Set-off in company liquidations

09 June 2015

In this Issue:

The significance of set-off under section 553C, Corporations Act
Limitations on the right to exercise set-off
Cases that usefully illustrate the operation of set-off

Introduction

On the winding up of a company a creditor generally loses all recovery rights against the company, so that a right of set-off arising out of reciprocal indebtedness between the parties may become the only right available to a creditor to invoke against the company.

If set-off was not available the creditor would have to pay its debt in full to the company in liquidation, and then only be able to claim a dividend in respect of the debt owed by the company. The courts have often recognized that such an outcome would be unfair.

It was to prevent such injustice that provisions were introduced into both bankruptcy and corporate winding up legislation. With respect to a company in liquidation, section 553C, Corporations Act provides that if a creditor and a company in liquidation had mutual dealings, the creditor is entitled to set-off any sum the creditor owes to the company against the debt which it is owed by the company. Section 86 of the Bankruptcy Act effectively achieves the same purpose with respect to bankruptcy.

Because statutory set-off is such a significant entitlement it is useful to review the basic principles that regulate the set-off process together with practical examples that enhance their understanding.

Set-off is an automatic right

Section 553C, Corporations Act is a statutory directive (“an account is to be taken”). It produces a balance upon which the winding up administration can proceed. Only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be. The section is self-executing in the sense that its operation is mandatory and automatic without the need for any action by the creditor or the company. Moreover, the statutory right of set-off cannot be excluded by pre- or post-liquidation agreement of the parties.

The mandatory nature of statutory set-off is well illustrated by Re Paddington Town Hall Centre Ltd (in liq) (1979) 41 FLR 239, SC (NSW). At the date when a winding up order was made the company had bank accounts with a credit balance of $8,218 and, with the same bank, accounts with a debit balance of some $70,000. Following his appointment the liquidator requested the bank to transfer the credit balances to the liquidator. The bank complied with this request and then submitted a proof of debt in the sum of the total of the debit accounts. Subsequently the bank became aware of its statutory right of set-off and sought to amend its proof, claiming reimbursement of the sum of $8,218 in respect of which it claimed a set-off.

These proceedings were then commenced by the liquidator seeking a direction from the court whether the liquidator was justified in retaining the $8,218.

In dealing with the issue the court was particularly influenced by the mandatory operation of statutory set-off concluding that “if the provisions….cannot be contracted out of, it would not be possible for an estoppel to negative the requirements of the section.”

In the circumstances the court directed the liquidator to repay the bank the sum of $8,218, the decision being consistent with the mandatory language of the set-off provision.

Mutuality

General rule

Section 553C, Corporations Act relates set-off to “mutual credits, mutual debts or other mutual dealings.” The requirement of mutuality ensures that creditors of the company in liquidation are not disadvantaged by a set-off being allowed to a creditor in circumstances where credits and debts or other dealings with the company are not genuinely “mutual.”

The essential requirements of mutuality are:

That the cross-claim must exist between the same parties; and
That the cross-claims arise between the parties in the same right, for example, where the parties are mutual debtors with respect to reciprocal trading debts.

Cross-claims must exist between the same parties

This first requirement of mutuality is well illustrated by cases where a creditor on the application of the liquidator is under an obligation to repay a preferential payment made to the creditor by the company prior to liquidation. In these circumstances the creditor may seek to set-off the debt owed by the company to the creditor against the creditor’s preference repayment obligation, thereby reducing or even eliminating the financial burden arising from the repayment obligation.

Traditionally it has been argued that set-off is not available in these circumstances (see Tolcher v National Australia Bank (2003) NSWSC 207, 14/3/2003). The approach most often adopted is that there are no cross-claims existing between the parties, with the preference repayment by the creditor arising out of proceedings initiated by the liquidator in a representative capacity, while the debt owed by the company arises from reciprocal dealings between the creditor and the company.

Recently the Queensland District Court in Morton & Anor v Rexel Electrical Supplies Pty Ltd (2015) QDC 49, 5/3/2015 held that a creditor of a company in liquidation was entitled to set-off the amount of debt owed to the creditor by the company against the amount payable by the creditor as an unfair preference, leaving the balance of the unfair preference recoverable by the liquidator.

In arriving at its conclusion the court found there was sufficient nexus between the cross-claims such that they could be seen to be between the same parties, thereby satisfying the mutuality requirement.

In view of the uncertainty that presently surrounds this significant issue a fully reasoned, authoritative decision from a superior court is imperative.

Cross-claims not arising in the same right

Lloyds Bank NZA Ltd v National Safety Council of Australia Victorian Division (in liquidation) (1993) 2 VR 506, is a useful case to review with respect to the second requirement of mutuality.

In the case the bank, as a result of a surplus arising on the sale of charged assets of the company in liquidation, held the surplus on trust for the company. The bank then sought to rely on its statutory right of set-off, seeking to set-off the surplus against loan account debts owed by the company to the bank.

In not allowing set-off the court reasoned that, in terms of section 553C, the parties were not in a mutual relationship, with the bank in the capacity of a trustee having obligations to account to the company as beneficial owner of surplus funds in the bank’s hands, whereas the company’s status was that of a debtor with debt obligations arising from loan agreements with the bank.

Because the relationship between the bank and the company was not legally mutual the bank was obliged to account to the company for the surplus funds and to participate in the winding up for the debt obligations.

Note: This outcome was arrived at in the absence of contractual cross-collateralization between the various accounts. The court recognized that “the situation may well have been different if….. an authority express or implied, had been given by the company to the bank to apply the proceeds (surplus) in satisfaction of other debts.”

No set-off where creditor had notice of insolvency

Section 553C (2), Corporations Act ensures that set-off is not available where the party seeking the benefit, at the time of dealing with the company, had notice of the company’s insolvency.

For example, this limitation on set-off will apply where a creditor of the company, with notice of the company’s insolvency, acquires goods or services on credit from the company, with the intention of setting off the debt payable to the company against the company’s liability to the creditor in the event that the company proceeds into winding up.

Concluding comments

Insolvency set-off under section 553C, Corporations Act is an important, mandatory entitlement that cannot be contracted out of. The section bestows a significant benefit where reciprocal indebtedness exists, while also ensuring that the operation of set-off occurs within the boundaries of an orderly winding up process.

In achieving the legislative purpose the courts have consistently recognized that the section should be given “the widest possible scope.” However, statutory set-off does have its limits, particularly the requirement that dealings are genuinely mutual, and the exclusion from set-off of reciprocal dealings that have arisen after notice of insolvency.