6.01  The principal source of rights of set-off in the event of a bankruptcy is the Insolvency Act 1986, s. 323,¹ which provides:

1. (1)  This section applies where before the commencement of the bankruptcy there have been mutual credits, mutual debts or other mutual dealings between the bankrupt and any creditor of the bankrupt proving or claiming to prove for a bankruptcy debt.

2. (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.

3. (3)  Sums due from the bankrupt to another party shall not be included in the account taken under subsection (2) if that other party had notice at the time they became due that a bankruptcy petition relating to the bankrupt was pending.

4. (4)  Only the balance (if any) of the account taken under subsection (2) is provable as a bankruptcy debt or, as the case may be, to be paid to the trustee as part of the bankrupt's estate.

In company liquidation, the relevant provision is set out in the Insolvency Rules 1986, r. 4.90,² and in administration r. 2.85.³ Set-off in bankruptcy and company liquidation (and, in England, administration) are referred to collectively in this book as ‘insolvency set-off’.

6.02  The availability of set-off may be crucial in circumstances where a bankrupt and a creditor have had prior mutual dealings giving rise to cross-demands. In the absence of a set-off, the creditor would be obliged to pay the full amount of his or her debt to the trustee in bankruptcy, and would be confined to proving with the other creditors in the bankruptcy for the amount owing on the cross-claim against the bankrupt. If, however, the requirements of the insolvency set-off section (or, as it is sometimes called, the mutual credit provision) are satisfied, only the balance remaining after deducting one claim from the other is payabl (p. 261) Therefore, if the bankrupt's claim against the creditor exceeds the creditor's cross-claim against the bankrupt, the creditor in effect obtains payment in full for the cross-claim in the form of a deduction from his or her liability and is only required to pay the balance to the trustee. Alternatively, if the creditor's claim is the greater,⁴ the creditor receives payment in full to the extent of the creditor's liability to the bankrupt and need only prove for the balance.

6.03  Notwithstanding the reference in s. 323(1) to a ‘creditor of the bankrupt proving or claiming to prove for a bankruptcy debt’, it is not necessary that the creditor should have lodged, or attempted to lodge, a proof in the bankruptcy as a prerequisite to invoking the section. Thus, the set-off may be given effect as a defence to an action brought by a trustee in bankruptcy or a liquidator rather than in the context of a proof in the insolvency.⁵ Indeed, it is now accepted that the insolvency set-off section takes effect automatically upon the occurrence of a bankruptcy or a liquidation,⁶ so that, to the extent of a set-off, nothing would remain that could be proved. In Stein v Blake,⁷ Lord Hoffmann said that the words in sub-s. (1) should be construed to mean a ‘creditor of the bankrupt who (apart from s. 323) would have been entitled to prove for a bankruptcy debt’.⁸

6.04  The mutual credit provision may apply in the event of a bankruptcy or a company liquid-ation, including when an insolvent partnership is wound up in accordance with the Insolvent Partnerships Order 1994.⁹ It also may apply in the winding up of a limited liability partnership incorporated under the Limited Liability Partnerships Act 2000.¹⁰ It is not expressed to apply, however, to an individual voluntary arrangement under Part VIII of the Insolvency Act,¹¹ or to an arrangement under the Deeds of Arrangements Act 1914 unless it has been expressly incorporated into the deed itself.¹²

6.05  Prior to the enactment of the Supreme Court of Judicature Act 1875, the insolvency set-off section in the bankruptcy legislation did not apply to company liquidation. There were instances of set-offs being enforced in liquidations,¹³ but the set-offs in those cases were founded upon the right of set-off conferred by the Statutes of Set-off in the case of mutual debts,¹⁴ as opposed to the bankruptcy section. In a number of respects, however, the courts appear to have departed from orthodoxy in allowing a set-off.¹⁵ The Statutes only operated as a procedural defence to an action at law to obtain payment of a debt.¹⁶ Prima facie they should not have justified a set-off in the context of a proof lodged in a liquidation.¹⁷ Nevertheless, a set-off was allowed in that context.¹⁸ Moreover, the application of the Statutes when the set-off was asserted as a defence to an action brought by the liquidator in a court ordered winding up¹⁹ or a winding up subject to the supervision of the court²⁰ is not free from difficulty. The debt sought to be set off should have been recoverable by action against the company.²¹ But after a winding-up order, or an order directing that a voluntary winding up should continue but subject to the court's supervision, an action could not have been brought against the company without the leave of the court.²²

6.06  The Supreme Court of Judicature Act 1875, s. 10, incorporated the rules of bankruptcy ‘as to debts and liabilities provable’ into the law of company liquidation whenever the assets (p. 263) of the company were insufficient for the payment of its debts and liabilities and the costs of the winding up, and it was confirmed by the House of Lords in 1884 that the incorporation included the set-off section.²³ The relevant provision is now set out in the Insolvency Rules 1986, r. 4.90.²⁴ When it was first made, r. 4.90 was similar in form to the corresponding bankruptcy section (the Insolvency Act 1986, s. 323), albeit with a number of changes which reflected the distinction between bankruptcy and company liquidation. In 2005, however, r. 4.90 was recast in order to address various issues that had arisen in relation to the construction of the rule.²⁵ Rule 4.90 now provides:

