“Set-off” is a means of netting cross-claims against each other. There are three different types of set-off recognized under Canadian law: 1. contractual; 2. legal; and 3. equitable. Each type of set-off has different requirements that must be met in order for the claim to be upheld by a court.

Generally, a creditor’s set-off rights are preserved in the context of insolvency proceedings. In insolvency, the use of set-off by a debtor of an insolvent person or corporation who is also a creditor permits that party to avoid payment of the full amount owing. This effectively gives that creditor a secured position, or quasi-lien, in the insolvency proceedings.

Contractual set-off rights exist where there is an agreement between the parties which expressly allows set-off rights. The nature of those rights will depend on the precise wording of the contract. With respect to the remaining types of setoff, the important difference between them is that with one you need to have the same parties involved but the debts do not need to be connected (legal) while in the other the parties do not need to be the same but there must be a connection between the debts (equitable). This is an important distinction because legal setoff rights are often lost in bankruptcy and receivership situations, due to the appointment of a trustee or a receiver.

In a recent decision of Madam Justice Romaine in the SemCAMS Companies Creditors’ Arrangement Act (“CCAA”) proceedings the Court considered the law of set-off in an oil and gas context. As a result of this decision, non-operators in customary Construction, Ownership and Operation Agreements (“CO&O”) may not be able to claim the right of set-off.

SemCAMS obtained CCAA protection in July 2008. At the time, SemCAMS owed Trilogy Energy L.P. (“Trilogy”) $4 million for gas purchases under an Inlet Purchase Agreement. Trilogy, in turn, owed fees to SemCAMS as operator of plants and facilities under a number of CO&O and Gas Processing Agreements. Trilogy purported to exercise set-off by withholding amounts due to SemCAMS as Operator under the CO&O and Gas Processing Agreements against amounts owing by SemCAMS as purchaser for the purchase of natural gas under the Inlet Purchase Agreement. At issue was whether Trilogy could set-off the unpaid purchase price against the fees?

Justice Romaine reviewed in detail the nature of SemCAMS’ relationship with its joint interest owners under the various CO&O and Gas Processing Agreements and found that, although none of the agreements contained express trust provisions, SemCAMS was a trustee for its joint interest owners. The court found that “characteristics of a trust relationship pervaded all of the agreements”.

The characterization of SemCAMS as a “Trustee” under the CO&O and Gas Processing Agreements resulted in the failure of Trilogy’s right to assert its claim for set-off. Trilogy was held not to be entitled to contractual set-off despite the fact that the Inlet Purchase Agreement expressly allowed set-off as against any amounts owning between the parties under “any other agreements”, because the court found that the wording was not broad enough to cover agreements in which SemCAMS was a trustee. Justice Romaine stated that for Trilogy to succeed on its argument for contractual set-off, it would have to establish that the set-off language was broad enough to cover agreements in which SemCAMS was contracting as a trustee.

Trilogy was not entitled to legal set-off for the reason that the requirement that the parties be the same was not met because SemCAMS was held to be a trustee. Equitable set-off did not apply because the cross-claims were not found to be closely connected (they arose out of 29 different contracts entered into over a period of 10 years). Further, the court stated that the remedy of equitable set-off must not result in any form of inequity. Trilogy was not able to satisfy the court that its purported set-off would not result in any unfairness.

Trilogy was required to pay all amounts due to SemCAMS as Operator under the CO&O and Gas Processing Agreements and its claim against SemCAMS for $4 million pursuant to the Inlet Purchase Agreement became an unsecured claim in the CCAA proceedings.

As a result of this decision, joint facility owners can be reasonably assured that even if the operator of a joint facility becomes insolvent, creditors of the operator with potential set-off claims will (absent a very broad contractual set-off provision) continue to be required to make payments to the operator so long as the operator can be seen to be holding the amounts received in trust for the benefit of all of the joint owners..