Neutral Citation Number: [2009] EWHC 740 (Ch)
Case No: GLC 228/08
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
Royal Courts of Justice
Strand, London, WC2A 2LL

Date: 8 April 2009
Before :

The Chancellor of the High Court
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In the matter of Kaupthing Singer and Friedlander Ltd
(In administration)

and

In the matter of the Insolvency Act 1986

Between :

	Newcastle Building Society	Applicant	
	- and -		
	Mill and others		
	Kaupthing Singer and Friedlander Ltd (Isle of Man) Ltd	Respondents	

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MR S MORTIMORE QC & MR D BAYFIELD  (instructed by Addleshaw Goddard LLP) for the Applicant
MR R DICKER QC & MR T SMITH (instructed by Freshfields Bruckhaus Deringer LLP) for the 1st  to 4th Respondents
MR L TAMLYN (instructed by  Nabarro LLP) for the 5th Respondent

Hearing date: 26 March 2009
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Judgment

The Chancellor : 
Introduction

1.	On three days between 12th August and 25th September 2008 the Newcastle Building Society (“NBS”) acquired three instruments of deposit issued by Kaupthing Singer & Friedlander Ltd (“KSF”), a wholly owned subsidiary of Kaupthing Bank hf the biggest bank in Iceland, in respect of the aggregate sum of £11m repayable with interest at varying rates on three maturity dates between 20th November and 17th December 2008 (“the KSF Instruments”).   On 29th September 2008 KSF bought a certificate of deposit issued by NBS in the principal sum of £10m repayable with interest on 6th January 2009 “without set-off, counterclaim or other deduction, save as required by law..” (“the NBS CD”).  On 4th November 2008 NBS was informed that such acquisition had been made by KSF on behalf and at the expense of, as it subsequently emerged, its indirect subsidiary Kaupthing Singer & Friedlander (Isle of Man) Ltd (“KSF(IoM)”). 
2.	On 8th October 2008 KSF went into administration and four partners in Ernst & Young LLP, the first four respondents, were appointed the administrators.   On 9th October 2008 a provisional liquidator was appointed in respect of KSF(IoM).   The KSF Instruments were not repaid on their respective maturity dates.  Thus, as of 17th December 2008, KSF owed NBS £11m together with interest at the rates and for the periods provided by the respective KSF Instruments.  NBS was concerned that as of 6th January 2009 it would be liable to KSF in respect of the NBS CD for £10m with interest but, seemingly, without the benefit of set-off or counterclaim.  On 15th December 2008 NBS issued the application in the administration of KSF now before me seeking a declaration that KSF was not entitled to payment or to enforce payment under the NBS CD because NBS had a legal right of set-off and a defence to any such claim arising out of the liability of KSF under the KSF Instruments.
3.	The application first came before the court on 17th December 2008.  The parties agreed a modus vivendi pending determination of the application on its merits.  Accordingly NBS paid the sum of £10,170,334 into a joint account in the names of the parties’ respective solicitors on terms that:
“...so far as possible the sum shall represent [the NBS CD] without prejudice to (a) the rights (if any) that KSF would have had to recover payment from [NBS] under the NBS CD and (b) the rights (if any) that [NBS] would have had to refuse to make any payment to KSF under the NBS CD.”
4.	Thus, the issue for my determination is whether NBS had any right to refuse to pay to KSF on 6th January 2009 the sum of £10,170,334 then due to KSF under the NBS CD.  If the answer to that question is in the affirmative the money in the joint account should be paid back to NBS. If it is in the negative the money in the joint account should be paid to KSF.

