Definition of an Unfair Preference
‘Unfair preference’ is the name for a certain type of transaction that a liquidator can attempt to ‘void’ or ‘claw back’ in the winding up of an insolvent debtor company. An unfair preference occurs where a creditor has been paid, and the creditor received more than they would have in the ordinary course of the winding up of the company (see section 588FA of the Corporations Act 2001 (Cth)).
To be voidable the transaction must have occurred within six months of the ‘relation back day’ (generally speaking, the day on which the winding up is initiated).
The effect of the unfair preference is that the transaction can be clawed back and the amount, if recoverable, can be added to the pool of assets available for the liquidator to distribute to unsecured creditors pari passu (ie. equally in proportion to the amount that they are owed).
For more information on unfair preferences in general see The Ultimate Guide to Liquidation Part 2: Preparing for Liquidation.
What is the Running Account ‘Defence’?
The Corporations Act 2001 (Cth) provides several relief options for creditors who seek to fight back against an unfair preference claim. In this blog post we focus on one of these options, the ’running account’ principle.
This principle is often called a ‘defence’ to a claim of unfair preference. However, this is, strictly speaking, incorrect. Rather than a defence to a claim of unfair preference which has otherwise been made out, where this principle applies, the amount that a liquidator can claw back as an unfair preference is reduced.
The running account principle set out in section 588FA(3) of the Corporations Act 2001 (Cth) provides that, where a transaction is an integral part of a “continuing business relationship” (for example a running account) and the amount of net indebtedness increases and decreases over time as part of that relationship, all the transactions will be treated as one for the purposes of calculating the unfair preference.
In practical terms, a ‘running account’ is a business arrangement commonly used by suppliers to provide goods on credit to a company where the goods and amounts paid are recorded on a running account statement or balance. At periodic intervals, amounts owing are then paid off by the debtor company, without differentiating between transactions.
The policy rationale for treating these transactions differently from a standard unfair preference is that the purpose of these transactions (generally speaking) is to induce the creditor to continue providing services, rather than pay off a debt (see Airservices Australia v Ferrier (1996) 185 CLR 483.
The running account principle is distinct from other relief options that can be used to push back against an unfair preference claim including:
- Good faith. A complete defence is available (see section 588FG of the Corporations Act 2001 (Cth)) where the party to the transaction: a) had no reasonable grounds for suspecting the company was insolvent or would become insolvent, and; b) no reasonable person in those circumstances would have had grounds for so suspecting.
- Mutual Credit and Set Off. Under section 553C of the Corporation Act 2001 (Cth), where there are mutual credits or debts, a creditor in a winding up can have this taken into account in calculating the extent of an unfair preference. The amount that would be an unfair preference can be ‘set off’ by this amount.
The ‘Peak Indebtedness’ Rule
Given how the running account principle is framed, the question arises as to the precise date which the liquidator can nominate as the beginning of the ‘running account’. The selection of this date can lead to significant variation in the relief provided by the running account principle.
Up until recently, it was established in Australian case law that the date to be chosen is the date of ‘peak indebtedness’. This principle was established in case law preceding the Corporations Act 2001 (Cth) and according to a range of decisions (eg. Victorian Court of Appeal in Sutherland v Lofthouse (2007) 213 FLR 157, ). This approach survives the Corporations Act 2001 (Cth).
The courts have generally been of the view that the Corporations Act 2001 (Cth) did not seek to interfere with the defence as it operated prior to that Act.
However, the ‘peak indebtedness’ rule has been called into question both in Australian academic commentary (see Stephen Russell and Sean Russell, ‘Unfair preferences: Putting an end to the peak indebtedness rule’ (2016) 24(2) Insolvency Law Journal 111) and in a 2015 case of the New Zealand Court of Appeal in Timberworld Ltd v Levin  NZCA 111, which dealt with an equivalent provision of New Zealand’s Companies Act 1993.
The court found that there was no statutory basis for the peak indebtedness rule and that a natural reading of that legislation provided that it was the totality of the business relationship that should be taken into account.
A recent decision of the Full Court of the Federal Court of Australia in Badenoch Integrated Logging Pty Ltd v Bryant, in the matter of Gunns Limited (in liq) (receivers and managers appointed)  FCAFC 64 declined to follow previous Australian decisions, agreeing with the rationale in Timberworld and therefore declining to apply the ‘peak indebtedness rule’.
This leaves the law on peak indebtedness relatively unsettled and an appeal to the High Court of Australia is possible.