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Bankruptcy and Insolvency

Using Setoff and Recoupment in the Bankruptcy Context

Monday, April 04, 2005

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Every business owner and operator understands the fact that no matter how careful they are, at some point they are likely to make the unpleasant discovery that they are doing business with a company on the verge, or in the process, of bankruptcy.  There are a variety of tools that businesses can use to protect their interests prior to and after a company enters bankruptcy.  Two of these tools are setoff and the lesser-known analogous right of recoupment.  This article introduces these two concepts and discusses a few examples of how companies dealing with business partners who are in bankruptcy used them to minimize their losses.

As the preeminent treatise on Bankruptcy points out, the doctrine of setoff is "an ancient one well grounded in practical logic."  The basic premise is this, if Company A is indebted to Company B, and Company B is likewise indebted to Company A, it makes straightforward sense that the debts should cancel each other out.  The courts support the doctrine because it decreases the number of lawsuits necessary when a company goes bankrupt, and thus decreases expense to the parties involved and the expenditure of judicial resources.

Section 553 of the Bankruptcy Code recognizes setoff and, in general, allows businesses to use the tool if the following four seemingly simple conditions are met: (1) the creditor holds a "claim" against the debtor that arose prior to the initiation of the bankruptcy case; (2) the creditor also owes a "debt" to the debtor that also arose prior to the initiation of the bankruptcy case; (3) the "claim" and "debt" at issue are "mutual;" and (4) the "claim" and "debt" are each valid and enforceable. Under the Code, the general rule is that most types of obligations are considered "claims" or "debts" for the purposes of setoff. In general, the petition date is considered the point at which the bankruptcy case is commenced.  Generally, a debt is considered mutual if it is between the same parties in the same right or capacity but arising from different transactions. Applicable non-bankruptcy law and other sections of the Code determine the question of whether the "claim" and "debt" are "valid and enforceable." However, while the four prerequisites for taking advantage of a setoff are seemingly simple, the Code and the courts have made the financially important determination of whether these conditions are met a relatively complex endeavor. 

An example of setoff occurred in the case of Studley v. Boylston National Bank.  In that case, Collver Tours Company, a business engaged in selling tickets on round the world tours, had a relationship with Boylston National Bank where it conducted its regular deposit and withdrawal banking activity and where it also sought lines of credit. After a troubled business period, Collver went bankrupt. Prior to its bankruptcy, Collver had both many outstanding loans and $22,500 in deposits with the Bank.  Prior to the bankruptcy filing the Bank kept the deposits as a setoff against the loans, the bankruptcy trustee in the case attempted to bring them back into the bankruptcy estate as an avoidable preference to the Bank.  After the parties wrangled over the issue in the lower courts, the Supreme Court took up the matter on appeal, and upheld the lower decision to allow the Bank to setoff and keep the $22,500 in deposits.

Though the Studley case went all the way to the Supreme Court, most efforts by companies to setoff are not nearly so controversial.  Additionally, while seeking legal help with regard to dealing with a failing company may add some to the expense of the ordeal, with the threat of "cents on the dollar" from the bankruptcy court in the balance, the inquiry can be well worth it.  If you have questions about how the law applies to a situation you are facing or how to structure your deals to avoid closing off your setoff options, contact your attorney for advice.

This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.