CREST

5.	The NBS CD was a dematerialised security issued and to be settled under CREST.  Accordingly it is necessary to explain the features of CREST which impinge on the issues I have to decide.  S.207 Companies Act 1989 authorised the Secretary of State to make regulations for enabling title to securities to be evidenced and transferred without a written instrument.  Those regulations are The Uncertificated Securities Regulations 2001 SI 2001 No:3755 as amended from time to time.  The securities to which they apply include eligible debt securities (“EDS”). The regulations enable such securities to be ‘uncertificated’ and transferable under a system run by an operator approved by the Treasury.   CREST is such a system.  It is operated by Euroclear UK and Ireland Ltd which is approved by the Treasury.  Both KSF and NBS are members of CREST.
6.	The rules of CREST provide that any security transferable in accordance with its rules 
“....must be transferable free from any equity, set-off or counterclaim between the issuer and the original or any intermediate holder of the security.”  (rule 7 para 3.2)
and that
“Any provisions in....any agreement, instrument, deed or record relating to payments to be made to or by an issuer...must be compatible with the CREST payment mechanisms set out in the agreements entered into by CREST users and participants and in the CREST Manual.”  (rule 7 para 5)
7.	The agreement required by Rule 7 para 5 is, in the case of NBS, a deed dated 10th October 2005 (“the Deed”).   The Deed recites the intention of NBS to issue EDS in uncertificated form in respect of which the holder will acquire the rights against NBS constituted or acknowledged by and under the Deed.   The payment obligations of  NBS are set out in clauses 2 and 3.  By clause 3.2 each payment of principal by NBS is to be by means of a CREST payment, as defined, and, by virtue of clause 3.5(a), “shall be made without set-off, counterclaim or other deduction, save as required by law.”   Clause 6 deals with the constitution, issue and transfer of units.  Clause 6.4(c) reflects CREST rule 7 para 3.2 in requiring units to be transferable free from any equity, set-off or counterclaim between the issuer and the first or any intermediate holder.  The definition of a CREST payment in clause 1 requires a payment which is made by means of the CREST relevant system.   It thereby brings in all the relevant provisions of the CREST rules for payments, including Rule 7 paras 3.2 and 5 quoted above.
8.	Thus, as counsel for NBS frankly recognised, to obtain the relief his clients seek it is necessary to displace the prima facie operation of both the CREST payment system and clause 3.5(a) of the Deed.  He seeks to do so by drawing a distinction between legal set-off, equitable set-off and the mandatory set-off in companies’ administration or winding up for which Insolvency Rules 2.85 and 4.90 provide.

