Legal Insights

The Unfair Set-Off

• 17 April 2023 • 17 min read

Originally published in the March 2023 issue of the Australian Restructuring & Turnaround Association Journal (ARITA), this article explores the interaction of statutory set‑off and unfair preference claims through its legislative origins, historical application and consideration by the courts, before discussing the High Court’s recent judgment and concluding with key takeaways for insolvency practitioners. Liquidators will find relief in the High Court’s judgment that has now simplified and settled this contested area of law.

The High Court of Australia’s first decision of 2023 has determined that creditors can no longer avail themselves of the statutory set‑off in s 553C of the Corporations Act 2001 (Cth) (Corporations Act) to reduce amounts owing in an unfair preference claim: Metal Manufactures Pty Ltd v Morton [2023] HCA 1 (Metal Manufactures v Morton). Following the Full Court of the Federal Court of Australia’s decision in December 2021,^[1] Australia’s judiciary has overwhelmingly sent a clear message to Australia’s insolvency profession: statutory set‑off and unfair preference claims cannot coexist in insolvency proceedings.

Legislative provisions

Unfair preference

In 1992, Federal Parliament introduced a range of measures in response to the 1988 General Insolvency Inquiry of the Australian Law Reform Commission (more commonly known as the Harmer Report) through the Corporate Law Reform Act 1992 (Cth) (CLRA). One of these measures was to address transactions from a company to one of its creditors that gives that creditor an advantage over the company’s other creditors (an unfair preference).

Parliament further intended that if entered into when the company is insolvent, an unfair preference transaction can be deemed an ‘insolvent transaction’ and would be liable to be set aside.^[2] This is not to say, however, that unfair preference laws only came into existence in Australia in 1992. Before the introduction of the CLRA, unfair preferences were applied to company liquidations by way of the various companies and corporations legislation across the states and territories and s 122 of the Bankruptcy Act 1966 (Cth) (Bankruptcy Act).

The CLRA, therefore, had the effect of simplifying the application of unfair preferences to company liquidations. Essentially, the laws pertaining to unfair preferences ensure creditors of a company are treated equally (where applicable) by preventing unsecured creditors from receiving an advantage over others.

Applied in practice, the unfair preference laws form part of the Corporations Act’s following voidable transactions regime (which this article defines as the unfair preference laws):

An unfair preference is defined in s 588FA of the Corporations Act to mean a transaction from a company to a creditor of the company where:
1. the company and a creditor are parties to the transaction (even if someone else is a party), and
2. the transaction results in the creditor receiving more from the company in respect of an unsecured debt than it would have received if the transaction were set aside and the creditor were to prove
Section 588FC then provides that an unfair preference is an insolvent transaction if the transaction occurred when the company was insolvent or the company becomes insolvent because of the transaction.
Section 588FE further provides that an insolvent transaction will be a voidable transaction if it occurred during the six months ending on the relation‑back date, or after the relation‑back day but on or before the day when the winding up began. This period is extended to four years ending on the relation‑back day where a party to the transaction was a related entity of the company.
A liquidator can then apply to the Court under s 588FF to seek orders regarding the voidable transaction. The most common order is an order for the payment of the money or transfer of property that comprised the unfair preference, the “claw back”. The purpose of s 588FF has been described by the Courts as to ensure that, the administration of a company being wound up is not distorted by preferencing debts ahead of other equivalent debts;^[3] and to secure equality of distribution amongst creditors of the same class^[4] The High Court has further noted that the cause of action conferred by s 588FF was not one exercisable by the liquidator as agent of the company, but rather as an officer of the court.^[5]

Statutory set-off

Section 553C of the Corporations Act provides that, where there have been mutual credits, mutual debts or other mutual dealings (mutuality) between an insolvent company that is being wound up and a person who wants to have a claim admitted against a company, the sum due to one party may be set‑off against the sum owing to the other and only the balance is admissible to prove (statutory set‑off). For example: before being wound up, a company owed a supplier $100,000 and the supplier owed the company $50,000. Under the statutory set‑off, the supplier would be entitled to $50,000 being the balance of the amounts set‑off.

Specifically, s 553C(2) prohibits anyone from claiming the set‑off where, at the time credit is given to, or received from, the company, they had notice of a company’s insolvency.

