Setoff Doesn’t Apply to Mutual Debts and Credits in Agricultural Commodities

When it comes to sales in perishable agricultural commodities, the usual rules of setoff do not apply, according to a Second Circuit opinion on January 9.

Well, actually, the usual rules do apply, but they don’t yield the expected result.

The Second Circuit’s opinion means that dealers in agricultural commodities must pay one other in cash, because there is no right of setoff if one goes bankrupt.

The debtor and a creditor were both dealers in perishable agricultural commodities falling under the Perishable Agricultural Commodities Act, known as PACA, 7 U.S.C. § 499a et seq. To protect farmers and dealers of fresh produce, Congress originally adopted PACA in 1930 to impose a floating trust on a purchaser’s inventory and proceeds. The rights of beneficiaries in a PACA trust in a debtor’s inventory and accounts receivable even come ahead of secured creditors.

The debtor and the creditor sold goods to one another. Rather than pay in cash, they kept a running net balance. In their invoices to each other, they preserved their PACA rights.

When the debtor filed a chapter 7 petition, the debtor owed the creditor about $260,000, while the creditor owed the debtor about $200,000. The creditor filed a proof of claim for the $260,000 and asserted a right of setoff. If allowed, the debtor would have owed the creditor $60,000, and the creditor would have owed nothing to the debtor.

Other suppliers protected by PACA sued the creditor, claiming that the creditor had no right of setoff and must pay the entire $200,000 into the PACA trust.

The bankruptcy court issued a report and recommendation to the district court, concluding that the creditor could not assert a setoff. Rather, the bankruptcy court ruled that the creditor was only entitled to a pro rata distribution from the PACA trust. The district court adopted the report, and the creditor appealed.

Circuit Judge Robert D. Sack affirmed for the Second Circuit, explaining that PACA assets are preserved as a nonsegregated floating trust. Because the assets are in trust, they are not assets of the bankruptcy estate.

Significantly, the $200,000 debt owed by the creditor constituted one of the assets of the PACA trust. All of the PACA suppliers, he said, hold an equitable interest in the trust until they are paid.

Because the assets of the PACA trust are held outside of the bankruptcy estate, Judge Sack said “their disposition is, therefore, governed by trust law rather than bankruptcy law.” Permitting a “bankruptcy offset,” he said, “would be inconsistent with Congress’s intent.”

Judge Sack explained that PACA gives “unpaid produce sellers . . . priority over other creditors and establishes that the disposition of PACA assets is governed by trust law.” Therefore, he said, the creditor was not entitled to offset.

Judge Sack said his conclusion was “buttressed” by Section 553 of the Bankruptcy Code, which permits offset of mutual debts and credits. The debts and credits were not mutual, he said, because the PACA plaintiffs were asserting rights as trust beneficiaries while the defendant-creditor was asserting rights as an ordinary creditor.

Judge Sack held that the creditor had no right of offset but was only entitled to a pro rata share of the PACA trust.

The Second Circuit opinion means that dealers in perishable commodities need to settle their sales in cash to avoid potential PACA claims if one goes bankrupt.