1. (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. (2)  The reference in paragraph (1) to mutual credits, mutual debts or other mutual dealings does not include –

   1. (a)  any debt arising out of an obligation incurred at a time when the creditor had notice that –

      1. (i)  a meeting of creditors had been summoned under section 98; or

      2. (ii)  a petition for the winding up of the company was pending;

   2. (b)  any debt arising out of an obligation where –

      1. (i)  the liquidation was immediately preceded by an administration; and

      2. (ii)  at the time the obligation was incurred the creditor had notice that an application for an administration order was pending or a person had given notice of intention to appoint an administrator;

   3. (c)  any debt arising out of an obligation incurred during an administration which immediately preceded the liquidation; or

   4. (d)  any debt which has been acquired by a creditor by assignment or otherwise, pursuant to an agreement between the creditor and any other party where that agreement was entered into –

      1. (i)  after the company went into liquidation;

      2. (ii)  at a time when the creditor had notice that a meeting of creditors had been summoned under section 98;

      3. (iii)  at a time when the creditor had notice that a winding-up petition was pending;

      4. (iv)  where the liquidation was immediately preceded by an administration, at a time when the creditor had notice that an application for an administration order was pending or a person had given notice of intention to appoint an administrator; or

      5. (v)  during an administration which immediately preceded the liquidation.

   5. (3)  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.

3. (p. 264) (4)  A sum shall be regarded as being due to or from the company for the purposes of paragraph (3) whether –

   1. (a)  it is payable at present or in the future;

   2. (b)  the obligation by virtue of which it is payable is certain or contingent; or

   3. (c)  its amount is fixed or liquidated, or is capable of being ascertained by fixed rules or as a matter of opinion.

4. (5)  Rule 4.86 shall also apply for the purposes of this Rule to any obligation to or from the company which, by reason of its being subject to any contingency or for any other reason, does not bear a certain value.

5. (6)  Rules 4.91 to 4.93 shall apply for the purposes of this Rule in relation to any sums due to the company which –

   1. (a)  are payable in a currency other than sterling;

   2. (b)  are of a periodical nature; or

   3. (c)  bear interest.

6. (7)  Rule 11.13 shall apply for the purposes of this Rule to any sum due to or from the company which is payable in the future.

7. (8)  Only the balance (if any) of the account owed to the creditor is provable in the liquidation. Alternatively the balance (if any) owed to the company shall be paid to the liquidator as part of the assets except where all or part of the balance results from a contingent or prospective debt owed by the creditor and in such a case the balance (or that part of it which results from the contingent or prospective debt) shall be paid if and when that debt becomes due and payable.

8. (9)  In this Rule ‘obligation’ means an obligation however arising, whether by virtue of an agreement, rule of law or otherwise.

6.07  In Australia, the company liquidation set-off provision is set out in the Corporations Act 2001 (Cth), s. 553C.

6.08  Formerly, the company liquidation set-off provision was considered to be applicable to any company in liquidation unless and until it was shown that the company's assets were sufficient to pay all the company's debts in full, together with the costs of the winding up.²⁶ This is no longer the position in England. Rule 4.90 can apply in any company liquidation, compulsory or voluntary, irrespective of the solvency or otherwise of the company.²⁷ It should be contrasted with the corresponding Australian provision, the Corporations Act 2001 (Cth), s. 553C,²⁸ which is expressed to apply only to insolvent companies.²⁹

6.09  Set-off in company liquidation provides a defence to an action brought by the liquidator for payment of a sum due to the company.³⁰ Because it is a defence to the action, it is not necessary to obtain leave to proceed against the company³¹ in order to assert the set-off.³² Leave is necessary, however, if the cross-claim against the company exceeds the debt due to the company and it is sought to pursue the balance by way of a counterclaim.³³

6.10  Prior to 2003, the Insolvency Rules conferred no right of set-off in the case of a company subject to an administration order as opposed to a liquidation.³⁴ Rights of set-off in administration were determined instead by reference to the forms of set-off available as between solvent parties.³⁵ The position changed in 2003 when the Insolvency Rules were amended by the substitution of a new Part 2.³⁶ This included a new r. 2.85, which permitted set-offs in circumstances where an administrator, being authorized to make a distribution,³⁷ gave notice to creditors of his intention to do so under r. 2.95. In 2005, r. 2.85 was recast in a form similar to the new r. 4.90 (above).³⁸

6.11  The notice to creditors under r. 2.95 must state whether the distribution is to preferential creditors or preferential creditors and unsecured creditors.³⁹ A set-off under r. 2.85 is only available to a creditor to whom a distribution would be made in accordance with the notice, were it not for a set-off. This follows from r. 2.85(2), which defines ‘mutual dealings’ in terms of 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 administration’. It is also consistent with r. 2.85(8), which provides that the balance of the account owed to the creditor is provable in the administration.

