Case law update
IPA Insolvency Practitioner newsletter, September 2024
An insolvency case law update prepared by Alexandra Withers, Associate Director at Manolete Partners PLC.
Alexandra Withers has over a decade of experience in all aspects of insolvency law. Previously she was an associate solicitor at a commercial firm in Newcastle upon Tyne where she specialised in contentious insolvency. She has been recognised in the Legal 500 as a Rising Star in the field of insolvency and corporate recovery, as well as a Key Lawyer in the field of commercial litigation. In 2021 Alexandra was appointed to sit part-time as a Deputy District Judge, and in 2024 became authorised to hear Business & Property Court cases. She is also a past chair of R3 North East. Alexandra is based in Newcastle upon Tyne.
Setting off against directors’ loan accounts?
“I paid £50k to a creditor of the Company, so that can come off my £200k overdrawn director’s loan account, right?”
With the number of liquidations involving re-financed pandemic support loans on the rise, directors who are keen to set up new companies are often paying off company creditors and attempting to argue that in doing so they should be able to set off the amount they have paid against their overdrawn directors’ loan accounts. Can they do this? In this article we take a look at the various arguments deployed and whether they can succeed.
Insolvency set off reminder
Insolvency set off in liquidation is dealt with under Rule 14.25. It applies when a creditor of the company is also owed money by the company. The effect of insolvency set off is to take the net position of the two balances. It applies automatically on commencement of liquidation, and cannot be excluded.
Insolvency set off is premised on there having been “mutual dealings” between the creditor and the company.
Are there mutual dealings?
The definition of mutual dealings in Rule 14.25(6) is rather unhelpful. It is simply that there are mutual credits, mutual debts or other mutual dealings. Directors often argue that of course there are mutual dealings between themselves and the company: they are a director of the Company! But that is not enough.
Long established case law (National Westminster Bank Ltd v Halesowen Presswork and Assemblies Ltd [1972] AC 785) makes it clear that the dealings must be between the parties in the same right. The director in operating a (usually unapproved) loan account does so in his capacity as director of the company. When it comes to him paying the creditor, he is not doing so in his capacity as director of the company. And of course, the company is not engaging in any dealing at all at this post-liquidation stage. It therefore cannot be said that there are mutual dealings in the same right.
Another requirement is that the mutual dealings must have taken place before the liquidation of the company (because a right of set-off which does not exist at the date of liquidation cannot be acquired afterwards). Therefore, the fact that the director has made payment after liquidation of the company is also fatal to his argument.
What about a formal assignment of the debt from the creditor to the director?
It is rare to see such an assignment, but this is sometimes argued as a last-ditch attempt for the director to be able to set off. However, even if there were an assignment this would not assist the director in his argument because Rule 14.25(6)(d) specifically precludes a debt which the director acquires by assignment after the company entered liquidation from the definition of mutual dealings. Therefore, in cases where an assignment has occurred, the argument of the director is not improved.
So where does that leave the director?
Well, firstly they have probably achieved their primary goal of appeasing the creditor they paid off so their newco can avail itself of future credit being extended to it.
In terms of the company in liquidation, the director of course can fall back on subrogation (which allows a person who has discharged the debt of another to step into the shoes of the person originally entitled to payment) and join the unsecured creditor class. Whilst they probably won’t be best pleased about having to pay £200k in, to only receive a share of £50k back – that is giving effect to the pari passu principle: that each creditor in the same class is paid equally and without preference to one another. The alternative would be that the director (as creditor in place of the original creditor) would effectively receive the benefit of the £50k they paid in full, £ for £, whereas other creditors of course would likely not receive payment in full.
Alternative claim in breach of duty
If progress is not being made in negotiations with the director, and they remain adamant that they can claim set off, all is not lost.
Insofar as the making of the director’s loan was a breach of duty, then the director will be liable to contribute to the company’s assets in the value of that directors’ loan account. In Manson v Smith (liquidator of Thomas Christy Ltd [1997] 2 BCLC 161, CA, the court held that making such a contribution is not a dealing under Rule 14.25, so set off does not apply to breach of duty claims.
It is, therefore, usually worth advancing a breach of duty claim in the alternative to a debt claim in respect of an overdrawn director’s loan account in order to minimise set off arguments being deployed and to maximise chances of recovery.
Disclaimer: This article provides a general overview of the case and is not intended to be relied upon in place of legal advice.
Content courtesy of IPA corporate partner Manolete Partners PLC.
Please note that guest content does not necessarily represent the views of the IPA.