The brewing controversy in Australia surrounding the application of the s 553C set-off defence to unfair preference claims

The most basic feature of insolvency law is the pari passu rule. It holds that in the liquidation of an insolvent company, creditors of the same rank are treated equally, with each paid rateably. However, the rule is not absolute. Among the exceptions to the pari passu rule in Australia is insolvency set-off, as provided for under s 553C of the Corporations Act 2001 (Cth) (the "Act").

The interplay between insolvency set-off provisions and a liquidator's unfair preference claims has become more controversial in recent years. In Australia the courts historically have favoured creditors' rights to rely upon insolvency set-off in order to avoid entirely or reduce their liability for unfair preference claims under s 588FA of the Act. To date, the weight of authority on this issue clearly favours creditors. This is unlike other jurisdictions, such as the United Kingdom and the United States, which prevent or limit a creditor's right to set-off against a preference claim in an insolvency case.

The creditor-friendly law in Australia cannot yet be regarded as settled. The two most recent cases in Australia are notable for suggesting that there are "powerful contrary arguments" to the Australian courts' current creditor-friendly approach. Consequently, the courts may come to a view on the availability of insolvency set-off in the context of unfair preference claims that differs from the current approach and is more favourable to liquidators. We discuss the historical creditor-friendly case law in Australia, the recent cases questioning that approach, and conclude by identifying two of the more persuasive arguments that may be relied on by courts to change the creditor-friendly approach.

Framework of the Act

Subject to the qualification set out in s 553C(2) of the Act, s 553C provides for the mandatory set-off of mutual credits, mutual debits or other mutual dealings between an insolvent company and a person making a claim in the winding up of that company. Section 553C(2) of the Act prohibits anyone from claiming insolvency set-off where, at the time credit is given to, or received from, the company, they had notice of a company's insolvency.

Unfair preference claims are one of a liquidator's most effective means of increasing the pool of assets available in a liquidation for the benefit of unsecured creditors. Under s 588FA of the Act, unfair preferences arise where:

1. The company and a creditor are parties to a transaction; and
2. The transaction results in the creditor receiving more from the company, in respect of an unsecured debt owing to the creditor by the company, than they would have if the transaction were set aside and the creditor had to prove for the debt in the company's liquidation.

For an unfair preference to qualify as a voidable transaction, under s 588FC, the transaction must have been entered into within six months of the 'relation-back day', and at a time when the company was insolvent, or become insolvent because of entering into that transaction. The remedies available in relation to voidable transactions include, under s 588FF(1)(a) of the Act court orders directing the creditor to repay to the company some or all of the money received under the transaction.

Re Parker

Although not an unfair preference case, we start our analysis with Re Parker (1997) 80 FCR 1. The case concerned the operation of insolvency set-off in the context of insolvent trading claims brought against a holding company by the liquidators of its subsidiary under ss 588V and 588W of the Act.

The holding company argued it was entitled to set-off pre-liquidation debts due and owing to it by its subsidiary, against any liability arising from insolvent trading. In determining that the holding company was so entitled, the Court held (at [10]) that "the two debts are between the same companies. The burden of them would lie in the same interests… [and] [t]hey are commensurable, in that they both sound in money".

Morton v. Rexel

The liquidator in Morton & Anor v. Rexel Electrical Supplies Pty Ltd [2015] QDC 49 sought to recover unfair preference payments made to the creditor totalling approximately A$200,000. Relying upon Re Parker, the creditor sought to set-off against this liability, a A$90,000 debt owed to it by the company for goods supplied and delivered.

The liquidator argued that:

1. Permitting a creditor to set-off debts which the company owed it, against any liability for unfair preference claims, would frustrate the purposes of Part 5.7B of the Act; and
2. At the time the company incurred liability for the amounts it owed to the creditor, the creditor had notice of facts indicating that the company was insolvent. Consequently, s 553C(2) of the Act prevented the creditor from setting-off against any unfair preference liability, the amounts owed to it by the company.

The Court held that the first of these arguments was inconsistent with Re Parker. This meant that if the Court was to accept the liquidator's argument, it would necessarily be departing from Re Parker. Citing Farah Constructions Pty Ltd v. Say-Dee Pty Ltd (2007) 230 CLR 89 at 151[135]), the Court considered it could only take this step if Re Parker was 'plainly wrong'. (As to whether this is the correct approach, there is conflicting authority. See, for example, the Walker Corporation Pty Ltd v. Sydney Harbour Foreshore Authority (2008) 233 CLR 259 which applied Marshall v. Director-General, Department of Transport (2001) 205 CLR 603 at 632-633 [62].) Unable to reach this conclusion, the Court rejected the first argument.

As to the second argument, subject to one exception, the Court found at the time the company incurred liability for the amounts it owed to the creditor, the creditor had actual notice of facts that would have indicated to a reasonable person in the creditor's position, that the company was insolvent. Consequently, the Court held that apart from the creditor's January invoice (in respect of which the creditor was entitled to a set off), the creditor was otherwise prohibited from setting-off any other amounts owed to it by the company under s 553C(2).