(p. 266) 6.12  In Australia, the insolvency set-off section does not apply when an administrator is appointed to a company under Part 5.3A of the Corporations Act 2001 (Cth).⁴⁰ The position is different in the case of a deed of company arrangement entered into pursuant to Div. 10 of Part 5.3A of the Corporations Act. Section 553C of the Act, which permits set-off in the case of company liquidation, is incorporated by Sch. 8A, cl. 8 of the Corporations Regulations into a deed of company arrangement unless the deed provides otherwise.⁴¹ If cl. 8 of the Schedule is excluded, the deed otherwise may expressly incorporate the set-off provision.⁴² Failure to incorporate set-off into a deed could provide grounds to have it set aside.⁴³

6.13  Under the English Insolvency Rules, if an administrator has not been authorized to make a distribution to creditors⁴⁴ or, being authorized, the administrator has not given notice that he or she proposes to make a distribution pursuant to r. 2.95, the set-off conferred by r. 2.85 does not apply in the administration. Other forms of set-off may be available, however. While a company is in administration, no legal process (including legal proceedings) may be instituted or continued against the company except with the consent of the administrator or the permission of the court.⁴⁵ This statutory moratorium should not (p. 267) prevent a creditor from relying on a substantive defence of equitable set-off,⁴⁶ or preclude a bank from asserting a combination of accounts.⁴⁷ Nor should it prevent a creditor from exercising a contractual right of set-off⁴⁸ before notice is given under r. 2.95.⁴⁹ None of these involve the institution or continuation of a legal process.⁵⁰ On the other hand, the Insolvency Act also prohibits any steps being taken to enforce a security over the company's property.⁵¹ Whether this would extend to the exercise of a contractual right of set-off would depend on whether the agreement takes effect as a charge. This issue is considered later.⁵²

6.14  Different considerations apply to the procedural defence of set-off available under the Statutes of Set-off. It is a requirement of this form of set-off that the debt sought to be (p. 268) set off be enforceable by action,⁵³ and that requirement would not be satisfied in relation to a debt owing by a company the subject of an administration order unless the consent of the administrator or the leave of the court has been obtained. Therefore, if r. 2.85 does not apply, it would appear that the debt would not be able to be employed defensively in a set-off under the Statutes in the absence of consent or leave.⁵⁴

6.15  In the case of a contractual right of set-off, if the administrator of a company in administration gives notice of intention to make a distribution under r. 2.95, so that the set-off regime in r. 2.85 becomes operative, the contractual right of set-off would no longer apply and any set-off rights would be determined instead by r. 2.85. This is because of the ‘British Eagle’ principle,⁵⁵ which is considered later.⁵⁶

6.16  There is special provision for set-off in the case of a bank insolvency⁵⁷ and a bank adminis-tration⁵⁸ under Parts 2 and 3 respectively of the Banking Act 2009. In the case of a bank administration, r. 2.85 of the Insolvency Rules⁵⁹ applies with some minor modifications.⁶⁰ In the case of a bank insolvency, the applicable set-off provision is set out in r. 72 of the Bank Insolvency (England and Wales) Rules 2009.⁶¹ This is similar in terms to r. 4.90 of the Insolvency Rules 1986, which applies generally in company liquidation.⁶² However, they differ in two respects. The first relates to the scope of the qualification to the operation of the set-off rule, to which reference is made later.⁶³ The second concerns the situation in which compensation is payable to an eligible depositor in respect of protected deposits under the Financial Services Compensation Scheme. The effect of r. 73 of the 2009 rules is that, to the extent that the bank's debt to the eligible depositor is covered by compensation, it is to be excluded from any set-off between the bank and the depositor.

6.17  Consider the case of a company voluntary arrangement (‘CVA’) under Part I of the Insolvency Act 1986 pursuant to which various assets (including claims) are held by the supervisor for the benefit of CVA creditors. This creates a trust of the assets in favour of the creditors.⁶⁴

6.18  The insolvency set-off section is not expressed to apply to a CVA. Unless the section is otherwise incorporated into the arrangement, any set-offs (in the absence of a contractual right of set-off) would depend upon the Statutes of Set-off and equitable set-off. If cross-claims were in existence before the trust arose, the CVA creditors as trust beneficiaries may take subject to a prior right of set-off available to the debtor against the company, on the basis that they take subject to equities.⁶⁵ Consider, however, that the claim against the company was incurred after the trust was established. Prima facie there would be a lack of mutuality for the purpose of the Statutes of Set-off,⁶⁶ since the claim against the debtor would be held on trust for the CVA creditors but the debtor's cross-claim would be against the company itself. Nevertheless, if the company has a right of indemnity from the trust assets in respect of the liability,⁶⁷ and a consequent lien over those assets, the lien may suffice to establish mutuality for the purpose of a set-off.⁶⁸ Alternatively, the cross-claims may be sufficiently closely connected to give rise to an equitable set-off.⁶⁹

6.19  Similar principles may apply in the case of an individual voluntary arrangement under Part VIII of the Insolvency Act 1986, where a similar trust may arise.⁷⁰

