This chapter from The Banker's Remedy of Set-Off (Bloomsbury Professional) is a guide to understanding the operation of set-off, a hugely important yet elusive principle in modern finance and commerce. It recognises that set-off is a powerful self-help remedy for creditors and examines how set-off actually functions. The book looks at problems of terminology, including terms such as lien and combination; and it considers whether set-off functions as a procedural claim, as a substantive or remedial claim, as a remedy, or as security. The impact of bankruptcy and liquidation is also addressed. This is an important and unique resource for all commercial practitioners.
Table of Contents
While clearly the ability to rely upon an exercise of set-off is not exclusive to bankers in the same way as, for example, a claim to exercise a banker's lien, the potential operation of a remedy which offers a means of settling debts has particular significance for the daily dealings of banker and customer, whose relationship has been well settled as that of debtor and creditor since the nineteenth century.
In order to examine the potential manner of application of a remedy of set-off, two common types of banking transactions have been chosen. The first type of transaction involves the relatively straightforward position where a customer maintains a number of accounts with a bank through which the customer's affairs are conducted. Typically, the customer might maintain two current accounts, one of which is overdrawn; a loan account; and a deposit account. In what circumstances can the balances in these accounts be subjected to a set-off?
The second type of transaction appears initially to be more complicated, generally involving a financing structure which is set up for a particular transaction. A common example would be a set-off purported to be granted to the bank in respect of a customer's obligations under a bill facility: a customer draws bills payable to itself which are accepted by the bank on the condition that prior to the maturity date the customer provides cash cover in the form of a deposit with the bank to which the bank is to have recourse in order to honour bills accepted by it under the facility.
These transactions will be used to illustrate the principles at work and the factors that will be required to be taken into account. The point sought to be made is that the analysis required remains constant despite the complexity of the particular financing technique in the context of which the remedy is sought to be exercised.
The structure of analysis suggested will also be examined briefly from the point of view of its potential application to a set-off exercised by the bank in respect of debts owed by it to third parties against debts owed to it by the customer, with a view to confirming that the structure remains equally effective in this type of situation.
In Chapter 4 four general questions were identified as relevant to determining the availability of set-off. To these must be added in the context of the banker/customer relationship two preliminary questions which are aimed at distinguishing an exercise of set-off from that of combination. As the discussion in Chapter 1 revealed, the failure to draw this distinction has often in the past obscured the boundaries within which the remedy of set-off operates. For the sake of completeness of the analysis, one further question has been added which considers the effect of the set-off if exercised. Hence the suggested checklist for the determination of the availability of set-off in any given banking transaction would run as follows:
if apparent liabilities arise under two or more accounts, on what basis are those accounts maintained?
are there two debts which are due and payable?
are the claims from which the debts arise capable of founding a set-off?
is there an adequate connection between these claims?
is an injustice suffered by the bank?
is the operation of set-off excluded?
what is the effect of the exercise of set-off?
There are essentially three stages at which each transaction needs to be examined. These represent the most likely occasions on which a bank would wish to exercise the remedy:
on demand by the customer for payment of the debt owed to it by the bank: eg on the withdrawal of funds standing to the credit of a particular account or on the drawing of a cheque requiring payment to be made to a third party;
on the occurrence of a particular event: eg on default by the customer in its obligation to make repayment of a particular amount or on the maturity of a particular instrument under which the bank is liable to make payment on behalf of the customer;
on the insolvency of the customer.
This question of the time at which the bank seeks to rely upon set-off is important for three reasons.
First, it is important for determining whether there are debts available for the operation of set-off. It became clear in Chapter 1 that the existence and availability of two debts is essential for the exercise of set-off. At each of the three crucial times at which the bank may seek to exercise the remedy such debts will not necessarily be in existence or available. Their existence and availability will depend on the manner in which the relationship has been conducted and the particular terms (if any) agreed by the parties.
