This article provides a brief overview of the somewhat related doctrines of setoff and recoupment in the Chapter 11 context. Setoff is recognized in the Bankruptcy Code to offset the claims of creditors and the debtor in a bankruptcy proceeding. Recoupment is a common law doctrine of similar effect. Sometimes overlooked by debtors and creditors alike, these doctrines can be of critical consequence in the settling of accounts between a creditor and the bankrupt debtor.

Setoff

The doctrine of setoff allows entities to apply their mutual debts against each other, thus “avoiding the absurdity of making A pay B when B owes A.” Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995). Section 553(a) of the Bankruptcy Code provides that “this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement ...” Thus, subject to certain limitations, the Bankruptcy Code does not create a right of setoff, but preserves rights of setoff that may exist under applicable non-bankruptcy law.

To effect a setoff, a creditor must file a motion seeking to lift the automatic stay.1 The creditor bears the burden of proving its right of setoff and must demonstrate that both claims arose prior to bankruptcy and that they are owing between the same parties.2

Prepetition Claims and Debt

If a creditor is seeking to offset its debt to the estate against its claim against the estate, both the claim and the debt must have arisen prior to the petition date. The question of when a debt “arises” in bankruptcy is one of bankruptcy law, not state law.3 In Lehman Bros., the Bankruptcy Court for the Southern District of New York found that “for purposes of setoff, a debt arises when all transactions necessary for liability have occurred, regardless of whether the claim was contingent when the petition was filed.”

In re Lehman Bros. Holdings Inc., 404 B.R. 752, 759 (Bankr. S.D.N.Y. 2009) (emphasis added). There, a bank creditor was denied the ability to set off its claim asserted against funds transferred by the bank into the debtor’s account following the commencement of a bankruptcy case. While the initial transfer instructions were issued on the business day prior to the bankruptcy petition date, the party that gave the transfer instructions maintained the right to change or reverse the transfer until three hours after the debtor filed for bankruptcy. Because the transfer was not “completed” and the actual book entry reflecting the transfer was not made until after the bankruptcy filing, the funds represented a post-petition debt and could not be set off.

On the other hand, courts have permitted setoff where a liability accrued prepetition, even where events relating to the liability occur after the petition date.4

Mutuality

Debts subject to setoff must be owed by and between the same two parties and in the same capacity. This requirement is often referred to as “mutuality.”

Generally speaking, the requirement that the debts be owed by and between the same two parties is strictly construed. For example, even “a subsidiary’s debt may not be set off against the credit of a parent or other subsidiary, or vice versa, because no mutuality exists under the circumstances.” In re SemCrude, L.P., 399 B.R. 388, 393-394 (Bankr. D. Del. 2009) (creditor not permitted to set off debt it owed to one subsidiary against claim it held against other subsidiaries) (omitting internal quotations). Further, even if the debts are owed between the same two parties, setoff is generally unavailable if the debts are not owed between the parties in the same “capacity.” This requirement means that each party must owe the other in its own name and not as a fiduciary or in the nature of a trust.

Several courts have suggested that mutuality is determined as of the petition date and have declined to find that a post-petition transfer destroyed mutuality.5

Recoupment

Recoupment, which is not addressed by the Bankruptcy Code, is a common-law equitable principle which focuses on netting credit and debt that arise out of the same transaction. Whereas setoff may be applicable among two parties irrespective of their contractual relationship, recoupment focuses on amounts that may be owing among parties to the same transaction. For example, the right of setoff might arise between a manufacturer and a customer/supplier where the manufacturer owes the customer/supplier a particular sum under a supply contract, and the customer/supplier owes the manufacturer under a purchase order where the supplier purchased products from the manufacturer. The right of recoupment is most likely to arise where the parties are each owed amounts from the same transaction, such as where a supplier has a claim for goods delivered under a supply contract, but the manufacturer may have corresponding claims under the contract because a shipment of goods did not meet the specified contractual standards. The key issue with recoupment is whether the offsetting debts arise out of the “same transaction.”

The Second Circuit has adopted a restrictive “single integrated transaction test,” under which “both debts arise out of a single integrated transaction so that it would be inequitable for the debtor to enjoy the benefits of that transaction without also meeting its obligations.” Westinghouse Credit Corp. v. D’Urso, 278 F.3d 138 (2d Cir. 2002). Even if both debts arise out of the same contract, recoupment is unavailable “where the contract itself contemplates the business to be transacted as discrete and independent units.” Id. at 147.

In Westinghouse, the parties entered into a $44 million sale of a business. Part of the purchase price was funded through an $8.2 million note secured by a purchase money mortgage on the property of the business. The sale contract provided that the seller would lease certain properties used in the business to the buyer, and also contained a provision for a purchase price adjustment based on a final valuation of the business. The district court ruled that the buyer was entitled to recoup the purchase price adjustment against the amounts owed for the note and the lease, finding that the adjustment, the note and the lease were all part of one integrated transaction. The Second Circuit disagreed. It held that the note and the lease were separate from the purchase price adjustment escrow, and were not subject to recoupment.

Similarly, in Malinowski v. NYS Department of Labor (In re Malinowski), 156 F.3d 131 (2d Cir. 1998), the New York Department of Labor sought to recoup previous unemployment benefit overpayments made to the debtor from later claims for benefits. The Second Circuit held that the two instances where the debtor sought unemployment benefits did not constitute a single transaction, because they were based upon different episodes of unemployment.

The takeaway is that where a contract provides for multiple transactions, each transaction must be viewed separately for recoupment purposes.

Some Applications and Further Considerations

Setoff and recoupment are important tools in the Chapter 11 context because they have the potential to fundamentally alter a creditor’s potential liability to the bankruptcy estate.

One of the classic cases of setoff would involve a debtor and its bank. The bank may have a claim against the debtor related to a prepetition unsecured loan, and the bank may owe the debtor for cash the debtor keeps on deposit with the bank. Absent setoff, the deposited cash may be available for the satisfaction of all unsecured claims, including those related to the bank loan, on a pari passu basis. With the right of setoff (so long as it is provided for under applicable non-bankruptcy law, and is otherwise compliant with the provisions of Section 553 of the Bankruptcy Code), the bank can use setoff in its claim against amounts held on deposit, and rather than share pari passu in the amounts held on deposit, use those amounts to set off its claim against the estate. A creditor who also owes a debt to the estate may potentially trade a claim that is worth cents on the dollar against the whole dollars it would otherwise owe the estate. For this reason, a creditor with a valid setoff claim is treated as the holder of a secured claim under Section 506(a)(1) of the Bankruptcy Code.6

Attempts to apply the doctrine of recoupment very often arise from a disputed transaction where there remains some payment owed by one party, but that party has been dissatisfied with the other party’s performance under the contract. As discussed above, one of the classic situations is a supply contract where the supplier has made delivery of subpar goods: The supplier is owed for its delivery, but there may be corresponding claims by the manufacturer for breaches of the contract.

Understanding where creditors may have rights of setoff and recoupment is also important to other creditors of the debtor. For example, a creditor valuing its claim against the debtor may make the assumption that the debtor’s cash will be available for the satisfaction of all unsecured claims, but will be unaware that a large creditor has a setoff claim against the cash. Similarly, the debtor may have affirmative litigations against one party that a creditor is counting on to provide value for its claim, but there may be recoupment claims by the defendant that would cancel out any affirmative recovery.