6.20  The right of set-off in insolvency has received almost universal approbation in English law. Its operation has been steadily enlarged since 1705,⁷¹ and the courts have said that it should be supported and given the widest possible scope.⁷² It is designed to ameliorate a perceived injustice, that a person should have to pay the full amount of his or her liability to a bankrupt and at the same time be confined to receiving a dividend on a cross-claim (p. 270) against the bankrupt.⁷³ But it should also be borne in mind that the effect of a set-off is to prefer one creditor over the general body of creditors,⁷⁴ and that consequently it operates against the policy favouring equal treatment of creditors. That being the case, it is perhaps surprising that the rationale for the existence of the right has not been questioned to any great extent, and that Lord Mansfield's aphorism: ‘Natural equity says, that cross demands should compensate each other, by deducting the less sum from the greater’,⁷⁵ has been accepted almost without reservation. While admittedly it may seem harsh that a creditor of the bankrupt should only receive a dividend for what the bankrupt owes him or her and at the same time be required to pay the full value of what he or she owes to the bankrupt, other creditors are similarly disadvantaged by being confined to a rateable dividend for the debts owing to them. It is debatable whether the justice in favour of setting off cross-demands is always so great that the assets available for distribution amongst the general body of creditors should be depleted in favour of a single creditor with a set-off entitlement, with the consequent reduction in the dividend payable generally. Consider, for example, that A has accepted a bill of exchange drawn in favour of C. A also happens to be a creditor of B. If B becomes bankrupt, the result would be that A would only be entitled to a dividend for the amount owing by B, and at the same time would be liable to pay the full amount of the bill to C. Assume, however, that, unknown to A, C had negoti-ated the bill to B before the bankruptcy. There would then be a situation of mutual credit between A and B which may result in a set-off in favour of A. As far as A is concerned, however, the negotiation of the bill to B was entirely fortuitous, and yet it may have the result of improving his or her overall position by effectively enabling A to obtain the full value of the claim against B to the extent of the set-off rather than merely a dividend. In that circumstance, it hardly seems just that A should be favoured with a set-off at the expense of the other creditors. In Forster v Wilson⁷⁶ Parke B commented that the object of the mutual credit provision is ‘to do substantial justice between the parties’.⁷⁷ But, as Marks J observed in the Victorian Supreme Court, justice must extend also to the unsecured creditors.⁷⁸

6.21  There is an alternative justification for the right of set-off, and that is that it enhances the provision of credit and generally acts as a stimulus to trade and commerce. If an enterprise (p. 271) wishes to raise cash, or does not wish to pay for goods or services immediately, but is otherwise reasonably sound, the possibility of a set-off in an insolvency may encourage other parties to deal with it, or to deal in negotiable securities upon which the enterprise is liable. In other words, the possibility of a set-off may be perceived as a form of security,⁷⁹ and while it is not a security in the strict sense of the word, it may give a degree of confidence to parties dealing with each other.⁸⁰ Nevertheless, in any particular case it could only be said that there may have been reliance on the security offered by a set-off if the party claiming the benefit of the set-off was aware, at the time of transacting the later of the two dealings upon which the set-off is sought to be based, of the possibility of there being cross-demands. Unless this were so, the possibility of a set-off would not have influenced his or her decision to deal with the bankrupt, in which case it is questionable whether indeed there is any justification for preferring that party over the other creditors by means of a set-off. It is difficult, then, to see why a set-off should be allowed in the situation posited above, where the bankrupt's right to sue the creditor came into existence as a result of a transaction with a third party, of which the creditor was unaware, after the creditor had entered into the dealing which gave rise to his or her own claim against the bankrupt. The conferral of a set-off effectively would constitute a windfall in comparison to what the creditor otherwise would have expected to be the overall financial position.

6.22  Counterclaim, when used in contradistinction to set-off, has no application after the occurrence of a bankruptcy or the commencement of a liquidation.⁸¹ A debtor of the bankrupt who has a claim against the bankrupt's estate is remitted to a proof in respect of the claim unless he or she has a right of set-off.

6.23  Similarly, the Insolvency Act 1986 and the Insolvency Rules made pursuant to it provide the sole statutory right of set-off⁸² available as a defence to an action brought by a bankrupt's trustee or the liquidator of a company for payment of a sum owing to the bankrupt or (p. 272) the company.⁸³ The Statutes of Set-off (including where equity would otherwise act by analogy with the Statutes⁸⁴) would not apply in that context. This has not always been the accepted view. In the eighteenth century, defendants in actions at law instituted by assignees in bankruptcy for the recovery of a debt commonly would base their argument for a set-off upon both the Statutes of Set-off and the bankruptcy section.⁸⁵ The Statutes of Set-off were said to apply on the ground that ‘the assignees are the bankrupt’.⁸⁶ According to Professor Christian,⁸⁷ it was only after 1786, when Buller J in Grove v Dubois⁸⁸ con-firmed that the bankruptcy section provided a defence to such an action, that pleaders began to rely solely on the bankruptcy provision. However, that early view as to the relevance of the Statutes would not be followed today. For example, if a person against whom a bankruptcy petition was pending (A) incurred a debt to another person (B) who was already indebted to A, B would not have the benefit of a set-off in the bankruptcy under the Insolvency Act, s. 323 if, at the time that sums became due to him or her, B had notice that the petition was pending.⁸⁹ Nor could that result be avoided by pleading a set-off under the Statutes of Set-off and arguing that A's trustee in bankruptcy took subject to the equity.