Secondly, the timing has consequences on the way in which the set-off is sought to be exercised. Where a customer makes demand for payment of its debt, the bank reacts defensively in exercising the set-off. By contrast, where the bank exercises the remedy upon the occurrence of a particular event such as default by a customer, it uses the set-off offensively. On the insolvency of a customer it may either react defensively to a claim made by the trustee in bankruptcy or the liquidator or it may act offensively in simply submitting a proof for the balance of the debts. The manner of exercise is important since there has traditionally been some doubt as to the validity of an offensive use of set-off.
Thirdly, the timing may restrict the availability of the forms of set-off. Under present authority, the exercise of the remedy in insolvency is precluded other than in the limited terms permitted by the insolvency legislation.
It is assumed initially for the purposes of analysis that a customer maintains two accounts with a bank; that No 1 Account has a credit balance of £500 and No 2 Account is overdrawn by £300; and that each account is held by the customer in his own name and in his own right. The transaction will be discussed in detail on the first hypothesis, that demand is made by the customer. Modifications to the analysis that are caused by the change in the time at which the set-off is sought to be exercised will be discussed subsequently.
If the customer seeks to withdraw £250 from the bank, whether by drawing on No 1 Account for his own use or by drawing a cheque on it in favour of a third party, the first step required to be taken by the bank is to consider the basis on which the two accounts in issue are maintained.
In the absence of an agreement to segregate either one or both accounts from the general single account that arises between them under the banker/customer contract, they will be regarded as forming part of that single account and accordingly as representing simply two entries in that account. In these circumstances, the bank can only exercise a right of combination over these two apparent balances, effectively ruling off the account for the purposes of establishing the amount due between banker and customer at the moment of demand. If the bank chooses to exercise the right, the amount owed to the customer is only £200. The bank will thus be able to refuse to make payment of the £250 demanded, on the basis of insufficiency of funds. It cannot purport to exercise a set-off, since as between the customer and itself there is in substance only one debt – a prerequisite to an exercise of set-off is the existence of two debts.
If, however, the bank had expressly or impliedly agreed with its customer that No 2 Account should be segregated from the single account maintained under the banker/customer contract, the bank would clearly be unable to exercise a right of combination, since there would no longer be two entries in the running account which could be combined. Instead, there would be two separate debts: namely, on the one hand, £500 credit balance on No 1 Account (and thus under the general account); and, on the other, £300 which by reason of the agreement gives rise to a distinct debt. Since these debts would be independent of each other, they would be capable of forming the subject matter of a set-off.
The balances on the two segregated accounts are debts as between the bank and customer but will not be available for an exercise of set-off until they are due and payable.
Liability on the part of the bank to make payment to the customer arises only on demand by the customer and hence the debt owed by the bank can only be available as from the moment of demand.
The liability of the customer in respect of the moneys owing under Account No 2 depends on the terms of the parties' agreement. The basis on which an overdraft is normally permitted is that the moneys are payable on demand. Assuming for the purposes of this example that this is so, the bank will only be able potentially to exercise a set-off if it either has previously made demand on the customer or immediately makes demand and, in either case, if the customer fails to make repayment. If not, the bank has nothing against which it can set-off its present indebtedness to the customer.
The source of both claims lies in contract. On the opening of the current account there is implied into the banker/customer contract an obligation on the part of the bank to pay the debt created by the lodgment of money. Where the account is allowed to go into overdraft, there will usually be either an express or implied agreement on the part of the customer to repay the moneys borrowed in this manner.
In view of the contractual source of the debts, there is no doubt that the claims are capable of founding a set-off.
Assuming at this stage the solvency of both customer and bank, the bank may seek to rely on the remedy granted by statute (where available) or equity, or on a specific arrangement expressly agreed between the parties.
To the extent that the bank relies upon statute or contract, the bank must show that the proposed set-off is covered by the terms of the relevant provision. Take by way of example the specimen clause proposed by Wood:
'The Bank may set-off against any obligation of the Borrower which is due and payable under this Agreement moneys held by the Bank for the account of the Borrower at any branch of the Bank anywhere in the world and in any currency.'
