Part II Description of Interests, 8 Rights Not Including the Transfer or Retention of Title
Hugh Beale, Michael Bridge, Louise Gullifer, Eva Lomnicka
- Guarantees and security — Cross-claims
8.01 Set-off1 is the process by which a claim is reduced or eliminated upon account being taken of a cross-claim. To take a simple case, if A brings a claim against B for £100, and if B is able to set off against that claim a cross-claim for £50, then the claim is extinguished to the extent of that cross-claim. The claim would be eliminated altogether if the cross-claim were for £100. And if the cross-claim were for, say, £150, then as a matter of pleading the defendant would claim set-off for the first £100 and would counterclaim for the remaining £50.2 B’s ability to set off the cross-claim has the same effect as if that cross-claim were secured.3 Indeed, since set-off can be invoked by way of passive self-help, it is better than security, the enforcement of which may incur cost and take time and energy.
Different forms of set-off
8.02 Set-off comes in a number of different forms arising by operation of law. Some of these forms may be expanded or abbreviated (even eliminated) by a contract between the relevant parties. There are also a number of rules that bear a close (p. 335) resemblance to set-off but that technically are, or may be, distinct. These include the ability of a buyer, receiving defective goods, to deduct a sum representing their diminished value from the purchase price claimed by the seller if he has not already paid the price;4 the adjustment at intervals of a running account between two parties, where for example each supplies the other with goods or services; and the contractual netting processes that take place in financial and other markets where participants, in their bilateral and multiple dealings with each other, at an agreed interval end up owing or being owed one single sum representing their dealings in gross with other members.5 In order to understand how these other rules may be distinct from set-off, it is necessary to examine the principal types of set-off arising by operation of law. These types of set-off include legal (sometimes referred to as common law, independent or statutory) set-off, equitable6 (sometimes referred to as transactional) set-off, and insolvency set-off. To these may be added, because of its association with lending and its functional similarity to the taking of security, the banker’s right to combine accounts. Of these various forms of set-off, it is, with the exception of certain contractual variations of set-off, insolvency set-off that is the most extensive because of its capacity to combine claims and cross-claims of all hues, whether connected or unconnected, liquidated or unliquidated, contingent or vested.
8.03 The common law did not originally accept the combination of a claim and cross-claim in a single action. The defendant, having been sued to judgment on a claim, would launch a separate cross-action against the successful plaintiff. From 1705 onwards, a number of statutes were passed to allow set-off, thus avoiding such wasteful circuity of actions. The statutes were repealed in 1879, subject to the repeal not affecting any ‘jurisdiction or principle or rule of law or equity established or confirmed, or right or privilege acquired’.7 The common law jurisdiction in set-off therefore survived.8
Limitations of legal set-off
8.04 Legal set-off is restricted in its operation. It is confined to cases where both claim and cross-claim are for ‘debts’.9 The scope of debt has been liberally extended to include liquidated claims10 and claims ‘capable of being quantified by (p. 336) reference to ascertainable facts which do not in their nature require estimation or valuation’.11 Moreover, the claim need not always be expressed in terms of a debt or other liquidated claim: it can be for the specific performance of a contract.12 Furthermore, in one important respect, the common law rule goes beyond anything developed in equity. Legal set-off operates even if there is no connection at all between the claim and cross-claim or anything in the way of justice pressing for their joint treatment. It is just a matter of accounting designed to avoid circuity of actions. In the words of Lord Hoffmann: ‘Legal set-off does not affect the substantive rights of the parties against each other … It addresses questions of procedure and cash-flow.’13 It is primarily in this respect that legal set-off is more expansive than equitable set-off, with which it shares a number of other features.14 This feature, in addition, accounts for legal set-off operating as a procedural defence so that judgment can be entered simultaneously on the claim and cross-claim,15 at which point a merger of the two takes place.16
Time of set-off
8.05 Legal set-off must be pleaded and is available only in legal proceedings, taking effect from the date of judgment.17 A cross-claim may not be the subject of a legal set-off if there is a procedural bar to its enforcement, such as might arise if the cross-claim is the subject of a binding arbitration agreement between the parties18 or is time-barred.19 Because of the procedural character of legal set-off, and in contrast with equitable set-off,20 (p. 337) the existence of a cross-claim that may be made the subject of a legal set-off will not prevent the failure to meet the claim from triggering various default provisions, such as an acceleration clause or an events of default clause in a contract giving rise to the claim.21
Due and payable
8.06 For legal set-off, both claim and cross-claim have to be due and payable at the date of the action,22 which excludes debts that are contingent and in the future. According to Lord Hoffmann in Stein v Blake: ‘Legal set-off is confined to debts which at the time when the defence of set-off is filed were due and payable and either liquidated or in sums capable of ascertainment without valuation or estimation.’23
8.07 Contingent and future cross-claims present particular difficulties for legal set-off in assignment cases. The third party assignee takes subject to a cross-claim of the debtor that has fallen due at the time the cross-claimant has notice of the assignment.24 An example of a cross-claim that has not fallen due concerns the purchaser of goods with a contractual right to a ‘rebate’ falling due only when the price has been paid and who is notified of the assignment when receiving the invoice for the goods.25 Again, in Business Computers Ltd v Anglo-African Leasing Ltd,26 the defendant debtor owed the plaintiff assignor a sum of money for computers acquired under a contract of sale. Under a separate contract between the same parties,27 the defendant leased a computer on hire purchase terms to the plaintiff. The sending in of a receiver into the plaintiff company under the terms of a floating charge crystallized that charge, which effected an assignment to the debenture holder of the sums owed under the contract of sale by the defendant.28 By this time, the plaintiff had defaulted on its hire purchase agreement, but the defendant had not yet accelerated future rentals under the hire purchase agreement. The defendant’s attempt to set off rentals accelerated after notice of the assignment against moneys it owed under the contract of sale was refused because those rentals had not accrued due at the relevant time.29 The issue between the parties in this case may further be explained in terms of mutuality.30
Debts due but not payable
8.08 If the debt has fallen due but is not yet payable when notice of assignment is given, the debtor may still exercise his right of set-off against the third-party assignee. In Christie v Taunton, Delmond, Lane & Co,31 a share call became due on 3 November but was not payable under the company resolution making the call until 20 (p. 338) November. The shareholder was also a debenture holder of the company, and assigned his rights under the debenture to a bank, with notice of this assignment being given on 6 November. The company was permitted to set off the call against the claim of the assignee bank.
Correcting the common law
8.09 Prior to the fusion of the courts of common law and equity, equity developed to repair the deficiencies of the common law. The intervention of equity in the area of set-off, akin to its intervention in other areas, took the form of an injunction to restrain the plaintiff from proceeding further in a court of common law, or from enforcing a judgment already obtained there, unless due credit were given for the defendant’s cross-claim. Pre-fusion courts of equity would certainly have followed the law by recognizing legal set-off. But they went further than that in permitting the setting off of connected unliquidated claims and cross-claims in those cases where justice required that they be taken together.
Equitable set-off as a defence
8.10 In contrast with the procedural character of legal set-off, equitable set-off gives rise to a defence that diminishes the cross-claimant’s liability.32 It has been asserted that the defence of equitable set-off is a substantive one in that, unlike legal set-off, ‘the failure to meet the claim cannot be regarded as a default so as to trigger self-help default remedies such as acceleration of payment, termination of an agreement, repossession of goods, the appointment of a receiver, and the like’.33 Lord Denning has firmly said34 that equitable set-off is an ‘equitable defence’ which is ‘on a par with the case of a defendant who says that the plaintiff has repudiated the contract by an anticipatory breach, or that the plaintiff has been guilty of a breach going to the root of the contract’. As a substantive defence, equitable set-off is open to the criticism that, in permitting a cross-claimant to resist contractual performance, it rewrites the contract by creating new contractual conditions, not based on the intention of the parties, that lie outside the recognized categories of conditions. More recently, Buxton LJ has played down the character of equitable set-off as a defence, in referring to it as a ‘sub-species of counterclaim’ and ‘an incident of litigation’,35 but these observations go against the grain of case law treating equitable set-off as a substantive and not merely a procedural defence.36 Equitable set-off (p. 339) has been said to extinguish the claim,37 whether pro tanto or fully, but this statement should be understood in a limited sense. Although equitable set-off may be relied upon outside legal proceedings38 and therefore before judgment, and even before the full extent of the set-off is established, so that any estimate of it at the time it is declared is liable to adjustment at a later date,39 it does not extinguish claims prior to judgment.40 The difference between the date when the defence of equitable set-off arises and the date when its consequences are calculated can be significant, for example, when claim and cross-claim are in different, fluctuating currencies. Where either or both claims are unliquidated, then the equitable set-off calculation will take place as and when the relevant claim (or claims) has been ‘established by agreement or judgment’.41
8.11 As a defence, equitable set-off differs from a counterclaim, though pleading practice treats as a counterclaim that portion of a set-off demand that exceeds the value of the claim. In a case of this sort, the successful claimant will recover the costs of his claim and the successful defendant those of the set-off and counterclaim.42 Where there is a set-off that amounts to less than the value of the successful claim, there will be only one judgment entered, on the diminished amount of the claim, and costs will normally go with the cause.43 The justification usually given for a plaintiff suffering in costs in the face of such a set-off is that he should have known of the existence and the extent of the cross-claim.44 Finally, as a matter of limitations, a set-off and counterclaim, even though amounting to a new claim when made in the course of legal proceedings, are deemed to have commenced at the date of the action on the claim.45 Consequently, they will not be ruled out of time if the claim is launched just before the expiry of the limitation period.
Equitable set-off excluded
8.12 In certain cases, a cross-claim bearing some resemblance to equitable set-off may arise and yet not take effect until pleaded in proceedings. This is the case for cargo claims against a shipowner claiming unpaid freight46 and for cross-claims (p. 340) against someone suing on a bill of exchange or promissory note.47 Consequently, in such cases a cross-claim might, by the time it is asserted in legal proceedings, be time-barred when the claim, where it is subject to a longer period, is not. Had the claim been pro tanto or fully extinguished at the time when the cross-claim arose, the time bar on the cross-claim would not have overridden the prior effect on the claim.48 Although the cross-claim might in such cases be pleaded by way of counterclaim and set-off when the matter comes on for trial, it does not function as a true equitable set-off.49
8.13 Where a claim is brought on a bill of exchange, cheque or promissory note, no unliquidated cross-claim will be admitted by way of set-off even between the immediate parties thereto.50 In Nova (Jersey) Knit Ltd v Kammgarn Spinnerei GmbH,51 the German buyer of machinery under a partnership agreement with the English seller was not permitted by the House of Lords to cross-claim for unliquidated damages for certain breaches of the agreement when the seller brought an action on bills of exchange accepted by the buyer. It is integral to the character of negotiable instruments that they be as good as cash. This principle was extended by the Court of Appeal in Esso Petroleum Co Ltd v Milton52 when it refused to allow equitable set-off where payment for fuel oil supplied to the defendant garage was made by means of a direct debit. The garage had purported to cancel the debit after deliveries had been made but before payment had reached the plaintiff supplier. In the view of the court, a supplier accepting payment by direct debit should be no worse off than one insisting upon a bill of exchange for the purpose of equitable set-off. Payment undertakings in instruments that are treated as the equivalent of cash, such as standby letters of credit, performance bonds and first demand guarantees, are not subject to the cross-claims of a third party applicant, since they are autonomous of the (p. 341) underlying transaction giving rise to the instrument.53 Nor are they subject to cross-claims on the part of the maker of the instrument, except for those liquidated cross-claims54 of the maker arising out of the same transaction or series of transactions.55 The use of negotiable instruments to reduce set-off rights bears some resemblance to the use of contractual clauses excluding set-off rights.56
Requirements of equitable set-off
8.14 The requirements of equitable set-off may first be summarized under three heads.57 First, the claim against which the set-off is to be made must be for a money sum or be based upon a claim for money. Secondly, the cross-claim must, in the eyes of a court of equity, be sufficient to ‘impeach’ the plaintiff’s legal title to the claim,58 which means that cross-claim and claim must be so intimately connected as to make it inequitable for judgment to be enforced against the defendant on the claim, with the defendant then having to launch a separate action against the plaintiff. Thirdly, there must be a sufficient degree of mutuality between claimant and cross-claimant to justify offsetting their respective claims.59
8.15 A money claim exists where the claim is for a debt or a liquidated sum. It also arises where the claim is for an unliquidated amount. In Hanak v Green,60 the plaintiff owner sought damages from the defendant builder for breach of a building contract and the defendant cross-claimed, inter alia, a quantum meruit sum for additional work performed. This was allowed. If it had been the builder suing the owner, the latter would on the facts have been given a set-off. It would have been anomalous to deny set-off just because the party with the debt entitlement was the defendant and not the plaintiff. Hanak v Green has also been described as ‘a sub silentio precedent for the proposition that an unliquidated cross-claim may be set off against an unliquidated primary claim’.61
8.16 Besides direct claims for a money sum, equitable set-off has been allowed where the claim is for specific performance of an agreement founded upon the defendant’s obligation to pay a money sum.62 BICC Plc v Burndy Corpn63 involved an application for specific performance of an agreement to transfer certain patent rights, due (p. 342) to be executed when the defendant failed to pay agreed sums under another contract. Against this claim for specific performance, the defendant sought a set-off of liabilities of the plaintiff arising under a related agreement made when the plaintiff and defendant dissolved their trading relationship. The Court of Appeal,64 by a majority, gave the defendant company its set-off. It saw no reason why the claim for specific performance had to be coupled with a money claim in the alternative for set-off by the defendant to be permissible.