6.24  This is not to suggest that that the right to set off mutual debts under the Statutes of Set-off has no application to bankruptcies and company liquidations. When it is said that an assignee of a debt takes subject to rights of set-off available to the debtor against the assignor,⁹⁰ it is meant rights of set-off which could have provided a defence to an action brought against the debtor by a solvent assignor, including pursuant to the Statutes. If the assignor has become bankrupt or is a company in liquidation, the debtor cannot have recourse to the wider right of set-off provided by the insolvency legislation.⁹¹

6.25  It has been suggested that insolvency set-off also displaces equitable set-off.⁹² In Re Daintrey,⁹³ Bigham J commented that the law regulating the adjustment of crossclaims between a bankrupt and his creditor is to be found ‘exclusively’ in the bankruptcy (p. 273) set-off section. Further, the Court of Appeal in Brown v Cork⁹⁴ accepted without demur the proposition that ‘there is, in bankruptcy at any rate, no equity outside the [set-off] section’. Opinions to a similar effect have been expressed in Australia and New Zealand.⁹⁵ More recently, the Court of Appeal, in Re Bank of Credit and Commerce International SA (No. 8),⁹⁶ rejected an argument that an equitable set-off was available in that case in circumstances that were outside the operation of the insolvency set-off section, and concluded that two cases⁹⁷ said to support the existence of an equitable right of set-off in bankruptcy that was wider than the statutory right in fact were not authority for that proposition.⁹⁸ However, the discussion was confined to an examination of the two cases in question, and moreover the conclusion seems correct that the circumstances in issue in BCCI (No. 8) were not such as to support an equitable set-off.⁹⁹ The better view, notwithstanding those opinions, is that equitable set-off may still apply after insolvency.

6.26  As a matter of principle, bankruptcy or liquidation should not preclude the application of the equitable doctrine.¹⁰⁰ The traditional ground for an equitable set-off is impeachment of title.¹⁰¹ If a debtor's title to sue was impeached before bankruptcy, so should the title of the debtor's trustee in bankruptcy, given that the trustee steps into the shoes of the debtor and takes the debtor's property subject to all clogs and fetters affecting it in the hands of the debtor.¹⁰² Similar reasoning should apply in company liquidation.¹⁰³ If a company's title (p. 274) to sue was impeached before liquidation, it should continue to be impeached during liquidation. Normally there would be little scope for equitable set-off in insolvency. If cross-demands would give rise to an equitable set-off, usually they would also come within the terms of the insolvency set-off section, with the consequence that the demands would be automatically set off under the section upon the occurrence of the bankruptcy or the liquidation.¹⁰⁴ But if in a particular case the insolvency set-off section would not apply, an equitable set-off should not be affected by the insolvency.

6.27  Consider, for example, that X entered into a contract with Y after notice that a petition for winding up Y was pending. X incurred a debt to Y under the contract, but Y reached the contract and as a consequence X has a cross-claim in damages against Y. A set-off would not be available to X in a subsequent liquidation of Y pursuant to the Insolvency Rules 1986, r. 4.90, since X had notice of a pending petition when the contract was entered into.¹⁰⁵ But it would be unjust to deny an equitable set-off otherwise available given the closeness of the connection between the cross-claims. Further, notwithstanding recent judicial statements suggesting the contrary, there may be situations in which equitable set-off is available notwithstanding a lack of mutuality.¹⁰⁶ This is in contrast with insolvency set-off, which requires strict mutuality. If in a particular case an equitable set-off is available notwithstanding the absence of mutuality, the right to rely on it should not be lost on the ground that the person against whom it is asserted has become bankrupt or gone into liquidation.¹⁰⁷ If the title to sue was impeached before insolvency, it is difficult to see why the commencement of a formal insolvency administration should affect that position. Certainly the insolvency set-off section itself says nothing about exclusivity.

6.28  Equitable set-off has been allowed in bankruptcy where fraud was involved, notwithstanding an absence of mutuality.¹⁰⁸ Further, in Ex p Hanson,¹⁰⁹ a set-off was permitted in (p. 275) a bankruptcy in circumstances where a surety had been made jointly liable with the principal debtor. Since the joint liability was no more than a form of security for the principal debtor's debt, Lord Eldon said that upon equitable considerations the principal debtor should be allowed to set off the debt in the creditor's bankruptcy against a separate debt owing to him by the creditor, even though the demands were not mutual.¹¹⁰

