Creditors and liquidators share the spoils.
On 8 February 2023 the High Court of Australia (High Court) handed down two much anticipated decisions in relation to unfair preference claims and in doing so, the law relating to two provisions of the Corporations Act 2001 that were subject to significant uncertainty for some time, has now been settled.
In summary, the decisions mean that:
- The peak indebtedness rule used by liquidators in calculating the amount of an unfair preference has been abolished.
- A creditor cannot rely on section 553C of the Corporations Act as a defence to an unfair preference claim by setting off another debt the company owes to the creditor.
Peak indebtedness rule abolished
In its decision in Bryant v Badenoch Integrated Logging Pty Ltd  HCA 2, the High Court upheld the decision of the Full Court of the Federal Court of Australia that the peak indebtedness rule is no longer available to a liquidator in establishing and quantifying an unfair preference claim under section 588FA of the Corporations Act.
Historically, when calculating the amount of an unfair preference claim where there was a running account between the company and a creditor, liquidators applied the peak indebtedness rule, which allowed them to select the "highest point" of indebtedness during the relation-back period as the point from which the net reduction in indebtedness is to be measured.
Using this method, liquidators subtracted the debt owing to the creditor at the time of liquidation from the point of "peak indebtedness" during the relation-back period. In adopting this rule, the quantum of many unfair preference claims was often maximised by liquidators.
In this case, the High Court unanimously held that:
- section 588FA(3) of the Corporations Act does not incorporate the peak indebtedness rule and 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-month relation-back period when the continuing business relationship started or when the company became insolvent, whichever is later.
- 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 relevant, but not the only factor.
The decision is seen as a win for creditors as it confirms that liquidators cannot simply pick a date within the applicable relation-back period to maximise their claim against a creditor and potential recovery of an unfair preference.
Statutory set off not available as a defence
In the matter of Metal Manufacturers Pty Limited v Morton as liquidator of MJ Woodman Electrical Contractors (in liquidation)  HCA 1, the High Court dismissed an appeal from the decision of the Full Court of the Federal Court of Australia.
The High Court unanimously upheld the decision of the Full Court that statutory set off under section 553C of the Corporations Act is not available against a liquidator's unfair preference claim and, in doing so, overturned a decades-old line of authorities to the contrary.
The High Court held that:
- The statutory right of set-off under section 553C(1) requires that the mutual credits, mutual debts or other mutual dealings be credits, debts or dealings arising from circumstances that existed before the winding up commenced.
- A creditor's debt to the company comes into existence only after the liquidation commences and the Court makes an order in unfair preference proceedings brought by the liquidator. Further, the right of a liquidator to sue for an order under section 588FF of the Corporations Act gives rise to a contingent liability, but one that did not exist prior to the winding up commenced.
- The requirement of mutuality was not capable of being satisfied because there was no dealing between the same persons (i.e. only a liquidator has the right to sue to recover an unfair preference) and there was no mutuality of interest.
So, what does this mean in practice?
If a creditor receives a liquidator's unfair preference claim of say, $50,000 and the creditor is still owed $100,000 by the company in liquidation, the creditor cannot apply section 553C of the Corporations Act to set-off the amount owed to the creditor by the company of $100,000 as a defence to the liquidator's unfair preference claim of $50,000.
It is important to note that while the section 553C set-off defence may no longer be available for creditors, there are still other potential defences a creditor can access under the Corporations Act.
Unfortunately, the High Court did not go so far as to express that the section 553C set-off provision is not applicable to all voidable transaction and insolvent trading claims that liquidators can bring.
However, it is arguable that the reasoning and principles in Metal Manufacturers would be equally applicable in the context of other forms of voidable transactions under the Corporations Act, such as:
- uncommercial transactions (section 588FB)
- insolvent transactions (section 588FC)
- creditor-defeating dispositions (section 588FDB).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.