International Development Law and Banking and Finance Law

¶ … 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 that occur after that notice will not allow creditors to claim the right of set-off. And, according to the Court of Appeals, claims that are merely contingent at the relevant date, but are not "due" are not employed in a set-off.

The right of combination differs from the right of set-off because, unlike set-off which assumes independent obligations between parties, combination allows full balancing of all liabilities. Unless there is an express or implied agreement to keep accounts separate, even accounts that are different in nature have been considered to be automatically combined in determining the final balance upon insolvency. The cases do not seem to offer a perfectly predictable rule, but generally there is an implied agreement that a loan account in debit and a current account in credit should be treated as separate. Unlike the right of set-off, the right to combine an account belongs only to banks. A bank may treat accounts kept at separate banks as combined, but a customer may not, for example, overdraw funds from one account claiming that funds from another account can cover it.

Basically, the insolvency of the customer is not as big of a concern for banks, in this system, because the process of going after the customer for repayment is made easier by the granting of the right. But conversely, the insolvency of the bank has grave consequences for a customer, because the customer may have severely limited abilities to recover deposits from an insolvent bank and is subject to great losses from its inability to combine accounts of loan and credit.

The English bankruptcy statute requires an account to be taken before set-off occurs. In Stein v. Blake, a plaintiff, who would soon be adjudicated bankrupt, brought claims for contractual breach against the defendant, who then counterclaimed for misrepresentation. The trustee in bankruptcy assigned the claim that the defendant had broken an agreement with the plaintiff to equalize his shareholding in various companies against the defendant to the plaintiff. The assignment was made with the intention that any proceeds recovered by the plaintiff would be split with the trustee. The judge stayed the action as the defendant asked. The higher court held that since the object of a set-off in bankruptcy was to do substantial justice between the parties "all mutual and commensurable claims are to be set off": a trustee in bankruptcy could assign the bankrupt's claims against the person entitled to exercise the right of set off so that the bankrupt's action against the creditor could be restored. The trustee in bankruptcy in not required to take the account nor prevented from assigning a cause of action.

The court reasoned that, "The language of the section draws a distinction between what is due- which is the word used in subsections (2) and (3) and what is payable or recoverable... The separate causes of action (claim and cross-claim) remain due, and do not cease to exist, until the set-off has been completed by payment one way or the other." The court went on to say, "It is also noteworthy that the section does not provide that only the trustee in bankruptcy may take the account: subsection (2) only states that 'an account shall be taken'" (emphasis added). Thus, some authority must realize and distribute an insolvent party's estate, but it does not prohibit the trustee from assigning a cause of action that is part of the estate and it doesn't require the trustee, rather than a bankruptcy judge to take the account.

In National Westminster Bank Ltd. V. Halesowen Presswork & Assemblies, the parties had agreed that the bank would freeze Halesowen's overdrawn account ("account 1"). They had agreed to keep a newly opened account in credit (account 2) without being able to claim a set off on the credit balance against the debit balance on the frozen account for a period of four months. During that period, the company gave notice of a creditors' meeting at which they resolved to voluntarily wind up.

The court reasoned that the debits on the first account and the credit on the second account amounted to "mutual credits, mutual debits or other mutual dealings." It held that set-off is mandatory and that parties cannot contract out of it, noting in passing that the Supreme Court of British Guiana had held that it was in fact possible to contract out of the statutory obligation to set off. It reasoned that in the agreement the bank had merely agreed not to try to secure payment of the amount the insolvent company owed them for four months unless there was a material change of circumstance, but that the agreement did not contemplate what course of action to follow in the event of the company's liquidation.

In a concurring opinion in Halesowen, it was remarked that, commonly, "mutual dealings" does not cover a transaction in which property is made over for a 'special' or 'specific' purpose. The justice wrote that Every payment of money, every contractual provision, is for a special or specific purpose in the ordinary sense of those words; something more is required to take the transaction out of the concept of 'mutual dealings.'... [M]oney is paid for a special or specific purpose so as to exclude mutuality of dealing within s 31 if the money is paid in such circumstances that it would be a misappropriation to use it for any other purpose than that for which it is paid."

The court in earlier cases had held that a special purpose could be found: where a solicitor held money entrusted to him by the bankrupt for future costs; where a solicitor held a surplus out a sum specially provided by the bankrupts for the satisfaction of pre-bankruptcy claims; where a fund was held as a guarantee against the carrying out of specific obligations. One Halesowen opinion remarked that in those cases, the funds had been given marked as intended as a quasi-trust, which destroyed mutuality in that the "right" involved was different.

As one opinion seems to suggest, it is not clear why, as a matter of social policy, two parties cannot agree to contract out of the right of set-off with a view to impending insolvency or bankruptcy. All that the Halesowen opinions focus on is the fact that the agreement didn't seem to contemplate what would happen in the event of a winding-up; the opinions don't offer concrete reasons why the right of set-off and combination is so important that two parties cannot consensually determine it will not be exercised. One could argue it is important because ultimately only the directors of a company really know how well it is doing and banks cannot be expected to check up on the financial status of every company to which they loan money. But, this is farfetched. The truth is that banks should check on financial status before loaning money or before entering into agreements. The right of set-off and combination greatly decrease the risk a bank takes in giving out a loan, and does encourage a bank to give loans to enterprises. Certainly, this is good for business. However, the overwhelming power of the right simultaneously diminishes the contractual freedom of companies and allocates an unusual amount of risk to customers in the banker-customer relationship. The decision makes it financially important for customers to keep accounts at multiple banks, rather than opening multiple accounts at one bank. Unfortunately, this means a lot more work in accounting for customers, especially because set-off operates as a defense only and may not be initiated by the debtor (even, apparently, a bank is likely to be unable to repay a security to a guarantor). If a customer becomes insolvent, the bank is free to combine accounts to avoid loss. If, however, a bank becomes insolvent, the customer is not similarly positioned to recoup the losses it incurred in trusting the bank with deposits. The following cases particularly illustrate that principle.