Assuming No 2 Account was regulated under the agreement and the moneys had become due and payable, the bank would be entitled to exercise the set-off.
In jurisdictions where the Statutes of Set-off remain in force and those in which their provisions have been specifically saved on their repeal, there is clearly no doubt that the claims would fall within the criterion of 'mutual debts' by virtue of the banker/customer relationship.
The requisite connection in equity turns on the interrelationship of the claims, rather than that of the holders. The banker/customer contract is not necessarily of itself capable of providing the connection, since the debt owed by the customer has been segregated from the general account arising under that contract and accordingly cannot be said to arise from the same contract nor even the same transaction.
The competing claims by banker and customer must thus be shown to be closely related. Where the set-off arises in relation to balances on bank accounts, the courts appear to have assumed that there is an adequate connection, although they have not articulated the reason. Their assumption may be explained on the basis that the customer's ability to obtain payment of his debt is closely connected with the ability of the bank to obtain payment of its debt by reason of the on-going nature of their relationship, the quid pro quo for the bank continuing to afford facilities to the customer.
This question is readily answered in the affirmative on the facts of the example if the bank is able to rely upon either statutory set-off or on an appropriate contractual set-off. As the discussion in Chapter 4 showed, it is sufficient as a practical matter for the bank simply to bring itself within the relevant provision under statute or contract, although at a theoretical level in both cases it can be shown that underlying the operation of these provisions is the desire to prevent injustice. The accepted view that the rationale behind the availability of statutory protection is the knowledge of the plaintiff of the outstanding claim can be used to explain the operation of the statutory set-off on the facts of the example where the customer is aware, or at the least ought reasonably to be aware, that it has an overdraft.
The position in relation to the operation of equitable set-off is not so clear. While the remaining doubts over the necessity of showing a breach of contractual duty by the customer need not be resolved on the facts of the example, since there is clearly a breach of contract by the customer in failing to make repayment of the overdraft, albeit not of the contract on which he rests his competing claim, the problem lies in determining whether the consequences produced by the customer's action would result in the bank suffering any injustice.
It is important to bear in mind the background against which the bank seeks to rely upon the set-off. It has long been established that the bank has a duty to pay within a reasonable time of presentment cheques drawn by a customer if there are sufficient funds available in his account. This is a clear rule on the basis of which the parties have contracted and is generally regarded as an implied term of the contract. Thus the fact that the customer has an outstanding debt to the bank under the agreement cannot of itself detract from the credit balance held under No 1 Account. The issue is therefore whether there is any equity on the part of the bank which is capable of overriding the customer's entitlement to payment of the funds held on that account.
On the bare facts of the example, there would appear to be no equity which is capable of modifying the bank's duty to pay. Furthermore, the fact that in such circumstances the bank could have protected itself in accordance with ordinary banking practice by taking standard form security documentation which provided for the operation in such circumstances of a contractual set-off might well influence a court in reaching a decision not to recognise an exercise of equitable set-off.
Policy reasons are unlikely to exclude the operation of statutory set-off which would otherwise arise on these facts, since a bank is not accorded a privileged status such as that of the Crown, which is exempt in certain circumstances from the application of the legislation.
Although the banker/customer relationship has from time to time under the general law been accorded different treatment from that of other debtors and creditors by reason of the nature of the banking business, the courts would on present authority appear reluctant to interfere with an otherwise valid contractual set-off, unless there is present some factor which would under normal legal or equitable principles vitiate the contract. In view of the dominant role usually played by the banker within the relationship, courts are most likely to be vigilant against abuse of bargaining power, in particular the exercise of undue influence. Nonetheless they have not as yet been prepared to recognise that the relationship of banker/customer is one which of itself gives rise to a presumption of undue influence without particular wrongful conduct on the part of the bank.
By contrast, where equitable set-off is relied upon, there is some indication from the English Court of Appeal that courts may well be prepared to take into account general policy considerations which, on the one hand, aim within the individual relationship to regulate the position of dominance maintained by the banker and, on the other, are directed within the broader commercial context to the conduct of banking business generally.