The statutory set‑off was first codified into Australia’s corporations law at the same time as the unfair preference laws in 1993. Before this, the historical equivalent resided under the Judicature Act 1876 (UK) and s 86 of the Bankruptcy Act. The Harmer Report recommended that the “situations for excluding a right of set‑off should correspond to the situations where a transaction may be avoided on the basis that it is preferential”.^[6]

The High Court observes that there are two critical features, or elements, to the statutory set‑off. Firstly, in what the High Court describes as the “temporal element”, the statutory set‑off is only concerned with debts against the company arising from circumstances which had occurred before the winding up of the company (or more precisely, before the relation back date). Therefore, the rights of the parties are to be taken and ascertained as at the time of winding up.^[7] Secondly, the requirement of mutuality has been previously clarified to require dealings between the same persons, that the benefit or burden of the dealings lie in the same interests, and that the set‑off must “ultimately sound in money”.^[8]

Historical application

Liquidators may be familiar with the historical practice up to this point: a creditor could use the statutory set‑off to reduce the amount of money clawed back by a liquidator under the unfair preference laws. The ability of creditors to rely on the statutory set‑off provided them with a defensive bulwark against a liquidator’s unfair preference claim.

The following example illustrates how creditors commonly used this in practice:

As at 20 January 2023 a company owes a creditor $1 million.
On 15 February 2023, the company pays the creditor $250,000 in part satisfaction of the outstanding debt. The creditor has no knowledge of the company’s financial position.
On 10 March 2023 the company is wound up.
The liquidator attempts to claw back that $250,000 under the unfair preference laws so it can be made available for the general body of creditors of the company.
The creditor claims the statutory set‑off as a defence to the unfair preference, arguing that the company’s payment of $250,000 should be set‑off against the $1 million already owing – therefore effectively reducing the amount capable of being clawed back down to zero, and leaving an outstanding debt of $750,000 still owed to the creditor and the creditor proving for the remaining $750,000.

This practice effectively escalated creditors who could rely on the statutory set‑off to the head of the queue ahead of other creditors and disrupted the pari passu principle of equal distribution, where applicable. Despite this creditor‑friendly approach, it has been regularly enforced by the Courts.

Several notable examples include:

The 1997 case of Re Parker (1997) 80 FCR 1 (Re Parker)

^[9] In this case, the Federal Court of Australia determined that a creditor could apply a statutory set‑off against an insolvent company’s debt. The amount of the statutory set‑off was the quantum of an insolvent trading claim brought against the creditor. Although Re Parker was not concerned with unfair preference laws, it permitted the application of statutory set‑off against claims capable of being brought by liquidators under the Corporations Act.
Re Parker was applied in the 2011 case of Buzzle Operations Pty Ltd (in liquidation) v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47 (Buzzle v Apple)

81 NSWLR 47 (Buzzle v Apple)^[10] where the New South Wales Court of Appeal held that the statutory set‑off should be available to set‑off an uncommercial transaction (and a voidable transaction under the Corporations Act). Despite this determination, the Court noted that “Re Parker virtually stands alone as the authority for set‑off” and further noted commentary from legal scholars that strongly criticised the use of the statutory set‑off for such a purpose.^[11]
In the 2015 case of Morton & Anor v Rexel Electrical Supplies Pty Ltd [2015] QDC 49 (Morton v Rexel)

^[12] The Queensland District Court determined that an unfair preference claim of $197,469.16 should be reduced by $64,658.15 pursuant to the statutory set‑off, leaving $132,811.01 recoverable by the liquidator.
The 2016 case Hussain v CSR Building Products Limited, in the matter of FPJ Group Pty Ltd (in liquidation) [2016]

FCA 392 highlighted “powerful contrary arguments” to the use of the statutory set‑off. However, and unfortunately, the case did not canvass the issues further as the Court found that the elements of establishing the unfair preference did not exist.

The facts in Metal Manufactures v Morton

Metal Manufactures Pty Limited (Metal Manufactures) supplied goods to MJ Woodman Electrical Contractors Pty Ltd (MJ Woodman) on credit, leading to debts owed by MJ Woodman to Metal Manufactures. During the relation back period, MJ Woodman made payments of $190,000 to Metal Manufactures in satisfaction of the debts.

Upon MJ Woodman being wound up, the liquidator claimed that the $190,000 paid to Metal Manufactures were unfair preference payments under s 588FA of the Corporations Act, and Metal Manufactures was therefore liable to pay the $190,000 to the liquidator upon obtaining a court order under s 588FF of the Corporations Act.

