English Right of Set-Off and Combination in the Circumstance of Insolvency
The right of combination and set-off, as developed under English law offer a number of safeguards to banks and creditors in general. These rights were expanded under the principles that they were necessary to effect substantial justice and that they would stimulate economic growth and trade. In the following paper, I suggest that the judicial application of these rights has tended to unfairly favor banks at the expense of the individual customer, which may initially stimulate growth by encouraging banks to provide loans, but in the long-term may serve to deteriorate trade, particularly at the international level. Customers in other countries, particularly civil law countries, experience much more risk when they do business with an English bank, and hence may be better off refraining from bringing their enterprises there, or at any rate must be extremely careful in drawing up contracts to insist on settlement of disputes in other jurisdictions. Historically, however, England has been loath to allow other forums to litigate the interests of its citizens and corporations.
Because the rights are interpreted rigidly, their existence also discourages customers from opening multiple accounts at a single bank (which would be more efficient) and lock the customers into positions that are unsound for private businesses. For example, the right may not be contracted out of even in contemplation of bankruptcy. Also, there has developed what seems to be a judicially-created doctrine that makes it crucial for personal liability to exist in order for the right of set-off's essential element of "mutuality" to be found. Thus, even though a third party in effect will experience loss as a result of an insolvent bank's ability to refuse to apply set-off for a principal debtor, if that party is not deemed personally liable on the debt and will ultimately have to go through the inefficient process of proving for the debt upon the bank's liquidation, that party may not compel the bank to set off the debt using the secured funds. These sorts of practical inequities suggest that some reform of the provisions setting forth these rights is needed as a public policy matter.
II. Right of Set-Off and Combination
Balance sheet insolvency occurs when a debtor company's total outstanding liabilities exceed its assets. Under English law, if there have been mutual credits, mutual debts or other mutual dealings between a debtor and a creditor prior to the commencement of the insolvency of the debtor, a self-executing "set-off" occurs by operation of law. Cross-demands are not automatically cancelled, but the procedure that leaves only the bankrupt party still in debt happens when an account is taken because the creditor has lodged a proof in bankruptcy proceedings or because the insolvent party raises set-off as a defense when an action is brought against him. Mutuality is essential to the English application of set-off, unlike set-off in other jurisdictions, but it entails not that the mutual liabilities arise from the same transaction, but that both parties have dealt with each other in the same or very similar capacities. Corporate set off is governed by Rule. 4.90 of the Insolvency Rules 1986, which provides in relevant part:
1) This rule applies where, before the company goes into 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 the liquidation.
2) An account shall be taken of what is due from each party to the other in respect of the mutual dealings, and the sums due from one party shall be set off against the sums due from the other...
4) Only the balance (if any) of the account is provable in liquidation.
Alternatively (as the case may be) the amount shall be paid to the liquidator
As part of the assets."
Basically, English set-off allows a creditor to use any money it owes an insolvent debtor to pay off the debtor's liabilities that have become due to the creditor. Thus, when liquidation commences, only the party that had the larger claim is still owed the net balance. Liquidation legally occurs when the company passes a resolution to voluntarily wind up or is judicially wound up. Effectively, eligible creditors (those that meet the mutuality requirement) are positioned alongside secured creditors to the extent of their debt to the insolvent party. Simultaneously, they continue to be placed within the pool of unsecured creditors who (as a result of the speeding of the recovery process for those creditors eligible for set-off, recover a diminished amount themselves) receive dividends on the portion of debt still owed to them by the insolvent party.
A number of cases have justified the right of set-off under the theory that it ameliorates "a perceived injustice, that a person should have to pay the full amount of his liability to a bankrupt and at the same time be confined to lodging a proof for what the bankrupt owes him." At first glance, the rights appear to afford some efficiency by streamlining the judicial processes so that two actions need not be brought separately. The right of set-off can be curtailed by an express or implied contrary agreement. The right is also limited so that contingent or unmatured-at-the-time-of-bankruptcy liabilities of a customer may not be set off against deposited funds. The right of set-off for banks is available where accounts are of the same customer, held in the same name and in the same right, such that "personal indebtedness can't be set off against money held by a customer in a trust capacity." Again, at first glance this appears to provide limits as to the speediness of recovery to the bank; it can't go overboard in trying to recover the loan. And as previously mentioned, the right of set-off only applies where there is "mutual credit." It does not apply where the creditor has been supplied funds by the bankrupt for a "special purpose." This paper will later examine that phrase with regards to Halesowen.
The mutual credit provision of the English bankruptcy rules first came into the statute on in 1705. Early on, there could only be set-off if the mutual liabilities existed prior to the act that created bankruptcy. But, later, eligibility to exercise the right of set-off was expanded to include those that were unaware of the act that created bankruptcy. By 1986, the English right of set-off had stretched such that it was applicable "in the event of mutual dealings between the bankrupt and any creditor of the bankrupt proving or claiming to prove for a bankruptcy debt." As a result of these expansions, the English rights of set-off are more far-reaching than those in other jurisdictions, making it a particularly good forum in which to institute proceedings to recover from an insolvent debtor. In the United States, also a common law country, set-off is a bit more limited by the interplay of the federal bankruptcy statute and state laws. Still, set-off in the United States is based on the somewhat myopic theory that a depositor has "impliedly consented" to the set off. One can only presume that consent has been implied by the fact that a customer typically doesn't want to open multiple accounts at multiple different banks, but would rather receive statements and charges from one source.
In contrast, civil law systems such as France or Japan are more likely to consider the right of set-off as a more narrow remedy, which is limited to those liabilities that stem from the same transaction. Non-English jurisdictions (excluding Canada and Australia, which offer similarly hefty rights) seem to be less pro-creditor, perhaps considering issues such as the unjust effect of the right of set-off on ineligible creditors -- whose own claims are otherwise just as pressing -- and the intentions or needs of the individual insolvent party.
Phillip Woods has written, "Potentially one of the most useful remedies available to a bank lender on a default by the borrower is the ability to use deposits of the borrower placed with the bank to pay out the defaulted loan." Theoretically, the right of set-off seems to work a windfall for banks in the jurisdiction of the U.K.. Banks are placed advantageously to recover more money than other creditors under these rules because banks more often meet the mutuality requirement with their customers than individual lenders.
Purportedly, the English right of set-off does "substantial justice" and stimulates trade and commerce because it is seen as a type of security. So, where an otherwise promising enterprise is insolvent in the small-scale, cash-flow sense, the existence of a set-off right may still encourage other parties to loan money to the enterprise or have other dealings with it. Debts that are entered into prior to liquidation but which is not payable until after the date of liquidation are subject to set-off. Once a company gives notice that it is unable to pay debts, transactions…