Hong Kong – Who Owes Whom What? Nature Of Set-Off Under Insolvency Rules.

Like the rest of the planet, we remain hopeful that global and local economies will recover quickly and robustly in 2021. The recent global rollout of successful vaccination options will hopefully mean that what was perhaps previously a vision of hope based on a ‘wing and a prayer’ will now become a reality and a return to a post COVID-19 new normal. However, for the time being, it sadly remains the case that COVID-19 has handed many businesses a one-way ticket to bankruptcy/liquidation in the face of mounting debts and substantially reduced revenues.
 

In this article, we examine the legal concept of ‘set-off’ under Hong Kong law and in the context of bankruptcy and insolvency as this is likely to be a well-used mechanism to adjust respective liabilities between debtor companies and creditors in the post COVID-19 landscape that lies ahead.
 

Set-off
 

In general, set-off refers to a method of adjusting monetary cross claims between two parties to deduct one’s liability from the other, so that only the remaining balance is due.
 

Under Hong Kong law, there are several forms of set-off:
 

1. A legal set-off operates as a defence to a court action. The relevant procedure to set up a defence of set-off is provided in section 16(2)(a) of the High Court Ordinance (Cap 4) as well as Order 18, rule 17 of the Rules of High Court (Cap 4A) (and the equivalent Rules of District Court): ‘Where a claim by a defendant to a sum of money (whether of an ascertained amount or not) is relied on as a defence to the whole or part of a claim made by the plaintiff, it may be included in the defence and set-off against the plaintiff’s claim, whether or not it is also added as a counterclaim.’ It is essential that there is ‘mutuality’ and that the cross claims must be liquidated and be between the same parties that are held in the same capacity, or right, or interest. The ‘mutuality’ is not concerned with the nature of the debts themselves, ie the two claims do not have to arise from the same or closely-connected transactions. Under section 35 of the Limitation Ordinance (Cap 347), a set-off claim or counterclaim is deemed to be a separate action and to have been commenced on the same date as the original action.
    

2. An equitable set-off requires that the cross claims are sufficiently connected, and is available even if the claims are unliquidated. An equitable set-off would occur when there were cross claims arising from a contract and it was inequitable for the plaintiff to insist on his terms without giving credit for any balance due to the defendant (Rawson -v- Samuel (1841) 41 ER 451). It may also arise by express agreement or implied by a course of dealing. The differences between legal set-off and equitable set-off are set out in Re Finbo Engineering Co. Ltd. [1998] 2 HKLRD 695.
    

3. A contractual set-off arises by agreement of the parties. When both parties to a transaction are due to make payments, instead of arranging separate payments to each other, the parties may agree that the smaller amount be set-off, and the party due to make the larger payment would pay the difference between the two amounts due. For example, say A owes B $600,000, but B also owes A $400,000; the parties may agree that the $400,000 can be set off by A and only pay to B the balance of $200,000.
    

4. A banker’s set-off is also known as the right to combine accounts. When a customer has two or more current accounts with the bank under the same capacity, where at least one of which is in debit and one of which is in credit, the bank may invoke the right to combine the accounts in order to give a net balance.
    

5. A statutory/insolvency set-off refers to the mandatory set-off that applies in liquidations where there have been mutual dealings. It can also apply to contingent and unliquidated claims. Set-off in insolvency must be distinguished from other types of set-off that aim to prevent cross-claims between two solvent parties. The rationale of set-off in insolvency is to achieve substantial justice between the insolvent and the creditor(s) in winding-up. Under the rules, it may be possible to set off an amount owed by the creditor to company against debt owed by company to the creditor, in order to determine the amount for which the creditor can prove in the winding-up. Otherwise, without such a set-off, the creditor would have to pay the whole of the liquidator’s claim owing to the company, and then compete with other creditors and try to recover the full amount of debt owed by the company to him.
    

For the purpose of this article, we are looking at insolvency mandatory set-off in further detail.
 

Insolvency set-off
 

The rule relating to set-off and mutual credits is enshrined under section 35 of the Bankruptcy Ordinance (Cap 6) (BO), which is imported into the winding-up of companies by virtue of section 264 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO) (Cap 32).
 

The statutory set-off under section 35 BO is mandatory and cannot be contracted out (National Westminster Bank Ltd -v- Halesowen Presswork and Assemblies Ltd [1972] AC 785). Case laws illustrate that the following conditions must be satisfied for set-off to apply:
 

1. There must be mutual credits, debts or other liabilities that permit a financial balance to be struck.

2. There must be mutuality.

3. The claim must be provable in the winding up.

4. The benefit of a set-off against an insolvent company cannot be claimed if the other party at the time of giving credit to the company had notice that the winding up had commenced. The notice here covers not only actual notice but also constructive notice.
    

