Setoff vs. Recoupment To Lift the Stay or Not That Is the Question

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May 2003

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As all bankruptcy practitioners are aware, filing a petition under the Bankruptcy
Code results in the imposition of an automatic stay. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §362(a)</a>. Pursuant to §362(a), certain actions are
stayed regardless of rights arising under state or other federal law.

This prohibition of
action applies despite the Bankruptcy Code's general application of
non-bankruptcy law where such law does not contradict its provisions. Among
these provisions that recognize and apply state law is §553,<a href="#1" name="1a">1</a> which
addresses the right of setoff.

However,
the right of setoff exists under applicable state law and is not
"created" by the Code. See 5
Collier on Bankruptcy
¶553.01[2] (15th ed. rev. 6/00). The Code "merely recognizes and
preserves" the right of setoff under applicable non-bankruptcy law. See

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;; see, also, Maizel, Samuel R., "Setoff
and Recoupment in Bankruptcy," 804 PLI/Comm 949, 955 (2000).

Similar
to setoff, though differing in certain important aspects, is the right of
recoupment. The right of recoupment is not expressly addressed in §553,
but is generally accepted as applicable via §553. Section 553 aside, it is
also generally accepted that the application of the automatic stay differs
between the right of setoff vs. the right of recoupment. As such, understanding
the differences between setoff and recoupment equates to understanding whether
relief from the automatic stay is necessary or not.

<h3>Setoff vs. Recoupment</h3>

In analyzing the
differences of setoff vs. recoupment, as well as the automatic stay's
differing application thereto, one must first understand the difference
between setoff and recoupment. "Set-off is an equitable right of a
creditor to deduct a debt it owes to the debtor from a claim it has against the
debtor arising out of a separate transaction." Maizel at 955. In other
words, without the right of setoff, "each obligation would be
independently enforceable." Collier
at ¶553.10.

<blockquote><blockquote>
<hr>
<big><center>
Setoff is an equitable right of
a creditor to deduct a debt it owes to the debtor from a claim it has against
the debtor arising out of a separate transaction.

</center></big>
<hr>
</blockquote></blockquote>

As
such, four conditions must be met before setoff can be used, which may vary by
the specific, applicable law. These conditions are:

<ol>
<li>the creditor holds a "claim" against the debtor that arose before
the commencement of the case;

</li><li>the creditor owes a "debt" to the debtor that also arose before the
commencement of the case;

</li><li>the claim and debt are "mutual;" and

</li><li>the claim and debt
are each valid and enforceable.
</li></ol>

Collier at ¶553.01[1].

Therefore,
setoff is only available when the obligations between debtor and creditor are
mutual—i.e., both obligations are
held by the same parties, in the same right or capacity, and both arise
pre-petition. See Maizel at 955; see,
also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
v. Welton, 901 F.2d 1533, 1537 (10th Cir. 1990)</a>.
"While the Code specifically allows pre-petition setoff, it is silent
regarding the offset of post-petition claims against post-petition credits.
However, courts have allowed the parties to offset claims post-petition in the
same manner as pre-petition." Maizel at 957. Regardless of whether the
claims or debts are pre- or post-petition, "mutuality" is usually
strictly construed. See Maizel at
955-56. Consequently, post-petition debts are not setoff against pre-petition
claims. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Ruiz, 146 B.R. 877, 879 (Bankr. S.D. Fla.
1992)</a>.

Recoupment,
on the other hand, is "...the appropriate vehicle for adjusting
obligations arising from the same transaction..." Collier at ¶553.03[3][f]. "The common-law
doctrine of recoupment, while frequently merged with the doctrine of setoff in
other contexts, is a distinct doctrine in bankruptcy cases." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…; 901 F.2d at 1537</a>. In fact, unlike
setoff, the Code does not reference recoupment. See Collier at ¶553.10.

