New Zealand Law Society - Peak indebtedness: rejected by the Court of Appeal

Peak indebtedness: rejected by the Court of Appeal

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The peak indebtedness rule will no longer be a part of New Zealand insolvency law, following the Court of Appeal declaring that it actually never was a part of New Zealand law.

In its long-awaited judgment, Timberworld Limited v Levin & Ors [2015] NZCA 111 (24 April 2015), the Court of Appeal rejected the rule on both policy and practicality grounds.

What was the peak indebtedness rule?

Section 292(4B) of the Companies Act 1993 provides:

“Where –

  1. a transaction is, for commercial purposes, an integral part of a continuing business relationship (for example, a running account) between a company and a creditor of the company (including a relationship to which other persons are parties); and
  2. in the course of the relationship, the level of the company’s net indebtedness to the creditor is increased and reduced from time to time as the result of a series of transactions forming part of the relationship;

    then –

  3. subsection (1) applies in relation to all the transactions forming part of the relationship as if they together constituted a single transaction; and
  4. the transaction referred to in paragraph (a) may only be taken to be an insolvent transaction voidable by the liquidator if the effect of applying subsection (1) in accordance with paragraph (c) is that the single transaction referred to in paragraph (c) is taken to be an insolvent transaction voidable by the liquidator.”
  5. Under s 292(4B), creditors who have continued to supply a company, which later becomes insolvent, will be protected if they have had a continuing business relationship with the company before its liquidation.

Instead of being able to attack every transaction made within that continuing business relationship, the liquidator is only able to challenge the net difference of that relationship, where the creditor has been preferred over the company’s other creditors. Said the Court of Appeal at [30]:

“[A] series of transactions will be treated as a single transaction where such transactions are an integral part of a continuous business relationship between the parties (as where the parties have used a running account) and the level of the debtor company’s indebtedness fluctuates from time to time as a result of the various individual transactions. With a transaction of this type the liquidator will only be entitled to claim the net difference of payments made and goods and services received from a creditor, where there is an ongoing business relationship with the debtor company.”

The issue for liquidators and creditors was the starting point for the series of transactions that were to be treated as a “single transaction”.

Under the peak indebtedness rule, liquidators could choose the point during the specified period when indebtedness was at its highest. The rule first came to light in Australia in the 1960s, when Chief Justice Barwick, in Rees v Bank of New South Wales (1964) 111 CLR 210, stated that, in his opinion, “the liquidator can choose any point during the statutory period in his endeavour to show that from that point on there was a preferential payment and I see no reason why he should not choose … the point of peak indebtedness of the account during the six months period” at [221].

Opting to commence the “single transaction” at the point of peak indebtedness bolstered the liquidator’s argument that that particular creditor had received a preferential payment which could then be challenged, voided, and brought back into the pool for distribution to the general body of creditors. As New Zealand’s Court of Appeal noted in Timberworld at [5]:

“Naturally liquidators will wish to use the point where the indebtedness of the company is at its highest. On that basis, any later transactions under which the creditor provides further value to the company will be exceeded in value by other transactions reducing the company’s indebtedness. Liquidators could then point to the net reduction in indebtedness as amounting to a preference. Suppliers, however, will seek to use an earlier date so that any increase in indebtedness is offset by earlier transactions through which the creditor supplier gave value to the debtor company.”

What does ‘all transactions’ mean?

The Court of Appeal considered the plain meaning of “all transactions” in s 292(4B), and held that it meant “all transactions constituting an integral part of the continuous business relationship and therefore falling within the running account” (at [69]). On this approach, said the Court, the assessment of the transactions commenced with the start of the two-year specified period – or from the first transaction within the specified period, if the relationship between the creditor and the company commenced after the specified period began.

The Court of Appeal found that if, as the liquidators argued, they could choose any point within that period as their start date (ie, the date of peak indebtedness), then this would “ignore the express wording used by Parliament”.

