Insolvency set-off does not protect creditors against unfair preference claims

In its recent decision in Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited [2021] FCAFC 228, the Full Court of the Federal Court of Australia (the Court) held that statutory set-off, under section 553C(1) of the Corporations Act 2001 (Cth) (the Act), is not available to a creditor in respect of a liquidator’s claim against that creditor for the recovery of an unfair preference under s 588FA of the Act.

The availability of set-off to defend against unfair preference claims has been a matter of some uncertainty in cases where the defendant creditor continues to be owed amounts by the company at the date of liquidation (even after receiving the payments that are alleged to comprise the unfair preference). Creditors have in some such cases asserted a right to set-off any amounts payable by them to the insolvent company to disgorge the unfair preference against the amounts still owed to them by the company in liquidation.

In determining that set-off was not available in such circumstances, the Court (Allsop CJ, Middleton and Derrington JJ agreeing) held that there was a lack of mutuality between the company’s indebtedness to the creditor and the liability of the creditor to pay the company at the suit of the liquidator, meaning that one of the essential requirements of s 553C was not fulfilled. This lack of mutuality arose from:

• the different interest in which the company: (i) owes money to the creditor (under a normal trading liability pre-liquidation); and (ii) receives money pursuant to a court order in an unfair preference action brought by the liquidator for the benefit of all unsecured creditors (not merely for the company’s own benefit); and
• the absence, at the relevant date, of any right or equity (vested or contingent) of the company to recover, or any duty or obligation of the creditor to repay, the preference.

Background

The case arose in proceedings by the liquidator of MJ Woodman Electrical Contractors Pty Ltd (the Company) to recover an alleged unfair preference received by one of its creditors, Metal Manufacturers Pty Ltd (the Creditor) prior to the liquidation.

The Company owed two separate debts to the Creditor. During the relation back period, the Creditor received payments amounting to $190,000 in respect to one of those debts – these payments were the subject of the unfair preference action taken by the liquidator under section 588FA of the Act. The Creditor claimed it was entitled to set-off any such amount that might be repayable by the Creditor as a preference against the other debt of $194,727.23 which remained outstanding to the Creditor.

Importantly, the Creditor did not seek to invoke section 553C to set off the debts that were the very subject of the asserted preference payments; it accepted that the circularity involved in doing so would entirely defeat the statutory purpose of the preference provision.

Derrington J, being the trial judge hearing the unfair preference case in the Federal Court of Australia, reserved the question of the availability of set-off under section 553C(1) in such circumstances to be considered by the Court. This was done as a special case under rule 38.01 of the Federal Court Rules 2011 (Cth), which gave effect to the reservation of the question for consideration by the Court under s 25(6) of the Federal Court of Australia Act 1976 (Cth).

Set-off under section 553C

Section 553C(1) of the Act relevantly provides that:

… 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 in proof against the company, or is payable to the company, as the case may be.

The Court noted that the object of statutory set off was to prevent injustice and do substantial justice where there are mutual debts and credits between the creditor and the insolvent debtor. The High Court of Australia has held that statutory set off provisions were to be given the widest possible scope as long as it is recognised that this is confined within the limits of genuine mutuality as a matter of substance.

The provision has a long history, tracing back to the United Kingdom’s Bankruptcy Act 1883 (UK). This was adopted in subsequent bankruptcy legislation in both Australia and the United Kingdom. In Australia, these bankruptcy set-off provisions (most recently contained in section 86 of the Bankruptcy Act 1966 (Cth)) were adopted mutatis mutandis into the companies legislation until the enactment of the Corporate Law Reform Act 1992 (Cth) (the 1992 Act).

The 1992 Act created section 553C in its current form in response to recommendations in the Harmer Report, which was in turn drawn closely by reference to the pre-existing provisions. The Court opined that it “would be surprising” if a new position emerged from “new drafting designed to be clear and simple and to maintain the policy of the existing law”.

Previous case law

The Court surveyed the case law prior to the enactment of the 1992 Act and considered it ‘tolerably clear’ that the accepted position under the bankruptcy legislation was that:

• there could be no set-off of the underlying debt against the obligation to disgorge the preference;
• the right to recover the preference was a right of the trustee or liquidator and not a right of the bankrupt or the company, thereby denying the mutuality essential to set-off; and
• this was reflected in the reasoning of various cases, and the use of the phrase “void against the trustee or liquidator”.

Observations on unfair preferences

The Court also considered the nature of the current unfair preference provisions under the Act (sections 588FA, 588FF and 588FI) and made a number of observations:

• the statutory purpose of the avoidance of unfair preferences is the just remedying of the dislocation of equality of creditors reflected in pari passu distribution – by securing equality of distribution it deters a “race to the courthouse” by creditors;
• unfair preferences do not automatically become void upon the insolvency of the company, but depend instead upon the liquidator electing to commence proceedings in that regard and the court ultimately ordering the relevant relief – this aligns with the pre-existing concept of “void against the liquidator”;
• an application to set aside unfair preferences can only be made in the period beginning with the relation-back date;
• the basis for an unfair preference being voidable is not drawn from any breach of duty of the creditor or emergence of a contingent or nascent right or equity of the debtor to have the preferential transaction set aside. As between the debtor and creditor the debt is paid and discharged;
• the proper plaintiff for an unfair preference action is the liquidator, rather than the company (although any payment is made to the company);
• whilst the 1992 Act made the recovery action for unfair preferences more flexible, the fundamental remedial purpose of remained the same – to remedy the dislocation of the statutory priorities of distribution;
• it is not necessarily the case that all voidable transactions “engage” with section 553 set-off in the same manner; and
• section 588FI envisages a situation where an order has been made in respect of an unfair preference which results in the company being put in the same position as if the transaction had not been entered into, and allowing the creditor to prove in the winding up in such circumstances. The court considered this as being inconsistent with section 553C being engaged.

