UNFAIR PREFERENCE CLAIMS AND SET-OFF UNDER SECTION 553C – NO SET-OFF “DEFENCE” AVAILABLE

26th April 2022

CASE LAW ALERT: UNFAIR PREFERENCE CLAIMS AND SET-OFF UNDER SECTION 553C – NO SET-OFF “DEFENCE” AVAILABLE (PART 2 of 3)

The section: Section 553C of the Corporations Act 2001 (Cth) (“Act”) provides for a statutory set-off between an insolvent company and a party seeking to have a debt or claim admitted in the company’s winding up. Provided that the creditor did not have notice of the company’s insolvency at the relevant time, the section is enlivened where there have been ‘mutual credits, mutual debts or other mutual dealings’ between the parties, and allows for an account and set-off of sums due between them in respect of those mutual dealings, with only the balance of that account being admissible to proof against the company or payable to the company as the case may be.

The case law development: In Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd (in liquidation) v Metal Manufacturers Pty Ltd [2021] FCAFC 228, the Full Court of the Federal Court concluded that section 553C does not offer creditors the benefit of a statutory set-off in responding to a liquidator’s claim for the recovery of an unfair preference under section 588FA of the Act[1].

Why it is important: The question of whether section 553C set-off is available as a complete or partial “defence” for a creditor facing an unfair preference claim has been the subject of ongoing debate and conflicting opinion. Although many industry participants have long held the view that set-off ought not be available, the position within the Courts was unclear and various authorities supported the contrary position. With the certainty offered by MJ Woodman, liquidators pursuing the return of unfair preferences no longer need to allow or compromise for the risk previously associated with the set-off defence. Disputes funders considering such claims will also have added certainty on the issue, which will likely lead to an increased number of claims receiving funding.

Action to be taken: Liquidators are encouraged to review any unfair preference claims that were previously considered to be uncommercial by reason of set-off risk. Such actions may now have much better prospects of attracting litigation funding and otherwise being monetised.

The facts: In MJ Woodman, the liquidator is pursuing the defendant for an unfair preference of $190,000 (“Preferentially Paid Debt”). By way of defence, the defendant points to a separate and admitted debt of $194,727.23 (“Unpaid Debt”) and seeks set-off under section 553C. The set-off issue is important because with the benefit of a set-off, the defendant would retain the amount of the Preferentially Paid Debt and reduce the amount of the Unpaid Debt by that sum. Without a set-off, the defendant would be liable to repay the full amount of the Preferentially Paid Debt, and would then need to seek payment of both debts (the Preferentially Paid repaid Debt and the Unpaid Debt) in the ordinary course of the winding up and on a pari passu basis with all other creditors.

The reasoning: Part 1 of this Case Law Update (link here) discussed the submissions that were made by the parties before the Full Court. In deciding the interaction between section 553C and the unfair preference regime, Allsop CJ (with whom Middleton and Derrington JJ agreed) traversed these submissions and, noting that the question before the Court was one of statutory construction, undertook a detailed analysis of legislative texts, history, context and evident statutory purpose, as well as recent authorities and academic commentary.

With respect to the statutory purpose of the relevant regimes, the Court noted that the Act’s unfair preference provisions (among others) serve the purpose of redressing imbalance that resulted from the favourable treatment of certain persons in transactions undertaken while the company was still a going concern. Without redress, such imbalance interferes with due operation of the pari passu principle by depleting resources that should form part of the insolvent estate for the benefit of creditors as a whole.

The Court favoured the liquidator’s argument that this statutory purpose would be undermined by allowing a section 553C set-off. Rather, it was found that disallowing set-off in such cases:

“… best reflects and vindicates the underlying purposes of both the law of set-off in insolvency and the law of preferences: by justly protecting creditors where genuinely reciprocal or mutual debts, credits or mutual dealings exist by netting such off in working out what is owed by and to the insolvent estate, which process in no way interferes with the pari passu distribution from the estate being part of an antecedent process to establish the estate and the claims upon it; and by ensuring that past preferential transactions are unwound to put the estate in the position in which it would have been had the preferential transaction not occurred, so that thereafter all creditors (including the erstwhile preferred creditor) may share equally in an estate unaffected by earlier preferential transactions”

The issue of mutuality was also central to the Court’s conclusion.

It is a requirement of the set-off provision that there were ‘mutual’ dealings between the parties. As His Honour acknowledged:

“… If there is genuine mutuality of debts or credits or genuine mutuality of dealing between the debtor and creditor, an insistence upon the creditor paying in full its debt and being required to prove (and only receive a pari passu distribution) for the debtor’s mutual obligation to pay its debt can be seen as unfair”

However, the Court found that such mutuality did not exist in cases like the present.

Firstly, this was found to be the case because the relevant transactions were not between the same parties: on one hand, the parties to the Unpaid Debt are the creditor and the company. On the other, the parties to the unfair preference claim on the Preferentially Paid Debt are the creditor and the liquidator:

“There is a lack of mutuality between the indebtedness of the company to the creditor and the liability of the creditor pursuant to court order to pay the company at the suit of the liquidator. The lack of mutuality arises from the different interest in which the company owes money to the creditor and in which the company receives money pursuant to the liability to repay not as a creditor of the preferred creditor, but as a payee pursuant to court order in an action brought by the liquidator in the execution of her or his duty to gather in the estate of the insolvent company for the benefit of all unsecured creditors and the administration of the estate.

Secondly, the Court found that the timing of the two transactions also indicated a lack of mutuality: unlike the timing of the Unpaid Debt (which forms while the company is a going concern), the right of a liquidator to reclaim the Preferentially Paid Debt can only form after the liquidator makes their unfair preference claim, i.e. after the liquidator is appointed. The liquidator cannot bring the unfair preference action before they are appointed and, therefore, the Preferentially Paid Debt cannot be payable before the company is wound up:

“The lack of mutuality also arises from the absence at the relevant date of any right or equity (vested or contingent) in the company or duty or obligation (vested or contingent) in the creditor to recover or to repay the preference, respectively. Thus, the essential requirements of s 553C are absent”

Watch this space: On 13 January 2022, the creditor applied for special leave to appeal to the High Court. In Part 3 of this Case Law Alert, LCM will report on the High Court’s decision once delivered.

[1]Although the decision does not affect other defences and exceptions that may be available to creditors responding to unfair preference actions, including the “running account” defence available under section 588FA(3) of the Act.

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Lina Kolomoitseva, Senior Investment Manager
lkolomoitseva@lcmfinance.com
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