16.01  There are four types of set-off in Hong Kong: legal, contractual, and equitable set-off (which are subject to common law principles), and set-off on bankruptcy¹ (which is regulated by section 35 of the Bankruptcy Ordinance²). The relevant principles which are applied are generally those of English common law, with local courts referring to English decisions and sometimes those of other common law jurisdictions, where appropriate.³

16.02  A bank will also be entitled to exercise rights which have some of the characteristics of set-off. In particular a bank has a right to combination, prior to the bankruptcy of the customer, whereby the bank may combine certain accounts of the customer in debit with those in credit.⁴ This right is a traditional one of law (p. 240) merchant given to the bank through its relationship with its customer, regardless of whether the customer is aware of the bank’s right to do so and regardless of whether the accounts are at the same branch or at different branches. Only the bank has this right; a customer is not able to demand that the bank combine accounts. However, as the right is subject to a contrary agreement between the bank and the customer, it is usual to extend the traditional right to cover all types of accounts.⁵

16.03  The right to combine lasts up until the time of bankruptcy, when it then gives way to the statutory right of the bank to set off (subject to the bank being able to show that it has come within the terms of section 35 of the Bankruptcy Ordinance⁶). In exercising the statutory right of set-off upon a bankruptcy, any contractual agreement concerning combination also becomes void.

16.04  A bank also has other rights to assist it in recovering unpaid debts, including the traditional right of lien against securities and other property deposited with the bank by a customer in the course of business (but not simply for safe keeping). Where the customer fails to pay any indebtedness owed to the bank, the bank may exercise a general or banker’s lien, thereby obtaining a ‘security’ over the deposited property. The lien does not function in the same way as combination or set-off. Instead it simply permits the retention of that property until the debt is paid.

16.05  Several other procedures used in commercial situations have similar characteristics to some types of set-off. These include subrogation⁷ and subordination. Subrogation is ‘an empirical remedy to prevent a particular kind of unjust enrichment’.⁸ It is available in various situations where it is used to reverse unjust enrichment.

16.06  Subrogation⁹ and subordination are sometimes referred to as examples of contractual set-off whereby the parties agree to alter priority of rights. Generally, subrogation¹⁰ involves a claimant stepping into the shoes of another, as, for example, where a surety takes securities lodged with a creditor after payment in full of the debt. Subordination largely rests in the alteration of priority.

16.07  Another procedure which is contrasted to set-off, and in some cases forms part of the process of specific set-off, is the counterclaim, which is a cause of action (p. 241) independent from that taken by the plaintiff but which is brought (by the defendant) at the same time as the plaintiff’s action; it relates to the same events as those in the plaintiff’s action. In equitable set-off, the counterclaim is added to the defence.¹¹

16.08  ‘Netting’ and ‘running accounts’ also have some of the elements of set-off, although they originated in different situations from set-off. These operate where there are numerous transactions between the parties and regular statements of their financial state are required. Netting involves the arithmetic combination of debts and credits, with the resulting balance being treated as ‘payments netting’. This one-off netting does give the creditor an advantage where the debtor has become bankrupt, because the creditor then uses its own indebtedness to the bankrupt to reduce the amount the bankrupt owes it. However, if netting results in an unfair preference,¹² the netting payment may be overturned, with the result that the creditor may be creditor for an amount but also a debtor for a lesser amount. The accounting procedure of ‘running accounts’ involves a continuous netting of debits and credits. The same consideration about unfair preferences is relevant as with netting proper.

16.09  The oldest form of set-off in Hong Kong is that of equitable set-off. It takes the form of an equitable defence to enable the defendant to reduce or completely negate the plaintiff’s claim at law for repayment of a debt. Originally, it was used in England by the Court of Chancery against an applicant for an injunction who was unable to resist the claim of the defendant who could show ‘some equitable ground for being protected against his adversary’s demand [where the] mere existence of cross-demands [was] not sufficient’.¹³ As such, the defence had little to do with the aim of achieving an arithmetic combination of debit and credit, with the remainder being the amount due, but had more to do with preventing one party acting unconscionably.