It would thus appear that even if the bank could point to an equity in favour of recognition of a set-off, it would further have to show that it did not detract from the good conduct of banking business. On the facts of the example, this would appear unlikely, the bank's duty to the customer to make payment to the extent of available funds precluding reliance on the remedy.
On the basis of the analysis put forward in Chapter 9, the effect of an exercise of set-off under the former Statutes of Set-off, which in this example is the more likely form of set-off to be relied upon, is to discharge the bank from its obligation to allow the customer to withdraw £500 and to require it only to honour cheques up to the amount of £200. In the unlikely event of a successful exercise of an equitable set-off, a similar result would ensue.
If the bank had protected itself by a suitable contractual provision, the effect would depend on the terms of the agreement. The stipulation could have operated to discharge the bank from its obligation by specifically providing for the discharge or, more controversially, by entitling the bank to apply part of the debt owed by it to reduce the outstanding balance of the customer.
Assume that the customer in the above example does not make a demand for £500 but rather commits a default under, for example, the agreement under which No 2 Account is maintained. The default might lie in a failure to repay or in the performance of a covenant on the basis of which the funds were advanced. To what extent does the analysis of the transaction change?
The above analysis applies equally on default, since the bank is at this stage concerned to determine whether its reliance on set-off is precluded by the ability simply to exercise a right of combination and calculate the debt owing between its customer and itself.
This point has to be resolved by considering the terms of the parties' agreement. Assuming again the exclusion on the facts of a right of combination, the crucial question of whether or not a debt is available for an exercise of set-off will depend on the agreed effect of the event of default which has occurred. If the default is expressly stipulated to cause the borrowed moneys to become due and payable, an obligation to repay will have arisen, potentially rendering the debt available for set-off. If, however, the default simply entitles the bank to make demand for moneys, no obligation to repay arises until demand has actually been made. Thus the question of whether or not set-off is available on default depends in the first instance on whether the default itself is capable of causing a debt to become due and payable, thus triggering the operation of set-off.
Since the claims are still contractual, they remain in nature capable of founding an exercise of set-off. Yet where the set-off is sought to be exercised on the occurrence of default, the position is complicated by the fact that the bank purports to exercise the set-off offensively without waiting for the customer to make demand for full payment of the competing claim. According to orthodox theory, set-off operated in equity and under the Statutes of Set-off only in response to demand for payment. If, however, the analysis in Chapter 6 is correct, there is no reason why the bank cannot on the occurrence of default seek to exercise the set-off and claim to be discharged from its original obligation to the extent of the amount set-off. The controversy could, however, be avoided by expressly providing for the operation of set-off: eg by stating that in the event of default the bank was to be discharged from its obligation to make repayment except to the extent of the balance (if any) or, alternatively but controversially, to apply part to the debt owed by it to diminish the outstanding debt.
The analysis remains the same: the connection under statute and contract depends on the wording of the relevant provision; that in equity relies upon showing a close relation between the claims.
The analysis remains the same where the set-off arises under statute or contract, the requisite injustice being assumed where the situation is covered by the terms of the provision.
Arguably, however, the bank's case for exercising an equitable set-off, which is likely to be rejected where the customer makes demand for repayment, may be strengthened by the occurrence of the default. The extent to which it is strengthened will depend essentially on the consequences that the default produces and, specifically, whether it renders it unfair on the bank (in the sense considered in Chapter 4) not to recognise the set-off.
On the facts of the example, however, a default in repayment is unlikely to provoke an adequate equity.
The analysis remains the same. Only an equitable set-off may potentially be excluded. Even if the bank could show injustice, the answer would still ultimately depend on whether the courts agree that an exercise of set-off in such circumstances is contrary to the accepted view of good conduct of banking business.
