Equitable set-off: what kind of connection do two claims need?
A version of this case note originally featured in the Commercial Bar Association’s blog, the Commbar Law Digest. A link to the original article can be found here.
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The New South Wales Court of Appeal, in a split decision, has allowed an appeal against a judgment granting equitable set-off. The Court’s decision provides a useful overview of the law of equitable set-off. In overturning the trial judge’s decision, the Court also considered the scope and application of the so-called Brickenden principle which prohibits speculation by a defaulting fiduciary as to what would have happened had there been no default.
The facts
In 2004, a property in Vaucluse, Sydney, was purchased in Mao’s name using, among other sources, money borrowed by Mao from the National Australia Bank (NAB) as well as funds provided by Bao. Under the arrangement for the property’s purchase, Bao was to pay the ongoing expenses — repayments toward the NAB loan and the like — for the property. The parties agreed that Mao held the property on trust for Bao.
In 2007 and 2008 and without Bao’s knowledge, Mao increased the limit on the NAB loan facility and withdrew money largely for his own purposes. These withdrawals were the factual foundation of the cross-claim made by Bao in the proceeding.
In April 2011, Mao lent Bao 11 million Chinese yuan for the purpose of a different property development in Sydney. The loan was to be repaid by 1 August 2011, with interest accruing at 2 percent per month. The loan was not repaid by that date. This was the factual foundation of the claim made by Mao in the proceeding.
In October 2011, Bao ceased making payments toward the Vaucluse property. Mao stepped in to make payments for a short period of time and when he stopped doing so the mortgage in favour of the NAB defaulted. In November 2011, Bao repaid approximately half of the April 2011 loan.
In March 2012, Mao sent Bao a letter of demand seeking repayment of the April 2011 loan. Bao did not comply.
The NAB sold the Vaucluse property in May 2014 for an amount less than the loan facility balance, such that no part of the net sale proceeds went to Bao. The NAB did not pursue Mao for the shortfall.
Mao sued Bao for repayment of his April 2011 loan. Bao filed a cross-claim seeking to recover certain amounts which he alleged Mao had withdrawn from the NAB loan facility, putting his claim on the basis of breach of contract or breach of trust.
At trial
In a judgment delivered in August 2021, the primary judge found that Bao was liable to repay the balance on the April 2011 loan together with interest at the contractual rate of 2 percent per month. At the same time, the judge accepted Bao’s cross-claim for breach of trust, and held that Mao was liable to account to Bao for amounts which Bao would have received from the NAB’s sale of the Vaucluse property had Mao not withdrawn money from the NAB loan facility without Bao’s knowledge. The judge directed the parties to carry out a taking of accounts in respect of the Vaucluse property and the NAB loan facility.
The matter returned for a subsequent hearing on quantum. The parties were in agreement on several matters, but one contentious issue was the point in time at which any set-off should be measured.
Mao contended for a statutory right of set-off in the Civil Procedure Act 2005 (NSW) s 21. (A similar provision exists in Victoria in the Supreme Court (General Civil Procedure) Rules 2015 r 13.14.) The New South Wales provision is considered to apply as at the date of judgment and, on that basis and given Mao would have been entitled to interest at 2 percent per month for approximately 10 years, the effect of a statutory set-off would have been a net judgment in Mao’s favour of approximately $3.4 million.
Bao however contended for a set-off in equity and sought that it be dated to May 2014, being when the NAB sold the Vaucluse property. On that basis, such a set-off would have resulted in a net judgment in Mao’s favour of only approximately $58,000. (Neither party raised the possibility of an equitable set-off arising from the date of Mao’s loan to Bao.)
In a judgment delivered in December 2022, the judge upheld Bao’s claim for an equitable set-off. His Honour identified the issue as being whether Mao’s obligation to Bao in respect of the Vaucluse mortgage impeached his entitlement to claim payment and interest under the April 2011 loan. His Honour observed that he had not been referred to any authorities specifically on point, and therefore approached the issue as one of principle. His Honour’s key conclusion was that ‘[Mao] cannot be heard to say that the money he appropriated should bear interest at court rates while he maintains a claim for interest on moneys owing to him by Mr Bao at a far higher commercial rate’.[1]
Mao appealed, arguing that the judge had erred in finding that Bao was entitled to an equitable set-off, instead contending that the set-off should have been carried out on the statutory basis.
On appeal
A majority of the Court of Appeal (Ward ACJ, Mitchelmore JA agreeing) allowed the appeal, holding that the judge had erred in awarding equitable set-off.[2]
Equitable set-off
In delivering the majority’s substantive judgment, Ward ACJ discussed in detail the doctrine of equitable set-off and the generally-accepted requirements for its application,[3] namely that the relevant cross-demand must go to the root of, challenge, call into question, or ‘impeach’ the initial claim or, put another way, it must be that the two claims sought to be offset against one another be so closely connected that it would be unconscionable or unfair to allow one party to enforce its legal right without first accommodating the other party’s countervailing right. As Ward ACJ also noted, the authorities have held that the mere existence of a cross-claim is not sufficient but, at the same time, it is not necessary that the two claims arise from the same transaction or contractual relationship.