6.29  It was assumed in Sovereign Life Assurance Co v Dodd,¹¹¹ that equitable set-off could apply in company liquidation. An insured had assigned a policy of insurance back to the insurance company as security for loans made by the company. Subsequently, the company went into liquidation. The company by its liquidator sued to recover the loans, whereupon the defendant sought to set off a claim that he had on the policy. The liquidator argued that, because the insured had assigned the policy back to the company, the insured could not employ the claim on the policy in a set-off in the liquidation.¹¹² However, Bowen LJ in the Court of Appeal accepted that, even if the assignment otherwise would have prevented a set-off, there was in any event a set-off in equity,¹¹³ and Kay LJ also suggested that that was probably the case.¹¹⁴

6.30  Consider also the situation in which A as a result of the expenditure of money in respect of B's land is entitled to an equitable charge or lien on the land, but A happens also to be personally indebted to B. In that circumstance, there is authority for the proposition that B may set off the debt owing to him or her against the sum secured on the land, so that the amount that B must pay in order to take the land free of the charge is the amount secured less the separate debt owing to B.¹¹⁵ In Baillie v Edwards,¹¹⁶ this occurred in circumstances where A was bankrupt, even though there was a lack of mutuality. While A was indebted to B, A's claim was not against B but rather it was against the land. Indeed, Lord Lyndhurst earlier had emphasized lack of mutuality as a reason for disallowing a set-off,¹¹⁷ his Lordship's decision to that effect being the subject of a successful appeal to the House of Lords in this proceeding. Bethell¹¹⁸ in his argument in favour of the set-off in the House of Lords acknowledged that it could not be supported on the strict legal principles of (p. 276) set-off in respect of mutual debts and demands, but instead described it as being in the nature of an equitable set-off.¹¹⁹

6.31  In Australia there is substantial authority supporting the continued application of equitable set-off after bankruptcy or liquidation. In New South Wales, Young J, in Re Trivan Pty Ltd,¹²⁰ considered that the equitable doctrine of set-off is not completely displaced by the insolvency set-off section, and, in Westmex Operations Pty Ltd v Westmex Ltd,¹²¹ the New South Wales Court of Appeal contemplated that there could have been a set-off in the liquidations in that case either on the basis of equitable set-off or pursuant to the insolvency section.¹²² Reference also may be made to Murphy v Zamonex Pty Ltd,¹²³ a decision of Giles J in the New South Wales Supreme Court. In that case one of the parties to a contract had contracted as the trustee of a unit trust. A debt was owing to the trustee under the contract but the debtor had a cross-claim for damages against the trustee for misleading conduct in relation to the contract.¹²⁴ The trustee went into liquidation and a new trustee was appointed.¹²⁵ The new trustee sued to recover the debt for the benefit of the unit holders beneficially interested in the trust property. It was accepted that the new trustee was in no better position than the original trustee, in that it took subject to equities.¹²⁶ Giles J held that the debtor could set off the damages cross-claim. The set-off was not under the insolvency set-off section consequent upon the liquidation of the original trustee, since there was a lack of mutuality. The claim was brought for the benefit of the trust beneficiaries whereas the cross-claim was against the trustee personally. Rather, the set-off was an equitable set-off. The lack of mutuality did not preclude that form of set-off.¹²⁷ A similar situation has arisen in the context of an equitable assignment of a debt, where the assignor had gone into liquidation and the debtor had a closely connected (p. 277) cross-claim against the assignor. The fact of the assignment meant that there was no mutuality for the purpose of a set-off under the insolvency set-off section in the liquidation, but the assignee nevertheless took subject to an equitable set-off available to the debtor against the assignor on the basis of the principle that an assignee takes subject to equities.¹²⁸

6.32  In Murphy v Zamonex, the beneficial owners of the claim (the unit holders) were not insolv-ent. The insolvency set-off section only applies in the administration of an insolvent estate.¹²⁹ It has no application outside of such administration. When a claim is enforced outside the insolvency administration, there is no reason why other forms of set-off should not be available. That point is illustrated also by the decision of the Full Court of the South Australian Supreme Court in Gertig v Davies.¹³⁰ A bankrupt prior to the bankruptcy had obtained judgment in a claim for damages for personal injuries, but had costs awarded against him. The personal injuries claim did not vest in the trustee in bankruptcy,¹³¹ with the consequence that it could not be the subject of a set-off under the bankruptcy set-off section.¹³² Nevertheless, the Full Court accepted that the judgments could be set off under the court's inherent jurisdiction to set off judgments and orders.¹³³ Subsequently, the Full Federal Court in Piccone v Suncorp Metway Insurance Ltd¹³⁴ accepted the principle that the defendant in a personal injuries action brought by a bankrupt can plead a provable debt by way of set-off in accordance with general law principles, as opposed to the bankruptcy set-off section.¹³⁵ In fact, the circumstances of that case would not appear to have supported a set-off,¹³⁶ but the fundamental proposition was not queried.