8.17 The classic formulation of the discretion to permit equitable set-off is expressed by Lord Cottenham in Rawson v Samuel:65
Equitable set off exists in cases where the party seeking the benefit of it can shew some equitable ground for being protected against his adversary’s demand. The mere existence of cross demands is not sufficient. [Previous decisions have allowed it where] the equity of the bill impeached the title to the legal demand.
The language of impeachment is nowadays regarded as outmoded.66 It speaks to the practice of issuing an injunction to restrain the prosecution of a legal claim when the courts of equity and common law were divided. Numerous attempts have been made in modern times to restate the equitable discretion.67 According to the most authoritative statement,68 set-off will be allowed between closely connected claim and cross-claim where it would be ‘manifestly unjust to allow [the claimant] to enforce payment without taking into account the cross-claim’.69 Lord Brandon has stressed the connectedness feature of set-off by mentioning the requirement of a cross-claim ‘flowing out of and inseparably connected with the dealings and transactions which also gave rise to the claim’.70 The inseparability of claim and cross-claim71 is what distinguishes equitable set-off from other types of set-off. Equitable set-off is not confined to claims arising in the same transaction;72 the claims may issue out of closely related transactions.73 Once the closeness of the claim and cross-claim (p. 343) is demonstrated sufficiently by their inseparability, it becomes then manifestly unjust to allow recovery on the claim without taking the cross-claim into account.74 It has been stressed that allowing the defence of equitable set-off is not just a matter of discretion but is to be dealt with in a principled way.75 This would suggest that equitable set-off should not lightly be permitted where claim and cross-claim arise out of different transactions. The discretionary character of equitable set-off has been maintained by deprecating any definition of it as though it issued from a statute: while it might be said that there are separate formal (close connection) and substantive (manifest injustice) aspects of equitable set-off, the two aspects cannot practicably be divorced from each other.76 A final point concerning the court’s discretion is that the speculative character of a cross-claim might have a negative effect on the exercise of that discretion.77
Examples of equitable discretion
8.18 The application of the equitable discretion is illustrated in a number of cases. The court in Rawson v Samuel78 provided the following two instances of close factual connection: the coupling of a landlord’s claim for rent with a tenant’s cross-claim for damage caused by the landlord in cutting down some timber,79 and of a solicitor’s claim for unpaid fees with the client’s cross-claim for damage caused by the solicitor’s negligence.80 In Rawson v Samuel81 itself, the defendant failed to obtain an injunction to restrain the plaintiff from taking further common law proceedings. The defendant had consigned goods to its commission agents in India, in whom the plaintiff had an interest, and the plaintiff had agreed to honour certain bills of exchange drawn for the goods consigned to the commission agents. Various breaches of contract by the defendant were alleged by the plaintiff: the invoicing of goods above cost price, instructing the commission agents not to sell the goods at certain times, and failing to renew certain bills of exchange as had been agreed. The plaintiff expected to finance his acceptance of the bills of exchange from the proceeds of sale of the goods in India. When these proceeds failed to materialize, as a result of the instructions given by the defendant to the commission agents, the plaintiff began to dishonour the defendant’s bills. The defendant then sought a set-off against the plaintiff’s demands. Even though the claim and the cross-claim arose out of the same contract, the court refused the defendant the injunction he sought, largely because of the extensive delay that would have resulted from the defendant’s attempts to establish the losses caused by the plaintiff’s dishonour of the bills.
Passing the test
8.19 Although the discretion to permit equitable set-off is a principled one, it involves an unavoidable measure of impressionistic judgement. In Hanak v Green,82 the claim was in respect of defective building work and the cross-claim, inter alia, for extra work done by the builder. Whereas Rawson v Samuel83 shows that set-off might exceptionally be (p. 344) refused where only one contract is involved, Hanak v Green allows it for separate but connected contracts. Equitable set-off was allowed too in Bim Kemi v Blackburn Chemicals Ltd,84 where an English company and a Swedish company entered into two contracts. Under the first contract, the English company granted a licence to the Swedish company to process and onsell in Sweden a chemical supplied by the English company. The second agreement related to distribution rights in respect of a different chemical. The first agreement was designed to give rise to a continuing relationship and the second was concluded within that relationship. There was consequently a close and inseparable connection between the English company’s claim for damages under the first agreement and the cross-claim for damages brought by the Swedish company under the second agreement.85
8.20 Equitable set-off was also allowed in Government of Newfoundland v Newfoundland Railway Co.86 A claim was made against the colonial government for failing to pay a number of subsidies that fell due as sections of a railway line were completed. The cross-claim was for damages for the railway company’s failure to complete the line as required by the same contract. Set-off was also allowed in Bankes v Jarvis,87 where a claim for the balance of the price due on the sale of a veterinary surgeon’s practice was extinguished by a cross-claim for damages for the plaintiff’s failure to pay rent to the landlord and for breaches by him of his covenant to repair.
8.21 The discretionary character of equitable set-off results in cases that are hard to distinguish though they reach different results. In The Aditya Vaibhav,88 the owners of a ship chartered on Shelltime 3 terms failed to clean its hold, with the result that the ship was delayed for fourteen days at Jeddah. The charterers sought to deduct their losses from hire due, not just in the period the ship was off hire, but also in a period when the ship was back on hire. The court held that the necessary close connection with the charterers’ cross-claim existed only for the hire falling due while the ship was off hire. Summary judgment was therefore allowed for further hire claimed by the owner. On the other hand, in Dole Dried Fruit & Nut Co v Trustin Kerwood,89 the plaintiffs, producers of prunes in California, engaged the defendants as their exclusive English distributors. In summary judgment proceedings under RSC Order 14,90 they claimed the price of goods supplied and the defendants sought to set off against this a cross-claim for unliquidated damages for unlawful repudiation of the distributorship agreement. Summary judgment on the claim was denied because of the defendants’ arguable defence. The close connection between claim and cross-claim was such that ‘manifest injustice’ would be caused if they were not taken together. It would also have been difficult for the defendants to launch separate proceedings against the foreign plaintiff.
Mutuality between claimant and cross-claimant
8.22 For both legal and equitable set-off, the claim and cross-claim must be due from the same parties in the same right.91 In Muscat v Smith,92 the purchaser of a reversion was therefore able to sue the tenant for unpaid current rent without suffering a set-off in respect of the tenant’s claim against the previous landlord for a breach of the landlord’s covenant to repair.93 But, so far as the purchaser’s claim was for past rent unpaid to the previous landlord, the right to which had been assigned by statute94 to the purchaser, the purchaser as assignee of the unpaid rent took subject to equities and thus to the tenant’s set-off. In Middleton v Pollock, ex p Nugee,95 Nugee was personally indebted to the claimant for certain sums secured by a mortgage. The claimant represented a deceased insolvent, who had advanced the mortgage sums to Nugee. The deceased insolvent, for his part, was personally liable to trustees of a residuary estate to account for certain rents received from properties that fell within that residue. Nugee was one of the trustees of that residuary estate. Nugee petitioned to set off the outstanding rents against the mortgage debt, but the court refused to allow set-off. Nugee owed money as mortgagor in his personal capacity and was owed money, not in his personal capacity, but in his capacity as trustee of the residuary estate.
8.23 The intervention of a trustee does not destroy mutuality where the trustee is acting for another in asserting that person’s claim or cross-claim, for this is tantamount to direct action by that person himself. In Bankes v Jarvis,96 an action was brought by the plaintiff, acting as trustee for her son, to recover an instalment outstanding from the sale to the defendant of a veterinary surgeon’s practice. The defendant, however, had a personal cross-claim against the son. Equitable set-off was allowed since the court was ‘unable to understand how a person, by creating a trustee to sue for him, can be entitled to any greater rights than he would be if he sued in his own name’. The trustee had no personal claim or liability. Both claim and cross-claim were personal; neither was a representative one.
Floating charges and crystallization
8.24 The issue of mutuality can cause problems in the case of assignment, a particular case of which arises where the claimant or cross-claimant has granted a floating charge to a third party. In Rother Ironworks Ltd v Canterbury Precision Engineering Ltd,97 the plaintiff company owed £124 to the defendant company. The plaintiff then contracted to supply goods for £159 to the defendant. A floating charge, granted (p. 346) by the plaintiff to a third party debenture holder, next crystallized. The goods were then delivered by the plaintiff and the defendant tendered a balance of £35 to the receiver and manager sent in by the debenture holder to manage the plaintiff company, claiming a set-off for the £124 owed by the plaintiff. The receiver and manager now sued for the £124 in the name of the plaintiff, and in substance contended that the £159 for goods supplied was owed, not to the plaintiff as such, but to the debenture holder, and that the £124 owed by the plaintiff was of no concern to the debenture holder. The court disagreed. The crystallization of the floating charge assigned the plaintiff’s assets, including its rights under the sale contract, to the debenture holder, who could be no better off than the assignor plaintiff. Further, although the goods were actually delivered when the plaintiff company was in receivership, it was the company itself that delivered them and not the debenture holder, since the receiver and manager acts as the agent of the company98 and not of the debenture holder.
Assigned claims and set-off
8.25 A creditor taking security over tangible assets may assert its security rights against third parties who purchase those assets from the debtor or who take a competing security over those same assets. In the case of an outright purchase, the rights of the third party will depend upon whether the security is legal or equitable.99 Where there is a second security interest, then similar principles will determine the priority contest between the two secured creditors.100 The similarity of set-off to security has already been noted.101 In like fashion, the cross-claimant, who has a functional security for that cross-claim measured against the other party’s claim, may exercise set-off rights against assignees of the claim. The relation between a cross-claimant and an assignee is a particular case of the mutuality that must exist between claimant and cross-claimant for set-off to be exercised.102 Whether the defence takes the form of equitable or legal set-off,103 it constitutes an equity for the purpose of section 136 of the Law of Property Act 1925, which states that the assignee takes ‘subject to equities having priority over the right of the assignee’.104 Although the relations of cross-claimant and assignee are mutual for the purpose of set-off, the assignee may not stultify the cross-claimant’s rights by earlier instructing the assignor not to submit to set-off in its business dealings.105 The assignee’s position dervives from that of the assignor.
Reasons for allowing set-off
8.26 Where the action is brought by the assignee, and the obligor wishes to set off the assignor’s liability to him,106 the justice of allowing set-off has been put by the Privy Council in these terms:107
It would be a lamentable thing if it was found to be the law that a party to a contract may assign a portion of it, perhaps a beneficial portion, so that the assignee should take the benefit, wholly discharged of any counter-claim by the other party in respect of the rest of the contract, which may be burdensome.
This is illustrated by Young v Kitchin,108 where the obligor pleaded, by way of set-off and counterclaim, that, as against the assignee of sums due under a building contract, he had the right to deduct his entitlement to damages for breach of that contract by the assignor builder. He was held entitled to exercise his right of set-off but not to counterclaim against the assignee for the excess over the claim. Since building enterprises are often financially precarious, this makes a particularly strong case for allowing the owner to set off, against an assignee from the builder, a cross-claim that could have been maintained against the builder.
8.27 Equitable set-off may be exercised against a claim even if notice of the assignment of the claim109 is given before the relevant cross-claim comes into existence.110 An assignment might be made of a future claim under a contract before that contract is performed by the obligee to the detriment of the obligor. If the obligor were not allowed a set-off in this case, the mischief referred to by the Privy Council111 would come to pass. The obligor may not, however, exercise equitable set-off against the assignee where ‘wholly new obligations’112 are assumed by the assignor to the obligor, after the latter acquires notice of the assignment. For common law set-off, notice of the assignment breaks mutuality in the case of new obligations. In NW Robbie & Co v Witney Warehouse Co,113 a debenture secured all moneys due to a bank by an Irish company. At a subsequent date, the floating charge crystallized with the appointment of a receiver and manager. The effect of this crystallization was to assign to the bank certain liabilities owed to the Irish company by another company. Later, after the obligor had notice of the receiver’s appointment, and hence of the crystallization of the floating charge, an associate company of the obligor assigned to it certain debts owed to the associate company by the Irish company. Faced with a claim by the assignee bank, the obligor now sought to set off the debts of the assignor Irish company that had just been assigned to it by the obligor’s associate. This was refused: the new rights of the obligor arose after it acquired notice of the assignment to the bank. There was thus no mutuality between the obligor and the assignee in respect of these later debts.
