When a company winds up, begins restructuring proceedings or goes bankrupt, a debtor or creditor may be able to cancel out the amount payable to the other party by using the remedy of “set‐off”. Set‐off involves the cancelling of crossliabilities between two parties who owe each other money. It is a valuable tool that can increase a creditor’s percentage of recovery and decrease the debt burden of a debtor.
Types of Set‐off: Contractual, Legal or Equitable
If a contract exists between parties, rights of setoff can be created by including set‐off provisions in the contract. Where a contractual set‐off provision does not exist, parties may still assert a claim for set‐off on the basis of legal set‐off or equitable set‐off. The common law has developed a number of formal requirements for the allowance of a claim for legal set‐off. In comparison, equitable set‐off is granted by the court in cases where the parties do not meet the formal requirements of legal set‐off, but where the circumstances of the cross‐obligations are so closely related or connected, that it would be unjust to permit one party to enforce its obligations without permitting the other to set‐off against it.
In order to establish a successful claim for legal set‐off, the following formal requirements must be met:
- the parties must be able to ascertain the exact amounts of the debts owing and the debts must be recoverable on the basis of a legally enforceable claim for monetary payment;
- all conditions to the debts becoming due and payable must be satisfied; and
- the debts claimed must be mutual in the sense that they are between the same parties in the same right and the parties are solely liable to each other for the debts.
In a situation where the requirements for legal set‐off cannot be met, the court may allow an equitable set‐off. Unlike legal set‐off, equitable set‐off requires that the debts owing between the parties be strongly connected. Generally, equitable set‐off requires that a cross‐claim be so clearly connected with a party that it would be manifestly unjust to allow a plaintiff to enforce payment without taking into consideration the cross‐claim by the defendant. In addition, a claim for equitable set‐off will only be granted in circumstances where:
- the party relying on set‐off has shown some equitable ground for being protected against the counterparty’s claim; and
- the equitable ground goes to the very root of the party’s claim.
In order to establish a successful claim for equitable set‐off, the plaintiff’s claim and the defendant’s cross‐claim need not arise out of the same contract nor is there any requirement that the claims be for liquidated amounts.
A claim for legal or equitable set‐off can be asserted in proceedings under both the Bankruptcy and Insolvency Act and the Companies’ Creditors Arrangement Act. Legal setoff is best claimed in situations where the exact amounts to be set‐off have been determined, the debts are owed between the same two parties, but are not necessarily connected and arising out of the same transaction. Equitable set‐off is more appropriate if the debt has been subject to an assignment or if the amount owing has yet to be determined since the remedy of legal set‐off is generally not available in either scenario. Common types of transactions where the court has allowed equitable set‐off include transactions where there has been defective workmanship by a contractor and the claimant is seeking to set‐off the amount payable to a contractor.
Whether or not a claim for set‐off is successful will depend greatly on the specific facts of the case. It is important that parties understand their rights of contractual, legal and equitable set‐off when structuring their arrangements, contractual or otherwise, to ensure that set‐off, in one form or another, is available down the road should one of the parties experience financial difficulties.