16.10  The modern effect of equitable set-off is to allow the defence where otherwise it would be inequitable for the plaintiff to be permitted to proceed with its claim without making allowance for the defendant’s claim against it. It operates in respect of a common law claim because there is such a relationship between the (p. 242) claim and the defence that equity cannot stand by and allow the common law claim to proceed without adjustment in light of the defendant’s claim. This makes the defence unlike other equitable defences because set-off in this context is not examinable by discretionary bars, something which is inherent to other equitable remedies and defences.

16.11  Equitable set-off does not require the defendant to show either

1. (1)  that he is claiming a liquidated sum (consequently the defence is available in cases of unliquidated debts),¹⁴ or

2. (2)  that there is mutuality between the common law claim and the equitable defence.¹⁵

16.12  What is required is that both the following must exist:

1. (1)  There must be a counterclaim, or cross-claim, which is ‘closely connected’ to the plaintiff’s action. The close connection has been described as having an ‘inseparable connection’ to the action.¹⁶ However, the counterclaim is not confined to money claims, and it does not have to arise from the same transaction as the action. The claim, not required to be liquidated, must ‘impeach’ the plaintiff’s action.

2. (2)  The defendant must have an equity to raise it, so that it would be unconscionable to deny it. In other words, the defendant must show that it would be ‘manifestly unjust’ to allow the claim to be enforced without regard to the defence.¹⁷

16.13  One of the peculiarities of the defence is that some experts consider that because it is a traditional and substantive defence it is ‘perpetual’ in that time is irrelevant, and so laches¹⁸ does not apply to prevent the party entitled to the defence from relying on it.

16.14  The clear distinction between equitable set-off and legal set-off relates to the state of the debt between the parties. Whilst equitable set-off requires that the defence be connected to the plaintiff’s cause of action it does not require the (p. 243) presence of a liquidated debt; on the other hand legal set-off operates only on liquidated debts.

16.15  One result of successful equitable set-off may be to relieve the defendant of the payment of the plaintiff’s costs of action. If the set-off has the effect of enabling the defendant to defend the action absolutely, then it will be the defendant who is entitled to an order for costs rather than the plaintiff.¹⁹

16.16  The English Statutes of Set-off²⁰ in the eighteenth century made the combination of debit and credit automatic in certain cases where the defendant had a right to seek to reduce the amount of the debt being claimed against him by reference to the amount the plaintiff owed him. The purpose behind the legislation was to provide some relief to a defendant who, on judgment being given against him for debt, might have been committed to a debtor’s prison even though the plaintiff was a debtor to the defendant in other circumstances.

16.17  Legal set-off has little to do with set-off on bankruptcy because it does not operate in such a situation. Instead it applies where there is a claim for repayment of a debt, and the defendant can show that there was:

1. (1)  mutuality of the debts sought to be set off; this means that the claims must be ‘between the same parties, and that they must be held in the same capacity, or right, or interest’;²¹ and

2. (2)  the debts have become liquidated in that the amount due has become certain by the time the action is commenced.

16.18  When these two factors are present, legal set-off operates automatically. The only way to avoid this automatic set-off, or arithmetical accounting, is to contract out of the Statutes; which is something that the Statutes do not prohibit.

16.19  There remains uncertainty as to whether legal set-off applies in Hong Kong. The position is not clear but ‘at a minimum there is an arguable defence based on legal set-off, the existence of such right raising a serious question’.²²

16.20  These uncertainties arose in 1966. Prior to then it had been thought that the two Statutes probably applied in Hong Kong from 1844 by reference to the provisions of the Supreme Court Ordinance.²³ The existence of this automatic set-off, as an instrument of statutory provisions, was not questioned. However, (p. 244) in 1966 the Application of English Law Ordinance²⁴ (AELO) came into force. The AELO provided that only those English statutes listed in the schedule to that Ordinance would apply thereafter in Hong Kong. The statutes of set-off were not listed. That seemed to mean that legal set-off no longer applied in Hong Kong. However, counsel in Re Finbo argued that, from 1844, legal set-off had been metamorphosing from its origins as a statutory procedure into a common law procedure where those statutory origins were ignored. This view was acceptable to the court.