Cross-claim against assignee
(p. 348) 8.28 This same requirement of mutuality in assignment arose in a different way in Bennett v White,114 which concerned an assignee, already personally liable to the obligor, who sought to set off an assigned debt against that liability. Applying the antecedent provision115 to section 136 of the Law of Property Act 1925, the Court of Appeal held that legal set-off could be invoked to protect the assignee in such a case as well as the obligor, in the more usual run of case. It was as though the assignee had at all times been the creditor of the obligor. Set-off was therefore allowed. In such a case, the position of the account debtor is simplified in that he only has to deal with one person in respect of both claim and cross-claim, namely the assignee.
8.29 Abatement is a common law doctrine and as such contains no discretionary element. It has a statutory base in the law of sale of goods116 but applies also to labour and materials and building contracts.117 In the development of the common law doctrine of discharge for breach of contract, the law moved from the notion that promises were essentially independent118 to the position that the interdependency of obligations in some cases meant that a promise could not be sued upon without prior compliance with a condition.119 This development seems to have fed the notion that in some cases claims and cross-claims should not be the subject of separate proceedings but should be integrated so that the one diminished the other.120 It should be emphasized that abatement is not and never was legal set-off and is more than a procedural defence that comes into play in litigation. A plea of abatement strikes at the root of a claim and amounts to a substantive law defence.121 In the case of sale of goods, for example, it permits a buyer, as an alternative to a claim for damages, to exercise self-help by withholding a part of the purchase price to the extent that the seller has failed to comply with its quality obligations.122 Abatement does not go so far as to allow the buyer to make a deduction from the purchase price in respect of incidental or consequential damages caused by the seller’s breach.123 To that extent, it does not go as far as equitable set-off and, moreover, does not seem to provide any advantages not otherwise available in equitable set-off.124
8.30 As a matter of banking custom,125 the bank has a right to combine the accounts of a customer,126 whether those accounts are held in the same or in different branches of the bank.127 This right may be exercised by the bank without giving the customer notice.128 The idea behind the banker’s right is a simple one. A customer maintains two accounts with the Loamshire Bank, for example, a deposit account and a current account. The deposit account is in credit in the amount of £5,000 but the customer has run up an overdraft of £7,500 in the current account. When the bank is entitled to combine accounts, the result is one single account showing a debit of £2,500. The deposit of £5,000, so long as it remains in the deposit account, there serves as partial security for the overdraft advance of £7,500. The treatment of the relationship of a customer and a bank as consisting of one account is consistent with the treatment of their relationship as one of debtor and creditor,129 the identity of each party as debtor or creditor depending upon whether the account is in credit or debit at a given time.
One or more accounts
8.31 It is not fully settled even today whether there is between the bank and the customer from the beginning just one single account or whether the bank by deciding to combine accounts and taking the necessary steps is then exercising a type of set-off.130 The former view is inconsistent with the language and expectations of the parties131 and indeed with the very description of the bank’s right. In addition, if a deposit and a current account are accounts with different characteristics, then it is not easy to see how they can be treated only as one account. Furthermore, a customer drawing cheques on the current account when it is in credit or below an overdraft limit, in those cases where the overall balance is negative, is liable to have those cheques dishonoured132 if the single (p. 350) account view is correct,133 unless an implied term in the contract supports a duty on the bank to honour cheques drawn on the account in credit before it gives notice of combination. Finally, if the bank can refuse to honour a cheque when the account on which it is drawn is in debit, when the overall accounting position is sufficiently in credit for the cheque to be paid,134 this is inconsistent with the single account view. To say that there is a single account but that the bank’s mandate to honour cheques is a limited one is artificial. The clearly preferable view therefore is that the two accounts are separate until the bank takes steps to combine them.
Modifying the right to combine accounts
8.32 The bank’s right to combine accounts can be excluded expressly or impliedly by the parties. An implied agreement exists in the case of a loan account and current account, since the purpose behind advancing the loan is liable to be stultified if the bank is at liberty to combine the two accounts.135 In National Westminster Bank Ltd v Halesowen Presswork and Assemblies Ltd,136 a financially troubled company’s overdrawn number 1 account was frozen by the bank. The bank and customer then opened a number 2 account ‘to be maintained strictly on a credit basis’. It was held to be the implied intention of the parties that the separation of the two accounts should last only as long as the company could be kept alive as a going concern for the more effective realization of its assets.137 The agreement therefore came to an end with the end of the company’s active life and did not continue to be effective at or after the commencement of winding-up.138 The view was, however, expressed that the bank was under a duty to notify the customer that the arrangement for the separation of the two accounts had come to an end. Notice was necessary so that the company could draw no more cheques on the number 2 account that the bank would then have to honour; the bank was bound to honour cheques already drawn.139
8.33 The effect of the agreement in National Westminster Bank was to remove the mutuality between the two accounts needed for exercising the right to combine them.140 Mutuality issues arise in other respects too. One question concerns whether accounts may be combined if they are in different currencies. The better view is that they can,141 since the foreign currency is not to be treated as though it were a commodity and English courts (p. 351) now give judgments expressed in foreign currencies. Another question concerns the identity of the customer. A customer’s personal account may not be combined with another account that he holds as trustee or nominee for another,142 though the bank is entitled to set off its indebtedness in the trustee or nominee account against an amount owed it by the person on whose behalf that trust or nominee account is maintained.143 So far as the bank is unaware of the trust behind an account, it may combine that account with another, personal account of its customer.144 This might seem harsh to the real account holder but there is a compelling case for that person and not the bank to bear the risk of secrecy.
8.34 The question is whether a bank may combine accounts when it has notice of an injunction freezing the account in which the customer holds a balance in his favour. In Oceanica Castelana Armadora SA of Panama v Mineralimportexport,145 a Romanian bank was indebted on various term loan agreements to a British bank, with which it had indirectly deposited a sum of money for the provision of certain guarantees that in the event did not have to be given. The bank sought guidance on whether it could rely on its set-off rights in respect of interest on these loan agreements, entered into prior to a freezing injunction issuing against the account holder. The court saw no reason why, if a defendant subject to a freezing injunction were given, as in the normal case, freedom to pay its debts as they fell due, an exception should be made if one of those creditors was a bank. Freezing injunctions were never intended to interfere with the rights of third parties, such as the bank in this case. The bank was therefore entitled to a variation of the freezing injunction so that it could exercise its set-off rights. To avoid the need for a bank in this position having to make an application to the court after an injunction had already been granted on the usual ex parte terms, the court in the present case recommended that a proviso protecting the set-off rights of banks be inserted in future orders served on banks.146
8.35 The law relating to joint accounts displays a lack of clarity and guidance. In Ex p Morier,147 Brett LJ equated combination with equitable set-off and supported a set-off in the case of a joint account of brother and sister only if ‘the brother was so much the person solely beneficially interested that a Court of Equity, without any further terms or inquiry, would have obliged the sister to transfer the account into her brother’s name alone’.148 So far as the bank would have to form a view on the (p. 352) contribution to a joint account of the person against whom it seeks a combination of accounts (or a set-off),149 this approach lacks the certainty that the bank would need. An exploration of the history of payments in is not a practical matter. The better approach, it is submitted, is that if drawings on the account may be made by either of the joint account holders on a single signature, so as to be able to exhaust the account, then the bank’s indebtedness on that account should be capable of being offset against a claim it has against just one of the account holders.150 Whether this is treated as a combination of accounts or as a set-off may not in the result be significant. In the case of joint accounts, particular care might be needed to determine whether the joint account is maintained for a particular purpose, such as the business of a partnership, so that for this reason alone the account ought not to be combined with the personal account of one of the joint account holders.151
8.36 Suppose that a company, for example, goes into insolvent liquidation, having a claim against a person (the cross-claimant) who also happens to be one of its creditors. The availability of insolvency set-off to the cross-claimant is a powerful resort since it combines the most advantageous features of legal and equitable set-off. The claim and cross-claim need not be liquidated, nor need they be connected.152 In addition, set-off is available to a cross-claimant even if the cross-claim is a contingent one and the contingency is not resolved before the liquidator has to put a value on it.153 The close kinship between a secured creditor and a cross-claimant with set-off rights is at its strongest in the case of insolvency set-off.154 It has been said that the purpose of insolvency set-off is ‘to do substantial justice between the parties’,155 yet it is not self-evident that a cross-claimant who has not bargained for security should be treated as if he had. In some cases at least, it will be a matter of coincidence that a claim is subject to a set-off at the time of commencement of insolvency proceedings. Since set-off is mandatory and automatic,156 at the (p. 353) relevant date157 the claim and cross-claim cease to exist, leaving only a claim to a net balance.158 As from that date, therefore, neither the original claim nor the cross-claim may be assigned.159 There is consequently a need for clarity in determining the net balance, which requires there to be ‘a single and final ascertainment process’.160
8.37 Legislative intervention in the area of bankruptcy set-off goes back to a temporary statute passed in the reign of Queen Anne. For a long time the relevant provision was section 31 of the Bankruptcy Act 1914,161 but this has now been superseded by section 323 of the Insolvency Act 1986.162 The wording has changed at various points in the history of the bankruptcy set-off provision, which calls for some caution when approaching earlier authorities. Set-off in bankruptcy cases remains subject to primary legislation, whereas for companies in administration and in a winding-up it is subject to more easily modified secondaray legislation, which, as will be seen, has given rise to some differences in the law as it applies to individuals and to companies.
8.38 While set-off was to be found only in bankruptcy legislation, it had no evident role to play in the case of companies prior to the Judicature Act 1873, which extended the bankruptcy set-off section to company liquidations.163 In adapting this provision to company liquidations, the courts had to find analogies in the case of companies for the receiving orders and acts of bankruptcy of bankruptcy law. This adaptation has not been needed from the time that particular provision has been made for company liquidations in the Insolvency Rules, made under the Insolvency Act 1986. The current rule, Rule 14.25, has in recent years been modified in a number of significant respects.164
This Rule applies in a winding up where, before a company goes into liquidation, there have been mutual dealings between the company and a creditor of the company proving or claiming to prove for a debt in the liquidation.165
The provision is phrased in terms of the creditor proving or claiming to prove in the settling of the company’s estate. Where the larger claim is pressed by the company in liquidation, so that the creditor raises set-off rights in a defensive way, the matter does not obviously fall within the provision. However, since rule 14.25(3) contemplates cases where the balance of the account is for or against the company in liquidation, it will not matter which of the parties is making the claim and which is seeking to exercise a right of set-off.166
Mutuality of claim and cross-claim
8.40 The phrase used to define the scope of all claims and cross-claims that might be set off against each other—‘mutual dealings’ (formerly ‘mutual credits, mutual debts or other mutual dealings’)167—is a very broad phrase, though not an unlimited one. First of all, there must be mutuality between the parties to the set-off.168 If A, in a winding-up, makes a claim against B, it would offend the principle of pari passu distribution to permit B to set off a claim that C has against A.169 Mutuality suggests a degree of connection, yet it is well established that the claim and cross-claim may be completely collateral to each other.170 Subject to one point, mutuality has come to mean commensurability, which refers to the requirement that claim and cross-claim, if not already monetary in form, be capable of being reduced to monetary form in order to settle the estate of the insolvent.171 In the words of Lord Hoffmann, ‘mutual debts’ requires only ‘commensurable cross-obligations between the same people in the same capacity’.172 A straightforward case is that of debts arising out of the same contract. It has also been long settled that a debt claim and a cross-claim for unliquidated damages for breach of contract may be applied against each other. Thus, in Mersey Steel and Iron Co v Naylor Benzon & Co,173 the buyer of goods, obliged to pay for deliveries previously made, was allowed to set off damages for non-delivery in the winding-up of the seller company. Problems have arisen in the past, (p. 355) however, in relation to the source of the cross-claim and in particular to the location of a cross-claim in tort law, though the modern view is to define mutuality according to the statutory definition of a provable debt.174
Mutuality and tort claims
8.41 Apart from there being mutuality, there must be dealings between the parties. A number of older authorities, including Re Mid-Kent Fruit Factory,175 stood for the view that claim and cross-claim must arise in contract for the necessary mutual dealings to exist. This stemmed from the proposition that the bankruptcy set-off section was confined in its operation to claims between traders. Where a claim for damages sounding in tort resembled a contract claim, however, a set-off was allowed. In Tilley v Bowman,176 for example, a contract for the sale of jewellery was rescinded because of the buyer’s fraud, leaving the buyer with a debt claim for the recovery of a pre-paid portion of the price. The seller sought to set off against this claim, brought by the buyer’s trustee-in-bankruptcy, a claim for damages caused by the buyer’s fraudulent misrepresentation. Though the seller’s cross-claim was in the tort of deceit, set-off was allowed because ‘the claim of the trustee being in the nature of a claim under the contract, the misrepresentation which led to the contract was a mutual dealing’.177 The nature of a dealing was further considered in Smith v Bridgend CBC,178 where a local authority had enforced a charge over a contractor’s equipment. The charge, however, had not been registered under the Companies Act, so that the authority’s action amounted to the tort of conversion. The authority’s action could not be considered a dealing in order for its liability to be set off against sums owed to it by the insolvent contractor. Similarly, a director guilty of misappropriating company funds was prevented in Manson v Smith179 from setting off, against his liability to the company, a sum owed by the company to him. Although the commission of a tort does not preclude the existence of a ‘dealing’, there must therefore be some degree of consensual activity between the two parties for there to exist a dealing between them.