Hussain v. CSR Building Products Limited

In Hussain v. CSR Building Products Limited, in the matter of FPJ Group Pty Ltd (in liq) [2016] FCA 392, the liquidators submitted that the cases referred to above had been wrongly decided. The liquidators argued this was because:

1. Allowing set-off in the context of unfair preference claims would lead "to the peculiar result that a creditor who is paid [its] entire debt by preference payments will be disadvantaged as compared [with] a creditor who is paid only part of [its] debt by preference payments" (at [233]); and
2. To allow creditors to "happily accept preferential payments knowing that those payments will be treated as 100c in the $ for the purposes of a set-off for the balance of the outstanding amounts" is 'perverse' (at [244]).

The Court rejected the first of these arguments, holding that there was nothing peculiar about the outcome described. It was instead, "the plain effect of the legislative provisions and the legislative policy". In other words, it was precisely the result that could be expected from a straight-forward application of the relevant provisions of the Act.

The Court also rejected the second of the liquidators' arguments. Unless a creditor is aware that a company is insolvent at the time payments are made, there is nothing perverse about the creditor accepting them. Further, any perversity which might otherwise arise from accepting payments with knowledge of a company's insolvency, is already dealt with by s 553C(2) of the Act.

Despite rejecting the grounds upon which the liquidators relied in arguing the above cases were wrongly decided, the Court went on to express the view that there are (at [235]):

"powerful contrary arguments that might have been made [by the liquidators in this case] to suggest that a set-off is not available against a liquidator's claim to recover preference payments."

Without identifying what the "powerful contrary arguments" were, the Court held that as a result of the liquidators' failure to raise them, it would be inappropriate for the Court to assess those arguments. There was also no utility in doing so, given the Court's finding that there was insufficient evidence to establish that the company was insolvent at the time of making the relevant payments.

Stone v. Melrose

Stone v. Melrose Cranes & Rigging Pty Ltd, Re Cardinal Project Services Pty Ltd (in liq) (No 2) [2018] FCA 530 is the latest case to be decided on these issues. The liquidators in this case sought to recover unfair preference payments totalling approximately A$310,000, while the creditor sought to set-off against this, an A$80,000 debt owed to it by the company.

The liquidators accepted that the balance of current authority allows creditors to rely on insolvency set-off in the context of voidable transaction claims. Despite this, the liquidators "made a formal submission" that insolvency set-off is not available in relation to preference claims. They urged the Court not to follow the cases referred to above, which they considered were "plainly wrong".

The purpose of the liquidators' formal submission was simply to preserve their ability to raise the above issues on appeal if necessary. Consequently, the liquidators made no attempt to develop these arguments in the context of this first instance proceeding. Without the benefit of detailed submissions to the contrary, the Court adopted the approach taken in Re Parker.

Despite this, on the basis that the creditor was found to have had actual notice of facts revealing that the company was insolvent, the Court held that the creditor could not avail itself of s 553C of the Act. It was relevant to this that the company had made multiple promises to make payment, none of which were met, despite the creditor's persistence in continuing to follow payment up.

The position in the UK and the US

Before turning to consider where to from here for insolvency set-off in the context of unfair preference claims in Australia, it is interesting to compare the Australian courts' approach against the approach taken in the UK and the US.

Rule 14.25 of the Insolvency (England and Wales) Rules 2016 (UK) provides for insolvency set-off in the UK on terms which are very similar to s 553C of the Act.  Under r 14.25, insolvency set-off applies where, before liquidation, there have been, "mutual credits, mutual debts or other mutual dealings between the company and any creditor of the company proving or claiming to prove for a debt in liquidation".  If there have been such mutual dealings then "an account must be taken … and the sums due from one party must be set-off against the sums due from the other".  “If there is a balance owed to the creditor then only that balance is provable in the winding up” and “[i]f there is a balance owed to the company then that must be paid to the liquidator as part of the assets”.  Like Australia, mutuality is essential - sums due from the company to another party will not be included in the set-off.

Despite the similarities between r 14.25 and s 553C, the courts in the UK have taken a very different approach to the application of insolvency set-off in the context of unfair preference claims.

In the UK, recoveries made from unfair preference claims are not considered company property. They are instead treated as having a special status which stems from the nature and underlying statutory basis for unfair preference claims. Relevant to this, unfair preference claims must be brought by liquidators (not the company), for the benefit of unsecured creditors, among whom liquidators must distribute any recovery made (see Re Oasis Merchandising Services Ltd [1998] Ch 170 at 181-183 and Lewis v. Commissioner of Inland Revenue [2001] 3 All ER 499 at [36]-[37]). For this reason, insolvency set-off is not available in the context of unfair preferences in the UK.