In Re Bank of Credit and Commerce International [1994] 3 All ER 565, a bank's loan to a company was secured by a third party's grant of a charge over his funds which were on deposit at the bank. The bank itself went into liquidation prior to repayment. The liquidators asked the court whether they should try to recover the full amount of each outstanding loan from the company, leaving the third party to prove in liquidation for the deposits charged to the bank.

The company and third party depositer argued that the liquidators should only get the extra over the amounts deposited claiming a right of set off. The court held that in such a situation there could be no set-off of the deposit against the amount owing by the company since the documentation did not make any of the principal debts due from the depositors. Consequently the depositers were left to prove for their deposits in liquidation of the bank, although up to that time the depositers had been unable to withdraw the funds.

Under earlier case law, a creditor who sues for a debt must return securities that it held in respect of the debt on payment of outstanding liability. If the creditor had disposed of the security and thus, could not return it, he could not exercise a right of set off. Where depositors have entered into joint personal liability with principal debtors, reasoned the majority of judges, the liquidators still have the power to release the depositors from liability, before any accounting between the depositors and the bank is taken.

The court stated that where there's no personal liability there isn't anything for the set-off to work from.

The issue of "personal liability" seems like an artificial and non-meaningful distinction. If the primary goal of set-off is really to work a "substantial justice," personal liability of a party, shouldn't be the issue; rather the issue should be ease of recovery for all parties who are owed money. Under this case, it seems like the insolvent bank is afforded the ability to recover at a faster rate than the depositor, who is then forced to prove the debt that secured the loan from the bank to the company. In practical terms, the third party does incur a liability or loss of some sort, yet through manipulation of legal terms of art, he's left unable to withdraw the funds because the funds secure an unpaid loan, nor can he recover them through recourse to the company. Instead the third party is stuck with the cumbersome process that the bank is able to avoid. The third party depositor rightly argued that the bank was unable to restore to the depositors the right to repayment of their deposits in full, which right is a form of property, and therefore, the bank should have given credit for the amount of those deposits on any claim against the principal debtors (the company) for repayment of the loans secured.

The BCCI depositors pointed to the case Ellis & Co's Trustee v. Dixon Johnson, in which stockbrokers sold some shares that had been deposited with them by the defendant as security for any debit balance that might be owed occasionally by him. The firm was later adjudicated bankrupt and the trustee in bankruptcy tried to sue the defendant to recover the balance of the amount owing on the defendant's account with the brokerage after giving credit for the unauthorized sales of the securing shares. The court in that case held that the value of the shares at the time of the suit was the proper measure of set off for the debt, since the bank was unable to return the securities without repurchase at that price.

Supposedly, the principle in that case is inapplicable to the case at bar. Counsel for the bank argued,

The property charged by the security documents was not the cash paid to the bank by the depositors, which on general principles became the property of the bank, but the choses in action consisting of the depositors' rights to repayment of the deposits. Once the principal debts are recovered in full from the principal debtors (if they are), these choses in action charged by the security documents will be restored intact to the depositors. The fact that the choses in action will now be subject in the hands of the depositors to the restrictions on enforcement imposed by law as a result of the liquidation of the bank, and will therefore almost certainly be worth very much less than when charged to the bank, does not alter the fact that the depositors will recover the property they charged to the bank."

Importantly, the cash paid to the bank by the depositor didn't become the property of the bank simply because it was deposited. If that were the case, of course, the bank could do whatever it liked with the deposits. Rather, these deposits became bank property as a result of the nonpayment by the company. So, in effect the bank not only had complete control of security that went towards the principal debtor's debt, but also had the right to full repayment of that debt. The passage moves from the mere possibility of banking recovery in full from the principal debtors, through use of the parenthetical "if they are" to the definitive: "the depositors will recover the property they charged to the bank." This passage seems like a terrible obfuscation of the real issue, which is that judicial curtailing of rights to repayment do create loss for the depositor, and as a matter of social policy it is not clear why the bank should favored over the depositor. If indeed substantial justice and stimulus to trade and commerce are the real goals of the legal grant of such a right, why so severely cut the rights of those who offer security for the bank's risk of loaning money in the first place? The court responds to the depositer's legitimate outcry over the injustice done to him by insisting that the bank hasn't done anything wrong by disposing of the security as if it were its own property, implied by bank's counsel's words: "which on general principles became the property of the bank.." The BCCI's mismanagement of funds in the instant case was certainly at issue in its liquidation (as will be discussed later in this paper), so it seems disingenuous to assume the depositor will get any money back. The judge's willingness to deal with the social inadequacy of the consequences of this holding -- that the bank has a stronger position against the company than if the depositors had undertaken "personal liability" -- ignores the theoretical goals of the right of set-off.