Legal set-off

9.	Given the starting point of counsel’s argument it is appropriate shortly to describe the nature of the set-off on which he relies.   The mandatory set-off for which Insolvency Rules 2.85 and 4.90 provide cannot be applicable even if, in the case of the latter KSF were in liquidation, because the equitable interest of KSF(IoM) precludes the dealings between KSF and NBS being mutual.  Equally equitable set-off could not apply because the KSF Instruments and the NBS CD are not connected the one with the other.  
10.	Legal set-off originated in the Insolvent Debtors Relief Acts 1729 and 1735.   S.13 of the former provided that, for the ensuing five years, where there were mutual debts between plaintiff and defendant “one debt may be set against the other”.  That provision was made permanent by s.4 of the latter Act.  S.5 extended the availability of such set off and expressly provided that 
“..judgment shall be entered for no more than shall appear to be truly and justly due to the plaintiff after one debt being set against the other as aforesaid.”
It is common ground that the rights originally conferred by those provisions have been continued in subsequent statutes and are now enshrined in s.49(2) Supreme Court Act 1981 and CPR Rule 16.6. 
11.	In Lechmere v Hawkins (1798) 2 Esp.626 the defendant had promised to pay the plaintiff without regard to the debt due by the plaintiff to the defendant and “without affecting to set one demand against the other”.  Lord Kenyon considered that the terms of the original statutes as to mutual debts being satisfied gave the defendant power to set off the plaintiff’s debt to him against his debt to the plaintiff, notwithstanding their agreement to the contrary.   Despite the identity of the reporter (see Megarry, a Second Miscellany-at-Law p.118/119) this case was followed by Lord Erskine in Taylor v Okey (1806) 13 Ves.Jun.181.  The two cases together were regarded by the editors of Halsbury’s Laws of England 4th Ed. Vol.42 para 434 as establishing that the legal right of set-off could not be waived.
12.	The correctness of that conclusion was considered by Hirst J in Hong Kong and Shanghai Banking Corporation v Kloeckner & Co AG [1990] 2 QB 514.  In that case Hirst J considered the availability of a legal set-off in two distinct contexts arising from dealings between the Bank, Gatoil and Kloeckner.  There had been substantial crude oil dealings between Gatoil and Kloeckner in both wet and dry cargoes.  The Bank had financed Gatoil’s acquisition of oil by paying its suppliers in return for a pledge of the relevant bill of lading.  Kloeckner gave an undertaking to the Bank to pay the debt of Gatoil against delivery of the bill of lading “without any discount, deduction, offset or counterclaim whatsoever..”.   The claim of the Bank under that undertaking was $8m.   The second context was in relation to unconnected dry cargo transactions in connection with which the Bank provided a standby letter of credit to Kloeckner in respect of the liabilities of Gatoil to Kloeckner.  The Bank accepted its liability under that letter of credit for a sum slightly less than $10m but sought to set-off against it a sum of about $10.2m under assignments or undertakings the subject matter of other litigation.  The question of set-off in the first context was the effect of the purported exclusion of the right of set off contained in the undertaking.  The question of set-off in the second context concerned the availability of set-off against a liability under a letter of credit.
13.	Hirst J dealt with the first issue on pages 519-521.  He referred to Lechmere v Hawkins, Taylor v Okey and Halsbury and noted that though very highly persuasive they were not binding on him.  He then referred to a passage in the judgment of Lord Denning MR in Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd [1971] 1 QB 1, 34 where he evidently considered that a right of set-off may be excluded by an agreement express or implied.  Hirst J concluded:
“Manifestly, as [counsel for Kloeckner] recognised, the Halesowen case makes at the very least a major inroad into the suggested general principle stated by Halsbury’s Laws of England in reliance on the two old cases.  However he seeks to distinguish [Halesowen] on the footing that it enshrines some special rule relating to bank accounts.  I am unable to see any sound foundation for this distinction.  Nor was [counsel for Kloeckner] able to suggest any rational basis for such a rule.   In my judgment the Halesowen case gives me very ample grounds for departing from the two old cases.  In consequence I hold that as a matter of law the Bank are entitled to rely on the clause excluding any right of set-off against the letter of undertaking, and that this effectively debars the set-off which Kloeckner seek to maintain.”
Hirst J dealt with the second issue on pages 521-526. He concluded that there was no principle that debars a bank setting off against a beneficiary under a letter of credit a claim by the bank themselves against that beneficiary.
14.	The first of the issues considered by Hirst J was also considered by the Court of Appeal in Coca-Cola Financial Corporation v Finsat International Ltd [1998] QB 43.  In that case the plaintiff sued on guarantees whereunder payments were to be made “free and clear of any right of set-off or counterclaim”.   On being sued the guarantors sought to set off sums due to them under their counterclaims.  The claim to set-off those sums was rejected and summary judgment for the full amount entered for the plaintiff.  The guarantors’ appeal was dismissed.  Neill LJ, with whom Hutchison LJ and I agreed, considered [p.50] that the clauses excluding the rights of set-off “define the extent of the obligation to pay”.   He then described the statutory origin of the right of legal set-off, the authorities to which I have referred and the judgment of Hirst J in Hong Kong and Shanghai Banking Corporation v Kloeckner & Co AG on the first issue.  He noted that counsel for the appellant submitted that the decision in Halesowen was limited to banking transactions or should not be followed.  He concluded at page 52:
“I have come to the clear conclusion that the right of set-off can be excluded by agreement.  In general English law permits the parties to a contract to include in it such terms as they consider to be appropriate.  This freedom of contract is subject to a measure of control based on grounds of public policy and to some statutory restrictions such as those contained in the Unfair Contract Terms Act 1977.  But I am unable to accept that a party is prevented from excluding the right of set-off by s.49(2) of the Supreme Court Act 1981 or by any ground of public policy.  There are many circumstances in which the general admonition in section 49(2) cannot be observed.  The court itself can order separate trials of different parts of an action where it is convenient to do so: see, for example, RSC Ord.15,r.5.  Moreover I can see no reason in principle why parties who are in a general contractual relationship cannot isolate one contract or one aspect of their dealing and provide that their rights in relation thereto are to be treated separately from their other dealings.  Furthermore this conclusion is supported by dicta in at least three cases decided in the House of Lords.”
Neill LJ then referred to relevant passages in Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd [1971] 1 QB 1, Modern Engineering (Bristol) Ltd v Gilbert-Ash (Northern) Ltd [1974] AC 689 and Mottram Consultants Ltd v Bernard Sunley Sons Ltd [1975] 2 Ll.Rep.197.

