The Court of Appeal has confirmed that liquidators cannot adopt the ‘peak indebtedness’ rule in calculating whether a trade creditor has received a preference under the voidable transaction rules in the Companies Act.
The result is that trade creditors will often be able to raise the running account provisions to extinguish or limit the claim that they would otherwise face if liquidators could rely on the rule. Together with the Supreme Court’s decision in the
Fences & Kerbs litigation1, the decision continues a general trend of the voidable transaction regime being interpreted in a creditor friendly manner.
The general position is that every transaction between a company and a creditor in the two years prior to the company being placed in liquidation is recoverable by a liquidator if the transaction results in an insolvent preference to the creditor. Since 1 November 2007, this principle has been altered by a “running account” exception which was based upon equivalent provisions in the Australian Corporations Act.
Under the running account exception, where the individual transactions are an integral part of a continuing business relationship between the company and creditor and the level of the company’s indebtedness fluctuates as a result of those transactions, the liquidator must treat those transactions as if they form a single transaction. The creditor will have received a voidable preference only if that single transaction resulted in a net reduction in the company’s indebtedness to the creditor. Whether there was a net reduction is assessed by comparing the level of the company’s indebtedness to the creditor at the beginning of the continuing business relationship with the level of indebtedness at the date of liquidation.
This raises the question of when the continuing business relationship begins for the purpose of calculating the single transaction. A line of Australian cases has held that liquidators can pick the point in time where the company’s indebtedness was at its highest (the peak indebtedness) as the starting point of the single transaction. The result is the level of any claim by the liquidator is maximised as is the possibility that the single transaction resulted in a net reduction in indebtedness.
The early practice of New Zealand liquidators was to apply the peak indebtedness rule following an initial High Court decision.2 From late 2013, that changed after a series of High Court cases took the position that the Companies Act did not allow liquidators to use the peak indebtedness rule.3
The Court noted that the plain wording of the provision did not support the availability of peak indebtedness. The section requires all transactions forming part of the continuing business relationship to be taken into account, not just those occurring from the point of peak indebtedness.
In the Court’s view, there were no compelling reasons to adopt a different interpretation from that pointed to by the plain meaning. The legislative background did not point to any intention to adopt the peak indebtedness rule. It said that although there is a line of Australian authority supporting peak indebtedness which precedes the enactment of the amendment, that case law provides little in the way of examination as to why the rule should apply and is in conflict with overarching approach taken by the principal High Court of Australia case on running accounts.4 That case stressed that a payment should not be viewed in isolation from the general course of dealing between the creditor and the company. The peak indebtedness approach does precisely this, as the supply preceding the payment made at the moment of peak indebtedness is ignored.
Finally, the Court found that there was no compelling policy objective that could be identified in support of the peak indebtedness rule. In passing the running account provisions, Parliament’s intention had been to extend protection to trade creditors to incentivise them to continue providing supply to companies in financial distress. Any concerns about preferring trade creditors was a matter for legislative concern, not judicial intervention through the allowance of the peak indebtedness rule.
When does the continuing business relationship begin from?
In the absence of the peak indebtedness rule, the Court confirmed that the continuing business relationship begins at the commencement of the specified period: being two years prior to the commencement of the liquidation of the company. The exception is where the relationship between the creditor and the company begins within that two years period, in which case the calculation is made from the first transaction in that relationship.
What this means
The Court of Appeal’s decision provides needed clarity on the issue of peak indebtedness, particularly following a High Court decision in late 2014 that allowed the application of the peak indebtedness rule.
It means that liquidators will find that many trade creditors have, in effect, a complete defence to a voidable claim or, at least, the claim will be of a much smaller (and perhaps uneconomic) value. Along with the Supreme Court’s decision in the
Fences & Kerbs litigation, it makes voidable claims against such creditors more uneconomic to pursue. Practically speaking though, for most liquidators, it will mark a continuation of the approach they will have adopted to running account claims since the High Court began rejecting the application of the peak indebtedness rule in 2013.
For trade creditors, the decision is further good news in resisting voidable claims brought by liquidators of former customers. Where they are confronted by a running account claim by a liquidator, they will want to verify that the liquidators have calculated the running account from the beginning of the two year period and not from the point of peak indebtedness.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.