Consider the following hypothetical: Client sues a corporation; corporation answers, files a counterclaim and then files a petition for bankruptcy relief and becomes a debtor under the Bankruptcy Code. Client's lawsuit is stayed pursuant to §362 of the Code. Client seeks bankruptcy counsel because it is concerned about retaining its right to a jury trial and wants to know how to, or whether it should, proceed in the bankruptcy proceeding. Counsel's advice to client is not to file a proof of claim, and client wants to know if it can still assert setoff as a defense if it doesn't file a proof of claim and ultimately debtor's counterclaim is successful. The answer may surprise some: Yes, the client can still assert setoff as a defense, but it may not be successful in actually obtaining the right to setoff.

Setoff, in General

The right of setoff is universally recognized by the bankruptcy court. 4 Collier on Bankruptcy 15th Ed. ¶553.02 (1986). In fact, §553 of the Code generally provides that a creditor's pre-bankruptcy setoff rights are not affected by the Code, except in certain defined instances. 11 U.S.C. §553.² If a creditor fails to file a proof of claim, the only remotely applicable defined instance where setoff rights may be affected is that a creditor cannot set off a claim that has been disallowed. 11 U.S.C. §553(a)(1). The circumstances that lead to the disallowance of a claim are set forth in 11 U.S.C. §502(d). None of the provisions of §502 that discuss disallowance deal with a failure to file a proof of claim. Accordingly, since setoff can be asserted in the absence of disallowance, and since a claim cannot be disallowed for failure to file a proof of claim, it can be concluded that a creditor's failure to file a proof of claim cannot affect the creditor's right to assert the setoff as a defense. See Omni, 835 F.2d at 1318.³

To fully understand this matter, it must be noted that there is a fundamental distinction drawn between the provisions of Code that deal with a proof of a claim and their effect on the administration and distribution of the estate, and the debt that gives rise to a claim. While a creditor who wishes to participate in the distribution of an estate is required to file a proof of its claim, and while that participation can be denied by the disallowance of the claim, the underlying debt continues to exist. Were it not for the continuing existence of the debt (or "claim"), there would be no need for a discharge of debts pursuant to 11 U.S.C. §727(b). Omni, 835 F.2d at 1318. Therefore, even though a creditor may be prevented from participating in the distribution of the estate, the debt has viability until it is discharged. Id. at 1318-19. Moreover, without relief from the automatic stay, the debt cannot be enforced, but it is still imbued with attributes. One of those is the right of setoff. Id. at 1319. See, also, 4 Collier on Bankruptcy 15th Ed. ¶553.05[2] 1986.

One court has stated that making the right to assert the attribute of setoff dependent on the filing of the proof of claim is an intrusion on the creditor's rights, which is not contemplated by the Code. In that court's opinion, it is also an improper application of the provisions of 11 U.S.C. §502(b). Setoff must be distinguished from a claim requesting a distribution from the liquidation of an estate. Id. at 1319. Until a discharge is ordered, a creditor need not file a proof of claim as a prerequisite to asserting a right of setoff pursuant to §553. Id.⁴

Cases for Consideration

Two notes of caution: Even though courts have established that failure to file a proof of claim does not act as an automatic bar against a creditor from asserting setoff as a defense at a later date, (1) it does not guarantee that the court at a future date will allow the setoff and find that the requirements for setoff have been met, and/or (2) there is some authority that states that asserting a setoff claim essentially is equivalent to asserting a claim, thus the bankruptcy court can find that the creditor cannot play coy with the bankruptcy estate, and will be deemed to have filed an informal proof of claim in the case and thus subjected itself to the jurisdiction of the bankruptcy court.