Submissions for the parties and my conclusions

15.	The first submission for NBS was to the effect that the passage in the judgment of Lord Denning MR in Halesowen was not sufficient justification for the conclusions of Hirst J on the first issue in Hong Kong and Shanghai Banking Corporation v Kloeckner & Co AG.  He pointed out that in Halesowen, not only did no question of legal set-off arise but also Buckley LJ (p.46) rejected the submission that the case concerned set-off at all and Winn LJ (p.41) appeared to consider that the case concerned the application of a right limited to dealings with bankers.  The suggested consequence was that the decisions in Lechmere v Hawkins, Taylor v Okey and statement in Halsbury’s Laws of England 4th Ed Vol 42 para 434 are still good law and preclude the exclusion of rights of legal set-off by Rule 7 para 3.2 and clause 3.5(a).  
16.	I reject that submission.  The correctness and ambit of the conclusion of Hirst J on the first issue in Hong Kong and Shanghai Banking Corporation v Kloeckner & Co AG, which was concerned with legal set-off, was specifically raised and rejected by the Court of Appeal in Coca-Cola Financial Corporation v Finsat International Ltd.   I am bound by that decision.  But even if the point had not been decided by the Court of Appeal in that case I should have been bound to follow that of Hirst J unless I had been convinced that it was wrong.   In my view it was right.  It was plain from the wording of the original statutes that the right of legal set-off was permissive.  In his judgment in Lechmere v Hawkins Lord Kenyon gives no reason for his apparent conclusion that the statutory provision for set-off was mandatory.   But Lord Chancellor Erskine, who had been the unsuccessful counsel in Lechmere v Hawkins, felt bound to follow it in Taylor v Okey (1806) 13 Ves. 180 because Lord Kenyon had recognised the ability of a Court of Equity to reach the contrary conclusion.   As both law and equity have since 1875 been administered by all courts the agreement to exclude the permissive legal right should be treated as effective.
17.	The second submission of counsel for NBS was to the effect that, given the differences between legal and equitable set-off, I should construe Rule 7 para 3.2 and Clause 3.5(a) of the Deed as excluding only the equitable right of set-off.  The differences on which counsel for NBS relied were, effectively, fourfold.  First legal set-off applies to debts which are unconnected.  Second, legal set-off is only operative at the time of entry of judgment. Third, legal set-off is concerned with cash flow and is designed to avoid multiplicity of proceedings.  Fourth, legal set off is available in cases of claims under negotiable instruments.  I did not understand there to be any disagreement between counsel that these differences between legal and equitable set-off existed (save that neither the Administrators nor KSF(IoM) accepted the fourth proposition), only as to their effect on the construction of Rule 7 para 3.2 and clause 3.5(a) of the Deed.
18.	A similar argument was urged on the Court of Appeal in Continental Illinois National Bank and Trust Company of Chicago v Papanicolaou [1986] 2 Ll.L.R 441.  In that case the relevant provision required payment by the guarantor of a secured debt “without set-off or counterclaim”.  It was submitted that it did not apply to counterclaims for negligence by the payee in the execution of its duties as mortgagee.  The argument was rejected by Parker LJ giving the judgment of the Court on two grounds; first, the commercial purpose of the provision was that the Bank should be paid quickly; secondly
“the natural meaning of the words is that all set-offs and counterclaims are excluded...not that all set-offs and counterclaims “other than set-offs and counterclaims for negligence or breach of the bank’s duties as mortgagee”...” 
19.	Quite apart from the fact that neither Rule 7 para 3.2 nor Clause 3.5(a) of the Deed draws any distinction between one type of set-off and another it would be inconsistent with both their express terms and their commercial context to do so.   So far as express terms are concerned both provisions exclude counterclaims as well as set-off.  There is no restriction on the nature of the counterclaim or the underlying cause of action.   Even if it could be maintained that the differences between an equitable set-off and what is commonly called a legal set-off justified a restricted construction of the word ‘set-off’ to equitable set-off the same argument could not be used to exclude cases of legal set-off from the exclusion of counterclaims.  But the commercial context demonstrates that all types of set-off or counterclaim are excluded for it is of the essence of the CREST system that bargains are completed immediately and without regard to any other transactions the parties may have entered into.  This is made plain beyond doubt by the elaborate system of CREST payments, as defined in the Deed, prescribed by the CREST rules.
