Thursday 23rd February 2012

The Importance of Set-Off in Financial Transactions

By Brenda Ntambirweki

Set-off is the right of a debtor who is owed money by his creditor on another account or dealing to secure payment for what is owed to him by setting this off in reduction of his own liability.[i] It is a right available within and outside bankruptcy and liquidation and in both cases provides a speedy remedy to secure payment.[ii] Set-off however, does not create a form of security since the debtor who asserts it is not acquiring it is not any rights over an asset of the creditor but simply seeking to reduce or extinguish the claim against him. The object of set-off is to reduce a monetary liability to a net balance.[iii]

The policy reasons for providing the remedy/right depends on the type of set-off involved. There are five major types of set-off, contractual set-off, current account set-off, independent or statutory set-off, equitable set-off and insolvency set-off (in the United Kingdom). Set-off as a right has been justified on various grounds, for instance equity, freedom of contract, and efficiency, and its importance in financial markets cannot be undermined. The importance of set-off in financial transactions is thus discussed below.

The foremost importance of set-off is the promotion of efficiency by cutting down on the number of actions and reduction of the cost of paperwork of processing a multiplicity of gross contracts. A case in point is independent/statutory set-off. This is a purely procedural defence, and operates where both claim and cross claim are liquidated and due. In Stein v. Blake[iv] Lord Hoffman recognized the importance of statutory set-off, or legal set-off as he referred to it, holding that as a matter of procedure legal set-off enables a defendant to require his cross claim be tried with the plaintiff’s claim without it having to be subject of a separate action. The defendants cross claim amounts to an admission that he is liable on the claim and a contention that he is entitled to set-off his cross claim in reduction or extinction of the amount for which the plaintiff is entitled to judgement. Since both claims are tried simultaneously, multiplicity of proceedings is avoided.

Set-off plays a key role in the reduction of exposures, especially the massive risk of systematic collapses or cascade meltdowns of the banking system, and is an essential tool in banking transactions and in mutual dealings in the financial markets.[v] Taking the clearing house system as an example, contractual netting in particular is a common feature of clearing houses[vi] , where all obligations arising from a particular trader are internalized and consolidated into a single credit or debit balance in the trader’s current account with the clearing house.[vii] This usually involves a bilateral or multilateral arrangement for conversion of mutual claims into a single net claim. [viii] Contractual obligations may require that in stated eventualities, all contracts between them shall be consolidated into and replaced by a single contract under which only the net balance is payable.

Set-off is also important for equitable reasons. With regard to transaction set-off in particular, a claim will be set-off where when faced with a cross claim even if not arising from the same transaction are so closely connected that it would be inequitable for one claim to be enforced without credit being given to another. The fact that the claims do not have to arise from the same transaction protects the defendant in equity, especially since all that has to be proven is that the claims are so inseparably connected.[ix] Furthermore the requirement of mutuality is construed differently, since equity concerns itself with beneficial interests as well.[x] A debtor may thus set-off against a beneficiary under a trust and vice versa, where the plaintiff makes the claim as a bare trustee. As such, the risk of insolvency is prevented.

Another important role set-off plays is creditor protection. Insolvency set-off in the United Kingdom for example is aimed at protecting creditors and is provided for under r. 4.90 Insolvency Rules 1986. In Halesowen[xi]  court recognized that the fact that insolvency set-off is mandatory and cannot be excluded by the parties, is aimed at regulating matters of public interest in the administration of the estate and are not purely a source of private rights enacted for the benefit of individual debtors of the estate having cross claims against it. Furthermore, in the case of independent set-off, the fact that it can only be asserted where proceedings have been brought does not reduce the creditor’s right to exercise extra judicial rights and remedies for default for instance, forfeiture of a lease, distress, contractual acceleration of the promisor’s monetary liability, termination of the contract, et cetera. [xii] In Re BCCI (No 8) it was held that set-off should not prejudice the right of a secured creditor to enforce his security at a time of his choice.

Set-off also addresses liquidity issues, most importantly the need for liquid assets when a debt becomes payable. Set-off ensures that an insolvent debtor is not bankrupted on a debt which the debtor does not owe after set-off is applied. In  Re BCCI (No. 8) court held that the effect of set-off is to allow the debt which the insolvent company owes to the creditor to be used as security for its debt to him, and the creditor is only exposed to insolvency risk only for the net  balance. Furthermore, the application of the hindsight principle in determining which claims can be set-off means that court will look at post liquidation events to determine the state of account as at the date of liquidation. In MS Fashions[xiii] Lord Hoffman held that in taking the account, court has regard to events that have occurred since the date of the winding up. By applying the hindsight principle, the need for liquid assets once a debt becomes payable is covered, since there will be an availability of funds to set-off the debt.

However despite its obvious importance, the right of set-off has several limitations. Set-off can be compared to an unpublished “security interest”. [xiv] Although it is not practical to register a right to set-off, it is impossible for a creditor to know whether or not a company’s assets will be removed or depleted on insolvency due to a right to set-off. In line with this is the argument that set-off and netting reduces the assets available to unsecured creditor on insolvency, and is therefore not debtor protective. The right to set-off also collides with corporate rescue policies, especially where set-off is mandatory.[xv] Professor Wood also argues that carve out statutes in some jurisdictions which prevent insolvency rules from precluding set-off has resulted in an increase in international legal complexity.

There are also inherent limitations in different types of set-off. In the case of contractual set-off in particular, the right cannot be fully effected unless both the claim and the cross claim have been reduced to money, and in the case of an unliquidated claim, until that claim has been liquidated.  The question as to when to exercise transaction/equitable set-off has also been the subject of much judicial debate, in particular, issues as to whether it is automatic and self exercising, whether it takes effect from the time it is asserted or whether it can be exercised in “due time”.

Despite this, the limitations of the right/remedy of set-off do not extinguish its importance in financial transactions. The role set-off plays in reducing systematic risk on financial markets cannot be ignored, judging from the sums usually involved and the degree of risk reduction. [xvi]Furthermore, set-off is inevitable whenever there is a series of contracts between parties, since mutual obligations are created automatically giving rise to the possibility of set-off. Set-off has been key in preventing circuity of actions and thus promoting efficiency.

 

ENDNOTES


[i] Goode, Principles of Corporate Insolvency Law, p. 213

[ii] Ibid.

[iii] Goode, Legal Problems of Credit and Security para 7-21

[iv] [1996] AC 243

[v] Goode, Legal Problems of Credit and Security, para 7-01

[vi] Ibid para 7-18-719

[vii] Ibid para 7-18

[viii] Ibid para 7-17

[ix] ibid para 7-51

[x] ibid para 7-53

[xi] National Westminster Bank Ltd. v. Halesowen Presswork and Assemblies Ltd. [1972] AC 785

[xii] ibid para 7-37

[xiii] [1993] Ch. 425 at p. 432

[xiv] Prof. Wood,  Law and Practice of International Finance, Chapter 14

[xv] Ibid.

[xvi] Ibid.

 

The writer is an Associate with Sebalu & Lule Advocates