¶ … English Right of Set-Off and Combination in the Circumstance of Insolvency
The right of combination and set-off, as developed under English law offer a number of safeguards to banks and creditors in general. These rights were expanded under the principles that they were necessary to effect substantial justice and that they would stimulate economic growth and trade. In the following paper, I suggest that the judicial application of these rights has tended to unfairly favor banks at the expense of the individual customer, which may initially stimulate growth by encouraging banks to provide loans, but in the long-term may serve to deteriorate trade, particularly at the international level. Customers in other countries, particularly civil law countries, experience much more risk when they do business with an English bank, and hence may be better off refraining from bringing their enterprises there, or at any rate must be extremely careful in drawing up contracts to insist on settlement of disputes in other jurisdictions. Historically, however, England has been loath to allow other forums to litigate the interests of its citizens and corporations.
Because the rights are interpreted rigidly, their existence also discourages customers from opening multiple accounts at a single bank (which would be more efficient) and lock the customers into positions that are unsound for private businesses. For example, the right may not be contracted out of even in contemplation of bankruptcy. Also, there has developed what seems to be a judicially-created doctrine that makes it crucial for personal liability to exist in order for the right of set-off's essential element of "mutuality" to be found. Thus, even though a third party in effect will experience loss as a result of an insolvent bank's ability to refuse to apply set-off for a principal debtor, if that party is not deemed personally liable on the debt and will ultimately have to go through the inefficient process of proving for the debt upon the bank's liquidation, that party may not compel the bank to set off the debt using the secured funds. These sorts of practical inequities suggest that some reform of the provisions setting forth these rights is needed as a public policy matter.
II. Right of Set-Off and Combination
Balance sheet insolvency occurs when a debtor company's total outstanding liabilities exceed its assets. Under English law, if there have been mutual credits, mutual debts or other mutual dealings between a debtor and a creditor prior to the commencement of the insolvency of the debtor, a self-executing "set-off" occurs by operation of law. Cross-demands are not automatically cancelled, but the procedure that leaves only the bankrupt party still in debt happens when an account is taken because the creditor has lodged a proof in bankruptcy proceedings or because the insolvent party raises set-off as a defense when an action is brought against him. Mutuality is essential to the English application of set-off, unlike set-off in other jurisdictions, but it entails not that the mutual liabilities arise from the same transaction, but that both parties have dealt with each other in the same or very similar capacities. Corporate set off is governed by Rule. 4.90 of the Insolvency Rules 1986, which provides in relevant part:
1) This rule applies where, before the company goes into liquidation, there have been mutual credits, mutual debts or other mutual dealings between the company and any creditor of the company proving or claiming to prove for a debt in the liquidation.
2) An account shall be taken of what is due from each party to the other in respect of the mutual dealings, and the sums due from one party shall be set off against the sums due from the other...
4) Only the balance (if any) of the account is provable in liquidation.
Alternatively (as the case may be) the amount shall be paid to the liquidator
As part of the assets."
Basically, English set-off allows a creditor to use any money it owes an insolvent debtor to pay off the debtor's liabilities that have become due to the creditor. Thus, when liquidation commences, only the party that had the larger claim is still owed the net balance. Liquidation legally occurs when the company passes a resolution to voluntarily wind up or is judicially wound up. Effectively, eligible creditors (those that meet the mutuality requirement) are positioned alongside secured creditors to the extent of their debt to the insolvent party. Simultaneously, they continue to be placed within the pool of unsecured creditors who (as a result of the speeding of the...
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