Set-off and provable claims
8.42 In Re DH Curtis (Builders) Ltd,180 Brightman J rejected the view that the set-off provision was confined to dealings between traders. He defined the scope of set-off in terms of the link between adjoining sections of the Bankruptcy Act 1914, section 30 (provable claims) and section 31 (set-off), then in force. Section 30 excluded proofs for unliquidated damages except those arising ‘by reason of a contract, promise or breach of trust’, a phrase that was not confined to contract181 but that did not include tort. By clear implication, Brightman J therefore excluded unliquidated tort claims from set-off, at least so far as they could not also be described as contractual claims. This stance must (p. 356) now be considered in the light of post-1986 legislation defining provable bankruptcy debts so as to include tort claims, as well as claims in bailment and restitution.182 Provable cross-claims should be treated as the subject of a set-off in insolvency proceedings, subject to the mutual dealings requirement.
Provable claims and contributories
8.43 The issue of whether a claim is provable and the effect of this on set-off is not confined to claims against the company. It arises also for claims made by the company. The Supreme Court has firmly accepted the principle that claims, to be the subject of a set-off in administration—and the same must also apply to a winding-up—need not be provable, whether the claim is by or against the company.183 The matter came up for consideration in Re Lehman Brothers International (Europe) (No 4), where administrators sought to set off, against subordinated creditors’ claims against the company in administration, the liability of those creditors in respect of future calls on them as contributors of the company. Set-off was in the event refused, though not for the reason that the company’s claim was not a provable one and so could not bring the insolvency set-off rule into play. Starting with liquidation, the Insolvency Act makes provision for calls in a winding-up.184 Furthermore, contributories the subject of calls have to make their contributions to the company fund before being permitted to make a claim against that fund.185 This is a judge-made rule which the Supreme Court in Re Lehman Brothers International (Europe) (No 4) decided should be extended to administrations, despite the fact that it had not previously applied in such cases and, moreover, although there was no statutory procedure available to an administrator to make calls on contributories. The position of contributories bound to contribute to the fund could be protected by the administrator retaining moneys in hand, pending either the demonstrated absence of any need for contributions to be made or the giving of security for any potential liability to make contributions.
Commensurability and proprietary security
8.44 Suppose that there are two claims, one secured and the other unsecured, but they are otherwise commensurable in that each is capable of being reduced to a monetary form. Security for present purposes may be understood as including title retention and trust. A distinction must now be drawn between cases where the security is possessed by the insolvent claimant and where it is possessed by the solvent cross-claimant. In the former case, the fact that the claim is secured does not affect the existence of set-off rights if otherwise the requisite mutuality exists, since debt can coexist with security.186 In Re ILG Travel Ltd,187 a holiday company in insolvent liquidation (p. 357) owed commission moneys to a number of travel agents who, in turn, held ‘pipeline moneys’ received from customers on the terms of a trust for the holiday company. This trust was held to give rise to a charge over the pipeline moneys. The court’s conclusion, first, was that insolvency set-off did not arise because the parties operated a running account settled at monthly intervals, producing a net balance. Consequently, there were no outstanding claims and cross-claims to set against each other when the holiday company went into insolvent liquidation.188 Nevertheless, if this had not been the case, the existence of a trust in favour of the holiday company did not repel the existence of mutuality between claim and cross-claim for the purpose of what is now rule 14.25 of the Insolvency Rules.189 Suppose, however, that the security is in favour of the non-insolvent party. A secured creditor is entitled to look to his security rather than prove in a bankruptcy or winding-up.190 On this basis, it was held in one case that set-off does not arise since the set-off rule only comes into play in the case of ‘any creditor of the company proving or claiming to prove for a debt in the liquidation’.191 If this is correct, the cross-claimant would enforce its security and the liquidator of the claimant would have to pursue the cross-claimant for the amount owed by the latter. As a practical matter, this laborious outcome should not greatly differ from an application of rule 14.25 except in those cases where the cross-claimant is also insolvent. Otherwise, there appears little to be gained from treating a case of this nature as falling outside the mandatory insolvency set-off rule.192 The above case, nevertheless, is not free from doubt. In Re Bank of Credit and Commerce International SA (No 8)193 Lord Hoffmann, citing the decision of the Court of Appeal in Mersey Steel and Iron Co v Naylor Benzon & Co,194 said in respect of what was then rule 4.90: ‘It has long been held that this does not mean that the creditor must actually have lodged a proof … but the debt must be one which would have been provable if he had.’195 These words are capable of having a limited application to cases such as the creditor with the lesser unsecured cross-claim who does not submit a proof but waits instead defensively for the insolvent (p. 358) company to make a claim before pleading set-off. Nevertheless, the mandatory character of insolvency set-off,196 coupled with the oddly discrepant difference between the two cases of secured insolvent claimant and secured cross-claimant stated above, make a strong case for applying Lord Hoffmann’s words, and thus rule 14.25, to the case of the secured cross-claimant.197 The same judge has also expressed the view198 that mutuality of dealings exists notwithstanding the presence of security between an insolvent party with security and a non-insolvent party.199 In the Court of Appeal in the same case, Dillon LJ said: ‘If there are indeed mutual credits or mutual debts or mutual dealings between a company, or a bankrupt, and a creditor, then the set-off applies notwithstanding that one or other of the debts or credits may be secured.’200 Nevertheless, the view that a non-insolvent party should be able to enforce security rights before the taking of the insolvency account, which may not happen for some time, has been firmly expressed.201 Otherwise, there might be a risk of liability in the tort of conversion arising out of the enforcement action.
Commensurability and special purposes
8.45 As stated above, claim and cross-claim have to be commensurable in order to achieve the state of mutuality demanded for insolvency set-off. Even if claim and cross-claim are both monetary in form, they will not be commensurable if one of them is for the return of money paid for a special purpose that cannot now be fulfilled.202 In Re Pollitt,203 a solicitor, owed money by his client, required payment of £15 to meet future costs before doing any further work. The £15 sum was paid and the solicitor then called a meeting of the client’s creditors and prepared a deed of assignment in bankruptcy. This act of bankruptcy took away the solicitor’s authority to do further work for the client, so the money in hand had to be paid back. It could neither be retained for unauthorized services performed after the act of bankruptcy nor, given the purpose for which it was paid, be deducted by way of set-off from the amount owed by the bankrupt before he paid the £15 to the solicitor.204
8.46 In Re City Equitable Fire Insurance Co Ltd (No 2),205 a portion of the share of the premiums to be paid by an insurer to a reinsurer was to be retained by the insurer against due performance of the reinsurer’s obligations. The reinsurer presented a winding-up petition and the treaty of reinsurance was determined, leaving a balance in favour of the reinsurer after all the rights and liabilities of the parties had been settled. The insurer then sought to set off this balance against moneys owed it by the reinsurer under other treaties and policies of insurance and reinsurance. Set-off was refused because of the absence of (p. 359) commensurability: ‘[T]he effect of handing over money for a specific purpose appears … to be that it is taken out of the course of accounts between the parties to be held, so to speak, in suspense between them.’206
Commensurability and claims for goods
8.47 The problem of commensurability has also presented itself where goods are handed over for a particular purpose, so that the trustee is seeking their return while the party in possession claims a set-off. In Rolls Razor Ltd v Cox,207 a salesman’s contract was terminated by his employer some time before it passed a resolution for a voluntary winding-up. The company owed the salesman a sum of money representing commission already earned and the contents of a retention fund, held by the company as security against the salesman’s defaults. The salesman had in his possession goods for sale purposes and goods for demonstration purposes. The Court of Appeal held that, whereas the value of goods held for sale could be the subject of a set-off, the goods held for demonstration purposes could not. For the purpose of commensurability, mutual credits had to terminate in debts,208 which was not the case for demonstration goods in the absence of a direction to sell giving rise to cash proceeds.209
Contingent and future claims: introduction
8.48 An area that has given rise to a number of difficulties is that of contingent, and to a lesser extent future, claims and cross-claims. The order of treatment in the following paragraphs begins with defining the relevant date for the purpose of taking the account, for this date determines whether a claim or cross-claim is a contingent or future one. The treatment of future claims will next be considered. After that, contingent cross-claims against the insolvent company or bankrupt will be discussed. The more difficult case of contingent claims by the insolvent company or bankrupt will then follow. At this point, because of changes in the rules in recent times,210 it will be necessary to draw a distinction between bankruptcy and winding-up. Lastly, the special case of contingency and suretyship will be considered. In the process, the rules relating to set-off and distributions in administration will also be noted. It may be assumed that the law set out hereafter for winding-up applies also to bankruptcy, except in the case of contingent claims by the insolvent company or bankrupt, where the difference between the two regimes will be noted.
Date of account in winding-up and administration
8.49 Rule 14.25(2)211 requires an account to be taken in the case of ‘mutual dealings’, an expression that is used to eliminate cross-claims arising after a creditor has notice of the commencement of insolvency proceedings. The definition of what constitutes the commencement of insolvency proceedings for the purpose of allowing set-off was not completely settled prior to the revision of the set-off rules in modern times. In Re Eros Films Ltd,212 a debtor had notice of a winding-up meeting (p. 360) of the creditor company when it took an assignment from a third party (the parent company of the debtor) of a debt owed by the creditor company to that third party. The set-off was disallowed for notice of insolvency, since insolvency was the proper inference to draw from a meeting convened to consider a creditors’ voluntary winding-up. Similarly, a bank in Re Gray’s Inn Construction Co213 was not allowed, after receiving notice of a creditor’s petition to wind up a debtor company, to credit certain sums of money to the debtor company’s overdrawn account. Otherwise, the debtor company would be preferentially discharged from its indebtedness to the bank. A conflicting approach was nevertheless adopted in Re Charge Card Services Ltd,214 where the relevant date in a winding-up was said to be the date of the winding-up order itself215 rather than the date the winding-up commenced.
8.50 The approach in Re Charge Card Services Ltd216 is no longer tenable in the case of companies in administration or liquidation in view of modern changes to the set-off rules.217 For liquidation, set-off is disallowed for debts ‘arising out of an obligation incurred at a time when the creditor had notice that—(i) a decision had been sought from creditors on the nomination of a liquidator … , or (ii) a petition for the winding-up of the company was pending’.218 The rule therefore affirms the decisions in Re Eros Films Ltd219 and Re Gray’s Inn Construction Co.220 Where the winding-up is preceded by administration, there is also excluded from mutual dealings those debts arising out of obligations incurred when the cross-claimant had notice of a pending application for an administration order or when notice of an intention to appoint an administrator had been delivered.221 In the case of administration, a set-off is not allowed for debts ‘arising out of an obligation incurred at a time when the creditor had notice that—(i) an application for an administration order was pending; or (ii) any person had delivered notice of intention to appoint an administrator …’222 The relevant time, therefore, will usually arise before the administrator serves notice of an intention to make a distribution.223 In addition, debts are excluded where the administration was immediately preceded by a winding-up and either the cross-claimant had notice of a meeting of creditors or of a resolution to wind up preceding that winding-up,224 or the debt was incurred in the course of the winding-up.225
Date of account in bankruptcy
8.51 In Re Daintrey,226 the relevant date for the existence of a bankruptcy set-off was said to be the date of the receiving order rather than the date of commencement of the bankruptcy, when the act of bankruptcy was committed.227 The old (p. 361) set-off provision, section 31 of the Bankruptcy Act 1914, used nevertheless to deny set-off where the applicant ‘had, at the time of giving credit to the debtor, notice of an act of bankruptcy committed by the debtor’. The concept of an act of bankruptcy no longer applies in insolvency legislation, so a reference to a bankruptcy petition being ‘pending’ is now taken to be the relevant date in section 323(3) of the Insolvency Act 1986228 for the taking of an account between claimant and cross-claimant.
