Insolvent transactions and the "running account" test
We share our thoughts about two recent Australian judgments, Badenoch and Badenoch No. 2, which reject the use of the “peak indebtedness rule” in Australia’s equivalent of “running account defence” to insolvent transaction cases.
The running account test in the Australian legislation is virtually identical to New Zealand’s (we copied theirs) so it will be interesting to see to what degree the New Zealand courts are influenced by the analysis in the Badenoch judgments. We expect our judiciary will watch the Australian cases with interest. (Associate Judge Bell stated in the 2014 case of Farrell v Max Birt Sawmills Limited that “where the identical words in the Australian statute have been inserted into s 292, it would be perverse for the meaning of the statute to change according to the side of the Tasman it is applied on”.)
As you’ll recall, New Zealand has already rejected the “peak indebtedness rule” in the 2015 case of Timberworld Limited v Levin & Anor. In Timberworld, the Court of Appeal held that the continuous business relationship must be calculated from the commencement of the lookback period, or from the first transaction in the relationship (if the relationship commenced during the lookback period).
By way of a recap: the “peak indebtedness rule” was used in the application of the “running account defence” contained in (New Zealand’s) section 292 of the Companies Act 1993. The running account defence provides that where there have been a series of transactions forming part of a commercial relationship between a company and its creditor, and over time, the amount owing by the company to the creditor fluctuates, then all transactions should be viewed as one single transaction for the purposes of testing whether a voidable transaction has occurred.
It had been the practice of liquidators in Australia (and, pre-2015, New Zealand) to choose the date within the lookback period at which the debt owing to the relevant creditor was at its highest, and use this as the starting point for the running account defence. By doing so, liquidators could conceptually maximise the reduction in debt which had occurred by the time the creditor had received all pre-liquidation payments from the insolvent company, which, in turn, had the effect of increasing the sum which could be recovered.
In the Badenoch decisions, the Australian courts referred to and agreed with the criticism levelled against them in Timberworld that “the Australian courts seem to have assumed the [peak indebtedness rule] had the weight of authority and sufficient pedigree to warrant its direct application. We have located no Australian authorities offering a considered analysis of the rule”, and then rose to the challenge of providing that considered analysis. As well as deciding that the “peak indebtedness rule” no longer applies in Australia, the Badenoch judgments contain some useful commentary on:
which transactions will and will not form part of a continuing business relationship – the Australian courts discuss the effect of an intention to reduce the level of indebtedness permanently, or to terminate the relationship, and examine at what point the continuing business relationship could cease to apply for the purposes of the running account defence;
the use and applicability of the good faith defence;
when the start date for the single transaction should arise. Unfortunately, on the facts, it was not necessary for the Court to determine how the start date should be calculated, but it left open the possibility that the start date could extend beyond the lookback period to and back to the commencement of the trade relationship. The Court said:
"It may also be observed that if the continuing business relationship commenced at the beginning of the running account (some years prior to 2012), questions may arise as to whether Badenoch received anything in relation to its unsecured debt at all. Expressed another way, if the single transaction is that evidenced by the whole of the running account, Badenoch appears to have supplied more than it received, such that there could be no unfair preference. Whether that is the intended operation of the Act is a question that may be deferred to a case where the outcome depends upon it.”
It seems to us that if the single transaction were deemed to commence at the same time the trading relationship began, it would usually be the case that the indebtedness of company to creditor increased by the end date of the single transaction, with the effect that there would be little point in liquidators pursuing creditors in a “continuing business relationship” scenario. If that analysis is adopted by the courts, liquidators will presumably need to subject the end date of the “continuing business relationship” to greater scrutiny (and consider, for instance, whether and when company and creditor have become overly focussed on permanent debt reduction).
The Badenoch liquidators have sought leave to appeal to the High Court of Australia. At a time when our judiciary has called for an overhaul of certain corporate insolvency laws, we will watch with interest how this case develops and the extent to which it influences New Zealand’s case law.
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