As all bankruptcy practitioners are aware, filing a petition under the Bankruptcy Code results in the imposition of an automatic stay. See 11 U.S.C. §362(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 §553,¹ 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 Id.; 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.

Setoff vs. Recoupment

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.

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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.

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

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.

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, Davidovich v. Welton, 901 F.2d 1533, 1537 (10th Cir. 1990). "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 In re Ruiz, 146 B.R. 877, 879 (Bankr. S.D. Fla. 1992).

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." Davidovich, 901 F.2d at 1537. 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 Schachter v. Tolassi (In re 105 East Second Street Assocs.), 207 B.R. 64, 68 (Bankr. S.D.N.Y. 1997). 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." Id.; 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, Tolassi, 207 B.R. at 68. This difference also affects the applicability of the automatic stay.

Application of the Automatic Stay

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..." 11 U.S.C. §362(a)(7)). 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 Id.

Recoupment, on the other hand, is not subject to the automatic stay because of its inherent difference from setoff. See New York State Elec. and Gas Corp. v. McMahon (In re McMahon), 129 F.3d 93, 96 (2d Cir. 1997). 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 Ruiz, 146 B.R. at 879. 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. Id.

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." Id.; citing In the Matter of Holford, 896 F.2d 176 (5th Cir. 1990). 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." Id.

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.

Conclusion

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.

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Footnotes

¹ Section 553(a), in part, states:

(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... Return to article