Assignment of claims during insolvency proceedings
8.52 The debts of a company in winding-up or administration or of a bankrupt may not be assigned to the insolvent party’s debtors once those debtors have notice of the relevant insolvency proceedings.229 If such post-insolvency trading in debt were allowed, the value of debts in the hands of an insolvent party’s creditors could be greatly increased if they were assigned to the insolvent party’s debtors. To the extent of those debtors’ set-off rights against the insolvent, the debts of the insolvent would be valued at 100 pence in the pound and not at the few pence in the pound of an insolvency dividend. There is no justice that requires the insolvent’s debtors to receive set-off rights in these circumstances. In addition, to permit the insolvent’s creditors to improve their position by assigning the debts for an amount exceeding their dividend worth would offend the pari passu rule of equal treatment.230 The position taken in the case law was affirmed in the 2005 changes to the Insolvency Rules.231 The rules draw an important distinction between an agreement to assign and the assignment itself. It is the making of the agreement that is referred to in the cut-off dates, for otherwise an assignment falling in after the commencement of insolvency proceedings, pursuant to a prior assignment of future debts,232 and perfectly valid for general insolvency purposes,233 would be disallowed in the case of set-off.
8.53 The statutory set-off provisions call for an account of sums ‘due’ from one party to the other in the process of setting off.234 In Stein v Blake,235 Lord Hoffmann stated that the taking of an account of sums ‘due’ did not mean that they had to be both due and payable, ‘whether at the bankruptcy date or even the date when the calculation falls to be (p. 362) made’.236 In this respect, the insolvency set-off rules depart from the legal set-off rules.237 Lord Hoffmann’s words have a particular application in the case of contingent claims, but they apply also to debts that are payable in the future. His lordship’s explanation of the application of the set-off rules to contingencies demonstrates that, despite the self-executing character of insolvency set-off, the claims or debts may not have even fallen due at the date the account is to be taken. This is because of the hindsight principle that allows for a debt ‘to be treated as having been owing at the bankruptcy date’.238 The more straightforward case of future debts is provided for by rule 14.25(7), which states that a ‘sum must be treated as being due to or from the company … whether … it is payable at present or in the future … ’. As for future debts owed by the company, the Insolvency Rules make provision for the calculation of dividend in a winding-up or in an administration where the administrator decides to make a distribution.239 The company’s future indebtedness is discounted to present value according to a formula set out in the Insolvency Rules.240 The position regarding future debts owed to the company is explained in the administration case of Re Kaupthing Singer and Friedlander Ltd.241 For the purpose of set-off, the provisions on the present valuation of future debts owed by the company are applied also to debts owed to the company by the cross-claimant.242 Any balance arising after the set-off that is owed to the cross-claimant will then be discounted to present value and payable as a dividend;243 a balance in favour of the company in administration is paid to the administrator only when it becomes due and payable.244 Where there is going to be a balance in favour of the company, only so much of the company’s future claim as is needed to cancel out the cross-claim is discounted to present value to effect the set-off.245 The balance of the company’s claim is not discounted and is paid in full when the company’s claim becomes due and payable.246 Any other result would be unduly favourable to the cross-claimant and hence detrimental to the company’s creditors. The rules on set-off are thus applied so as to accelerate debts owed by the company but not to accelerate debts owed to the company, except in so far as is necessary to give effect to a set-off.
Contingent claims and cross-claims
8.54 The winding-up of a company, or the completion of administration prior to a winding-up, or the settlement of a bankrupt’s affairs cannot be allowed to wait upon the occurrence or not of a contingency affecting a claim by or against the insolvent person. As will be explained below, statutory machinery exists for the valuation of contingent claims by and against companies and for the valuation (p. 363) of contingent claims against a bankrupt247 but not by a bankrupt.248 These claims can be revalued at intervals in accordance with the so-called hindsight principle. Moreover, that same principle may in some instances be relied upon to eliminate contingencies that mature between the commencement of the insolvency proceedings and the actual taking of the account.249 In this sense, a contingent claim against a bankrupt firm was permitted in Baker v Lloyds Bank Ltd,250 where the firm had discounted with the claimant bank certain bills of exchange that it had drawn, accepted or indorsed and that had been dishonoured. At the time when the firm’s property was assigned to the plaintiff as trustee for its creditors, the bills had not yet fallen due and the firm had thus not yet incurred liability under the bills. Roche J permitted set-off because, although the amount that would have to be set off against moneys owed by the bank to the company was unknown at the date of the assignment in bankruptcy, it was ‘certain’ that there would be a deficiency as regards the accepted bills.251
8.55 A further example of the elimination of a contingency arose in Re Asphaltic Wood Pavement Co,252 where a company in liquidation was contractually entitled to recover from the Commissioners of Sewers the agreed price for laying certain streets. Under that contract, the company was obliged to keep the streets in repair. Although that obligation had not yet been breached when the company went into liquidation, by going into liquidation the company had put it beyond its power to perform its contractual repair obligations in the future. The Commissioner was therefore entitled to lodge a proof in the company’s liquidation for the non-performance of the company’s repair obligation and, the amount of the claim already having been assessed by a judge in chambers, could claim a set-off of that amount against the agreed price for laying the streets.253
Contingent claims by the insolvent party
8.56 As stated above,254 the current bankruptcy rule, which used also to be the rule in a winding-up, is that it is permissible only for the creditor of the bankrupt, and not the bankrupt himself, to have a contingent claim for the purpose of set-off in bankruptcy.255 No set-off is allowed where it is the bankrupt who has the contingent claim since there is no machinery for valuing that contingent claim.256 Prior to modern changes in administration and winding-up, the same position held in those proceedings. In MS Fashions Ltd v Bank of Credit and Commerce International SA, a winding-up (p. 364) case, Hoffmann LJ stated that the cross-claimant might prove in the claimant’s winding-up without an account being taken in respect of his contingent liability to the company.257 To the extent, however, that the contingency later eventuated, the company could be restored to the register so as to bring a claim against the cross-claimant.258 The latter would then be able to set off his cross-claim, minus any amount received by way of dividend earlier when the company claimant was wound up. This extraordinary procedure is now unnecessary in the case of insolvent companies. Rule 14.25(7)(b) of the Insolvency Rules now states that ‘[a] sum must be treated as due to or from the company … whether … the obligation by virtue of which it is payable is certain or contingent …’. The same rule applies in the case of administration.259 The valuation of the contingent claim is provided for in rule 14.14(1): ‘In an administration or in a winding-up, the office-holder must estimate the value of a debt that does not have a certain value because it is subject to a contingency or for any other reason.’ The estimation made ‘must be based on a genuine and fair assessment of the chances of the liability occurring’.260,261 Furthermore, that estimation may subsequently be adjusted: ‘The office-holder may revise such an estimate by reference to a change of circumstances or to information becoming available to the office-holder.’262 The procedure now in place would seem to dispense with the proposal put forward in Re MS Fashions. It would hardly be appropriate to restore the company to the register to pursue a claim for the difference between the actual and the estimated contingency if, in the converse case, there could be no question of the cross-claimant’s dividend being increased because the contingency had come to nothing.
Contingent claims and suretyship
8.57 Particular difficulties are presented in the case of suretyship by contingent claims and cross-claims. Although modern changes to the Insolvency Rules263 have affected to a substantial extent the way that contingent cross-claims have been dealt with, the subject of set-off in the field of suretyship, especially in so far as problems are presented by the rule against double proofs, justifies the separate treatment of suretyship. In Re Fenton,264 Fenton guaranteed advances made by a bank to a textile company in which he had an interest and later executed deeds of arrangement in favour of his creditors. The textile company also went into liquidation, leaving the bank with a debt claim against an insolvent company and a claim over against a bankrupt guarantor. The liquidator of the textile company lodged a proof against Fenton’s estate in respect of (p. 365) various sums due from Fenton to the company. This proof was rejected by Fenton’s trustee, who claimed an entitlement to set off the advances made by the bank to the company and guaranteed by Fenton. The bank had proved against Fenton’s estate but nothing had been paid to it. Refusing a set-off, the Court of Appeal pointed out that none of the sums in question had been repaid by Fenton or his trustee to the bank.
8.58 The liquidator of the company had argued the case on two grounds. One was that Fenton’s claim against the textile company was contingent, dependent upon the company’s failure to repay the bank and the calling in of the guarantee. This ground elicited a difference of opinion in the Court of Appeal. Lord Hanworth saw the statutory set-off provision265 as ‘connot[ing] an account capable of ascertainment on either side if not immediately, yet based upon authority or liability definitely undertaken … [As regards Fenton] there was not a debt or certain liability, but one in respect of which there was a right of protection and no more …’ .266 Romer LJ, however, asserted that contingent liabilities are in general provable debts,267 which is the recognized position today.268 The refusal of set-off in the case appears to rest principally upon the second ground put forward by the company liquidator, which was the prohibition against lodging a double proof in bankruptcy.269 According to this rule, the company in liquidation could not be subject to a claim by both the bank and by Fenton as guarantor in respect of the same debt. The rule against double proof could have been avoided if Fenton had been able to pay off the bank on his guarantee, but Fenton was insolvent and so unable to do this.270
8.59 The contingent claim aspect of Re Fenton271 was taken further in Re a Debtor (No 66 of 1955).272 Waite owed Clark money for goods supplied to him by Clark. In order to extend credit to Waite, Clark had had to borrow from his bank. As security for Clark’s loan, Waite had guaranteed Clark’s bank overdraft and deposited certain title deeds with the bank as security. A receiving order was later made against Waite, and Waite’s trustee then had to pay off the bank to secure the release of the title deeds. The Court of Appeal refused to permit Waite’s trustee to set off the sum paid to the bank against Clark’s claim for the price of goods. This was because, at the date of the receiving order, no payment had been made to the bank by Waite or on Waite’s behalf. Waite’s rights against Clark were therefore only the ‘special but contingent rights of a surety who had not been called on to make any payment by the principal creditor and had not exercised what has been called the protective right of the surety to require the principal debtor to relieve him of his liability by paying the debt owed to the principal creditor’.273 Re Fenton was explained as turning principally on the double proof difficulty, but the core of the decision in Re a Debtor was that, at the date (p. 366) when Waite’s set-off right had to be in existence, no debt owed by Clark to Waite had yet fallen due. Clark’s later indebtedness to Waite, arising out of the payment made to Clark’s bank, was not the mere quantification of an obligation predating the receiving order. Re a Debtor goes beyond Re Fenton in making it plain that a surety who pays off completely the principal debtor does not improve his set-off position.
Other contingent claim cases
8.60 Re a Debtor, as a bankruptcy case, is unaffected by changes to set-off in the case of contingent claims owed to companies.274 The case was reined in to a degree by Peter Gibson J in Carreras Rothman Ltd v Freeman Mathews Treasure Ltd,275 when he said that a sum could be due at the relevant date for the purpose of the set-off section, even if it could not be precisely calculated until a later date.276 But the obligation had to exist at that date and could not itself be a contingent one.277 A more radical treatment of Re a Debtor, however, was made by Millett J in Re Charge Card Services Ltd.278 Under a factoring agreement, the factor had a discretion to retain moneys owed to the assignor company to cover the risk, inter alia, of default on the part of account debtors. The agreement also provided that, if the assignor went into a winding-up, the factor could require it to repurchase at face value any outstanding accounts receivable. Various sums were owed by the factor to the assignor at the time of the latter’s voluntary liquidation but the factor had not yet served notice on the assignor to repurchase outstanding accounts. The assignor’s liquidator contended that any repurchase price owed to the factor could not be set off against the retained sums owed by the factor to the assignor. This was because the assignor’s repurchase obligation was contingent at the time of the liquidation.279
8.61 Despite the contingent character of the factor’s repurchase rights at the date of the winding-up, Millett J held that the factor was entitled to set off the repurchase price of receivables against sums due from it. Set-off was not confined, as Carreras Rothman280 had proposed, to existing claims whose quantum was unknown at the date of winding-up but extended to claims still contingent at that time, provided that they later matured into pecuniary demands capable of being set off.281 Millett J explained Re Fenton282 as turning upon the double proof rule. Re a Debtor283 was criticized and then distinguished in these terms:
[T]he true ratio of Re a Debtor is that to come within [the set-off section] the liability must be exclusively referable not merely to an agreement already existing at the date of the receiving order, but to an agreement between the same parties as the parties to the set-off, and that the liability of the principal debtor to indemnify a surety who has paid the principal debtor does not pass this test.
(p. 367) It was therefore the absence of mutuality between the parties rather than the issue of contingency that was fatal to the set-off claim in Re a Debtor. The surety’s right of indemnification arose by virtue of its agreement with the creditor and not by virtue of any agreement with the debtor, to whom it owed money.
