Set-off against insolvent companies is, in my experience, the largest contributory factor preventing substantial recovery by debenture holders and creditors alike in the construction industry. As a practice it may seem quite proper under normal circumstances but, I suggest, is quite damaging when exercised against an insolvent company.

The distribution of the assets of a bankrupt and setting off of credits and debits has long been the subject of legislation and case law. As far back as Elizabethan times statute required the Commissioners in bankruptcy to pay "to every of the said creditors a portion, rate and rate alike, according to the quantity of his or her debts".

The basic objectives of modern insolvency laws are said to be that:
1. Actions by individual creditors against the inso]vent company are frozen. This is generally true in fact and in practice.

2. All assets of the insolvent company belong to the pool which is available to pay creditor claims. This is doubtful and is particularly not true when there is a charge on those assets or when set-off is exercised.
3. Creditors are paid pro rota out of the assets according to their claims. In reality this is not the case because of the statutory application of preferences and set-off.

Insolvency law is now very complex indeed and goes to extreme lengths to ensure the proper distribution of assets, in accordance with preferential rank. Yet in the absence of more measured and tangible security, the act of setting off against the insolvent company persists to the express benefit of certain parties and the dis-benefit of others of equal or higher rank.

In reality, the ranking of creditors could be set out as follows:
1st : "Super Priority" Creditors
Banks, Debenture-Holders and creditors with set-off
2nd : Priority Creditors
Employees, Government
(another sensitive area)
3rd : "Ordinary" Creditors
Trade Creditors (if not able to "promote" themselves by set-off)
4th : Deferred Creditors
Equity and Equitably Subordinated Creditors, Interest
5th : Equity Shareholders
Members, Shareholders
6th : Expropriated Creditors

Late Claimants, Tort Claimants, Foreign Currency
In the majority of insolvency situations, there are many creditors and, by the nature of the insolvency, simply insufficient funds to satisfy the creditors' claims. There will inevitably be damaging repercussions on a number of these creditors who just so happened, by coincidence of time, to be trading with, and in credit with, the now insolvent party.

A typical situation to consider is where construction company 'C' becomes formally insolvent and, being at the time concurrently in two similar contracts with employers 'A' and 'B', leaves both with substantial claims for the additional cost of completing the Works and/or rectifying defective work.

Employer 'A' may, by a coincidence of events or timing, or just by the fact that it is an honest and fair employer, have paid 'C' on time and in full and will therefore have to make an unsecured creditors claim.

Employer 'B' on the other hand, not having paid on time or in full due to a coincidence of events and/or timing, or by design, will, according to most construction contract conditions and the body of current law, simply be able to set-off its claim against the monies due, or becoming due to the now insolvent contractor, simultaneously reducing any monies available to satisfy employer A's claim.

The difference in outcome for the two employers in this example is stark and may apply in almost any trading situation; employer/ contractor, contractor/subcontractor, subcontractor/sub-subcontractor, supplier/contractor and so on.

The apparent injustice of this is clear, and has the further added injustices of:
(a) possibly depriving other creditors of the insolvent company of recovery, be they charge-holder, preferential or just unsecured creditors, possibly bringing about their own insolvency, together with further repercussions down the line to their own creditors, and
(b) increases the tendency towards late payment by debtors which is naturally exacerbated at a time when it may be felt that the company is at risk of becoming formally insolvent and may itself bring about or accelerate formal insolvency.

The potential for knock on effects elsewhere in the industry is clear because the subcontractors and suppliers are as dependant themselves on cash-flow as the main contractors. Difficulties experienced by subcontractors and suppliers will impact on another project, for another main contractor, for another employer... and so the spiral continues - a contributory factor to the boom-and-bust nature of the UK Construction Industry.

When a set-off is exercised by a potential creditor company against the insolvent company, the effect is to 'promote' that creditor above others, to the detriment of those others who may have higher ranking claims or even be secured. This flies in the face of the underlying principle of pari passu (i.e. that there should be no preference between creditors). This seems to have come about by the Courts use of equitable set-off in discrete cases, permitting a cross claim against an insolvent company without considering the wider effect in depriving other creditors of their recovery.

SO WHAT IS EQUITABLE SET-OFF?
Set-off is, primarily, the setting of two or more claims against each other in order to produce a single balance.

As a procedure, it provides a defence to an action but is not necessarily dependant upon the instigation of an action in the Courts, i.e. it may mitigate against a balance due in a set of mutual transactions, producing one balance due to one party or the other, which is paid in the normal course of business.

Equitable set-off does not rely on any contractual provision and case law has shown that in the absence of very specific wording in the contract or subcontract, the right to equitable set-off cannot be excluded. What is required for equitable set-off to apply is sufficient connection or nexus between monies due on the one hand and monies claimed to be set-off against these on the other so as to merit such set-off.

Whilst equitable set-off is a relatively wide remedy, it does not usually extend to setting off claims under different contracts unless there is express contractual provision to so do, but then this would be a contractual right of set-off rather than equitable.

It may be allowed against a receiver even though it arises after the date of the notice of assignment and is hence the form of set-off commonly applied against the insolvent, e.g. for defects coming to light after the contractor has become insolvent.

However, even though the claim and cross claim arise from the same transaction, this does not mean that equitable set-off will always apply.
In the case of Dole Dried Fruit and Nut Company V Trustin Kerwood Limited, it was held:

"It may even be insufficient that claim and cross-claim arise out of the same transaction, unless they are so inseparably connected that one ought not to be enforced without taking account of the other."

A MATTER OF CONSCIENCE?
In the case of an employer seeking to reduce or entirely avoid payment of an outstanding Certificate for Payment or subsequent release of retention monies by the use of equitable set-off, the test used by the Courts is that the claim and cross-claim must be so closely bound as to make it 'unconscionable' to disregard the cross-claim. The application of this test in practice in allowing set-off for the benefit of one party, e.g. employer 'B' in my example, seems to disregard the dis-benefit to other creditors of equal or higher rank.

In terms of pari passu, and the equity upon which such set-off was founded, would it be more 'conscionable' for these two creditors to receive, potentially, a dividend of equal proportion than for one to be satisfied in full and the other, as a consequence, receive nothing?

Bob Pearce is a Consultant to Trett Consulting on insolvency matters.