In turn, Metal Manufactures claimed that the $190,000 it was liable to pay to the liquidator should be set‑off against $194,727.23 from debts still owing by MJ Woodman to Metal Manufactures. Effectively, Metal Manufactures sought to use the statutory set‑off as an alternative defence against the liquidator’s unfair preference claim to reduce the amount owing to the liquidator.

In 2021, these facts were brought before the Full Court of the Federal Court of Australia where it was asked to consider whether a creditor who had received an unfair preference under s 588FA of the Corporations Act could avail itself of the statutory set‑off in s 553C of the Corporations Act (the question).

What did the Federal Court decide?

Chief Justice Allsop of the Federal Court delivered a 71‑page judgment (with both Justices Middleton and Derrington concurring) and concluded that the answer to the question is ‘no’: Metal Manufactures could not avail itself of the statutory set‑off to reduce amounts owing under the unfair preference laws.

The Chief Justice reasoned that in order for the statutory set‑off to apply to unfair preference laws, there must be mutuality between MJ Woodman and Metal Manufactures. As noted above, there must be ‘mutual credits, mutual debts or other mutual dealings’. Because Metal Manufactures’ liability to pay back the $190,000 arises from a court order made under the unfair preference laws, the Chief Justice reasoned that “there is simply no mutuality between debtor and creditor”.^[13]Simply put, Court orders are incapable of meeting the requirements of mutuality. Therefore, because unfair preference laws do not contemplate mutuality between a debtor and creditor, a creditor is unable to utilise the statutory set‑off to set‑off the amount of money being clawed back by the liquidator.

The Chief Justice also spoke of the public policy underpinning the separate provisions of statutory set‑off and unfair preference laws. In essence, it would be unfair and contrary to the purpose of the Corporations Act for a creditor to use the statutory set‑off as a mechanism to take priority of other creditors in the winding up of a company:

Ultimately, the matter is one of statutory construction. The words of s 553C are to be read in the context of the Act as a whole in a way that conforms with its operation, set in the context of an orderly administration, built on the foundation of genuine mutuality, recognising the importance of the vindication for the general body of creditors of remedies to cure efficaciously the effect of a preferential transaction, of equality of distribution, and of the statutory regime of administration. A conclusion of mutuality for the purposes of s 553C as propounded by the creditor would see … the consequence that proceeds of a preference recovery action under s 588FF would go first to pay (by a set‑off) an erstwhile preferred creditor in priority to priority creditors, such as employees of the insolvent company. Such a conclusion offends the notion of fairness that underpins mutuality in s 553C and the statutory order of priority of certain creditors, built in respect of some (in particular employees) upon the protection of the vulnerable.^[14]

The Federal Court’s decision quickly found its way into other court judgments.^[15] Just four days later on 20 December 2021, Justice Kerr in the Federal Court of Australia relied on the Federal Court’s decision for the authority that a creditor’s obligation to pay a liquidator assets obtained from a voidable transaction arises from an order of the court sought upon the application of the liquidator – it is not an obligation owed to the company arising from a right it has against the creditor.^[16]

In May 2022, Metal Manufactures appealed the Federal Court’s decision to the High Court of Australia, seeking the Federal Court’s decision be set aside and that the answer to the question should instead be ‘yes’: that a creditor could avail itself of the statutory set‑off to reduce amounts owing under the unfair preference laws.

What did the High Court decide?

In a majority judgment (Kiefel CJ, Gordon, Edelman and Steward JJ), the High Court agreed with the Federal Court’s decision and similarly answered ‘no’ to the question. The High Court referenced the Federal Court’s decision sparingly, and instead appeared to approach the question with a fresh set of inquiring eyes; focusing on the timing of the company’s insolvency as a lens with which to draw distinctions between the unfair preference laws and statutory set‑off.

The High Court held that the unfair preference laws are directed at what might have been provable in the winding up which means that it is concerned with a transaction that is an unfair preference entered into before the commencement of the winding up.^[17]The unfair preference laws are a “specific statutory right held by the liquidator for the purposes of recovering preference payments to secure the equitable distribution of assets amongst creditors”.^[18]Immediately before the commencement of the winding up, MJ Woodman owed money to Metal Manufactures, but Metal Manufactures owed nothing to MJ Woodman. Therefore, because the two parties shared no mutuality, the statutory set‑off cannot apply.

