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Setoff and Recoupment in Bankruptcy -- Setoffs (cont'd), Recoupment
Samuel R. Maizel|
Commercial Litigation Branch
U.S. Department of Justice
January 26, 1996
SETOFF AND RECOUPMENT IN BANKRUPTCY
"The right of setoff ... 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, 116 S. Ct. 286, 289 (1995) (quoting Studley v. Boylston Nat'l Bank, 229 U.S. 523, 528 (1913)). Setoff "occupie[s] a favored position in our history of jurisprudence," Bohack Corp. v. Borden, Inc., 599 F.2d 1160, 1164 (2d Cir. 1979), with which courts should interfere "only under the most compelling circumstances." In re Utica Floor Maint., Inc., 441 B.R. 941, 944 (N.D.N.Y. 1984). "The rule allowing setoff ... is not one that courts are free to ignore when they think application would be unjust." In re Applied Logic Corp., 576 F.2d 952 (2d Cir. 1978). To the contrary, "the justification for permitting setoff is based on notions of fairness," In re IML Freight, Inc., 65 B.R. 788, 791-92 (Bankr. D. Utah 1986), and "[t]he primacy of setoffs is essential to the equitable treatment of creditors. ... Absent a setoff, a creditor ... is in the worst of both worlds: it must pay its debt to the debtor in full, but is only entitled to receive a tiny fraction of the money the debtor owes it. It was to avoid this unfairness that setoffs were allowed in bankruptcy in the first place." In re DeLaurentiis Entertainment Group, Inc., 963 F.2d 1269, 1277 (9th Cir. 1992).I. SETOFF AND RECOUPMENT GENERALLY
A. 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. Recoupment differs in that the opposing claims must arise from the same transaction. 4 Lawrence P. King, Collier on Bankruptcy ¶ 553.03 (15th ed. 1991).
B. The Bankruptcy Code is not an independent source of law that authorizes setoff or recoupment; it recognizes and preserves rights that exist under non-bankruptcy law. Therefore, a creditor seeking to setoff or recoup a debt must establish a claim and a right to do so under state or federal law. See In re Dillard Ford, Inc., 940 F.2d 1507, 1512 (11th Cir. 1991); In re Public Serv. Co., 884 F.2d 11 (1st Cir. 1989); Durham v. SMI Indus., 882 F.2d 881 (4th Cir. 1989); In re Pieri, 86 B.R. 208 (Bankr. 9th Cir. 1988); United States v. Norton, 717 F.2d 767 (3d Cir. 1983); In re McLean Indus., 90 B.R. 614 (Bankr. S.D.N.Y. 1988).
C.Both setoff and recoupment can be affirmative defenses or counterclaims. Outside of bankruptcy the distinction is usually not significant. In bankruptcy, however, the distinction can be important. For example, the Code codifies and governs setoff but is silent as to recoupment. See In re B&L Oil, 782 F.2d 155 (10th Cir. 1986); 11 U.S.C. § 553. Most significantly, setoff is available in bankruptcy only when both the opposing claims arise on the same side of the time line described by the petition's filing; i.e., both must be prepetition claims or both must be postpetition claims. Recoupment is not so limited. See generally Lee v. Schweiker, 739 F.2d 870 (3d Cir. 1984).
A. Mutuality. 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 either prepetition or postpetition. 11 U.S.C. § 553(a); In re Davidovich, 901 F.2d 1533, 1537 (10th Cir. 1990); In re Public Serv. Co., 884 F.2d 11 (1st Cir. 1989); In re Bay State York Co., 140 B.R. 608, 613 (Bankr. D. Mass. 1992); In re Mastroeni, 57 B.R. 191 (Bankr. S.D.N.Y. 1986); 4 Collier on Bankruptcy ¶ 553.04.