The analysis remains the same. The set-off generally operates to discharge the bank from its obligation to make repayment, this effect being occasionally purportedly modified by contract to enable the bank to appropriate the debt owed by it to the customer.
Assume that neither demand has been made nor default occurred; rather, the customer has been declared bankrupt, or, if a company, placed in liquidation.
The right of combination survives the insolvency of the customer, since it is simply a means of determining the amount of the debt between banker and customer, and thus the first step for the bank on this third hypothesis remains the determination of whether the right of combination has been excluded on the facts and whether there are two independent debts available for set-off.
The analysis remains essentially the same as where the customer makes demand, with the exception that the terms of the parties' agreement may make the moneys due and payable in the event of insolvency.
The analysis in the previous situation is affected by the fact that on present authority the exercise of the remedy of set-off is precluded from operation other than in the limited terms permitted by the insolvency legislation.
Within that restricted framework, however, no problem arises. Contractual claims which give rise to debts are clearly within the statutory provision.
As discussed above, the insolvency legislation makes the assumption that in the event of its various criteria being fulfilled there would be an injustice if the bank's exercise of set-off were not recognised. The answer is therefore again in the affirmative.
There are no policy reasons which would prevent the insolvency legislation from operating.
The effect of the set-off will again be to discharge the bank from its original obligation to pay the customer (or rather the trustee in bankruptcy or liquidator) £500, reducing its liability simply to the balance of £200.
It is clear that the structure is adequate to determine the availability of set-off in this type of situation. Its efficacy is further evident if the particular facts are slightly modified. While the facts may change the responses to the questions listed in (1) to (7), they will not alter the form of analysis.
Hence, for example, if No 2 Account in the above example had not been a current account but rather a loan account, the first question as to the availability of the right of combination would have been more easily answered in the negative since it has been clear, at least since Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd, that the courts are very willing to imply an agreement to segregate accounts where one is a loan account. If the account had been a deposit account with a fixed maturity date which had not yet arrived, there could have been neither combination nor set-off until that date when the funds became available. If the liability of the customer had arisen under a guarantee rather than under an overdraft, the issue of combination would have been excluded since two independent debts would have been involved and only the questions as to set-off need have been considered.
One of the most common practical examples of a more involved transaction in which set-off is sought to be relied upon arises under a bill facility. Assume that the customer is entitled to draw bills to the amount of £500,000 on the bank which the bank has agreed to accept; that the parties have agreed that as between themselves the customer is to be primarily liable, indemnifying the bank for sums paid out under the facility; and, accordingly, that prior to the maturity date the customer will make a deposit with the bank of the amount in respect of which the bank is liable under the particular bill becoming due.
Once again there are three possible stages at which the bank may seek to rely upon an exercise of set-off which require to be examined briefly in turn. In this type of transaction, however, the bank is not usually provoked into seeking to exercise the remedy by actual default by the customer, as in the case of general dealings. The motivating factor is rather the occurrence of a specified event such as, in this example, the payment by the bank of the amount due by it under the bill in its role as acceptor.
The liability of the customer arises under the agreement by the customer to indemnify the bank for moneys paid out on the bill. In this situation the courts are likely to hold that the account arising under this transaction has been segregated from the general account and hence the accounting principle which the right of combination implements has nothing on which to operate.
The answer to this question depends on the terms of the particular facility, but typically provision would be made for, on the one hand, the deposit representing the cash cover to be repayable on demand and, on the other, the debt in respect of a bill to arise under the indemnity on the maturity date of that bill. Thus the earliest date at which an exercise of set-off would be possible would be the relevant maturity date, but the actual date would depend on demand by the customer having been made.
Once again both debts are contractual in origin and hence there is no difficulty on present authority in concluding that they could found a set-off.
Under this type of bill facility provision would usually be specifically made for the bank to exercise a set-off and hence demonstration of an adequate connection would depend on satisfying the terms of the provision.
