Two commonly misunderstood remedies in the young bankruptcy practitioner's tool box are the defenses of setoff and recoupment. Section 553 of the Bankruptcy Code preserves the nonbankruptcy right of a "creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case...." 11 U.S.C. §553(a). The requisite elements of a §553 setoff are as follows: (1) the creditor holds a claim against the debtor that arose before the commencement of the case; (2) the creditor owes a debt to the debtor that also arose before the commencement of the case; (3) the claim and debt are mutual; and (4) the claim and debt are each valid and enforceable. In re Steines, 285 B.R. 360, 362 (Bankr. D. N.J. 2002). Setoff, in effect, elevates an unsecured claim to secured status, to the extent that the debtor has a mutual, prepetition claim against the creditor. See 11 U.S.C. §506(a). Because §553 does not define "mutual," the definition must be determined under state law. In re Palmieri, 31 B.R. 111 (Bankr. N.D. Ga. 1983). Mutuality is generally defined as meaning that the debts must involve the same parties, and mutual demands must exist between the debts owed. See All American Auto Salvage v. Camp's Auto Wreckers, 679 A.2d 627, 632 (N.J. 1996).
The right of setoff in bankruptcy allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding "the absurdity of making A pay B when B owes A." Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995). In Strumpf, the Supreme Court, holding that a bank's temporary administrative hold on a debtor's bank account was not an exercise of setoff rights in violation of the automatic stay, highlighted that §553(a) sets forth a general rule, with certain exceptions, that a creditor's prepetition right to setoff is not affected by the Bankruptcy Code, and that §542(b) of the Code, which requires turnover of property to the estate, specifically excepts property from turnover "to the extent that such debt may be offset under section 553 of this title against a claim against the debtor." 11 U.S.C. §542(b).
Setoff is limited, however, by the provisions of §553(a). Among those limitations is that prepetition claims against the debtor cannot be set off against postpetition debts to the debtor. Lee v. Schweiker, 739 F.2d 870, 875 (3d Cir. 1984). Pursuant to §553(a)(3), the creditor can lose its right to setoff if the debt owed to the debtor was incurred during the preference period-i.e., in the 90 days preceding the bankruptcy filing. This is known as the "improvement-in-position" test. Durham v. SMI Industries Corp., 882 F.2d 881, 883 (4th Cir. 1989). Finally, the right to setoff is limited by the provisions of the automatic stay under 11 U.S.C. §362. Steines, 285 B.R. at 362 (citing In re Patterson, 967 F.2d 505, 509 (11th Cir.1992)). In order to exercise a valid right of setoff, a creditor must move for relief from the automatic stay under 11 U.S.C. §362(d). Id.
Notwithstanding the basic proposition articulated in Strumpf that a creditor's prepetition setoff rights are generally not affected by the bankruptcy court, with limited exceptions, cases have continued to express the view that the application of setoff is permissive and can be modified through the exercise of the equitable powers of the court. See, e.g., In re Lazar, 219 B.R. 212, 213 (Bankr. N.D. Ohio 1998). "Setoff may be denied where the creditor acted inequitably; where the setoff would jeopardize the debtor's ability to reorganize; or in a liquidation context where the setoff would result in either a preference or priority over other unsecured creditors." Steines, 285 B.R. at 363 (quoting In re Lykes Bros. S.S. Co., 217 B.R. 304, 313 (Bankr. M.D. Fla. 1997)).
Conversely, as discussed below, the doctrine of recoupment may prove to be a much more powerful tool, as recoupment is not constrained by the timing requirements of the Bankruptcy Code. Additionally, a creditor will normally not be required to seek relief from the automatic stay to assert its right to recoup funds owed to it.
The common-law doctrine of recoupment provides an exception to setoff in bankruptcy cases. Recoupment is applied when the limitations of setoff in bankruptcy prove inequitable. University Med. Ctr. v. Sullivan (In re University Med. Ctr.), 973 F.2d 1065, 1079 (3d Cir. 1992). In order for the recoupment doctrine to be applied, both debts must arise out of a single "integrated transaction" such that it would be inequitable for the debtor to enjoy the benefits of that transaction without also meeting its obligations. Id. at 1081. Because recoupment does not involve separate mutual debts, it is an exception to the automatic stay and thus does not require relief from the automatic stay. See In re Malinowski, 156 F.3d 131, 133 (2d Cir. 1998). Accordingly, as recoupment is a more powerful remedy and does not require court approval, a creditor may often be better served by framing its offset of a debt owed to a debtor as a recoupment rather than as a setoff under the Code.
In the context of a bankruptcy, recoupment has most often been applied when the creditor's claim against the debtor and the debtor's claim against the creditor arise from the same contract. Schweiker, 739 F.2d at 875. Recoupment allows the defendant, in a suit between the estate and another, "to show that because of matters arising out of the transaction sued on, he or she is not liable in full for the plaintiff's claim." 4 Collier on Bankruptcy, §553.03 at 553-17 (Lawrence P. King et al. eds., 15th ed. 1996). Thus, so long as the creditor's claim arises out of the "same transaction" as defined under the recoupment doctrine, the creditor's claim may be offset against the debt owed without regard for the timing and other requirements stated in §553 of the Bankruptcy Code. In re Davidovich, 901 F.2d 1533, 1537 (10th Cir. 1990).
It should be noted that some courts have found that not all cases in which a claim and counterclaim arise from the same contract are appropriate for recoupment. See Conoco Inc. v. Styler (In re Peterson Distributing Inc.), 82 F.3d 956, 962-63 (10th Cir. 1996) (overarching distributorship agreement governed many different types of sales and related activities, which were considered separate transactions); California Canners & Growers v. Military Distributors of Virginia (In re California Canners & Growers), 62 B.R. 18 (9th Cir. BAP 1986) (each delivery under contract a separate transaction). Additionally, where a creditor withholds post-petition payments based upon the faulty assertion of a recoupment, the creditor could be liable for violating the automatic stay. See University Med. Ctr., 973 F.2d at 1079.
The moral of the foregoing story is simple. The next time your client is faced with an adversary proceeding seeking to recover funds owed to a bankruptcy estate, make sure to ask your client if they are owed anything by that debtor. The answer to this simple question and the often forgotten defenses of setoff and recoupment might just provide a complete defense and save the day.