Set-off in Insolvency Contexts

“A set-off in insolvency contexts involves the crossing out of mutual debt obligations between a debtor and a creditor. It can be used in any type of contract; not just financial contracts.”

Set-Off under the Corporate Insolvency and Restructuring Act, 2020 (Act 1015)

Continuing from our piece on netting arrangements… Insolvency legislations generally frown upon schemes and devises which either have the potential of reducing the assets available to a liquidator in an insolvency or preferring one creditor over the general class of creditors. As a quick run through the Corporate Insolvency and Restructuring Act, 202o (Act 1015) will show, the Act leans heavily towards securing good returns for the entire creditor class as opposed to any particular creditor or class of creditors. It is therefore not surprising that the administrator (in the context of an administration) or the liquidator, (in the context of a liquidation) unlike a receiver, are not the agent of the persons who appointed them but rather agents of the company.

Set-offs are one of the schemes that have the potential of reducing the asset stock available to the liquidator. And it is therefore not surprising that the CIRA puts in place specific provisions to regulate the use of set-off as a risk allocation tool.

What is a set-off?

A set-off involves the crossing out of mutual debt obligations between a debtor and a creditor. It is important to note that set-offs can apply to any type of contract and not just financial contracts. The CIRA defines a set-off as “the application of a sum of money owed to a person in satisfaction or reduction against a claim by another party for a sum of money owed by that first party”. In this light, a set-off is a discharge of reciprocal obligations. As pointed out, the CIRA regulates set-offs very closely. For set-off to apply, a number of conditions must be present.

What conditions must be met for a set-off in insolvency contexts to be upheld?

First, the set-off must only be confined to pre-application debt obligations by the creditor and debtor company. The reference to “pre-application debt obligation” refers to debt obligations that arose prior to the application to place the company either in administration or in liquidation.

The second condition is that the set-off must not have rendered the company insolvent. This second point relates directly to the first point. A set-off which renders the company insolvent is perceived as fraudulent and a scheme designed to prefer one creditor over the entire creditor class.

Finally, a set-off will only be upheld where it was entered into in the ordinary course of business of the company. This means that a hurriedly arranged scheme designed at a point where the company is insolvent to give either the company’s directors, shareholders or specific creditors some advantages will not be recognised as a set-off. The CIRA specifically considers an act to be fraudulent where the transaction is entered into after an application has been made for the winding up of the affairs of the company or the transaction was such that the creditor knew or ought to have known that the company was insolvent.

Rationale for the CIRA’s position on set-off in insolvency contexts

Though the CIRA provides no reasons for its position, the rationale may be gleaned from the Australian case of Morton v Metal Manufacturers Ltd[1]. In that case, the creditor entered into an agreement to set off with a creditor. This agreement was made in the period after the company had been declared insolvent but before a liquidator had been appointed. After the liquidator was appointed, he sought to reverse the setting off arrangement. The English Court allowed the transaction to be reversed.

The court took the view that once the company was declared insolvent, the creditors acquired an immediate direct interest in the assets of the company. Therefore, any amounts previously owed to the company would now be owed to the company and the entire creditor pool. However, the debts owed by the company were debts of the company alone. If a set off is done during insolvency, all the other creditors lose out without getting a commensurate benefit. This takes away the key component of mutuality of obligations which is central to a set off.

Conclusion

In summary, there is no automatic right to set-off under the insolvency regime. For a set-off to be upheld, specific conditions must exist. Once an application is placed before either a court or the registrar for the winding up of the affairs of the company, any move aimed at achieving a setting off will be ruled out under the liquidator’s power to reverse and set aside fraudulent transactions.

[1] Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Ltd [2021] FCAFC 228 (Australia).

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