Insolvency update: Recent High Court clarification

Metal Manufacturers Pty Ltd v Morton and Bryan v Badenoch Integrated Logging Pty Ltd

In its first decisions for 2023, the High Court has provided liquidators and creditors with long awaited clarification on two important issues relating to insolvency and preference claims. 

Clarification of the law in respect of the set off of mutual debts

The decision in Metal Manufacturers Pty Ltd v Morton [2023] HCA 1 confirmed that the Full Federal had been right in deciding that the creditor (Metal Manufacturers) was not entitled to “set off” a debt, that was owed to it by the insolvent company (Woodman) at the time it went into liquidation, against a preference claim being made by the liquidator of Woodman. 

Section 553C of the Corporations Act 2001 operates to permit the set off mutual debts between creditors and companies in liquidation, so that liquidators cannot compel creditors to pay debts they owe to the insolvent company without any possibility of the insolvent company satisfying a mutual debt it owes to the creditor. 

In this case, Metal Manufacturers argued that s553C allowed it to set off its obligation to repay a preference payment it had received from Woodman against debts that Woodman still owed to it.

As has been acknowledged by the bench in a number of decisions relating to s553C and preference claims, there were mixed authorities as to whether set off under s553C was available in respect of unfair preference claim debts.  As a result, creditors have regularly raised the alleged availability of set off in response to preference demands by liquidators, and liquidators have denied the application of the set off, without any real certainty as to which position was supported by the legislation and the Court. 

The High Court held that the set off in section 553C required the existence of mutual credits, debts or other dealings arising from circumstances that subsisted before the commencement of the winding up.  In circumstances where the contingent right of a liquidator to sue for an unfair preference could not/did not exist prior to the winding up, it could not meet this requirement.

Whilst the High Court decision in Metal Manufacturers will be celebrated by liquidators more than by creditors, the Court’s explanation as to why s553C does not apply to funds claimed by liquidators as preference claims is a welcome clarification of the law in this area.

Peak indebtedness rule

In better news for creditors, the High Court’s decision in Bryant v Badenoch [2023] HCA 2 has removed the “peak indebtedness rule” from a liquidator’s arsenal in determining the value of potential preference claims in circumstances where the running account defence applies.

Section 588FA(3) of the Corporations Act is commonly known for providing the “running account” defence.  Under this provision, if a transaction between a creditor and a debtor company is an integral part of a continuing business relationship (for example, a running account) and, over the course of that relationship the debtor company’s indebtedness to the creditor has fluctuated, then all transactions forming part of that relationship should be treated as if they were a single transaction for the purpose of determining if a creditor has received an unfair preference.

Despite the statutory provision making no reference to peak indebtedness, or expressly providing that liquidators could choose the starting point for the “single transaction”, for many years court’s have applied the “peak indebtedness rule”. This has allowed liquidators to choose the start date for the “single transaction” in order to maximise any potential preference payment and minimise the effect of the running account principle.

Significantly, the High Court held that:

  • the peak indebtedness rule is not supported by s588FA of the Corporations Act; and
  • the first transaction in the “single transaction” for the purpose of s588FA(3) is either the first transaction after the beginning of the relation back period, or the first transaction during the relation back period after the beginning of the continuing business relationship.

The effect of the decision is that liquidators are no longer permitted to choose the high point of a company’s indebtedness to a creditor as the starting point for calculating a preference claim when s588FA(3) applies. This will allow liquidators to recover as a preference only the difference between the debtor’s indebtedness at the beginning of the “single transaction” and the debtor’s indebtedness at the end of the “single transaction”, as intended by s588FA, rather than the difference between the high point of the indebtedness and the low point of the indebtedness.

Key takeaways for creditors

The primary defences to preference claims, set out in the Corporations Act, remain unchanged. That is, creditors who receive demands from liquidators for the repayment of preference payments can still defend those claims on the basis of:

  • good faith;
  • a section 553C set off; and
  • a running account/continuing business relationship.

However, it is no longer open to recipients of preference claims to set off a debt incurred prior to the appointment of liquidators against the debt the liquidator claims is owed to the company as a preference claim. Set offs are still available for mutual debts where those debts were incurred prior to the appointment of liquidators.

Of particular benefit to creditors who receive payments during the relation back period as part of a continuing business relationship, is the High Court’s clarification that, for the purposes of calculating a preference claim, a liquidator is no longer able to seek to maximise the claim by choosing the point in the six month period to begin the “single transaction”.

This article may provide CPD/CLE/CIP points through your relevant industry organisation.

The material contained in this publication is in the nature of general comment only, and neither purports nor is intended to be advice on any particular matter. No reader should act on the basis of any matter contained in this publication without considering, and if necessary, taking appropriate professional advice upon their own particular circumstances.

Andrew Shute

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