Set Aside: Australian Creditors Unable to Rely on Statutory Set-Offs to Defend Unfair Preference Claims

Background

During a winding up, the statutory duty of a liquidator is to gather in the estate of the company, which includes recovering any amounts owing to the company. Creditors then submit proofs of debt and receive distributions. These distributions are governed by the pari passu rule, whereby creditors of the same rank are treated equally.

Mutual Set-Offs

An important exception to the pari passu rule exists where a creditor also owes debts to the company.  According to s 553C(1) of the Corporations Act 2001 (Act), if there have been mutual credits, debts or dealings between a company being wound up and a creditor, the sum due from one party is automatically set off against any sum due from the other. This set-off mechanism avoids a situation where a creditor would be required to pay the debt it owes in full but only receive a pro-rated distribution in relation to the debt owed to it.  

A set-off is only available in limited circumstances as there must be mutuality in the type of interest or claim held by creditor and company.  Among other requirements, both creditor and company must be owed debts for their own benefit for the set-off to apply.

Unfair Preference Claims

A key tool for liquidators in maximising the size of an insolvent company’s assets for distribution is a claim that a creditor has obtained an unfair preference. Unfair preferences arise where an unsecured creditor receives a payment that is greater than what they would have obtained if the creditor were to prove for the debt as part of the liquidation process.

An unfair preference is a voidable transaction and is required to be repaid. This ensures that creditors of the same class are treated equally and prevents a "dislocation [of] the order of priorities" by allowing one creditor to be preferred above another. 

We discuss the operation of the unfair preference regime in further detail in our Commentary, "After a Peak Comes the Fall: Australian Federal Court Rejects "Peak Indebtedness Rule," which addressed the recent Australian Court’s rejection of the availability of the Peak Indebtedness Rule. This development provided more certainty for creditors who were using the running account defence to an unfair preference claim. 

The Special Case

The liquidator of MJ Woodman Electrical Contractors Pty Ltd commenced an unfair preference claim against a creditor concerning $190,000 in payments made by the company during the relation back period.

The defendant creditor sought to defend the claim by relying on a $194,000 debt owed by the company to set off any liability arising from the unfair preference claim. The liquidator contended that s 553C(1) did not apply but acknowledged that, if the set-off were available, the unfair preference claim would necessarily fail.

There has been long-standing uncertainty as to whether creditors can rely on a mutual set-off to defend an unfair preference.   Trial judgements confirming a creditor’s right to invoke the set‑off have been subject to forceful academic criticisms. In light of this debate, the trial judge hearing the preference claim elected to refer the following question to the Full Court as a "special case": 

Is statutory set-off, under s 553C(1) of the Act, available to the defendant in this proceeding against the plaintiff’s claim as liquidator for the recovery of an unfair preference under s 588FA of the Act?

The Decision of the Full Court

The question for the Full Court was one of statutory interpretation. After considering the legislative purpose and history of the mutual set-off and unfair preference regimes, Allsop CJ (with whom Middleton and Derrington JJ agreed) concluded that the answer to the above question is "no."  

This is because there is a lack of mutuality between the indebtedness of the company (the $194,000 debt) and the liability of the creditor (the unfair preference). Unlike normal set-off claims, where both company and creditor share mutual interests in their respective claims, the Full Court emphasised that the nature of an unfair preference claim was incongruous with the operation of s 553C(1):

There is simply no mutuality between debtor and creditor in respect of the obligation of the creditor to comply with an order of the Court made under [the unfair preference provisions of the Act] on the application of the liquidator. It is a new right; and a new obligation; one to cure the dislocation to the order of priorities made by the payment … The obligation to pay under s 588F is not owed to the company by virtue of a right it has against the creditor. It is an obligation found in a judgment or order of the Court of which the company is the recipient pursuant to a successful application brought by the liquidator in his or her own right.  

The lack of mutuality arises from the different interest in which the creditor and company owe money.  A debt owed by company to creditor is a right held by the creditor for his or her own benefit. By contrast, the company is repaid an unfair preference not as a creditor, but as a payee pursuant to a Court order in an action brought by the liquidator. This action is commenced in the execution of the liquidator’s statutory duty to gather in the estate of the company for the benefit of unsecured creditors, as opposed to being for the benefit of the company itself.  

This emphasis on the need for mutuality provides further certainty for insolvency practitioners. Although other defences (such as the running account and good faith defences) remain available to creditors in response to unfair preference claims, the Full Court’s decision in this case resolves long‑standing uncertainty as to the role of mutual set-offs in the unfair preference regime.