6.33  The insolvency set-off section has a long ancestry which can be traced back to legislation enacted during the reign of Queen Anne.¹³⁷ But even before then accounts between merchants used to be balanced when one became bankrupt, and indeed the judgment of Flemming CJ in Powel v Stuff and Timewell¹³⁸ suggests that the practice had been adopted as early as 1612. The case involved an application of s. 13 of the statute (1603) 1 Jac, c. 15, which empowered the commissioners appointed in a bankruptcy to assign to a creditor of the bankrupt a debt owing to the bankrupt by a third party. The creditor could then institute proceedings in his or her own name to recover the debt.¹³⁹ The present case concerned such an action. The Chief Justice in the course of his judgment is reported as having commented that, ‘if the plaintiff had been in debt, in as great a sum as the bankrupt was indebted unto him, and yet his debt assigned, this assignment had not been good’.¹⁴⁰

Similarly, in 1689 reference was made in Chapman v Derby¹⁴² to an earlier judgment of Sir Matthew Hale CJ, in which the Chief Justice is said to have commented to the effect that, where there were dealings on account, a man should not be charged with the account on the credit side and be put to come in as a creditor for the debt owing to himself, but should only answer to the bankrupt's estate for the balance of the account.

6.35  There are two competing explanations as to how the right to a balanced account in bankruptcy developed before the enactment of the first mutual credit provision in 1705.¹⁴³ The first is that it may have originated as a principle of equity. This appears to have been the view of Lord Eldon,¹⁴⁴ of Fletcher Moulton LJ,¹⁴⁵ and possibly also of Sir George Turner.¹⁴⁶ Professor Christian,¹⁴⁷ on the other hand, argued that it had a statutory basis. The law of bankruptcy in force during the seventeenth century was set out primarily in an Elizabethan statute, (1570) 13 Eliz, c. 7. The commissioners in bankruptcy were required by s. 2 of the Act to pay ‘to every of the said creditors a portion, rate and rate like, according to the quantity of his or their debts’. Christian suggested that quantity of the creditor's debt was taken to mean any balance due to the creditor.¹⁴⁸ The early cases referred to above support that explanation, and it should be preferred over the view that a right of set-off in bankruptcy was developed in equity.¹⁴⁹

6.36  A significant point is that both North and Hale were common law judges. This by itself is not conclusive, because they may have been enunciating a principle that had been adopted by the commissioners as a result of the influence of the Chancellor. However, there are two arguments which detract from that explanation. The first is the apparent lack of Chancery cases reported from this period in which a right of set-off was enforced in a bankruptcy.¹⁵⁰ It is true that, towards the end of the seventeenth century, equity was beginning to enforce set-offs in actions at law by restraining the plaintiff at law from proceeding with his or (p. 280) her claim unless he or she gave credit for the defendant's cross-demand.¹⁵¹ Those cases, however, were not concerned with bankruptcies, and indeed there is evidence to suggest that equity was encouraged to advance its jurisdiction in this area because of the fact that such a practice already existed in bankruptcy.¹⁵²

6.37  There is a second reason for doubting that the Chancellor may have originated the early practice of balancing accounts. This arises from an examination of the development of the Chancellor's jurisdiction in matters of bankruptcy. In particular, it brings into question the assertion made by Fletcher Moulton LJ in Lister v Hooson,¹⁵³ that ‘the jurisdiction in bankruptcy was from the first an equitable jurisdiction’. What he meant by that statement is unclear. The jurisdiction and power of the commissioners over the person and property of the bankrupt arose by force of an Act of Parliament, and presumably his Lordship meant that the exercise of those powers was controlled and influenced by the Chancellor. In fact, this is not an accurate description of what appears to have happened. Section 2 of the statute 13 Eliz, c. 7 empowered the Lord Chancellor to commission ‘wise and honest discreet persons’ in each case to conduct bankruptcy proceedings. This was the only power conferred on the Chancellor by the statute, and initially it seems to have represented the extent of the Chancellor's involvement in bankruptcy. Cooper explained in 1828¹⁵⁴ that, while the Chancellor would act to prevent unfair dealing or abuse of power by the commissioners he had appointed,¹⁵⁵ he did not exercise an extensive jurisdiction in matters of bankruptcy in the early years of the operation of the legislation. The common law courts from early times had reserved the right to review a finding by the commissioners that a person was bankrupt.¹⁵⁶ Moreover, when the Elizabethan bankruptcy legislation was first enacted, commissioners acting in bankruptcy proceedings often applied to the common law judges, rather than to the Chancellor, for advice as to how they should exercise the extensive powers conferred upon them.¹⁵⁷ It was (p. 281) only in 1676¹⁵⁸ that the Chancellor was prepared for the first time to review a decision made by the commissioners, in that case whether a creditor ought to be admitted to proof.¹⁵⁹ It appears from the report of the decision that Lord Nottingham's initial reaction was not to interfere, but to ‘leave it to the Course the Statute hath provided’.¹⁶⁰ Ultimately, however, he changed his mind and ordered that the creditor's debt should be admitted.¹⁶¹ Thus it was only in the last quarter of the seventeenth century that it can be said that the Chancellor began to exercise any great influence over bankruptcy law,¹⁶² and indeed it was not until Lord Hardwicke's time that the jurisdiction flourished.¹⁶³ The Chancellor does not appear to have been active in matters of bankruptcy when North and Hale mentioned (p. 282) the right to a balanced account,¹⁶⁴ and it is unlikely that the Chancellor was influential in its development.

