High Court to rule on set off against unfair preferences

In the recent case of Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Ltd [2021] FCAFC 228 (Woodman's case), the Full Federal Court weighed in on a legal question that has challenged the insolvency industry for decades: Is statutory set-off on insolvency (section 553C of the Corporations Act 2001 (Cth)) available against claw back of an unfair preference (s 588FA of the Act)?

In December 2021, the Full Federal Court said: No.

But in May this year, the High Court announced it would take the case on appeal.

An authoritative decision on the issue will provide certainty for commercial parties and insolvency practitioners at a time when economic headwinds loom and insolvencies, particularly in the building sector, are coming into sharper focus.

Woodman's case

MJ Woodman Electrical Contractors (Woodman) became insolvent. Metal Manufacturers supplied goods on credit to Woodman. Woodman owed two debts to Metal Manufacturers: one for $190,000 and another for around $195,000.

Woodman paid the first debt ($190,000) and the liquidator sought a court order to claw it back as an unfair preference.

At that point, Metal Manufacturers sought to set off its obligation to pay back the unfair preference for the first debt ($190,000) against the second debt owed by Woodman ($195,000).

If allowed, the set off would reduce the net exposure of Metal Manufacturers in the liquidation from $385,000 to $195,000, placing it in a better position than other creditors in terms of the recovery obtained in the liquidation.

Set off in insolvency

In Australia, s 553C(1) of the Act provides for statutory set off on insolvency in these terms:

"[W]here there have been mutual credits, mutual debts or other mutual dealings between an insolvent company that is being wound up and a person who wants to have a debt or claim admitted against the company:

(a) an account is to be taken of what is due from the one party to the other in respect of those mutual dealings; and

(b) the sum due from the one party is to be set off against any sum due from the other party; and

(c) only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be."

This statutory set off provision is modelled on equivalent laws in England dating back to the 1700s. It is directed at balancing accounts before calculating insolvency distributions. A person who is both a creditor and a debtor of an insolvent company need pay only its net, not gross, debt into the insolvent estate of a company.

The importance of mutuality

The scope of statutory set off on insolvency has been steadily expanded over the centuries. In modern times, it is said to have "the widest possible scope" (Gye v McIntyre (1991) 171 CLR 609).

The key limitation is one of "mutuality", as enshrined in section 553C. In this context, mutuality means the accounts must be between the same parties for the same interest. A person who owes a debt in a personal capacity and is owed a debt as trustee cannot balance the accounts because the accounts are not for the same interest. One is a personal account and the other is a trust account; the trust account's ultimate interest lying with the beneficiary not the trustee.

Unfair preferences

Voidable transactions regimes are another long-standing feature of sophisticated bankruptcy and insolvency regimes the world over. In Australia, the voidable transactions regime is contained in Division 2, Pt 5.7B of Chapter 5 of the Corporations Act. Voidable transactions regimes serve to enhance the prospect of distressed companies trading out of financial difficulty by removing the incentive for a run on the company by creditors seeking to jump the queue ahead of a looming insolvency.

The voidable transactions regime empowers liquidators to apply to the courts to unwind (or "void") certain transactions that were entered into by an insolvent company shortly before a formal insolvency process commenced. This allows a liquidator to re-establish the order of distribution that otherwise would have prevailed among creditors.

Unfair preferences (section 588FA of the Act) are one type of voidable transaction. An unfair preference occurs if an insolvent company prefers one creditor over another, shortly before entering a formal insolvency process, in a way that results in the preferred creditor receiving more than it otherwise would have received in an orderly liquidation of the company's assets.

In Woodman's case, the liquidator argued that the payment of the first debt was an unfair preference. The question was whether Metal Manufacturers could set off its obligation to repay the first debt ($190,000) against Woodman's obligation to pay the second debt ($195,000).

A liquidator's nightmare

Whether or not statutory set off is available in this scenario has been debated by insolvency practitioners for decades.

It is universally accepted that the preferred creditor cannot set off the repayment of the unfair preference against the very debt being repaid — that would entirely defeat the purpose of the voidable transactions regime — but what about other debts?

On one hand, preferred creditors argue that statutory set off (section 553C) is to be given the 'widest possible scope'. Absent an express exception for voidable transactions, set off should be allowed. The debts appear to be "mutual" in the sense that, once repaid but before distribution, the proceeds belong to the company in the same interest as the company owes its debts.

On the other hand, liquidators (and other creditors) argue that such a reading undermines the purpose of the voidable transactions regime. If allowed, the set off would prevent the liquidator from re-establishing the order of distribution that otherwise would have prevailed among creditors. It would do so by creating a new debt for the preferred creditor to set off against that, absent the voided transaction, would not otherwise exist — in effect, not unwinding the voided transaction.

The Federal Court decision

This was the question for the court in Woodman's case: Is statutory set off (section 553C) available against recovery of an unfair preference (section 588FA)?

The Full Federal Court unanimously (and emphatically) said: No.

To arrive at its decision, the court scrutinised the centuries-old history of statutory set off on insolvency, and the cases for and against, over a 50-page judgment.

The decision turned on two key findings:

• First, that the debts lacked the requisite quality of "mutuality" because, once an insolvent company is in liquidation, the ultimate interest in a clawed back preference lies with the liquidator on behalf of the creditors of the company to distribute in accordance with the statutory order of priority. Unless and until the company enters into liquidation, the company has no contractual, legal, equitable or statutory right of any kind to call for repayment.
• Second, that as a matter of statutory interpretation, the legislature cannot have intended that set off on insolvency was available against unfair preferences, as this would have the effect of undermining the voidable transactions regime (for the reasons advanced by liquidators, as outlined above).

The High Court weighs in

The decision by the High Court to grant special leave to hear the issue on appeal is a welcome development for commercial parties and insolvency practitioners. An authoritative decision from the High Court should put the issue to rest, setting a binding precedent for the lower courts, and giving much-needed certainty for commercial parties and insolvency practitioners.