Indeed,
recoupment differs from setoff in that the doctrine of recoupment "is the
setting up of a demand from the same transaction as the plaintiff's
claim, to abate or reduce that claim." Maizel at 969. Stated otherwise,
recoupment is a recovery of money owed 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. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
v. Tolassi (In re 105 East Second Street Assocs.),
207 B.R. 64, 68 (Bankr. S.D.N.Y. 1997)</a>. In fact, recoupment
"is merely the means used to determine the proper liability on the
amounts owed..." and is "derived from the common-law pleading rules
concerning counterclaims." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;; see, also, Collier at ¶553.10
("In contrast, recoupment is in the nature of a right to reduce the amount
of a claim and does not involve establishing the existence of independent
obligations.").

Since
recoupment is typically defensive in nature and used to establish the proper
amount of liability, pre-petition claims can be withheld from post-petition debts.
See Maizel at 973; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 207 B.R. at 68</a>. This difference also
affects the applicability of the automatic stay.

<h3>Application of the Automatic Stay</h3>

The
automatic stay applies to "the setoff of any debt owing to the debtor
that arose before the commencement of the case under this title against any
claim against the debtor..." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §362(a)(7)</a>). Although the automatic stay "enjoins the
enforcement of the creditor's [setoff] right pending the orderly
examination and administration of the estate," it does not
"defeat" such right. Collier

at ¶553.06[1][a]. Therefore, a motion seeking relief from the automatic
stay must be pursued before setoff can occur. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;

Recoupment,
on the other hand, is not subject to the automatic stay because of its inherent
difference from setoff. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
York State Elec. and Gas Corp. v. McMahon (In re McMahon), 129 F.3d 93, 96 (2d Cir. 1997)</a>. For
example, in In re Ruiz, a
debtor/insurance agent owed certain sums to its employer/insurance company for
advances contemplated by the agency agreement. The debtor was also due certain
sums from the insurance company for commissions on policies sold. The insurance
company moved for relief from the automatic stay to set off the commissions
against the advances.

However,
since the commissions became payable post-petition, the bankruptcy court held
that the remedy of setoff was not available because §553 did not permit a
creditor to collect a pre-petition debt by withholding payment of a
post-petition debt due the debtor. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; 146 B.R. at 879</a>. The court based its
ruling on the fact that the debts were not mutual as they were between a
pre-petition creditor and a post-petition debtor. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;

However,
the court held that "[w]hile setoff under §553 is limited to
instances involving mutuality of obligation, the doctrine of recoupment simply
requires the claims to arise from the same transaction, and that the amount
recouped does not exceed the amount of the original sum owed." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… the Matter
of Holford, 896 F.2d 176 (5th Cir. 1990)</a>.
The court held that "the advances of commissions and the post-petition
renewal commissions involved in this case unquestionably arise from the same
transaction. Both grow out of the pre-petition insurance policies written by
the debtor. [The insurance company] advanced commissions to the debtor in
anticipation of the collection of the expected renewal premiums." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…;

Thus,
in Ruiz, there was a single agreement,
the debtor received advances based on sales under the agreement, and the
commissions arose from the same sales under the same agreement. As such, the
insurance company had the right of recoupment despite the fact that the
transactions occurred both pre- and post-petition because recoupment is an
adjustment of debts, as opposed to an attempt to collect.

Thus,
recoupment, in its doctrinal definition, is not a violation of the automatic
stay because it is not an attempt to collect a debt. Instead, the doctrine of
recoupment is used as a mandatory counter-claim to establish a liability. Thus,
it is defensive in nature, whereas setoff is typically offensive in nature.

<h3>Conclusion</h3>

The
difference between setoff and recoupment is subtle, yet very important. The
above discussion, however, only addresses the application of setoff and
recoupment in their typical form. Due to the application of the appropriate
state law for setoff and recoupment, these doctrines are not always available.
Further, differing states may have differing concepts of setoff and recoupment,
which may alter the analysis of their application between pre- and
post-petition claims, as well as the automatic stay's application
thereto.

Certain
states, for example, may have altered their doctrine of recoupment so that it
is now more offensive in nature, and therefore stayed by §362. As such,
prior to the use of either the rights of setoff and/or recoupment,
practitioners are wise to verify their existence and application under the
applicable non-bankruptcy law.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Section 553(a), in part, states:

<blockquote>
(a) [T]his 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 of the case... <a href="#1a">Return to article</a>

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Thursday, May 1, 2003 - 12:00

Bankruptcy Rule

2003