In the absence of such a clause, or simply as an alternative, the bank might seek to rely on either the former Statutes of Set-off or an equitable set-off. In the former case, the connection is shown by the presence of 'mutuality', which is satisfied by the banker/customer relationship. In the latter case, the degree of interrelationship of the claims required by equity is satisfied by the fact that the competing claims arise out of the same transaction and that the customer is seeking to enforce the contract under which he is in breach.
Again this point can be assumed to be in the affirmative where the set-off sought to be exercised depends on statutory or contractual provisions.
The case for supporting the existence of a requisite equity in favour of the bank which is capable of overriding its obligation to make payment is arguably stronger in this type of financing transaction where the parties have specifically agreed on a particular purpose for the deposit. On demand by the customer, the bank's exposure is increased. On the one hand, it becomes liable to make repayment while, on the other, it may be unable to recover the moneys due to it under the indemnity. The situation differs from that arising under general dealings since the bank has attempted to protect its position.
In the absence of factors which could vitiate a contractual provision under which the set-off is effected, it is again only reliance on equitable set-off which might be vulnerable to challenge on this basis. As noted in the discussion in relation to general dealings, the outcome is dependent on the extent to which the purported set-off might conflict with the good conduct of banking business. It is suggested, however, that in these circumstances the courts are unlikely on a policy basis to refuse to recognise an exercise of set-off where the transaction has by agreement been carefully structured by the parties and in respect of which the exercise of set-off is integral to the provision of the finance.
The effect of an exercise of set-off is not altered by the structure adopted in a particular transaction. Hence it should generally operate to discharge the bank from making payment of the deposit to the extent of the amount sought to be set-off, unless there is an agreement between the parties to use the deposit as a form of payment.
Again the right of combination would appear to be inapplicable since the liability of the customer arises under the indemnity and is likely to have been segregated from the operation of the general account.
On this hypothesis a debt in favour of the bank arises under the indemnity. Thus the potential availability of set-off depends upon demand being made by the customer. It would not be uncommon, however, to find a further provision in the agreement attempting to provide in the circumstances for the debt to arise at an earlier date. If such a provision was effective, there would clearly be two debts in existence.
The analysis remains the same, the contractual nature of the claims rendering them capable of founding the set-off. The only question is whether the fact that the bank seeks to use its claim offensively to effect the set-off, rather than defensively in response to a demand by the customer, can prevent the operation of the set-off. The arguments noted in relation to this manner of operation in connection with general dealings are equally applicable here and it is suggested that this particular manner of operation should not preclude an exercise of set-off.
There is no change in the analysis, the connection being provided by either satisfying the terms of the contractual or statutory provision relied upon or by the clear interrelationship of the claims arising from the particular structure adopted in the transaction.
Again the question arises only in relation to an exercise of equitable set-off because of the assumptions made under the statutory and contractual provisions. The argument that there is a sufficient equity to override the bank's duty to make repayment of money lodged with it by reason of the nature of the transaction set up by the parties is as applicable in these circumstances as when the customer makes demand.
The timing at which the set-off is exercised does not affect policy considerations for the exercise of set-off, and hence if the set-off would have been recognised in the situation where the customer made demand, as was argued, it should equally be recognised in this situation.
There would still appear to be no basis on which the right of combination can operate due to the segregation of the liabilities.
The answer depends on the terms of the facility, as discussed under (i), the only potential change depending on whether there is a specific agreement by the parties that particular debts are to be deemed to be due and payable on the occurrence of bankruptcy or liquidation.
As in the example of general dealings, the claims must come within the terms of the insolvency legislation on account of the fact that this legislation precludes the availability of other forms of set-off to the extent that their terms differ. The contractual nature of the claims brings them potentially within the terms of the provision.
A special problem has in the past arisen, however, by reason of the fact that one of the claims may be contingent in nature: namely, the debt potentially arising under the indemnity on the payment by the bank as acceptor to the holder of the bill. On present authority in both England and Australia it would appear that such a claim can come within the terms of the relevant insolvency legislation.
The requirement of 'mutuality' under the insolvency legislation is clearly satisfied by the banker/customer relationship.