Turning to the facts, Ward ACJ held that Mao’s and Bao’s claims — on the one hand, liability under a loan agreement between the two and, on the other, liability under the mortgage with the NAB — lacked sufficient closeness or interconnectedness so as to found the element of unconscionability and thereby allow equitable set-off. In so holding, Ward ACJ noted:
Insofar as the primary judge was influenced by the intuitive unfairness of the circumstance that Mr Mao had the benefit of the unaccounted for funds while Mr Bao was continuing to accrue a liability in relation to the high rate of interest, such unfairness does not suffice to establish the necessary connection between the respective claims (those claims arising out of separate and distinct transactions both in time and as to their subject matter).[4]
Among the factors Ward ACJ considered when reaching her Honour’s view regarding the lack of interdependence between the claims were:
the purpose of the NAB loan facility — her Honour held that the evidence did not clearly point to Mao having been motivated to make the drawings against the possibility of future loans to Bao;
the temporal connection between Mao’s demand for repayment and Bao’s ceasing to make payments toward the NAB loan — her Honour held that this kind of connection would not make unconscionable Mao’s enforcement of the loan; and
Bao’s contention, on appeal, that Mao’s failure to account contributed to Mao’s loan claim against him by compromising Bao’s financial capacity to repay that loan — her Honour found no evidence of this.
Although White JA dissented in the result, there was no discernible difference between the majority and White JA as to the relevant legal principles; their Honours differed however on the application of the relevant legal principles to the facts.
White JA identified a quality in the connection between Mao’s and Bao’s claims so as to create the necessary impeachment and establish a right to equitable set-off; his Honour held there ‘was a direct connection between Mr Mao’s failure to account and the continued accrual of interest at the high rate of 2% per month on the loan’.[5] His Honour went on to describe the requisite connection as follows:
[T]he failure to account at the time the Vaucluse property was sold contributed to the continued accrual of interest for almost four years until Mr Bao learned the facts during the course of preparation for trial. Not to allow an equitable set-off would permit Mr Mao to profit from his breach of fiduciary duty in not providing that account.[6]
Application of the Brickenden rule
An issue arose on appeal as to application of the so-called Brickenden principle, named after the Privy Council decision in Brickenden v London Loan & Savings which prohibits speculation by a defaulting fiduciary as to what would have happened had there been no default.[7]
The question on appeal was whether it was open to Mao, as a defaulting trustee who failed properly to account for the sale proceeds of the Vaucluse property in respect of his unauthorised borrowings, to speculate as to what would have happened had he complied with his duties as trustee and accounted to Bao for the surplus from the sale of the Vaucluse property. A related question arose as to which party bore the onus of demonstrating what would have happened had Mao not breached his duty as trustee. Such matters went to the question of the sufficiency of the connection between the two transactions for the purpose of the claim for equitable set-off. Mao, in opposing any equitable set-off, argued that his failure to account upon sale of the Vaucluse property did not cause or contribute to Bao’s liability to Mao for his debt. Bao argued that Mao was precluded from arguing that the evidence had not established such a link.
The majority rejected Bao’s argument, holding that the Brickenden principle did not apply to a claim for equitable set-off. In analysing prior judicial decisions and academic commentary which had expressed doubt about the viability of the principle in Australia, Ward ACJ held:
The Brickenden principle, to the extent that it still applies, can thus be seen as part of the strict requirement that the trustee be kept to the trust (such that proof of loss is not required for an account by the trustee beyond the fact of the unauthorised disbursement or dissipation of trust funds) … .[8]
Ward ACJ held that the Brickenden rule ‘stands for a relatively narrow principle’ along those lines rather than a ‘general principle that a defaulting trustee may not point to counterfactuals as a defence to causation’.[9]
As to the role and application of the Brickenden rule, White JA noted the general prohibition in equity of speculating about what might have happened had there been no breach of fiduciary duty and that this was ‘[a] matter of policy in holding fiduciaries to high standards of loyalty and in recognition of the difficulties of proof and the speculation involved in a counterfactual’.[10]
Without appearing to rule on the application of Brickenden one way or the other, his Honour considered that the various principles governing the onus of proof of loss and profits in cases of breach of fiduciary duty, as well as the underlying policy to which his Honour earlier referred, had ‘an analogical application to the present facts’[11] and that, for present purposes, Mao was not permitted to speculate as to what would have happened had he not breached his fiduciary obligation. His Honour held in the alternative that the onus was on Mao to demonstrate that even on the counterfactual there would have been no claim by Bao for set-off at the time of sale of the Vaucluse property. Finally, White JA held that in any event it could be inferred that, had Bao discovered Mao’s conduct in 2014, he would have invoked an equitable set-off.
Comment
The split decision of the Court of Appeal speaks to the complex task involved in identifying the kind of connection between a primary claim and a cross-claim necessary to establish an equitable set-off. There also appear to be unresolved issues about the role of counterfactuals and, so far as the Brickenden rule is concerned, the relevance of speculation, when approaching the question of equitable set-off. It may be that such matters are ripe for clarification by the High Court.
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Postscript
On 11 April 2024, the High Court refused Bao’s application for special leave to appeal, citing among other things the Court’s view that the case was ‘not a suitable vehicle to consider the nature of an equitable account of administration in common form or its operation as part of the rules of equitable set-off’.[12]
[1]: Mao v Bao (No 2) [2022] NSWSC 1699, [54].
[2]: Mao v Bao [2023] NSWCA 278.
[3]: Ibid [54]–[67].
[4]: Ibid [184].
[5]: Ibid [225].
[6]: Ibid [241].
[7]: [1934] 3 DLR 465.
[8]: Mao v Bao [2023] NSWCA 278, [172].
[9]: Ibid [175].
[10]: Ibid [234].
[11]: Ibid [242].
[12]: Bao v Mao [2024] HCASL 110, [1].