16.21  Since 1 July 1997 a further complication has arisen in that the AELO was not one of the Hong Kong Ordinances adopted by the Government of the Hong Kong Special Administrative Region (HKSAR). Had the AELO provided for the Statutes of Set-off to apply in Hong Kong from 1966, the rendering obsolete of the AELO should have enabled a definitive view to be taken to the effect that the Statutes were no longer applicable. However, if the metamorphosed legal set-off no longer depended on the Statutes for its existence, it was immaterial that the AELO was rendered obsolete. In such a case legal set-off was applicable as part of the law, practice, and procedure of Hong Kong, without any need for statutory backing. However, if legal set-off does require the backing of the Statutes of Set-off then it was abolished in 1997 in Hong Kong.

16.22  The better view would seem to be that of Le Pichon J in Re Finbo, where her Ladyship accepted that legal set-off had passed into the unwritten law of Hong Kong regardless of what the AELO provided.

16.23  The Hong Kong courts have more recently²⁵ accepted the description of the nature of a legal set-off as set out in the judgment of Lord Hoffman in Stein v Blake [1996] AC 243 at 251C-D:

16.24  When is legal set-off used? Outside bankruptcy, set-off, which meets the two requirements that the debts be mutual and liquidated, will be automatically applicable where there is a dispute between debtor and creditor for the payment (p. 245) of a debt. To avoid this, the parties may effect whatever contractual arrangements they wish, so long as the agreement does not involve illegality.

16.25  Once bankruptcy has intervened, legal set-off is no longer applicable unless the transaction between the parties is outside the terms of section 35 of the Bankruptcy Ordinance.²⁶

16.26  Contractual set-off is a device used to avoid the consequences of legal set-off. Generally, it is used where a creditor has not effected a security in the usual way, or where he has lent money to a debtor who has already exhausted his assets by securing them to prior creditors. Contractual set-off then seeks to put repayment in the control of the parties, at least until bankruptcy.

16.27  There are various forms that contractual set-off can take to be effective prior to bankruptcy. These include the use of a negative pledge in the loan contract which may function as a contractual set-off by giving the creditor priority over any other party dealing with the debtor.

16.28  The contract sets out the manner in which the debt is to be repaid, including giving the instant creditor priority over other creditors, both prior and subsequent. A well-drafted contract will get around some of the problems with other forms of set-off. This is because:

1. (1)  no mutuality is required before the contractual terms take effect,

2. (2)  no liquidated sum is required to trigger operation,

3. (3)  the contract can postpone or accelerate payments, and

4. (4)  the contract may be able to operate as a negative pledge.²⁷

16.29  Contractual arrangements may permit a creditor to set off a debt owed to it by one company against an obligation owed by the creditor to a separate company (such as in a corporate group). Such arrangements would not, however, survive the insolvency of any such company, and in the absence of such specific contractual arrangements the creditor would not be entitled to exercise a set-off of debts and credits prior to insolvency.

16.30  Contractual set-off is effective without the need for registration, unless the effect of the arrangement is effectively to create a charge, in which case the agreement by a company incorporated or carrying on business in Hong Kong would be registrable if considered to be a floating charge or securing book debts.

(p. 246) 16.31  A negative pledge clause would not normally be violated by contractual set-off rights, although, should the structure of the arrangement effectively constitute a charge and not simply a contractual set-off right, the terms of the negative pledge would likely be breached.

16.32  Once bankruptcy has occurred, the contractual set-off is ineffective to withstand set-off under section 35 of the Bankruptcy Ordinance unless the contract is converted into, and able to be treated as:

1. (1)  a charge (ie a security transaction) and not merely a contract (ie a personal transaction). However, the problem for the creditor seeking to avoid the operation of section 35, in respect of a contractual set-off with a company debtor, is that unless the charge has been registered prior to the event leading to the operation of section 35, it will be too late to protect the charge; that is, too late to protect the contractual set-off as producing a proprietary interest in the assets of the company. This would mean that the creditor (if incorporated or carrying on business in Hong Kong) should have registered the charge under section 335 of the Companies Ordinance²⁸ in good time; or

2. (2)  a trust, more usually in the form of the Quistclose trust—that is, a purpose trust—or perhaps, depending on the court, in the form of a ‘constructive trust as a remedial trust’.²⁹

16.33  Once the debtor has become bankrupt the contractual set-off becomes void³⁰ on the ground that it is against public policy in seeking to overturn bankruptcy legislation. It can no longer be enforced. The whole purpose of the bankruptcy legislation is to protect preferential and unsecured creditors so that a contract bypassing this legislation cannot be allowed to stand. Where the form of the contract is that of a charge or a trust, these transactions would be able to continue to function because their effect is to cause the contractual set-off to lose its identity as a contract.