Assuming that the claims come within the statutory provision, the statute makes the necessary assumption.
The exercise of set-off discharges the bank from its obligation to repay the deposit to the extent of the amount sought to be set-off.
Once again the basic analytical structure discussed above should be sufficient to answer the issue of availability of set-off in any similar banking transaction. Hence if the particular facility extended by the bank was structured on the basis of an issue by the bank of a letter of credit, under which the bank would make payment to a third party and in respect of which the customer would indemnify the bank, the same structure could be used to determine whether the bank could rely upon an exercise of set-off. The same structure also applies if the arrangement concerned a back-to-back deposit.
The proposed structure is also sufficient to deal with the not uncommon situation where a bank wishes to exercise a set-off by having recourse not to the debt owed by it to the customer but rather to a debt owed by it to a third party: eg the parent company of a subsidiary corporate borrower. Such a debt might have arisen simply by reason of an account maintained by the parent with the bank or by the former entering into a guarantee of its subsidiary's obligations to the bank. In such circumstances, it is clear that combination is not available since there is no single account maintained between the banker on the one hand and the two companies on the other. Thus the issue is simply the availability of set-off. The difference in the identity of the owners of the debt will mean that both statutory and equitable set-off will be precluded from application and accordingly the questions posed in (3) to (7) would need to be asked only in relation to the possible operation of a contractual set-off. As the prior discussion indicates, the responses will depend on the terms of the contract relied upon.
Difficulties may appear to arise where a third party claims an interest in or rights over the debt owed by the bank to the customer, potentially raising a conflict as a consequence of which the bank's ability to exercise the set-off might be restricted. Certainly, the remedy of set-off, to the extent that it operates to discharge the bank from its contractual obligation to make repayment, is generally a personal remedy which does not purport to confer on the bank a proprietary interest over the debt and thus must cede to a third party's proprietary interest, both prior to insolvency and thereafter.
A problem may arise, however, where the set-off sought to be relied upon is contractual in nature and the terms of the particular provision purport to grant to the bank an interest by way of charge. In such circumstances the bank will have to show on the basis of the arguments considered in Chapter 10 that the contractual rights granted do amount to a charge and that the charge has conferred upon it a proprietary interest rather than a mere equitable chose in action. Where a bank can provide adequate evidence of the nature and effect of the charge, the potential conflict with third parties will be resolved according to normal principles, either under the companies legislation, if appropriate, or at common law.
The exercise of the remedy of set-off is not without risk to the bank.
In the first place, if the bank purports to exercise a set-off which is subsequently challenged and found to be erroneous, the bank may be sued both in contract and in tort by reason of the course of action it adopts on the assumption that it was entitled to exercise the remedy. Furthermore, if the customer is successful, it is likely to have to pay at least a substantial part of the costs involved in litigation.
The bank's potential liability arises on two fronts. First, its refusal to make payment by reason of an alleged insufficiency of funds may lead to an action for breach of the banker/customer contract, under which the bank has expressly or impliedly agreed to make repayment to the customer of an amount equivalent to the funds deposited with it. Secondly, its consequential dishonouring of a cheque drawn by the customer on the particular account, again on the alleged basis of insufficiency of funds, will leave it open to both an action for breach of the banker/customer contract and an action for defamation by the customer.
From a practical perspective, the bank is most likely to be concerned by its possible liability in damages for the breaches of the banker/customer contract, which potentially in the commercial context are likely to be far in excess of those available for defamation. In particular, it will be concerned as to liability under the second limb of the rule in Hadley v Baxendale for:
'[damages] such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract as the probable result of the breach'.
Where a substantial corporate borrower is in financial difficulty and the bank erroneously exercises a set-off, thereby wrongly depriving the borrower of funds to meet its obligations, the effect may be to cause defaults under other financing agreements which could eventually lead to the receivership, if not the liquidation, of the borrower. The crucial issue to be faced by the bank is the extent to which it might be found liable for the damages. It is possible to argue that these consequences fall squarely within the rule.
