Setoff And Recoupment In Bankruptcy: A Brief Overview

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...