This section has formed the foundation of the modern right of set-off in bankruptcy, although subsequent amendments have considerably enlarged the scope of its operation. The language of the provision was simplified in 1718,¹⁶⁷ and in 1732¹⁶⁸ the ambit of the right was expressed in terms of mutual credit and mutual debts, rather than simply mutual credit.¹⁶⁹

6.39  It was a feature of the early legislation that there could only be a set-off if the mutual debts or mutual credit existed ‘at any time such person became bankrupt’,¹⁷⁰ by which was meant when an act of bankruptcy was committed.¹⁷¹ In 1806 the legislation was amended so as to (p. 283) offer some protection in the event that the person giving credit to the bankrupt was not aware of the commission of an act of bankruptcy.¹⁷² Subject to two qualifications, s. 3 of the statute (1806) 46 Geo III, c. 135 allowed one debt or demand to be set against another notwithstanding that a prior act of bankruptcy had been committed by the bankrupt before credit was given to or a debt contracted by the bankrupt. The qualifications were that the section only applied when the credit was given to the bankrupt at least two calendar months before the date of the commission,¹⁷³ and the person claiming the set-off must not have had notice of an act of bankruptcy committed by the bankrupt at the time of giving credit or notice that he or she was insolvent or had stopped payment.

6.40  In 1825 the various statutes which until then had set out the law of bankruptcy were repealed and replaced by a consolidating statute 6 Geo IV, c. 16.¹⁷⁴ The new mutual credit provision was set out in s. 50 of the Act, and it contained a number of amendments to the pre-existing law. In particular, there was a further liberalization of the right to a set-off in the event of credit being given to, or a debt contracted by, the bankrupt after the commission of a secret act of bankruptcy. The proviso in (1806) 46 Geo III, c. 135, s. 3, that the credit must have been given at least two calendar months before the date of the commission in bankruptcy, was deleted,¹⁷⁵ while the scope of the second proviso was narrowed so that only notice of a prior act of bankruptcy at the time that credit was given to the bankrupt would operate to prevent a set-off. Notice of the fact that the bankrupt was insolvent or had stopped payment was no longer sufficient. The legislation also provided that every debt or demand made provable by the Act could be the subject of a set-off against the bankrupt's estate. The idea that all provable debts could be the subject of a set-off was not new.¹⁷⁶ However, the insertion of this principle into the 1825 mutual credit provision ensured that contingent debts could be set off, since it was only as a result of s. 56 of (1825) 6 Geo IV, c. 16 that contingent debts became provable.

6.41  The terms of the 1825 set-off section remained essentially unaltered when the law of bankruptcy once again was consolidated in 1849,¹⁷⁷ the only difference being that the creation in 1831 of a separate Court of Bankruptcy with jurisdiction over all matters in bankruptcy¹⁷⁸ meant that the court, rather than the commissioners, was to control the balancing of the accounts.

6.42  When another consolidation took place in 1869,¹⁷⁹ the ambit of the right of set-off was extended from mutual credit and mutual debts to cover also mutual dealings. The proviso relating to notice of an act of bankruptcy was also amended. Whereas it had been (p. 284) a prerequisite to the operation of the previous sections that the person claiming the benefit of the set-off should not have given credit to the bankrupt after notice of an act of bankruptcy, the new section stipulated that the notice had to be of an act of bankruptcy that was available against the bankrupt for adjudication. This referred to s. 6 of the Act, and required that the act of bankruptcy must have occurred within six months of the presentation of the petition.¹⁸⁰ In addition, the legislation no longer specifically provided that every debt or demand which was provable against the estate of the bankrupt could also be the subject of a set-off, although this omission was of little consequence because the courts in any event continued to emphasize that point.¹⁸¹

6.43  The 1869 mutual credit provision was, with one exception, virtually identical to the set-off section in the 1914 legislation. The 1869 Act stipulated that the mutual dealings had to be between a ‘bankrupt and any other person proving or claiming to prove a debt under his bankruptcy’. However, in the Bankruptcy Act 1883, s. 38,¹⁸² which was similar to the Bankruptcy Act 1914, s. 31, the language was altered so that the mutual dealings had to be ‘between a debtor against whom a receiving order shall be made under this Act, and any other person proving or claiming to prove a debt under such receiving order’. The concept of the receiving order was introduced in the 1883 Act¹⁸³ as a step between the presentation of the petition and the adjudication of bankruptcy. It served to stay all actions against the debtor, and to vest the possession and control of the debtor's property in an official receiver,¹⁸⁴ while the creditors considered whether any proposals for a composition or scheme of arrangement should be accepted, or whether it was expedient for the debtor to be adjudged bankrupt.

6.44  The concept of the receiving order was discarded in the Insolvency Act 1986. Reference to it was therefore deleted from the set-off section (s. 323), which is drafted in terms of sanctioning a set-off in the event of ‘mutual dealings between the bankrupt and any creditor of the bankrupt proving or claiming to prove for a bankruptcy debt’. It has been said of the current section that it was recast in a simpler and more modern form than its predecessor, but that it was not intended to alter the substantive scope or effect of the earlier section.¹⁸⁵