16.34  As discussed above, legal set-off is not applicable between the parties upon the onset of insolvency unless the transaction is not covered by section 35 of the Bankruptcy Ordinance. Likewise, contractual set-off is effective only if it can (p. 247) meet the requirements set out in the preceding section. There are provisions, however, for statutory set-off.

16.35  Statutory set-off is provided for in section 35 of the Bankruptcy Ordinance³¹ to the effect that:

16.36  Statutory set-off is:

1. (1)  automatic: it applies immediately the bankruptcy order has been made, and it does not depend on the option of either the debtor or the creditor who is claiming payment;

2. (2)  mandatory: there is no possibility of avoiding it, unless the creditor fails to prove the debt; and

3. (3)  exclusive: all other arrangements must yield unless the creditor is a secured creditor.

16.37  There is no right to contract out of section 35; the only way to do so is for the creditor to decline to prove his debt, thereby rendering it unenforceable until the bankrupt has been discharged.³²

16.38  In the application of section 35, the following factors are relevant:

1. (1)  the underlying debts can be legal or equitable;

2. (2)  the section operates only in respect of transactions between the bankrupt and the other party (although in recent years courts have allowed section 35 to be relied upon by a third party in particular circumstances, generally where a surety can show that as a ‘principal debtor’ he is in fact indemnifying (p. 248) the creditor and that he has a personal obligation to discharge the debtor’s obligations³³);

3. (3)  the debt must be valid; and

4. (4)  the indebtedness of the bankrupt must not be contingent but must be a present, liquidated debt at the time of the order for bankruptcy.³⁴

Where the debt becomes a debt due to the requisite demand having been made prior to the making of the order for bankruptcy, then it will come within the operation of section 35. But if the required demand has not been made prior to the making of that order, then section 35 does not apply. Accordingly a creditor would then need to prove in the bankruptcy as an unsecured creditor. Where the bankrupt has been an unsuccessful defendant in an action, and costs have been awarded against him, those costs are not liquidated until an allocatur³⁵ has been issued by the taxing master. In respect to the interest, on a judgment awarded against the defendant, that interest runs from the date of the judgment (incipitur) and not from the date of the allocatur.

16.39  If a Hong Kong company goes into insolvent liquidation, the Hong Kong courts are able to look at prior activities of the company to determine (among other things) whether it has given an ‘unfair preference’ to any person. A payment or payments (including through the exercise of contractual set-off) to a particular creditor to the exclusion of others could be considered an unfair preference.

16.40  A company gives an ‘unfair preference’ to a person if that person is one of the company’s creditors or a surety or guarantor for any of the company’s debts or other liabilities, and the company does anything or suffers anything to be done which has the effect of putting that person into a position which, in the event of the company going into insolvent liquidation, will be better than the position that person would have been in if that thing had not been done.

16.41  If the court considers that the company was influenced, in deciding to give that unfair preference, by a desire to put that person in a better position, the court may make an order that it thinks fit for restoring the position to what it would have been if the company had not given that unfair preference (and if the unfair preference was given to a person ‘connected’ with the company there would be a rebuttable presumption that it was so influenced).

16.42  The court will only look at an unfair preference which occurred during the six months (or, if the person is a ‘connected person’, two years) prior to the (p. 249) commencement of the winding up of the Hong Kong company, and only if at the time the preference was given the company was unable to pay its debts, or becomes unable to pay its debts in consequence of the unfair preference.

16.43  A person is ‘connected’ with a company if that person is an associate (which includes a spouse, relative, controlling shareholder, affiliated company, etc) of (a) a director or shadow director of the company, or (b) the company.

16.44  It is unlikely, however, that the exercise by a creditor of a contractual right of set-off would be considered an ‘unfair preference’ as, in the absence of collusion between the creditor and the Hong Kong company in effecting the set-off, the exercise by the creditor of its right of set-off would not involve the Hong Kong company being influenced by a desire to put the creditor in a better position.

16.45  However, if the creditor were to attempt to exercise a contractual right of set-off after the commencement of the winding up of the Hong Kong company, the official receiver or liquidator would be able to challenge any amount recovered by the creditor which exceeded such creditor’s entitlement under the application of the statutory set-off.