At a practical level, the Court considered there to be an arbitrariness to peak indebtedness in operation which was dependent upon a creditor’s individual credit arrangements with the company (at [90]).

Referring to the examples used by the Australian Credit Forum, where three creditors supplied an insolvent company with the same value of goods, received the same value of payments, with the company owing $60,000 at the beginning of the specified period and $10,000 at the end of the specified period, but with each creditor on different credit terms, the Court of Appeal observed that the peak indebtedness rule operated “to produce vastly different outcomes, merely on the basis of the particular credit arrangements in each case”.

There was “simply no correlation between the quantum of the amount calculated as a preference taken from the peak indebtedness of one creditor and any entitlement of any other creditor”, the Court of Appeal said at [94].

The Court also found that the “harm” caused to other creditors where such payments were made was not an injustice to other creditors, nor did it disadvantage them. While value had been taken out of the general pool of resources as a result of those payments, trade creditors had either returned the value they had received in supplies, or, where the transaction was an insolvent transaction, would be required to return the value of their preference over and above the supplies they had provided.

At the policy level, the Court found that s 292(4B) had been enacted for the purpose of effecting Parliament’s intention to set apart certain trade creditors from the general pool of unsecured creditors (at [95]). The reforms were intended to extend protection to trade creditors to give them an incentive to continue providing value to companies in financial distress, the Court noted.

In tune with Australia?

The Court of Appeal’s review of the legislative history of s 292(4B) confirmed that the running account principle had been adopted from s 588FA(3) of the Corporations Act 2001, with the expectation that it would “allow New Zealand courts to benefit from the Australian courts’ experience in applying s 588FA” (at [52]).

However, the Court of Appeal could find no discussion concerning the peak indebtedness rule in the section’s legislative history, and stated at [73] that it rejected “as a matter of principle” the submission made on behalf of the liquidators that the adoption by the New Zealand legislature of s 588FA(3), in similar language, meant New Zealand had also imported the peak indebtedness rule.

“The legislature,” the Court said, “was plainly aware of the principles of Australian case law governing the running account provisions but it does not follow that the peak indebtedness rule must also be adopted.”

The Court of Appeal concluded that as Parliament had not chosen to adopt peak indebtedness – which it could have done without difficulty – it was not part of New Zealand law (at [99]).

Keeping it within the specified period

Following the release of the Court of Appeal’s decision, the peak indebtedness rule is no longer an option for liquidators looking to void insolvent transactions. However, has the issue regarding the start time for the “single transaction” been properly clarified by the Court?

Timberworld, in its appeal, had claimed that the running account defence was not restricted to the specified period. It had argued instead that the phrase “all transactions forming part of the relationship” should be interpreted as meaning all transactions in the running account itself.

The Court of Appeal did not agree. It considered the Australian case law which had already addressed this issue, and stated at [107]: “Although there is an issue of interpretation of ‘transactions’, it is now settled the provision applies to transactions occurring within the specified period, to ascertain whether a net increase or decrease in indebtedness resulted”.

And while the Court of Appeal acknowledged that s 292(4B) did not “specifically reference the specified period”, the Court was satisfied that the operation of that section was subject to the principle contained in s 292(1) to that effect.

It would seem, then, that the running account will commence at the time that the specified period commences.

However, it is arguable that liquidators cannot just use this as the go to rule in every running account situation. Section 292(1) requires that the transaction be an “insolvent transaction”. An insolvent transaction is a transaction that was entered into at a time when the company was unable to pay its due debts.

Therefore, as s 292(4B) operates in accordance with the principles contained in s 292(1), it is arguable that the starting point for the “single transaction” is the date from which, during the specified period, the company is no longer able to pay its debts as they come due. 

Dale Nicholson is a litigation partner in Duncan Cotterill’s Auckland office and Darise Bennington is a senior solicitor who is also based in Duncan Cotterill’s Auckland office. They both specialise in commercial dispute resolution and insolvency.

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