Guarantees and mutuality of parties
8.62 The issue of mutuality of parties has been placed in clear focus as a result of bank insolvency,284 when the bank holds a director’s personal deposit after making an advance to a company in which the director has at least a major stake. The deposit is required to supplement any personal guarantee or proprietary security285 given by the director in respect to the bank’s advance to the company. When the bank goes into liquidation, two questions arise. The first is whether the liquidator’s claim against the company for the repayment of the loan is subject to any set-off to the extent of the director’s claim against the bank for the recovery of his deposit. The benefit thus accruing to the director in his capacity of shareholder of the company would exceed any meagre dividend otherwise paid to him by the liquidator. Because there is no justification for piercing the corporate veil, set-off in this form has been firmly refused. In the words of Rose LJ:
It is not the function of insolvency set-off to confer a benefit on a debtor of the insolvent who has not been a party to the mutual dealing, nor to afford a preference to a creditor who has no liability to the insolvent or whose liability is only secondary and is capable of being satisfied by the party primarily liable.286
8.63 The second question is whether, as between the bank and the director, a set-off can be taken as between the bank’s liability for the repayment of the director’s deposit and the director’s commitment in the form of a personal or proprietary security. As the cases demonstrate, if the director has not given a personal guarantee of the company’s indebtedness, there can be no set-off as between director and bank. If, however, the director has given a personal guarantee, the position appears to be quite different.287 Although some doubt exists as to whether a non-insolvent party may or may not elect to enforce a security, so as to take its claim outside the insolvency set-off process,288 the view expressed in MS Fashions Ltd v Bank of Credit and Commerce International SA was that a depositor who had granted a bank a charge-back over the deposit was entitled to set off his personal liability to the bank as guarantor of his company’s debts against that liability. The bank, in other words, could not enforce its charge-back outside the set-off rule. In the words of Hoffmann LJ: ‘The account to be taken by rule 4.90 must require an unwinding of that arrangement so that the deposit is set off against the debt it was intended to secure.’289 It (p. 368) had been argued unsuccessfully on the part of the bank that the director had no beneficial interest in the deposit obligation of the bank.290 The availability of set-off is important in those cases where the director’s company is unable to repay the advance so that the director is subjected to the calling in of the personal or proprietary security.
Suretyship: first variation
8.64 In MS Fashions Ltd v Bank of Credit and Commerce International SA,291 three directors individually signed agreements with the bank by which they undertook a liability as ‘principal debtor’ to repay a sum advanced by the bank to their company. Since they thus incurred primary liability to the bank and set-off was mandatory, an account was taken as between the bank’s duty to repay their deposits and their liability on the loans advanced by the bank. In addition, the company’s own indebtedness to the bank was diminished to the extent of the set-off since, by exercising their right of set-off, the directors had to that extent repaid the loan.
Suretyship: second variation
8.65 In contrast, in Re Bank of Credit and Commerce International SA (No 8)292 the beneficial owner of a company gave a charge over a bank deposit back to the same bank, which was advancing money to his company. He did not expressly promise to repay the loan and the court declined to imply such a promise in the agreement. There was therefore no set-off between the bank and the beneficial owner and the bank’s liability to repay him his deposit meant that on the bank’s insolvency he was entitled only to a dividend, leaving the bank free to pursue his company for the repayment of the loan in full.
Suretyship: third variation
8.66 An intermediate case concerns the depositor who does not undertake primary liability but does undertake secondary liability as surety in the event of the primary debtor’s default. Where the surety becomes liable to pay only in the event of a demand being made by the creditor, no cause of action exists in the bank until it makes a demand on the guarantee. Where, in the more common case, the surety becomes liable when the primary debtor defaults,293 no cause of action exists until the default occurs. Meanwhile, in both cases the surety’s liability is a contingent one.294 Where the surety is a company, the changes to the set-off rules mean that the surety’s contingent liability may be assessed and taken into account.295 When the primary debtor defaults, the contingency is resolved either by the bank making a demand or automatically upon the default. The account between the surety and the insolvent bank is thereupon adjusted.296 Where the (p. 369) surety is an individual, the position is as follows. So long as the surety’s liability on the guarantee remains contingent, the surety will in the usual way put in a proof and look forward to receiving a dividend without suffering a set-off, given the absence of any provision for assessing that contingency.297 This will be the conclusion if the company borrower is solvent and makes repayment in full. If the company borrower is insolvent or defaults on repayment, this removes the contingency from the surety’s liability, exposing the surety to a set-off as between its claim on the deposit and the bank’s claim against it as surety for the third-party debt.
Excluding insolvency set-off
8.67 In National Westminster Bank Ltd v Halesowen Presswork and Assemblies Ltd,298 the customer of a bank was in trading difficulties and the bank sought to provide it with support that it might be sold off as a going concern. With the company’s agreement, it therefore froze the company’s trading account, which was in deficit, and opened another trading account which, by agreement with the customer, was to be kept in surplus. When a creditors’ voluntary winding-up resolution was later passed, the question raised was whether a surplus in the later account could be offset against a deficit in the earlier account. This depended upon whether the bank’s right to combine the two accounts had been excluded,299 whether such exclusion was intended to operate during winding-up proceedings and override the statutory rules on set-off in winding-up proceedings,300 and whether these statutory rules could lawfully be excluded. The House of Lords held that the parties had not intended the separation of the two accounts to continue when the company ceased to be a going concern, so the parties had not sought to exclude the insolvency set-off rules. Nevertheless, if they had sought to exclude these rules, they could not lawfully have done so because the rules were mandatory.301
8.68 The court’s ruling on the mandatory character of the set-off rules in a winding-up302 was therefore obiter dicta. The reasons given were that the weight of authority was against exclusion,303 the language of the legislation was mandatory (‘shall’, not ‘may’)304 and set-off was not a matter of purely private right but was part of a system for the ‘proper and orderly’ administration of insolvents’ estates.305 The conclusion of the court in this matter is difficult to reconcile with the position that a creditor can give a binding undertaking not to prove in a bankruptcy or winding-up, the effect of which is to prevent the question of excluding set-off ever from arising.306
8.69 Property is demised to a tenant at a rackrent. The tenant in turn sub-lets the property to an undertenant and then defaults on rental payments under the head lease. In seeking redress, the landlord is not limited to an action on the tenant’s personal covenant, coupled with any further action that might be taken to forfeit the lease, but may exercise self-help to recover payments due from the sub-tenant to the tenant. This right was formerly governed by section 6 of the Law of Distress (Amendment) Act 1908, but, when the landlord’s common law right of distress was abolished,307 the landlord’s right was restated in different language and restricted to leases of commercial premises308 by being linked to the new commercial rent arrears recovery (CRAR) action. The right of a landlord to recover rent from a sub-tenant is now laid down in section 81 of the Tribunals, Courts and Enforcement Act 2007.309 It provides that, where CRAR is exercisable,310 a landlord may serve a notice on the sub-tenant stating the amount which the landlord is entitled to recover from the tenant with the aid of CRAR.311 When this notice takes effect,312 the consequences of it are that there is transferred to the landlord ‘the right to recover, receive and give a discharge for any rent payable by the sub-tenant under the sub-lease’,313 subject to ‘any permitted reduction’. This procedure is tantamount to the interception of sub-rental payments314 and their application to the reduction of the rent due from the tenant. For the purposes of the section 81 notice, the sub-tenant is treated as the immediate tenant of the landlord and, like the tenant, is susceptible to the CRAR procedure affecting its goods.315 In practical terms, the availability of this remedy for non-payment by the tenant provides security to the landlord because it supplements the tenant’s personal covenant with additional recourse to the sub-tenant.316 Once payment by the sub-tenant is made,317 the tenant is entitled to deduct the same amount from the rent due under the sub-lease.318
Effect of section 81 notice
8.70 The statutory predecessor of section 81 (section 6 of the Law of Distress (Amendment) Act 1908) was considered at length in Rhodes v Allied Dunbar Pension Services Ltd,319 in the course of settling priority between the claim to sub-rental (p. 371) payments of the landlord, serving a statutory notice, and the claim of a debenture holder of the company tenant, which, under a charge by way of legal mortgage of the tenant’s sub-lease, had procured the sending in of receivers and managers of the tenant.320 The effect of the notice was ‘to transfer to [the landlord] the right to recover, receive and give a discharge for all future payments of rent by the undertenants until the arrears of rent due to the [landlord] have been paid’,321 in other words to ‘divert’322 the sub-rental payments away from the tenant. The landlord’s right of intervention would continue so long as the debenture holder did not itself go into possession of the premises, an act that in the context of a sub-lease would take the form of a direction to the sub-tenants to pay the sub-rentals directly to the debenture holder. Since the debenture holder had not gone into possession, the tenant retained the right to receive the sub-rentals and thus remained susceptible to the statutory notice served on the sub-tenants. If the debenture holder had gone into possession, and if the debenture holder had defaulted on the payment of rent to the landlord, then on that account the landlord would have been entitled to serve a statutory notice on the sub-tenants.
8.71 The rules of insolvency set-off may not be modified by the parties, given the interest of the law in providing for an orderly distribution of insolvents’ estates,323 but contracting parties are free to enter into subordination agreements.324 The bank’s right to combine accounts is sometimes made the subject of an express or implied agreement to contrary effect.325 This leaves equitable and legal set-off as subjects of a contractual provision. Contractual set-off is sometimes referred to as though it were a distinct type of set-off, though it is more a case of existing types of set-off being modified by agreement between the parties, which may either increase or diminish to the point of extinction rights of set-off that would otherwise arise.
Modifying set-off rights
8.72 There is no reason at all in principle why set-off rights might not be expanded326 or diminished; it is a matter of freedom of contract. Rights of legal and equitable set-off may be limited or excluded by agreement between the parties and remain (p. 372) effective in administration327 and receivership328 cases, though not in a winding-up.329 Indeed, netting arrangements, so far as they represent continuing indebtedness amongst the members of a clearing house or exchange, represent a modification of set-off rights. Subject to the Unfair Contract Terms Act 1977,330 contracting parties are at liberty to exclude or limit otherwise available set-off rights.331 The clause excluding set-off is like a flawed asset clause in the sense that it defines the payment obligation,332 though it does so to opposite effect. Its effect is similar to including a payment obligation in a negotiable instrument; as with a negotiable instrument,333 there will be exceptional cases where a claim will be stayed pending the determination of a counterclaim.334 Language of general exclusion in a contract, however, may be read down so as not to extend to set-off rights. In BOC Group plc v Centeon LLC,335 a contract for the sale of a business on instalment payment terms provided: ‘The Purchaser’s obligations to make payments of the deferred instalments … shall be absolute and unconditional …’ The price was payable in instalments to reflect the nature of the business as not income-producing for some considerable time. Unlike a shipbuilder, the vendor therefore did not need an income stream from the purchaser to finance work in progress, nor was the transaction like a financing agreement. There was therefore no business sense behind excluding set-off, with the consequence that an implied exclusion would not be inferred from general language.336
Assignment and exclusion of set-off
8.73 A type of exclusion of set-off rights occurs in the case of assignment where by agreement the debtor is debarred from raising equities and defences, available against the assignor, against the assignee. This is permissible,337 though privity problems may arise if the assignee is a third party beneficiary of an undertaking in (p. 373) the contract between debtor and assignor.338 An agreement between assignor and assignee that the assignor will not suffer any set-off rights to arise between it and the obligor will not, for privity reasons, bind the obligor.339
Types of netting
8.74 Netting, when it takes place between two parties, is the process by which obligations running in both directions are consolidated into one single obligation at stipulated intervals. For equitable and legal set-off, in contrast, the obligations retain separate existences prior to settlement. Insolvency set-off, which takes effect automatically giving rise to a single net obligation, in this respect resembles netting. When conducted multilaterally, netting may result in a series of entitlements in favour of some parties, matched in gross if not individually by a series of liabilities of the remaining parties to the netting scheme.340 Apart from the distinction between bilateral and multilateral netting, netting can take place in broadly three different ways.341 First, it may take the form of transactional or novation netting, sometimes known as payment netting. In the case of contracts between two parties, this means that contractual positions, prior to their settlement dates, are consolidated at intervals into one contractual account favouring one party or the other from time to time.342 This amounts to a type of running account agreement, distinguishable from set-off.343 The expression ‘novation netting’ can also be used to describe the position where, on a regulated exchange, a contract between two members is subdivided, so that the two contracting members are separated from each other and each is then connected by contract to a central counterparty. The seller becomes a seller to the counterparty and the buyer a buyer from that counterparty.344 This practice is sometimes called market netting. The second type of netting referred to above is termination netting, which is the process by which contracts, previously separated, are bundled together for the purpose of effecting a settlement on the due date between the parties. It may take place bilaterally or multilaterally. The third type of netting is close-out netting. This is seen, for example, in foreign exchange and interest rate swaps transactions.345 Close-out netting is a form of termination netting that is preceded by an essential step. Contracts for the sale of commodities or securities are reduced first to money obligations so as to acquire the necessary mutuality of subject matter for them to be settled in gross.346 Usually provided (p. 374) for under the terms of a master contract governing the relations of all market participants, close-out netting takes effect bilaterally when triggered by events of default.347 When it is effective, close-out netting prevents a liquidator or administrator from ‘cherry-picking’, that is, choosing to enforce only those contracts that favour the insolvent person whilst exercising the power to disclaim onerous property in the case of the others.