The second major point of concern to the bank caused by a failure to recognise the validity of a purported exercise of set-off, which at a practical level may cause it a more immediate problem, is its own exposure in the market place. Not only will it be liable to pay to the customer the amount standing to the latter's credit but also it may be unable to recover the amount lent by it to the customer. Where a bank has, for example, lent a customer £1m, which it believes 'covered' by a corresponding deposit made by the customer of an equivalent amount, and wrongly exercises a set-off, it may find itself liable to repay that deposit of £1m to the customer and, depending on the particular circumstances, at risk of being unable to recover its own debt of £1m, thereby potentially suffering a reduction in its assets of £1m.
The implications of such an event are furthermore not confined to the bank itself. It potentially has also far reaching repercussions for the operation of the particular market in which the bank operates. If that market is not protected through appropriate netting legislation, the substantial nature of the figures often involved may mean that the bank may be unable to make adequate provision and accordingly may itself become insolvent. Wood has pointed out that in the worst scenario:
'there is the hazard of domino insolvencies and the catastrophe of a systemic failure'.
 Foley v Hill (1848) 2 HL Cas 28, 9 ER 1002.
 It is not proposed at this stage to repeat the discussion that lies behind the conclusions reached in the previous chapters; rather, cross-references will be made to the earlier discussion as appropriate.
 Ibid at pp 24–32.
 Ibid at pp 31–32.
 Ibid at pp 40–41.
 Joachimson v Swiss Bank Corpn  3 KB 110, CA.
 Supra n 11.
 See infra for a discussion of the position on insolvency.
 Law and Practice of International Finance, op cit at p 176.
 Ibid at pp 99–108.
 Ibid. An argument might be run that they arise from the same transaction to the extent that they operate under the general banker/customer relationship, drawing an analogy with the assumptions made as to the landlord/tenant relationship in British Anzani (Felixstowe) Ltd v International Marine Management (UK) Ltd  QB 137: see discussion in Chapter 4 at pp 100 et seq.
 Eg, Bhogal v Punjab National Bank, Basna v Punjab National Bank  2 All ER 296.
 Ibid at pp 124–125.
 See eg, Garnett v McKewan (1872) LR 8 Exch 10 where the court considered that a customer must be taken to know the state of his various accounts.
 Gray v Johnston (1868) LR 3 HL 1.
 Bhogal v Punjab National Bank, Basna v Punjab National Bank supra n 23 on p 307 at 300–301.
 See eg, N Joachimson v Swiss Bank Corpn supra n 11 on p 306.
 See National Westminster Bank plc v Morgan  AC 686, followed in Australia on this point by James v Australian and New Zealand Banking Group Ltd (1986) 64 ALR 347.
 See generally Chapter 11. The insolvency of the customer will also have the effect of opening to challenge a prior exercise of the remedy on the basis that it operated, for example, as a preference. This effect is not, however, relevant to the example under consideration.
 See supra n 19 on p 307.
 Under Stein v Blake  2 All ER 961, the original claims are extinguished and replaced by a new claim for the net balance. This analysis was questioned in Chapter 5 and it was argued that there was instead a pro tanto discharge of obligations. On either analysis, however, the bank is on these facts liable for the balance.
 Assuming that there was no specific contractual arrangement which would entitle the bank to have recourse to the account.
 Day & Dent Constructions Pty Ltd (In Liquidation) v North Australian Properties Pty Ltd (Prov Liq Appted) (1982) 40 ALR 399; Re Charge Card Services Ltd  Ch 150. Stein v Blake  AC 243; Secretary of State for Trade and Industry v Frid  2 All ER 1042.
 Whether both claims are extinguished and replaced by a new claim for the balance or there is a pro tanto discharge remains open to question: see n 48 supra.
 (1854) 9 Exch 341 at 354, 156 ER 145.
 Wood, EISO, op cit at p vii. Writing in 1989, he suggested that sums well in excess of £100m were not then uncommon.