The wordings of ‘mutual credits, mutual debts, or other mutual dealings’ are wide, covering present debts and liabilities, future and contingent debts, as well as other kinds of transactions, events and statutory duties that may result in monetary liability. As such, contingent debts may be set-off against presently payable debts, so long as the contingent obligation existed at the commencement of the winding up (Young Hong Yui, William -v- Bank of Credit and Commerce Hong Kong Ltd [1994] 2 HKC 89). However, statutory set-off will not be applicable if the debtor only becomes a creditor after the adjudication of bankruptcy or the date of the winding-up petition.
 

Examples of insolvency set off
 

1. In Tam Wing Chuen and Skai Import-Export Ltd -v- Bank of Credit and Commerce Hong Kong Ltd (in liquidation) [1996] 1 HKC 692, insolvency set off was not allowed due to lack of mutuality in charge document, in respect of a company’s debt owed to a bank under a loan facility and a money deposit made to the same bank by the director and shareholder of said company.
    

2. In contrast, ‘mutuality’ was found in MS Fashions Ltd -v- Bank of Credit and Commerce International SA (No. 2) [1993] Ch 425. Two brothers held directorship in three companies. They executed a mortgage to secure advances by the bank to their companies. In the mortgage document, the brothers guaranteed their companies’ debt to the bank as ‘principal debtor’, empowering the bank to withdraw money from his personal deposit account with the bank towards repayment of the loan. The ‘principal debtor’ was defined as including the brothers and the companies. On compulsory winding up of the bank, one of the brothers, Mr. Sarwar had about £300,000 in the deposit account with the bank and his companies owed the bank about £572,000. Mr Sarwar claimed to set off his deposit against what he owed the bank under the mortgage deed and the letter of charge, and the set off would pro tanto extinguish liability of the companies as well. Hoffman LJ found that since Mr Sarwar was liable to the bank as a principal, and the bank was also principally liable to Mr Sarwar himself, there was mutuality, and therefore, set-off was allowed.
    

3. Sy Chin Mong, Stephen -v- Xian Karkiu Electric Power Limited Company [2009] 6 HKC 1 involved insolvency set-off in the context of a joint and several debt. Sy and BT China (in liquidation) were jointly and severally indebted to Karkiu for about RMB ¥3.5 million (the Sum) under an arbitral award. At the same time, Karkiu was indebted to BT China for RMB¥ 2.5 million. The issue was whether Sy was entitled to set off the RMB¥2.5 million owed to Karkiu to BT China against the Sum he and BT China owed to Karkiu.
   Le Pichon JA cited [12.21] of Derham’s The Law of Set-Off as the correct statement of the law in the context of a joint and several debt:

   ‘In the case of a joint and several debt, each of the debtors is severally as well as jointly liable. The creditor in such a case may sue all the debtors in the one action, or he may proceed against one or more of them separately. The indebtedness of a truly joint and several debtor, and a debt owing by the creditor to that debtor, constitute mutual debts, and may be set off. The occurrence of the set-off would bring about a pro tanto reduction in the joint and several debt, and would release the other debtors as well.’ 
   Le Pichon JA held that by the automatic and self-executing nature of set-off under the insolvency rules, a set-off would have occurred upon between BT China and Karkiu, which also in effect bringing a pro tanto reduction in the joint and several debt for all the debtors. As Sy was willing to pay the remaining balance after set-off, all the debt owing to Karkiu was extinguished.
    

Some limitations of statutory/insolvency set-off
 

Insolvency set-off is subject to some exceptions:
 

1. Section 45 of the Securities and Futures Ordinance (Cap 571) provides that the proceedings of a recognised clearing house prevails over the law of insolvency.

2. It is legally permissible for a creditor to contractually alter his position to his detriment, placing himself in a worse position under the pari passu rule. (Re Maxwell Communications Corp plc [1994] 1 All ER 737)

3. Where a creditor has both preferential and non-preferential/ordinary claims against the insolvent company, a creditor must set off rateably in proportion to the amount of the two claims (Re Unit 2 Windows Ltd [1985] 3 All ER 647). Where a creditor has both secured and unsecured claims, set-off may only applied against the unsecured one unless the creditor elects to surrender his security and prove in the liquidation (Re Norman Holding Co Ltd (in liq.) [1990] 3 All ER 757).
    

Our Hong Kong Restructuring and Insolvency team can offer support and legal advice and guidance on all types of debt restructuring and insolvency related issues and disputes.
 

For further information, please contact:

 

Bryan O'Hare, Partner, Hill Dickinson

bryan.o'hare@hilldickinson.com
 

Damien Laracy Partner, Hill Dickinson

Damien.Laracy@hilldickinson.com

 

Nicole Wong, Hill Dickinson

Nicole.Wong@hilldickinson.com

 

Andy Hong, Hill Dickinson

Andy.Hong@Hilldickinson.com