Similar to the Federal Court’s reasoning, the High Court also had regard to the purpose and policy of the unfair preference laws and statutory set‑off, remarking that the outcome of applying both provisions in practice would “diminish the pool of assets available for priority payments and rateable distribution”; and “permit a preferred creditor to use each dollar owed to it by the company to set‑off in full each dollar of liability arising from receipt of an unfair preference”.^[19]Therefore, the amount sought to be set‑off by Metal Manufactures “must be applied under the statutory scheme of liquidation and be made available, amongst other things, for the making of priority payments and for distribution to creditors in accordance with the pari passu principle”.^[20]

The High Court also paid particular attention to s 588FI of the Corporations Act. That section essentially provides that a creditor who receives an unfair preference cannot prove in the winding up of a company until it has repaid the amount preferentially paid to it in full.^[21]

Key takeaways

Liquidators can breathe a sigh of relief now knowing that unfair preference claims brought against creditors can no longer be defended by statutory set‑off.

Because the High Court considered the enforcement of voidable transactions under s 588FF, creditors will unlikely be able to use the statutory set‑off to defend other forms of voidable transactions such as uncommercial transactions (s 588FB), insolvent transactions (s 588FC) and creditor‑defeating dispositions (s 588FDB).

If liquidators encounter a creditor attempting to raise the statutory set‑off against an unfair preference claim from now on, in the early dispute resolution stages liquidators may wish to cite the High Court’s judgment to remind the creditor that they are welcome to prove in the winding up along with all other creditors once the unfair preference has been paid back: Metal Manufactures Pty Ltd v Morton [2023] HCA 1 at [58].

Liquidators should keep in mind that the High Court’s decision only specifically considered the statutory set‑off as it interacts with voidable transactions. Creditors are still entitled to rely on s 553C of the Corporations Act where mutuality existed between the company and creditor before the company went into liquidation.

Learn more about the authors

Melissa Jeremiah and Michael Wells are part of the Maddocks Restructuring & Insolvency practice. Find their contact details below

Melissa Jeremiah Michael Wells

^{1
Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited (2021) 289 FCR 556; [2021] FCAFC 228. 2
Explanatory Memorandum, Corporate Law Reform Bill 1992 (Cth) at [374]. 3 Federal Commissioner of Taxation v Jaques (1956) 95 CLR 223 at 229‑230. 4 G & M Aldridge Pty Ltd v Walsh (2001) 203 CLR 662 at [30]. 5 Metal Manufactures Pty Ltd v Morton [2023] HCA 1 at [24]. 6 Australian Law Reform Commission, General Insolvency Inquiry, Report No 45 (1988) at 330 [818]. 7 Hiley v Peoples Prudential Assurance Co Ltd (1938) 60 CLR 468 at 480. 8 Gye v McIntyre (1991) 171 CLR 609 at 623. 9 Re Parker (1997) 80 FCR 1; [1997] FCA 1264. 10 Buzzle Operations Pty Ltd (in liquidation) v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47; [2011] NSWCA 109. 11 Ibid at [276]. 12 Morton & Anor v Rexel Electrical Supplies Pty Ltd [2015] QDC 49. 13 Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited (2021) 289 FCR 556 at [154]. 14 Morton as Liquidator of MJ Woodman Electrical Contractors Pty Ltd v Metal Manufacturers Pty Limited (2021) 289 FCR 556 at [155]. 15
Brooks (liquidator), in the matter of NB Contracting Pty Ltd (in liq) v Jamp Hardware Pty Ltd [2021] FCA 1612; Rockment Pty Ltd trading as Vanilla Lounge v AAI Limited trading as Vero Insurance [2021] FCA 163. 16 Brooks (liquidator), in the matter of NB Contracting Pty Ltd (in liq) v Jamp Hardware Pty Ltd [2021] FCA 1612 at [15]. 17 Metal Manufactures Pty Ltd v Morton [2023] HCA 1 at [28]. 18 Metal Manufactures Pty Ltd v Morton [2023] HCA 1 at [46]. 19 Metal Manufactures Pty Ltd v Morton [2023] HCA 1 at [51]. 20
Metal Manufactures Pty Ltd v Morton [2023] HCA 1 at [54]. 21
N A Kratzmann Pty Ltd (In liq) v Tucker [No.2] (1968) 123 CLR 295 at 297. 22 Shirlaw v Lewis (1993) 10 ACSR 288 at 295‑296; Hall v Poolman (2007) 65 ACSR 123 at 215‑217 [415]‑[431]; Stone v Melrose Cranes & Rigging Pty Ltd [No.2] (2018) 125 ACSR 406 at 479‑481 [279]‑[283].}