Payment netting issues
8.75 Suppose that one of the parties to a bilateral payment obligation is ‘in the money’, that is, can look forward to receiving the net balance from the other party at the due date, but before that due date commits an event of default by becoming unable to pay debts as they fall due or entering into administration.348 The question now is what happens to the payment obligation of the party who is not in default. Before the matter was settled by the Court of Appeal,349 contrasting views were expressed about the meaning of an International Swaps and Derivatives Association (ISDA) netting clause providing that ‘[e]ach obligation of each party under [the payment clause] is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing …350 According to one line of authority,351 the effect of an event of default was that the party out of the money was under no obligation to pay the net balance to the defaulting party who was in the money because the event of default meant that the obligation to pay did not come into existence. Another line of authority was to the effect that the netting clause dealt with payment and not with the accrual of debt, so that a duty to pay was held in suspense until the event of default was expunged, at which point it was activated.352 In Lomas v JFB Firth Rixson Inc,353 the Court of Appeal came to the firm conclusion that the ISDA clause was a clause dealing with payment and not indebtedness and that the payment obligation of the party out of (p. 375) the money was not extinguished by the event of default but rather was suspended during its continuance. The events of default were so many and various that it would be too harsh for a fairly trivial event to have the effect contended for by the party out of the money.354 The party out of the money had been seeking to avoid having to terminate the contract, which would have triggered its obligation to pay the net amount, but the decision of the court meant that its duty to pay continued as long as the event of default continued,355 the court declining to hold that suspension for only a reasonable time was implied in the agreement, unless it terminated the contract.
8.76 Netting is a creature of contract and freedom of contract prevails, except that it must comply with vital principles of insolvency law. These principles, discussed below, include the rule of pari passu distribution and the so-called anti-deprivation rule. Since netting will often go beyond the limits set by insolvency set-off, it is open to challenge for offending these principles unless sanctioned by legislation.356 Close-out netting is particularly vulnerable to challenge on either or both of these grounds. Multilateral netting is vulnerable too, with the additional reason that it offends the principle of mutuality of parties.
8.77 It is hard to overstate the importance of netting in the financial markets.357 The importance of close-out netting, for example, is demonstrated by its legislative implementation in numerous countries.358 Netting guards against systemic risk, which is the risk of a catastrophic series of defaults like a sequence of dominoes, as might happen where one actor defaults in respect of another, which enforces a default by that other as against a third actor and so on. The intervention of a central counterparty, where this occurs, diminishes this risk. Netting also provides for protection against liquidity risk by minimizing the number of remittances and cross-remittances. Again, it reduces credit risk by limiting one actor’s exposure to another to the net position at any given time as the actors engage in a series of matched or balanced transactions.359 Multilateral netting goes further to reduce credit risk but arguably, since it distributes the credit risk of each party to all the parties involved, creates the moral hazard of reducing an individual party’s need to assess the creditworthiness of each of its counterparties.
8.78 The expression ‘negative pledge’360 concerns at least two different cases. The first case is where a floating charge is taken over a company’s assets and language is inserted in the debenture to restrict the company’s normal licence to deal with its assets in the normal course of business, whether by outright disposal or by granting security over them. The negative pledge clause in this sense is designed to restrict a company’s authority to burden (p. 376) its assets with additional security that, by virtue of being either fixed or falling within a company’s apparent authority to encumber assets forming part of its circulating capital, would rank prior to the earlier floating charge.361
Different types of negative pledge
8.79 Of relevance here is the use of negative pledges in a different way, often to be found in international unsecured lending. The negative pledge clause has been described as ‘the most fundamentally important covenant in an unsecured term loan agreement’.362 Expressed in various ways, a negative pledge clause in this second sense may prohibit outright a debtor to grant, or allow to subsist, security363 over any of its assets364 to any of its other creditors.365 Sometimes the clause will function as a pari passu provision, like the following:
[T]he Indemnitors shall procure that all obligations and liabilities to the Surety under this deed shall at all times rank equally and rateably (pari passu) in point of priority with all other present and future obligations and liabilities of the Indemnitors …366
An alternative (or so-called affirmative) form of negative pledge may provide that, if such security is given, an equal and rateable or even higher-ranking security will be given on demand to, or will arise automatically in favour of, the lender. The negative pledge clause is sometimes expressed as an outright prohibition; at other times, the borrower is forbidden from taking certain action without first obtaining the consent of the lender.
Pledgor and pledgee
8.80 There is no reason why contractual effect may not be given to a negative pledge clause as between pledgor and pledgee. Consequently, a negative pledgee, apprised of steps being taken by the pledgor to grant security to a third party, may take proceedings to secure a prohibitory injunction against the pledgor.367 The pledgor’s breach of contract may, apart from giving rise to liability in damages, which would be hard to quantify, in practice trigger an events of default clause in the lending agreement.
Proprietary consequences of negative pledge?
8.81 Two further questions of a major character arise in connection with negative pledge clauses. The first is whether the clause gives rise to proprietary consequences and, if so, with what effects. A clause taking the form of a prohibition on the grant of security to a third party cannot, without more, confer a property right by way of security in any assets that are charged in favour of another creditor or indeed in any assets of the borrower.368 A restriction on the use or disposal of property does not without more create a positive obligation to hold that property as security for the (p. 377) promisee.369 So the clause must take an enhanced form370 and purport conditionally and affirmatively for a matching security to be granted to the lender if it is to have proprietary consequences. This raises a number of points of relevance to both promises by the pledgor to grant security in the event that the negative pledge clause is breached and to automatic grants of security in that event.
8.82 First, a clause that purports to grant security in comparable assets or in some assets of comparable value should fail for lack of certainty,371 at least in the case of automatic security clauses. A more tolerant view might possibly be taken of contractual promises to grant security on the ground that something is certain as long as it can eventually be ascertained, but since this would involve a choice amongst different assets, which might also affect third-party rights, it is submitted that this also would be too uncertain to be enforced.372 The problem of uncertainty ought not to arise in the case of a clause purporting to grant security in all assets or in the same assets as the charge whose grant infringed the negative pledge clause.
8.83 Secondly, it has been asserted that an affirmative negative pledge clause will fail because no consideration is provided for the promise to grant or for the grant of security when the contingency occurs.373 This argument, however, assumes that the only valid consideration is an actual advance of money at the time of attachment of the security and, since no such new value is forthcoming at that time,374 an affirmative negative pledge clause will fail because of its lack of compliance with equity’s demand that consideration support the grant of security. Nevertheless, there is no reason why contract principles should not be applied in a conventional way to underpin the contingent grant of, or promise to grant, security. Hence, the relevant consideration may be the same consideration given by the pledgee at the time of the contract containing the negative pledge clause.375 At that time, an undertaking to advance value is given, followed by the actual advance of value. The contingency underlying the negative pledge clause occurs, transforming a contingent (p. 378) promise or grant into a current promise or grant. There is no good reason to differentiate between contingent grants and promises, on the one hand, and unconditional grants and promises, on the other. In this latter case, there is no requirement of fresh consideration in order for the grant to be effective.376 The consideration argument against negative pledge clauses is therefore unpersuasive. A liquidated damages clause is not ineffectual as a matter of contract law on the ground that no fresh consideration is given by the promise when the promisor’s undertaking to pay is sprung on breach. The position with affirmative negative pledges is no different.
8.84 Thirdly, so far as the description requirement is satisfied, the date of the grant will be significant in relation to registration requirements and the timing of the grant in relation to the commencement of insolvency proceedings. In Re Gregory Love & Co,377 a company promised in a letter to grant a charge to one of its directors, who had deposited certain title deeds with a bank, in the event of the bank pressing the company for payment of its overdraft. The court held that the charge was not granted at the date of this conditional promise.378 Rather, it was granted at a later date when a formal debenture in the director’s favour was given.379 This later debenture fell foul of the provision concerning floating charges granted without new value in the vulnerable period preceding a winding-up.380 A conditional promise to grant a charge is not the same as a promise to grant a charge; only the latter may be treated as a present charge.381 As and when the condition is triggered, the charge springs into existence at that date and its priority is to be measured against competing charges as of that date. In construing any conditional grant of a charge, care must be taken to define the condition. If the condition contemplates a further act by (p. 379) the supposed grantor, such as the execution of a charge or mortgage document, the condition will not be satisfied by a demand that such document be executed.382
8.85 Any attempt in a negative pledge clause to deem a charge to arise automatically in identified assets, the instant that a charge over them is given in favour of another creditor, does not produce two charges of exact contemporaneity. There has to be the grant of the competing charge for the condition in the negative pledge clause to be sprung and that competing charge will always predate the charge sprung by the condition.383 How a clause would fare if it provided that a charge should be granted the moment before a competing charge is granted, or when negotiations commence for the grant of a competing charge, is less easy to say. Much might depend upon the drafting of the clause. If the charge were over the same assets as the competing charge, that competing charge would have to be granted for coverage of the conditional charge to be defined. Assuming a clause were drafted that survived hostile judicial construction, which would not be easy to accomplish, it would fail for want of registration in twenty-one days if the existence of the competing charge did not come to the attention of the negative pledgee in time. There would of course be the prospect of late registration,384 but late registration would merely cement the negative pledgee’s charge as a second security, since the usual terms on which late registration is permitted would protect the rights of intervening secured creditors.385
8.86 The second major question is whether the negative pledge clause is capable of binding third parties. Any attempt by contract to impose burdens will contravene the privity of contract rule but there will be circumstances where a third party can commit the tort of inducing breach of contract. Until recent years, this was a tort of uncertain scope that raised difficulties centring on three points; first, the notice that is required of the contract that is the subject of the inducement; secondly, the existence of any requirement that the contract be breached; and thirdly, the availability of the defence of justification to a defendant asserting a personal commercial interest. As for the second point, the House of Lords has made it clear that there must be a breach of contract for the tort to be committed; interference with the contract that does not give rise to a breach will not be sufficient.386
Liability for inducing breach of contract
8.87 For liability to arise, the defendant must have knowledge of the contract and must intend to induce a breach of it.387 The idea that there (p. 380) can be liability for interfering with the remedies available for a breach of contract, which has already occurred before the intervention of the defendant, has received no support.388 The necessary knowledge of the contract need not be exact and might arise from the widespread trade knowledge of certain contracts and their terms.389 Consequently, if a third party were aware of the existence of a major unsecured financing facility entered into by the borrower with a prior lender, there is some possibility that that third party would be fixed with knowledge of the negative pledge term, whose presence in such financing arrangements is widespread and notorious.390 Recent developments in the tort rein in to a significant degree a form of liability that expanded in a series of labour relations cases, decided at a time of national labour unrest, and that in its expanded form would have been mischievous in the more rarefied world of finance. Liability can, nevertheless, arise from knowingly entering into a contract that is inconsistent with the other party’s existing contractual commitments.391 The requirement of an intention to induce the breach of a preceding contract, on the part of a competing financier advancing its own interests, will not easily be satisfied.392 Moreover, though the defence is a limited one, in some cases a defendant intentionally inducing a breach will be successful in pleading justification on the basis of a legitimate interest.393 Judicial reference has been made to ‘moral or perhaps economic facts which may mitigate even to the point of justifying conduct otherwise incurring a prima facie liability’.394
8.88 The expression ‘flawed asset’ is not a precise term of art. It may for present purposes be taken to signify a contractual right to payment of a debt that is of a conditional character.395 The burden of compliance with that condition will affect the value more or less of that right to payment. A provision in a contract that renders an obligation to pay (p. 381) a conditional one may function as a form of security, though this is by no means always the case.396 Suppose that A owes a sum of money to B and that, under a separate though usually related transaction, B owes a sum of money to A or to a person related to A.397 This situation might arise398 where B is a bank advancing money to A, a company, and requiring that A, sometimes A’s directors as well,399 maintain a deposit account with B. The deposit of funds with B creates a debt owed by B to A.400 Suppose now that A defaults under the loan contract. It is in B’s interest to apply its own indebtedness to A against the moneys due from A to B. The question is by what means this can be done.
The ‘triple cocktail’
8.89 The practice of banks like B is to take advantage of a so-called ‘triple cocktail’. First, they take a security by way of charge over their own indebtedness to the account holder.401 Secondly, they rely upon their right to combine accounts so as to produce a single, consolidated account in which the sum they owe the account holder is offset against the sum the account holder owes to them.402 Thirdly, they rely upon a flawed asset clause, the purport of which is to convert their indebtedness to the account holder into a conditional debt. In this last case, the relevant condition that must be fulfilled in order for the bank’s indebtedness to fall due is that the depositor shall first have paid the moneys it owes the bank under the loan agreement. If those moneys are never paid, the bank’s obligation under the account agreement remains incurably contingent. Suppose that, in our example above, A is also indebted to another creditor, C. The consequence of the flawed asset clause is that, if A has granted a charge in favour of C over B’s indebtedness to A, C cannot call upon B to pay C as an assignee by way of charge of B’s indebtedness to A. B does not need to establish any priority entitlement as against C. It is enough that B’s obligation to repay A the amount of its deposit has not yet matured and may never mature.
