Almost 5 years ago (in April 2005) we published an article in this newsletter series on the availability of setting-off debts under section 553C of the Corporations Act. Three different circumstances have occurred in files recently that involved the practical effect of set-offs and we thought that revisiting that earlier article was warranted.
A right of set-off arises through the mutuality of a debit and a credit, in its most basic form, when a person is both owed money by and owes money to someone, the net balance is calculated and that balance is then payable or receivable.
This right applies outside insolvency law, but it has been placed into Part 5 of the Corporations Act for various reasons, including that it will not apply when the person had notice of the insolvency of the company at the time of giving or receiving the credit. This provisions stops people manufacturing a beneficial set-off when then know the company is insolvent.
The Act provides this restriction under 553C(2).
533C(2) A person is not entitled under this section to claim the benefit of a set-off if, at the time of giving credit to the company, or at the time of receiving credit from the company, the person had notice of the fact that the company was insolvent.
Normally we have encountered this when a creditor (owed money) believes that he will not be paid and buys something on credit from the company shortly before the liquidation (so he owes money) and attempts to set the balances off.
We have also had the position that a director owed money by the company did not want to repay that loan just prior to liquidation, as the payments would have been preferential. Instead he borrowed money from the company under a separately recorded loan account and argued that the new loan to him was not the repayment of the previous loan that the company owed him. He argued that the payment to him could not be preferential as it did not repay a debt (the payment was not to him in the capacity of a creditor), and that the amounts should be set-off so that he did not need to repay the new loan to him. We did not even get as far as the preference argument, we relied upon the statutory restriction on the set-off argument.
The right of off-set is detailed in 553C(1) as:
533C(1) Subject to subsection (2), where there have been mutual credits, mutual debts or other mutual dealings between an insolvent company that is being wound up and a person who wants to have a debt or claim admitted against the company:
(a) an account is to be taken of what is due from the one party to the other in respect of those mutual dealings; and
(b) the sum due from the one party is to be set off against any sum due from the other party; and
(c) only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be.
This provision was applied recently in a situation where a director owed significant money to his company through loan accounts. He had also guaranteed the bank’s overdraft to the company. The bank had security over the company assets and over a property owned by the director.
The director’s property was sold and the bank was paid out. The director then stood in the shoes of the bank and became a secured creditor for the amount of the bank’s debt given that he had paid out the bank from his own monies. He attempted to claim the company assets as a secured creditor.
The right of set-off was applied and the money that he owed the company under the original loan accounts extinguished the amount that he was owed by the company from paying out the bank. The greater majority of the director’s loan account was ‘paid’ in the process reliving him from that obligation, but the assets were no longer secured as there was no debt owed to the director and attached to the security.
In our 2005 article we confirmed that set-offs only apply where there is mutuality, the title of the section in the Act being ‘Insolvent companies–mutual credit and set-off’. We said:
“It is critical that mutuality must be present for a set-off to apply. This means, for example, that the amount due by the company must be due to the exact legal entity claiming the benefit of set off. An amount due to A by B cannot be set off against an amount due to B in the capacity as trustee. Similarly debts due by associated parties, holding company etc would be excluded, as would payments due to the liquidator.”
The last circumstance is one that we encounter often. It was where a creditor attempted to avoid having to repay a preferential payment because they were still owed money by the company and the amount that we were claiming should be off-set against the amount of their debt.
The creditor quickly dropped that argument when it was explained that the claim for the preference was made by the liquidator, not the company and only occurred after the liquidation had commenced. There was therefore no mutuality between that claim (owed to the liquidator) and the debt (owed by the company). The creditor quickly took up a range of other arguments.
In most cases, whether a set-off applies or not can be determined fairly easily. Occasionally however, the circumstances are more complicated. Parties may need to really examine the consequences to determine whether a set-off does or does not apply.