Legal update: An introduction to statutory insolvency set-off

Business relationships are not straightforward, and a company can be a supplier and a purchaser at the same time. It is not an uncommon practice for companies to off-set their debt owed to another company with the receivables they should be receiving from that same company. However, when you are owed money by a company that has gone into liquidation, what happens then?

General rule to insolvency set off

The general rule is that creditors of liquidated companies are entitled to set off and they only need to pay any net amount due to the company (or the individual), or receive the net amount owed by the company. Unlike general set off between solvent companies and individuals, insolvency set off does not aim at avoiding cross actions, but rather aims at doing substantial justice. The general rule was discussed in detail in Stein v Blake (No.1) [1996] A.C. 243.

In Stein v Blake (No.1) the Plaintiff commenced proceedings against the defendant for breach of contract and the defendant counterclaimed for damages for misrepresentation. Before the trial of the case started, the plaintiff was adjudicated bankrupt and his estate, including the action he had started against the defendant, passed automatically to his trustee. The trustee then tried to assign to the plaintiff the right of action against the defendant so that the plaintiff could continue the action against the defendant. The defendant took out a summons to stay the proceedings on the ground that the assignment was invalid since the plaintiff’s claim and the defendant’s counterclaim could be set off against each other.

The House of Lords held that whereas legal set off did not affect the parties’ substantive rights, bankruptcy set off does (in effect) give the creditor security to the extent of his own indebtedness. Bankruptcy set off applies to all claims from mutual credits or dealings prior to the bankruptcy, including claims which at the time of the bankruptcy were due but not payable, unascertained or contingent. There is no such requirement for the parties to meet at a particular point of time or calculate the extent of each other’s liability. In this particular case, the claim and the counterclaim were automatically reduced to a net balance and the trustee in bankruptcy was entitled to assign the net balance like any other chose of action.

Position in Hong Kong – the relevant statutory provision

In Hong Kong, section 35 of the Bankruptcy Ordinance (Cap. 6) provides:-

“Where there have been mutual credits, mutual debts or other mutual dealings between a bankrupt against whom a bankruptcy order is made under this Ordinance and any other person proving or claiming to prove a debt under the bankruptcy order, an account shall be taken of what is due from the one party to the other in respect of such mutual dealings and the sum due from the one party shall be set off against any sum due from the other party and the balance of the account, and no more, shall be claimed or paid on either side respectively; but a person shall not be entitled under this section to claim the benefit of any set-off against the property of a bankrupt in any case where he had, at the time of giving credit to the bankrupt, notice that the petition had been presented.”

Although there is no equivalent provision in the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32), insolvency set off is also applicable in winding up proceedings pursuant to section 264 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32), which provides:-

“In the winding up of an insolvent company the same rules shall prevail and be observed with regard to the respective rights of secured and unsecured creditors and to debts provable and to the valuation of annuities and future and contingent liabilities as are in force for the time being under the law of bankruptcy with respect to the estates of persons adjudged bankrupt, and all persons who in any such case would be entitled to prove for and receive dividends out of the assets of the company may come in under the winding up, and make such claims against the company as they respectively are entitled to by virtue of this section.”

Section 35 of Bankruptcy Ordinance (Cap. 6) provides a wide protection to the creditors as the statutory definition of debts include not only present debts and liabilities, but future, certain and contingent debts as well. The inclusion of the words “mutual credits”, “mutual debts” and “mutual dealings” means that the provision covers also any such debts as will in their nature end in debts and all kinds of transactions and events, including statutory obligations and liabilities which will most probably end in a pecuniary liability. Case authorities identify certain features of a statutory insolvency set off:-

1. It is mandatory;
2. It cannot be excluded by any prior agreement between the parties;
3. Its operation does not depend on any step having to be taken by any of the parties; and
4. It takes place automatically on the bankruptcy date (or date of the winding up).

As such, under the current statutory regime, creditors are automatically entitled to statutory set off once the bankruptcy order or the winding up commences.  In the latter case the relevant date will be the date of the presentation of the petition which is deemed to be the commencement of the winding up.

Limitation of statutory insolvency set off

Even though the scope of the statutory insolvency set off is wide enough to cover most claims brought by creditors, it is also subject to some limitations.

First of all, the statutory set off is limited to mutual claims ascertained at the date when the bankruptcy order or winding up order is made, and it does not cover any claims by any third party. Thus, even if a third party consents that you can use his claim against the company or a certain individual to off-set the amount you owed to the company or that individual, statutory set off does not apply as it lacks the “mutuality” element.

Second of all, the use of the term “mutual” means the claims must be between the same persons (or companies) and in the same right. Thus, a director cannot off-set a debt due to him as a director against a debt due from him personally. However, creditors are entitled to off-set debts of different nature, i.e. a legal debt can be used to off-set an equitable debt, provided that the element of mutuality is satisfied.

Also, statutory insolvency set off is only applicable when a debtor becomes a creditor before the other individual is adjudicated bankrupt or before the company is wound-up. In other words, if the debtor only becomes a creditor after the date of adjudication of bankruptcy or after the presentation of the petition, he is not entitled to any statutory insolvency set off.

Most importantly, a creditor is not entitled under the statutory provision to claim any benefit of set off if he had notice that the petition had been presented at the time when he gave credit to the bankrupt or the company. The notice here includes not only actual notice but also constructive notice. Thus, any communication or information known to that creditor that would make a reasonable person believe that a winding up petition had been presented would constitute constructive notice and would bar the creditor from claiming any benefit of set-off.

Ian De Witt

The above is not intended to be relied on as legal advice and specific legal advice should be sought at all times in relation to the above.

If you would like to discuss any of the matters raised in this article, please contact:

Ian De Witt
Partner | E-mail

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.