20.	The third submission of counsel for NBS seeks to build on the second distinction, as described in paragraph 17 above, to the effect that neither Rule 7 para 3.2 nor clause 3.5(a) of the Deed qualifies in any way the rights of NBS under the KSF Instruments.  Accordingly, so the argument ran, if NBS defaulted on its CD and was then sued by KFS it could resist judgment in respect of its liability under its CD by reference to its entitlements under the KSF Instruments.
21.	Though put as a separate argument, it is little different from the second submission.  If Rule 7 para 3.2 and clause 3.5(a) of the Deed exclude all rights of set-off then NBS has no entitlements under the KSF Instruments which it can pray in aid in response to a claim by KSF under its CD.  In addition NBS would be seeking to benefit from its own breach of contract which, in principle, it is not entitled to do, see Chitty on Contracts 30th Ed. Para. 12.082.
22.	I should also note an argument which is, in substance, not dissimilar to the second and third.  This is to the effect that the purpose of a provision excluding rights of set-off etc is, as Neill LJ noted in Coca-Cola Financial Corporation v Finsat International Ltd at p.50, to define the extent of the payment obligation so as to equate it with the obligation under a negotiable instrument.  And because in certain circumstances a stay of a claim under a negotiable instrument will be granted pending the determination of a counterclaim, see for example Hong Kong and Shanghai Banking Corporation v Kloeckner & Co AG, pp. 524F-G and 526C-E, so in this case judgment on the NBS CD would be stayed pending trial of the liability of KSF under the KSF Instruments.  There are a number reasons for rejecting that argument.  First, it makes an assumption as to the purpose of Rule 7 para 3.2 and Clause 3.5(a) of the Deed which is unjustified.  There is no indication that those provisions were inserted so that the payment obligation might be equated to payment obligations under negotiable instruments rather than, as observed by Parker LJ in Continental Illinois National Bank and Trust Company of Chicago v Papanicolaou p.444, to ensure quick payment.  Second, the examples given of a judgment under a negotiable instrument being stayed pending the determination of a counterclaim are not comparable because in none of them was there a provision excluding set-offs and counterclaims.  Third, even if a negotiable instrument contained such a clause and even if the court was prepared to grant a stay on the judgment under the negotiable instrument pending the trial of an independent counterclaim it cannot be assumed that such stay would be granted in respect of what is required to be a CREST payment with all that that entails.
23.	The fact is that in a number of related situations the courts have recognised that clauses excluding set-offs and counterclaims are agreed for the good reason that neither party’s right should depend on the continuing solvency of the other.   The fact that the other party has become insolvent and either gone into administration, as in Morrison Knudsen Corpn of Australia Ltd v Australian National Railways Commission (1996) 22 ACSR 262 and Isovel Contracts Ltd v ABB Building Technologies Ltd [2002] BCLC 390, or into receivership, as in John Dee Group Ltd v WMH (21) Ltd [1998] BCC 972, 976, is no ground for reducing or minimising the effect of the exclusion of rights of set-off and counterclaim.   It is in precisely those circumstances that the provision is intended to operate.
24.	In short I consider that the point on which NBS seeks to rely, in all the different guises in which its counsel has paraded it, was concluded against NBS by Hirst J in Hong Kong and Shanghai Banking Corporation v Kloeckner & Co AG [1990] 2 QB 514 and by the Court of Appeal in Coca-Cola Financial Corporation v Finsat International Ltd [1998] QB 43.  In those circumstances I dismiss this application.