(a) Mutuality as to parties is strictly construed. See, e.g., Gray v. Rollo, 85 U.S. 629 (1873) (mutuality is lacking where a partnership has a claim against an individual, but the individual has a claim against only one of the partners); WJM, Inc. v. Mass. Dep't of Pub. Welfare, 840 F.2d 996, 1011 (1st Cir. 1988) (offset not permitted between nursing homes under common ownership); In re Bacigalupi, 60 B.R. 442 (Bankr. 9th Cir. 1986); In re Candor Diamond Corp., 76 B.R. 342 (Bankr. S.D.N.Y. 1987) (principal of corporation not the same as corporation). See also Darr v. Muratore, 8 F.3d 854, 860 (1st Cir. 1993) ("Where the liability of the party seeking the setoff arises from the breach of a fiduciary duty, mutuality of debts does not exist and therefore no setoff is available."); In re Photo Mech. Servs., Inc., 179 B.R. 604, 613 (Bankr. D. Minn. 1995) (creditor's claim acquired through equitable subrogation satisfies mutuality with debtor); In re Metco Mining and Minerals, Inc., 171 B.R. 210, 216-17 (Bankr. W.D. Pa. 1994) (that creditor's claim is obtained through assignment does not defeat mutuality); In re K Town, Inc., 171 B.R. 313, 319 (Bankr. N.D. Ill. 1994) (although common law setoff limits setoff to "identical legal entities", contractual right to setoff between two accounts can provide the requisite mutuality for § 553). But see In re Davidson Lumber Sales, Inc., 66 F.3d 1560, 1566-68 (10th Cir. 1995) (general contractor who pays a bankruptcy subcontractor's suppliers or materialmen may setoff this payment against its debt to the subcontractor); McCall Stock Farms, Inc. v. United States, 14 F.3d 1562 (Fed. Cir. 1993) (in non-bankruptcy case, SBA allowed to pierce corporate veil and hold corporation liable for principal's debts through offset of ASCS payment otherwise due to debtor).
(b) The United States is one party for mutuality purposes and can setoff claims held by different agencies. See, e.g., Cherry Cotton Mills v. United States, 327 U.S. 536 (1946); In re Turner, No. 94-6191 (10th Cir. May 23, 1996) (en banc), vacting panel decision at 59 F.3d 1041 (10th Cir. 1995) ("We are convinced that the presence or absence of a bankruptcy proceeding does not affect the United States' status as a unitary creditor." Moreover, the definitional sections of the Code "in no way demonstrate an intent to erode the right of administrative offset that exists outside of bankruptcy ...."); Doe v. United States, 58 F.3d 494, 498 (9th Cir. 1995) ("all agencies of the United States, except those acting in some distinctive private capacity, are a single governmental unit" for setoff against the United States); Luther v. United States, 225 F.2d 495, 498 (10th Cir. 1954) (Bankruptcy Act case); SBA v. Rinehart, 88 B.R. 1014 (D.S.D. 1988) (ASCS and SBA), modified, 887 F.2d 165 (8th Cir. 1989); Malman v. United States, 207 F.2d 897 (2d Cir. 1953); In re Holder, 182 B.R. 770 (Bankr. M.D. Tenn. 1995) (IRS and Customs); In re Martech USA, Inc., No. A93-00889 (Bankr. D. Alaska May 25, 1995) (order granting relief from stay to setoff); In re HAL, Inc., No. 93-01072 (Bankr. D. Haw. Mar. 17, 1995) (findings of fact and conclusions of law granting United States' motion for setoff), aff'd, BAP No. HI-95-1354-JVO (Bankr. 