Recoupment Or Setoff? - A Distinction With A Difference

Setoff is commonly encountered in bankruptcy and non-bankruptcy situations. If there are mutual debts between two entities, either may generally offset the debts. These debts frequently arise where one entity is a vendor to a customer and selling on credit, and at the same time is also making occasional purchases on credit from the customer. If one entity owes $100 to a second entity but is owed $300 by this second entity, these mutual debts may be offset, leaving just the $200 owed by the second entity.

Recoupment is a subset of setoffs. It has been defined as "the setting up of a demand arising from the same transaction as the plaintiff's claim or cause of action, strictly for the purpose of abatement or reduction of such claim."1 In addition to mutuality, an element necessary for recoupment is that the two sets of claims must have been part of a single integrated business transaction between the two entities.

A factual situation involving recoupment and setoff.

Associated Wholesalers Inc., a large cooperative food distributor serving supermarkets and convenience stores, filed for Chapter 11 under the name ADI Liquidation, Inc., along with related entities. As is common in Chapter 11 cases, the debtors were not reorganized under a stand-alone plan of reorganization, but instead were sold as operating entities under an auction procedure known as a Section 363 sale.

Pursuant to the order approving the sale, the buyer of the debtors' assets purchased the assets free and clear of all claims and liens, with the liens to attach to the proceeds of the sale. Included in the purchased assets were the debtor's accounts receivable. The sale order further provided that the purchased assets were free and clear of all setoff rights held by creditors and that these setoff rights would be preserved and would attach to the proceeds of the sale as held by the debtors.

What is the effect of these provisions? Assume a vendor is owed $100,000 by the debtors but also owes the debtors $30,000 for prepetition purchases from the debtors, and further assume that prepetition unsecured claims in the bankruptcy case will receive a distribution of 10 percent. Under Scenario A, assuming no sale, but after applying the vendor's setoff rights, the vendor's claim would be reduced by $30,000 by virtue of the setoff against the $30,000 the vendor owes the debtors, with the remaining claim against the estate of $70,000 receiving a distribution of $7,000.

As a result of the...