Setoff May Not Be Successful

Since setoff is predicated upon having a "valid and enforceable" pre-petition claim, one court has found that setoff, whether as a defense or counterclaim, invokes the claims-allowance process. A bankruptcy court in Oklahoma found that it was within the exclusive province of the bankruptcy court to determine whether a claim will be allowed. In re Comm'l. Financial Serv., 251 B.R. 397, 405 (N.D. Okla. 2000). The bankruptcy court reasoned that a defendant and debtor cannot argue they have "mutual debts and claims" for the purposes of setoff without asserting a claim against the estate. The bankruptcy court failed to see a distinction between obtaining something of value from the estate by asserting setoff as a defense or asserting a claim. Id. at 407. The bankruptcy court stated: "[r]egardless of the disguise under which a claim is asserted, and regardless of the intent of the party to preserve a right to a jury trial, the bankruptcy court must look to the substance of the assertion to see if [the] claims-allowance process has been involved." Id. at 408. The bankruptcy court also found it notable that any claim filed, if allowed, would be paid in "tiny bankruptcy dollars" while a setoff would be offset in "real" dollars to the extent the debtor could recover against the defendant and, ultimately, take money out of the coffers available to other creditors. Id. at 405.

The bankruptcy court concluded that by asserting the defense of setoff, the defendant has asserted a breach-of-contract claim against the estate and invoked the bankruptcy court's core jurisdiction to determine his claim and his right to setoff pursuant to §553 of the Code. Upon the assertion of a claim against the debtor's right to recover from the defendant, the bankruptcy court found that the proceeding became a part of the claims-allowance process and "integral to the restructuring of the debtor-creditor relationship." Id., citing Langenkamp, 498 U.S. at 44, 111 S.Ct. at 331. The bankruptcy court further concluded that it had "core" jurisdiction over the breach-of-contract claim and setoff defense pursuant to 28 U.S.C. §157(b)(2)(B) and (O) that according to Langenkamp, the defendant had waived his right to jury trial on the breach-of-contract claim. Id., citing Langenkamp, 498 U.S. at 45, 111 S.Ct. at 331 (jury trial waived upon asserting claim against the estate).

Danger: Consent to Bankruptcy Court Jurisdiction May Be Inferred

A district court, presented with whether a governmental entity could assert setoff as a defense even though it had not filed a proof of claim, determined that the assertion of setoff rights subjected the defendant to the court's claims-adjudication process. The district court further found that the assertion of the setoff rights constituted an informal proof of claim and ultimately led to the defendant being subject to the jurisdiction of the bankruptcy court and waiving its right to sovereign immunity. Town & Country Home Nursing Serv. Inc., 963 F.2d 1146 (9th Cir. 1992).

Diligence at Reorganization Plan Stage

One final note of caution: A creditor should review a reorganization plan carefully in the case and, if appropriate, object if the plan seeks to discharge all claims or debts by which a proof of claim has not been filed and/or the special discharge of any setoff rights that may be construed against the creditor if it attempts to assert setoff as a defense in the future.

Conclusion

Even though failure to file a proof of claim will generally not be considered a bar to asserting setoff as a defense, careful consideration to strategy must be given in advising a client not to file a proof of claim if preservation of setoff rights, and/or the consent to bankruptcy court jurisdiction, are important factors in the case. Setoff may ultimately be disallowed, and assertion of setoff may be construed as consent to bankruptcy jurisdiction by invoking the claims-adjudication process. Finally, careful review of any reorganization plan is important to ensure that setoff rights are not affected as a result of the terms of the plan.

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Footnotes

¹ Ms. Brighton is special counsel with Kennedy Covington Lobdell & Hickman in Charlotte, N.C., in the Financial Services Department - Financial Restructuring Group, where she practices primarily in the area of bankruptcy, workouts and secured lending. She is a contributing editor for the ABI Journal, serves on its Editorial Board and on the Advisory Board for the ABI Law Review, is certified in Business Bankruptcy by the American Board of Certification and is a frequent author and lecturer on bankruptcy-related topics. Return to article

² See, also, In re G.S. Omni Corp., 835 F.2d 1317, 1318 (10th Cir. 1987). Return to article

³ See, also, In re Stratton v. Equitable Bank N.A., 104 B.R. 713 (Md. 1989); 912 F.2d 464 (4th Cir. 1990); Bernstein v. IDT Corp., 76 B.R. 275, 281 (S.D.N.Y. 1987); In re Sutton Investments Inc., 53 B.R. 226, (W.D. La. 1985). Return to article

⁴ See other cites at fn. 3, supra. Return to article