account principle”, as the only principle actually found in section 588FA, that is paramount:

“[t]he purpose of the “running account principle” is not to maximise the potential for the claw-back of money and assets from a creditor, but that is the effect of the “peak indebtedness rule”. The “running account principle” recognises that a creditor who continues to supply a company on a running account in circumstances of suspected or potential insolvency enables the company to continue to trade to the likely benefit of all creditors.”¹⁷

Justice Jagot’s judgment effectively removes the manner in which a liquidator could previously apply the “peak indebtedness rule.” Now, a liquidator must consider objectively the nature of the relationship between the company and its creditor to determine if and when payments began to be made “looking backwards rather than forwards; looking to the partial payment of the old debt rather than the provision of continuing services.”¹⁸

In practical terms, the first transaction that can form part of the “continuing business relationship” is either the:

• first transaction after the beginning of the prescribed period or after the date of insolvency; or,
• in the event that the relationship began after the beginning of the prescribed period or date of insolvency, the first transaction after the beginning of the continuing business relationship,
whichever is later.

Metal Manufacturers is an obvious finding, but an important one

To some, the Court’s determination in Metal Manufacturers likely appeared a long-foregone conclusion, however this does not diminish the importance of the clarification. It being open for a creditor to say “I am entitled to keep this unfair preference because I am still owed a greater debt” can create significant issues in the liquidation of any company, with some more obvious examples being:

• creditors aware of or suspecting insolvency prior to winding up would be more encouraged to attempt to extract partial payment of their debt prior to liquidation, placing a greater strain on an already distressed company;
• employee entitlements could go unpaid, placing greater strain on the Fair Entitlements Guarantee;
• a liquidator would be unable to void even the most obvious unfair preferences, depriving them of necessary working capital to continue administering the liquidation; and
• the ultimate return to the remaining creditors, if any at all, would be substantially reduced.

Conversely, denying the benefit of section 553C to recipients of an unfair preference upholds the pari passu principle upon which the Australian insolvency framework is built. This may encourage liquidators to strategically pursue unfair preference claims against creditors early in a company’s liquidation – potentially providing the liquidator with sufficient working capital to pursue other claims that may increase the ultimate return to creditors (including the creditor that is the subject of the unfair preference claim).

Bryant is a Reminder to Carefully Consider Even the Most Entrenched “Assumptions”

The “peak indebtedness rule” favoured liquidators to an extent that was ultimately incompatible with their duties and the Australian insolvency framework – it allowed a liquidator to select when a debt owed to a creditor was at its greatest extent and to compare that to the amount owing at the end and claim the balance as a preference. This was good for the liquidator, as it maximised the amount of the preference claim, but defeated the purpose of the running account principle. It also painted an arguably unfair target on creditors who had continued to trade with a distressed entity, providing them a final lifeline (albeit only a short one). 

By Bryant, the court undid the assumption that the “running account principle” included the “peak indebtedness rule” by undertaking a thorough examination of the authorities said to underpin the assumption. It is perplexing that for so long so many assumed the “peak indebtedness rule” was codified by implication despite no provision for it ever being included in the words of the Act. Perhaps the explanation for this long held assumption lies with practitioners rarely having the time or commercial incentive to delve fully into the reasons and context of older authorities when a more recent one appears to summarise the law succinctly.

Takeaways

Having regard to the determinations made in Metal Manufacturers and Bryant, insolvency practitioners should keep the following in mind:

• an unfair preference claim is now a more attractive claim available to a liquidator to obtain funds early in a liquidation, but the paramount consideration in deciding whether to pursue a claim remains what would be in the best interests of all creditors;
• creditors who potentially have the benefit of an unfair preference should be advised to prepare for an order requiring them to repay the unfair preference to a liquidator or to rely on other reasonably arguable defences, such as those found under section 588FG, regardless of whether the company is still indebted to them; and
• liquidators may no longer rely on the “peak indebtedness rule” to maximise the quantum of a claw-back from a creditor, and must instead undertake the more difficult task of objectively assessing the relationship between that creditor and the company to determine when the “continuing business relationship” commenced.

Seamus Brand is an Associate at Wallmans Lawyers and Travis Shueard is a senior Associate at Piper Alderman.

1 Corporations Act 2001 (Cth) ss 588FE, 588FF.
2 Corporations Act 2001 (Cth) s 9.
3 Corporations Act 2001 (Cth) s 588FA (3).
4 Corporations Act 2001 (Cth) s 588FA(3).
5 Corporations Act 2001 (Cth) s 553C.
6 Corporations Act 2001 (Cth) s 553C (2).
7 Metal Manufacturers Pty Ltd v Morton as Liquidator of MJ Woodman Electrical Contractors (in liq) [2023] HCA 1, [16] (Kiefel CJ, Gordon, Edelman and Steward JJ).
8 Ibid.
9 Ibid [46] (Kiefel CJ, Gordon, Edelman and Steward JJ).
10 Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2, [28] (Jagot J).
11 Ibid [29].
12 Ibid [32].
13 Ibid [33].
14 [1964] HCA 47, [12] (Barwick CJ).
15 Bryant v Badenoch Integrated Logging Pty Ltd [2023] HCA 2 [58].
16 Ibid [76] (Jagot J).
17 Ibid [70] (Jagot J).
18 Ibid [84] (Jagot J) quoting Airservices Australia v Ferrier [1996] HCA 54, [30] (Dawson, Gaudron and McHugh JJ).