Set-off rights miss the mark!

Key takeaways

A recent court decision is a timely reminder of the limitations that can affect a person’s ability to rely on set-off rights when a debtor or contract counterparty becomes insolvent.

The decision of Tottle J of the Supreme Court of Western Australia in Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (in liquidation) (receivers and managers appointed) has given much needed clarification of the operation of the statutory set-off provision in section 553C of the Corporations Act 2001 and the effect of the attachment of a security interest under section 19 of the Personal Property Securities Act 2009 (PPSA).

The case involved a contest between the rights of a secured creditor and the rights of set-off of a debtor’s counterparty. Tottle J’s key findings were that:

1. section 553C of the Corporations Act constitutes a code that regulates set-off between an insolvent company and a counterparty seeking to have a debt or claim admitted against the company to the exclusion of any equitable and contractual set-off; and
2. section 19 of the PPSA operates in such a way that the attachment of a security interest over personal property causes mutuality of interest between the debtor and its counterparty to cease.

The facts

Forge and Hamersley were party to two engineering, procurement and construction contracts entered into in 2012 (EPC Contracts). Later in 2012 Forge, the contractor, commenced the works pursuant to the EPC Contracts.

In July 2013, Forge entered into a General Security Agreement by which it granted to ANZ collateral over all of its present and after-acquired property (GSA). ANZ registered the GSA on the PPSR on the same day.

In February 2014, Forge appointed voluntary administrators, on the same day ANZ appointed receivers and managers pursuant to the GSA and in March 2014 Forge went into liquidation.

The EPC Contracts

Tottle J found that the relevant provisions of the EPC Contracts entitled Hamersley to elect to set-off the money claimed by Forge for work done pursuant to the EPC Contracts against the money owed to Hamersley in losses and damages arising from their breach. In doing so, Tottle J rejected Hamersley’s submission that the relevant clauses of the contracts operated to automatically net-off the money due to Hamersley.¹

Put simply, the EPC Contracts gave Hamersley a discretion to exercise its rights of set-off. Hamersley failed to exercise those rights before the administrators were appointed. This failure resulted in a debt arising that was due and payable to Forge.

Contractual, equitable and statutory set-off rights in insolvency

Tottle J next considered whether Hamersley’s contractual or equitable set-off rights could be relied on by Hamersley when Forge was put into liquidation.² In finding that they could not, and that the statutory set-off rights under section section 553C constitutes a code that regulates set-off in insolvency, Tottle J relied on:

1. the mandatory language of the statutory text and the commercial certainty derived from an orderly process for the determination of the setting-off of claims in liquidation;³
2. the breadth of the provisions in the Corporations Act governing the admission of proof of debts and claims, particularly where an alternative system of contractual set-offs operating in parallel to the statutory scheme would be inimical to the orderly administration of the affairs of insolvent companies;⁴
3. the damage such a construction would do to the finality of the proof of debts and claims process by allowing a party to improve its position by raising a set-off outside the statutory regime;
4. the purpose of the statutory provisions to achieve “substantial justice” between a company and its debtors and its creditors as a whole, and the potential unfairness that may arise if set-off is not confined by the statutory limits;
5. the cases that suggest, and with which Tottle J implicitly agreed, that section 553C cannot be contracted out of by the parties; and
6. the weight of authority, including in New Zealand and England, that other forms of set-off cannot be relied upon independently of the statutory scheme.

Statutory set-off and PPSR security interests

The fundamental submission advanced by Hamersley, and rejected by Tottle J, was that ANZ’s security interest was a floating charge that had not crystallised. It followed, submitted Hamersley, that mutuality of interest between Forge’s claims and Hamersley’s claims continued to exist.

In rejecting that submission, Tottle J concluded that the process of attachment provided in section 19(2) of the PPSA renders the equitable concept of crystallisation redundant in the context of a security interest over personal property regulated by the PPSA.

Statutory set-off

Section 553C(1) of the Corporations Act provides that where 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:

• an account is to be taken of what is due from the one party to the other in respect of those mutual dealings;
• the sum due from the one party is to be set off against any sum due from the other party; and
• only the balance of the account is admissible to proof against the company, or is payable to the company, as the case may be.

The concept of mutuality conveys the notion of reciprocity and is concerned with the status of the parties and their relationship to each other. The central principle being that one party’s money shall not be applied to pay another party’s debt.

The nature and consequences of the attachment rule in section 19 of the PPSA

Section 19(2) of the PPSA provides that a security interest attaches to collateral when:

• the grantor has rights in the collateral, or the power to transfer rights in the collateral to the secured party; and
• either value is given for the security interest or the grantor does an act by which the security interest arises.

Tottle J found that, on satisfaction of the conditions in this section, the PPSA operates to confer on the secured party a proprietary interest in the collateral. By so doing, Tottle J confirmed that the use of the mechanism of a floating charge for taking security over circulating assets is redundant.⁵

Tottle J concluded that a statutory proprietary interest of the nature conferred by a security interest under the PPSA is sufficient to destroy mutuality of interest for set-off purposes.

Conclusion

The Hamersley Iron decision highlights:

• the difference between set-off clauses that are not self-executing and netting clauses and the need for careful contract drafting;
• the perils of delaying an election to exercise contractual set-off rights;
• that a security interest that has attached to a monetary obligation will prevent a party relying on the statutory right of set-off.

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¹ [139].
² [144].
³ [211].
⁴ [212].
⁵ [342].

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