8.90 Lord Hoffmann, in Re Bank of Credit and Commerce International SA (No 8),403 recognized that a bank could lawfully enter into a ‘flawed asset’ arrangement with a depositor, the effect of which was to provide a ‘security [that] will in most cases be just as good as that provided by a proprietary interest’. Since the House of Lords in that case recognized the validity of the so-called ‘charge-back’, by which a bank might take a security over its own indebtedness, this raises the question whether there is an appreciable difference between the bank’s position in respect of a flawed asset clause and a charge back. The bank’s rights under a charge-back must now be protected by registration if they are to be opposable to designated third parties,404 which would not previously have been the case if the bank’s charge was fixed, which surely it would be, given that a deposit in a bank account does not (p. 382) give rise to a book debt.405 It therefore needs to be determined whether a bank may invoke a flawed asset in its capacity of debtor rather than chargee in the, admittedly unlikely, event of failing to register a floating charge. It is submitted that a bank prevented from relying upon an unregistered charge is entitled to rely upon a flawed asset clause instead, just as it might rely upon a right of set-off instead of a charge. The taking of a charge as well as the drafting of a flawed asset clause should not lead to the invalidation of the latter as a consequence of the invalidation of the former.
Construction of flawed asset clause
8.91 In Re Bank of Credit and Commerce International SA (No 8), the flawed asset clause was to be found in a so-called letter of lien that, besides giving the bank a ‘lien’406 on the balance in the deposit account, also provided:
It is understood that the balances held in the demand deposit/call deposit/term deposit/ current accounts under the bank’s lien are not to be released to me/us, my/our heirs or assignees unless or until the amount of the loan/overdraft/accommodation and facilities have been fully repaid with interest to the bank by [the principal debtor] …407
The wording of the flawed asset clause did not come in for consideration in any of the judgments delivered in this case. As a matter of wording, language expressing that the balance held in the deposit account is not to be ‘released’ is not apt to express the nature of a flawed asset but, rather, quite closely resembles the language of charge.408 It does not deny or retard the existence of a debt but asserts instead a defence to the bank’s obligation to repay the deposit and renders the deposit non-payable. Had the clause said that the bank was under no obligation to repay the deposit until the amount of the principal obligation owed to it had been paid, then that would have been a different matter.
Charging conditional debts
8.92 Now, when drafting a flawed asset clause, the bank is in a difficulty. It can take a charge over its own indebtedness but, if it is not bound to repay the deposit until the principal obligation has been paid, can it be said that there is a charge in existence? A bank can of course take a charge over present and future property—that occurs in the case of a charge over any revolving assets—but this statement is misleading. The charge does not extend to the future assets409 but instead, as existing assets depart and new assets come into the debtor’s estate, extends automatically to those new assets.410 The reason for automatic attachment, confined to cases where consideration has been furnished by the chargee,411 is that equity looks on that as done that ought to be done. As soon as an asset the subject of a charging instrument comes into existence, equity implements (p. 383) the promise to charge that is inherent in any purported charging of a future asset.412 The response of equity here is that a promise to charge is enforceable, not that a future asset can be the subject of a present charge.413 Nevertheless, the charge over present and future property remains one and the same charge for the purpose of priority.414
Present and future assets
8.93 The case of a charge over both present and future assets, which most certainly passes the test of a present charge, is altogether different from the case of a so-called charge that purports to cover an asset that exists only in the future. A debtor cannot grant security over such a non-existent asset any more than he can convey land that he does not own.415 In this regard, the question is whether a conditional debt can be treated as a present asset because, if not, then it cannot be said that a charge has been created.416 Although a charge is an encumbrance and not a proprietary transfer,417 the law relating to assignments of future property throws light on this issue.
Assignments of future property
8.94 A bank’s ability to take a charge over its own conditional indebtedness is on all fours with a depositor’s entitlement to assign that conditional indebtedness to a third party assignee. In Norman v Federal Commissioner of Taxation,418 Windeyer J419 stated:
Assignment means the immediate transfer of an existing property right, vested or contingent,420 from the assignor to the assignee. Anything that in the eye of the law can be regarded as an existing subject of ownership, whether it be a chose in possession or a chose in action, can to-day be assigned … But a mere expectancy or possibility of becoming entitled in the future to a proprietary right is not an existing chose in action.421
This statement is consistent with the approach taken by English law, which takes a robust line in treating as existing debts sums due under a contractual obligation that has yet to be performed by the assignee.422 An assignment by a builder of sums to be paid for building work is no less a present assignment because the work has not yet been done fully or at all. Hence, the Court of Appeal in G&T Earle v Hemsworth Rural District Council423 treated as an existing debt, and not a mere expectancy, a contractor’s right to be paid the amount of a retention fund, notwithstanding that this sum could not be released until the architect’s (p. 384) final certificate and might be held back in full or in part if further work remained to be done. It can therefore be maintained that a depositor may presently assign a bank’s conditional debt, so defined by virtue of a flawed asset clause in the deposit agreement, and that the bank itself may take a present charge over its own conditional indebtedness. The bank is in no position unilaterally to prevent the condition from accruing and the depositor can take active steps to make the deposit due and repayable by ensuring the payment of the principal sum owed to the bank.
Conditional debts and insolvency principles
8.95 A major issue is whether a conditional debt in some way offends the rule against pari passu distribution or any other rule associated with the proper and orderly administration of the insolvency process. The rule against which the validity of conditional debt structures must mainly be measured is the anti-deprivation rule424 laid down in Re Jeavons.425 This rule, which is ancillary to the pari passu rule,426 provides that the property of an insolvent person may not be divested upon insolvency427 and applied other than in accordance with rules of distribution laid down in insolvency legislation.428 Otherwise, the beneficiary of such an arrangement would obtain an impermissible additional advantage at the expense of the general creditors.429 A great number of intricate distinctions are to be drawn from reconciling the case law430 and there are signs of a judicial disinclination to give too much play to the anti-deprivation rule.431 The conviction that the rule might benefit from statutory treatment432 is evidence of some (p. 385) unease in adopting an active, law-making judicial role in an area of law like insolvency, so profoundly the subject of legislative intervention.433 Subject to this, the following propositions, by no means helpful or consistent in gross, may be derived from the case law.434 They are, first, that a provision in a grant that a person’s proprietary interest shall be determined upon his entry into insolvency proceedings is valid.435 Secondly, a provision that a person’s property right is forfeited upon his insolvency is void,436 unless a fair value is paid for it.437 The distinction in these first two propositions between interests that are determined and interest that are forfeited, though much criticized, appears to have survived.438 Thirdly, an exception to the invalid effect of a forfeiture arises if the property goes upon forfeiture to the person with whose money the property was acquired.439 Fourthly, the conditional grant of an interest to take effect upon the grantor’s insolvency is void.440 Fifthly, the acceleration of a reversion to the lessor in the event of a lessee’s insolvency is valid.441 Sixthly, the (p. 386) forfeiture of property rights upon insolvency will not be valid just because the forfeiture provision is expressed other than in terms of insolvency.442 In this same vein, the rule is not to be avoided by adding other deprivation events to insolvency proceedings. Seventhly, nevertheless, such a forfeiture may be valid if the parties had no intention of avoiding insolvency laws.443 This last proposition could, until recently at least, have been described as debatable because, with the best will in the world, a forfeiture of assets upon insolvency works to the disadvantage of the insolvent’s other creditors and to the advantage of the party exercising forfeiture rights. It has, nevertheless, been authoritatively stated that ‘in borderline cases a commercially sensible transaction entered into in good faith should not be held to infringe the anti-deprivation rule’.444 An incorporation of a good faith standard gives the anti-deprivation rule a measure of flexibility denied to its statutory cousin, the pari passu rule.445 This may not differ in substance from confining the rule by limiting it to cases of fraud, so long as this is based on an objective approach to the intention of the parties, inspired by broader equitable notions of fraud.446 An application of this objective approach in the case of flawed assets, it should be noted, would involve a judicial rewriting of the contract so as to remove the flaw from the asset. This would seem also to be implicit in those cases where a dispensing power, based on the notion of good faith, is withheld. As for good faith, if the source of the assets that are divested upon insolvency is the person in whose favour those assets are divested,447 this may be an ‘important’, even ‘decisive’, factor in concluding the transaction was entered into in good faith and without an evasive intent.448 All told, the law in its current state gives a clear judicial signal that the anti-deprivation rule should not lightly be invoked to strike at sound commercial transactions, but that is as far as clarity goes. The extent of this judicial reserve remains unacceptably (p. 387) obscure.449 If good faith is to be a safe harbour for those seeking for good commercial reasons to avoid the anti-deprivation rule, it is unlikely to provide the degree of assurance needed by those planning complex and large financial transactions.450 Indeed, the application of the anti-deprivation rule has been said to turn upon a case-specific approach.451 Despite all the attention paid to it in recent years, the anti-deprivation rule remains in an unsettled state.
Anti-deprivation and insolvency proceedings
8.96 In Fraser v Oystertec Plc,452 an agreement provided for the transfer of intellectual property where the owner’s liabilities exceeded its assets. The court held that the anti-deprivation rule applied even where the owner did not go into liquidation. If correct, this ruling would open up to challenge any disadvantageous property transfer if it could be established that a technical state of insolvency existed at the time, however briefly and even if insolvency could not be proven until some time after the transaction. The transfer in this case, moreover, was challenged not by creditors but by minority shareholders. In Perpetual Trustee Co Ltd v BNY Corporate Trustee Services Ltd,453 where the divesting event was not the commencement of insolvency proceedings respecting the company but rather its parent, the Fraser case was considered to have been overruled on this point.454 The anti-deprivation rule did not come into play.455 In like manner, the House of Lords in British Eagle International Airlines Ltd v Cie Nationale Air France456 drew a distinction between debts that had already passed into the clearing house arrangement prior to the winding-up resolution and those that had not, striking down the clearing house arrangements only as they affected the latter. Authority also exists that the anti-deprivation rule does not apply where a transfer is triggered by receivership, even if the receivership is later followed by bankruptcy.457 For present purposes, insolvency proceedings include also entry into administration, at least where this occurs effectively with a view to a winding-up.458
Direct payment clauses
(p. 388) 8.97 Flawed asset clauses arise in other circumstances quite different from those concerning deposit accounts and referred to above. They have in the past been seen also in the form of so-called direct payment clauses in building and similar contracts,459 where an employer reserves the right to make payment directly to sub-contractors and deduct sums so paid from the amount owed to the main contractor. This right is exercisable upon the default of the contractor in paying the sub-contractors, which can happen in a number of cases, including the contractor’s insolvency. While the direct payment clause does not function explicitly as a form of security, it benefits the employer in so far as the employer is able to have the works completed notwithstanding the default of the contractor. To that extent also, it preempts the accrual of a substantial damages claim for breach of contract claim by the employer against the contractor, and to that extent again relieves the employer from having to prove in the bankruptcy or winding-up of the contractor. In Re Tout & Finch Ltd,460 in default of a contractor supplying an architect with reasonable proof that sub-contractors had been paid, the employer was entitled to pay such accounts directly to the sub-contractors and ‘deduct the sum so paid from any sums otherwise payable to the contractor’. Treating the matter mainly as one of construction of the payment clause,461 the court held that the payment so made was effective in the event of the contractor’s insolvency. Reliance was also placed by the court upon the earlier case of Re Wilkinson, ex p Fowler,462 where an engineer acting for a council had the ‘power if he thinks fit to order direct payment’ to firms supplying machines where the contractor was ‘unduly delaying proper payment’. Although the engineer exercised this power when the contractor became insolvent, the payment to the suppliers was effective because it was not just a matter of the suppliers benefiting from the payment. The council also had an interest in seeing that the suppliers were paid.463 The effect of the direct payment clause, if effective in promoting the council’s interests, would be to prevent the council from suffering a loss that would make it a creditor of the insolvent contractor. The clause on that account would not infringe the pari passu rule by singling out the council at the expense of the contractor’s other creditors because it would operate so as to prevent the council from becoming a creditor. A different question is whether direct payment clauses offend the anti-deprivation rule by forfeiting the contractor’s right to payment in favour of sub-contractors.
Current status of direct payment clauses
8.98 The fate of such direct payment clauses became a matter of considerable doubt after the decision of the House of Lords in British Eagle International Airlines Ltd v Cie Nationale Air France.464 Nevertheless, an