16.46  If in the course of the winding up of a Hong Kong company it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose, the Hong Kong court may declare that any persons who were knowingly parties to the carrying on of the business in such manner shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the court may direct.

16.47  However, in the absence of collusion between the creditor and the Hong Kong company, it is difficult to consider how a company or its directors could be considered to be involved in fraudulent trading where a creditor effects the settlement of a payment which is due and payable through the exercise of a contractual right of set-off.

16.48  Hong Kong law recognizes four distinct types of set-off, in addition to other rights which may exist in certain circumstances, such as the banker’s right of combination. Two rights of set-off (legal and equitable) arise in the course of a court action in respect of the relevant debt, one arises by contract between the parties, and the fourth arises by law upon the onset of bankruptcy or insolvency. Other than these four cases, there is no right of set-off in Hong Kong law which would permit a person to set off a liability of another against such person’s liability to that other person.

(p. 250) 16.49  Equitable set-off arises pre-bankruptcy as an equitable defence to allow a defendant’s claim if it is closely connected to the plaintiff’s action and it would be manifestly unjust not to allow it. Due to the nature of equitable set-off as a defence in an action before the Hong Kong courts, there would be no cross-jurisdictional issues, with the parties to the action having submitted to the jurisdiction of the Hong Kong courts and the procedural aspects, including defences, arising where matters are determined in such courts.

16.50  Legal set-off arises pre-bankruptcy as a contractual or common law right to reduce the amount of a debt claimed by reference to the amount a plaintiff owes to the debtor where there is a mutuality of liquidated debts. In the absence of an agreed contractual set-off right, legal set-off would arise automatically where there is a dispute before the Hong Kong courts for the repayment of a debt, irrespective of the nationalities of the debtor and creditor or the law governing the liquidated debts, and by bringing the dispute before the Hong Kong courts the parties would have accepted the application of legal set-off.

16.51  Contractual set-off arises pre-bankruptcy as a contractual arrangement between the parties, and can apply even where there are no mutuality of debts and no liquidated sums. The right arises under the terms of the relevant contract, and would be governed by the governing law of such contract.

If a right of set-off under a Hong Kong law contract permitted the inclusion of debts in currencies other than Hong Kong dollars and under contracts governed by laws other than Hong Kong law, the Hong Kong courts would recognise and give effect to such contractual set-off.

Hong Kong law also recognises the right to choose the applicable law of a contract and would give effect to the choice of a law other than Hong Kong law to govern contractual obligations of a Hong Kong person, so long as that choice of law is freely made in good faith by the respective parties to the contract and was not made with the intention or effect of avoiding the laws of the jurisdiction with which any such party has its most substantial connection and there is no reason for avoiding such choice on the grounds of public policy in Hong Kong.

Where there is no express choice-of-law provision, the Hong Kong courts would determine the substantive law of the contract by applying the common law ‘closest and most real connection’ test.

Where a contract is governed by a law other than Hong Kong law, due either to an express choice-of-law provision or to the closest and most real connection being such other law, a contractual set-off provision in such contract would be recognised and given effect by the Hong Kong courts (subject, in any case where Hong Kong bankruptcy or winding-up proceedings have commenced at the time the contractual set-off is effected, to any recovery being consistent with the recovery under the statutory set-off—see below).

(p. 251) 16.52  Statutory set-off arises automatically upon the granting of the bankruptcy or winding-up order to require mutual debits and mutual credits to be set off, and any inconsistent contractual set-off provision shall cease to apply. It would arise only where the Hong Kong court was the appropriate court to hear the winding-up or bankruptcy proceedings, and therefore only where the relevant company is a Hong Kong company or the relevant individual is domiciled in Hong Kong and has been ordinarily resident, or has a place of residence, or has carried on business in Hong Kong at any time in the preceding three years.

Where a party to a contract attempts to exercise a contractual right of set-off (whether under a contract governed by Hong Kong law, or by another law) after the commencement of Hong Kong bankruptcy or winding up proceedings against the other party to such contract, the official receiver, liquidator or bankruptcy trustee would be able to challenge any amount recovered by the party under the contractual set-off which exceeded the amount such party would be entitled to recover under the mandatory statutory set-off.(p. 252)