Analysis of the Court

The Court noted that for set off to be available under section 553C, the character of the funds must be such as to reflect the underlying mutuality: the funds must reflect that the debts or obligations are between the same parties in the same interest. In this case, the relevant funds and obligations to be compared were: (i) the debt of the Company in respect of pre-insolvency trading; and (ii) the obligation of the preferred Creditor to make payment under the preference provisions.

Funds payable in respect of the preference recovery are for the benefit of the unsecured creditors in the winding up, even if this does not amount to the creditors acquiring a beneficial interest or ownership distinct from the company (or giving rise to any trust). This means that a preference claim has a different character from debts owed to the Creditor for the purposes of mutuality under section 553C:

That the funds are beneficially those of the company for one purpose does not answer the question of mutuality for the purposes of s 553C, in its statutory context. For the purposes of reciprocity and the statutory purpose within s 553C, the funds are received by virtue of the interest and right, and for the benefit of the creditors and those charged with the administration. This is not the same interest as the company was liable for or the creditor entitled to receive the second debt of the company to the creditor.

Furthermore, the Court noted whilst set-off can, in some circumstances, extend to claims which accrue after the “relevant date” (being the day on which the winding up is taken to have begun under Division 1A of Part 5.6 of the Act), for there to be mutuality, the claim must have developed from a relevant right or duty that is in existence at the relevant date. In this case however, at the relevant date, the Creditor owed nothing to the Company, as the Company’s payment was effective to discharge a debt owing to the Creditor. There was, at the relevant date no contractual, equitable or statutory duty of any kind (vested or contingent) in the company to call for repayment. The right to apply for an order for repayment of the amount as an unfair preference could only arise after the liquidator had been appointed (after the relevant date). This right of the liquidator was a new right, and created a new obligation.

Finally, the court noted that if section 553C was to apply in these circumstances the proceeds of a preference recovery action would go first to pay (by a set-off) the preferred creditor in priority to priority creditors, such as employees of the insolvent company. Such a conclusion “offends the notion of fairness that underpins mutuality in section 553 and the statutory order of priority of certain creditors, built in respect of some (in particular employees) upon the protection of the vulnerable.” As such, the application of set off in these circumstances would ill-conform with the policy of the Act.

Distinguishing the insolvent trading cases

As part of its argument, the Creditor pointed to a number of Australian insolvent trading cases, including Re Parker, Hall v Poolman [2007] NSWSC 1330 and Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd [2011] NSWCA 109.

In those cases, the liquidators of the insolvent companies pursued claims against creditors (being a holding company and shadow directors, respectively) to recover losses in connection with the alleged contravention of the insolvent trading provisions of the Act by those creditors. Mansfield J and Young JA, respectively, held that set off was available under section 553C to reduce the liquidators’ insolvent trading claims in those cases.

Mansfield J considered the debts were mutual in that they were reciprocal (even if they did not result from mutual dealings). The insolvent trading claim was a mutual debt as it recoverable as a debt due to the company, and the fact that it may be enforced by the liquidator was merely a “procedural device” for enforcing   what was “clearly” a claim of the company. The conduct constituting the contravention occurred prior to the relevant date, and the claim was “perfected” by the liquidation. This analysis was later adopted by Young JA.

The Court avoided ruling on whether the analysis by Mansfield J was correct. Instead, the Court distinguished set-off cases involving insolvent trading claims from those involving unfair preference claims. The Court noted that the purpose of the insolvent trading provisions was to protect the insolvent company and its creditors from conduct that is a contravention of the Act. This can be contrasted with the unfair preference provisions, which are intended to protect the insolvent estate from the effects of an otherwise valid inter partes transaction that has the effect of dislocating the order of distribution.

Accordingly, the Court stated:

In such circumstances, it may be reasonable to view the insolvent trading claim as arising from the previous contravention and so be contingent by the existence of a form of statutory equity in the [insolvent company] against the [creditor], to be vindicated through any future liquidator. Looked at thus one can see a sense of equitable fairness in a characterisation of genuine mutuality.

The Court considered that this insolvent trading claim analysis was not applicable to unfair preference claims. This was because the voidability of unfair preferences does not depend on a wrong or contravention of the Act occurring before the relevant date (and therefore there was no contingent right or obligation existing at the relevant date).

Comment

The decision of the Court will be welcomed by liquidators and insolvency practitioners as reflecting a sensible approach which provides them with greater certainty to pursue unfair preference claims against creditors. It is hard to see any coherent policy rationale for allowing creditors to use statutory set-off as a defence to unfair preference claims. The position also reflects the historic position under the Australian bankruptcy statutes.

The case does, however, raise the question as to whether the availability of section 553C set-off in other cases, such as where a liquidator pursues insolvent trading claims, may come under increased scrutiny in future. Could it similarly be argued that (and contrary to the analysis of Mansfield J) an insolvent trading claim is a claim of the liquidator for the benefit of unsecured creditors and therefore not mutual with a pre-existing debt? Such issues will need to await future cases to be further explored.