In the US, the US Bankruptcy Code limits a creditor's ability to set-off a debt against a trustee's preference claim. Under s 547(c)(4) of the US Bankruptcy Code, a preference defendant may only seek to set-off debts for "new value" in the form of "money or money's worth in goods, services or new credit" that is provided by the creditor to the company after the preference payment at issue was received by the creditor. The policy behind the US approach is to incentivise creditors to continue doing business with distressed companies. However, the timing is critical since unlike in Australia, a debt already in existence at the time that a preference payment is received cannot be used to offset against a preference claim, The debt must have been the result of a subsequent extension of credit.

Looking forward

By noting that there are "powerful contrary arguments" to the courts' current creditor-friendly approach, Hussain v. CSR Building Products and Stone v. Melrose suggest that insolvency set-off could yet be held to be unavailable in the context of unfair preference claims. Of the various arguments in favour of such a view, those identified below relating to mutuality are likely to be among the more persuasive.

A lack of mutuality between a creditor's liability for unfair preferences and any amounts owing to the creditor by the company may be said to arise in one of two ways:

1. First, there is arguably a disconnect between the parties against whom the above claims may be brought; and/or
2. Second, there is a timing issue relating to when liability arises for unfair preferences the effect of which means that, as at the time insolvency set-off ought to be assessed, there are arguably no mutual credits, mutual debits or other mutual dealings capable of being set-off.

The first issue arises because unfair preference claims are required to be brought by liquidators, whereas the creditor seeks to set-off against this, amounts owed to it by the company. The Court in Re Parker rejected this argument (albeit in the context of an insolvent trading claim) having regard to s 588FF of the Act. This enables orders to be made directing creditors to pay unfair preference amounts "to the company" (at p 11). On this basis, the Court in Re Parker downplayed the 'procedural' role played by liquidators in bringing insolvent trading claims which were, "as a matter of substance", company claims (at p 11).

Even if this analysis is accepted, however, it is not a sufficient basis upon which to establish mutuality. As Rory Derham points out in relation to unfair preference claims (see Derham R, Set-off against statutory avoidance and insolvent trading claims in company liquidation, 89 ALJ 459 at 475), this is because the company is not the beneficial owner of such claims. It follows from this that the company cannot charge or assign such claims prior to it being wound-up, and any recovery made from such claims cannot be accessed by the company for its own purposes, but must instead be distributed by the liquidator for the benefit of unsecured creditors.

There is a strong argument for saying that, absent beneficial ownership in any unfair preference claims by the company, there is a lack of mutuality between such claims and any amounts owing to the creditor by the company. In those circumstances, insolvency set-off should not be available to creditors in defence of unfair preference claims.

In relation to the timing issue identified above, Re Parker held (at p 15) that the date for assessing whether insolvency set-off should be allowed ought to be the same as the date fixed under s 553 of the Act for determining what debts are provable.

Section 553 establishes that to be provable in a winding-up, the circumstances giving rise to a claim must have occurred before the 'relevant date'. (Unless a company enters into administration prior to being wound-up, the 'relevant date' will be the day a winding up order is made, or a resolution winding the company up is passed.) For the purposes of insolvency set-off, this principle should apply both to the creditor's claim against the company and to the unfair preference claims against the creditor.

The principle that insolvency set-off must be assessed having regard to circumstances in existence before the relevant date, creates obvious difficulty in the case of unfair preference claims. Before an unfair preference claim may be brought, the company must first have been wound-up. However, in the case of a company that is wound-up without first being put into administration, the winding-up necessarily commences on the relevant date, not before it. This would appear to rule out the availability of insolvency set-off.

Against this, it has been suggested that insolvency set-off may still be available in relation to liquidator claims on the basis that these constitute contingent liabilities (Re Parker at p 11-12). This appears contrary, however, to the generally accepted view as to when contingent liabilities arise. In order to constitute a contingent liability, there must be an existing obligation out of which, on the happening of a future event, an obligation to pay a sum of money would arise (see McLellan v. Australian Stock Exchange Ltd (2005) 144 FCR 327 at [9]).

This cannot easily be applied to unfair preference claims. Among other things, payments made may only be recovered as unfair preferences where a company is being wound-up and a court is satisfied that the payments are voidable in accordance with 588FE. Only then may a court make one or more of the orders set out in s 588FF of the Act. It is difficult to reconcile the language and scheme of these provisions with an obligation which could be said to exist before a winding-up.

For these reasons, we consider that a court could yet determine that insolvency set-off is not available to creditors in defence of unfair preference claims. This would upend current Australian law, but at the same time bring it closer in line to other similar jurisdictions such as the UK and the US.

Daniel Vizor is a senior associate in our Melbourne office in the firm's financial restructuring and insolvency group. We would like to thank Sarah Gard, a graduate in our Melbourne office, who assisted in the preparation of this article.