9th Cir. Apr. 24, 1996) (Panel rejects "Turner and extends reasoning of Doe to the issue of mutuality and setoff under § 553;" "federal government agencies, with the exception of those acting in a distinctly private capacity, are a single entity for purposes of setoff under § 553."); In re Reed, 179 B.R. 353 (Bankr. S.D. Ga. 1995) (FmHA and CCC); In re Medina, 177 B.R. 335 (Bankr. D. Or. 1994) ("The federal government's common law right of setoff ... belongs to the United States. ... Mutuality is not destroyed simply because a claim arose against the debtor in one agency of the executive branch while the debtor is owed an amount from a different agency."); In re Gibson, 176 B.R. 910 (Bankr. D. Or. 1994) (claims of federal agencies are "assets of the United States" which can act only through its agency, department or instrumentality); In re Kalenze, 175 B.R. 35, 37 (Bankr. D.N.D. 1994) (IRS and FCIC); In re Apex Int'l Mgmt. Servs., Inc., 155 B.R. 591 (Bankr. M.D. Fla. 1993) (IRS and Air Force); In re Butz, 154 B.R. 541, 544 (S.D. Iowa 1993) (ASCS and FmHA); In re Young, 144 B.R. 45 (Bankr. N.D. Tex. 1992) (FmHA and CCC); In re Mohar, 140 B.R. 273, 277 (Bankr. D. Mont. 1992) (FmHA and ASCS one entity for setoff because "there is but one federal government, made up of independent agencies, which ... satisfy the mutuality of parties [for] setoff"); In re Stall, 125 B.R. 754 (Bankr. S.D. Ohio 1991) (Education and IRS); In re Gore, 124 B.R. 75 (Bankr. E.D. Ark. 1990) (SBA and ASCS); In re Julien Co., 116 B.R. 623, 625 (Bankr. W.D. Tenn. 1990) ("each federal entity is a 'aprt of the Government'"); In re Evatt, 112 B.R. 405, 413 (Bankr. W.D. Okl. 1989) (FmHA and ASCS/CCC); In re Art Metal, 109 B.R. 74 (Bankr. D.N.J. 1989) (applying Cherry Cotton Mills factors to determine whether PBGC as separate self-sustaining quasi-governmental entity entitled to setoff debts of United States); In re Defense Servs., Inc., 104 B.R. 481 (Bankr. S.D. Fla. 1989); In re Hazelton, 85 B.R. 400 (Bankr. E.D. Mich. 1988) (FmHA and CCC), rev'd on other grounds, 96 B.R. 111 (E.D. Mich. 1988); In re Thomas, 84 B.R. 438 (Bankr. N.D. Tex. 1988), modified on other grounds, 91 B.R. 731 (N.D. Tex. 1988); In re Britton, 83 B.R. 914 (Bankr. E.D.N.C. 1988); In re Pinkert, 75 B.R. 218 (Bankr. N.D. Tex. 1987) (ASCS and FmHA); Waldron v. FmHA, 75 B.R. 25 (N.D.Tex. 1987) (FmHA and CCC); In re Parrish, 75 B.R. 14 (N.D.Tex. 1987) (CCC and FmHA); In Re Sound Emporium, Inc., 48 B.R. 1 (Bankr. W.D. Tex. 1984), aff'd, 70 B.R. 22 (W.D.Tex. 1987) (IRS and Army). see generally Hubbard v. United States, 115 S. Ct. 1754 (1995) (in criminal context, the "term 'agency' includes any department, independent establishment, commission, administration, authority, board or bureau of the United States or any corporation in which the United States has a proprietary interest, unless the context shows that such term was intended to be used in a more limited sense"); Lebron v. National R.R. Passenger Corp., 115 S. Ct. 961 (1995) (Amtrak is part of federal government despite statute which states to the contrary; what Congress chooses to call federal agency does not alter its essential nature); Bosarge v. United States, 5 F.3d 1414, 1419 (11th Cir. 1993) (IRS and DOE "mutual" for offset purposes outside of bankruptcy), cert. denied, 114 S. Ct. 2720 (1995). Contra In re Chateaugay Corp., 1995 WL 386483, *5 (S.D.N.Y. Jun. 28, 1995) (holding that there is no common law right to offset tax refunds against claims of other federal agencies); Westamerica Bank v. United States, 178 B.R. 493 (N.D. Cal. 1995), order revised and opinion withdrawn, Aug. 18, 1995 (reversing earlier decision because court finds Doe compels different result); In re Pyramid Indus., Inc., 170 B.R. 974 (Bankr. N.D. Ill. 1994) (SBA and Dep't of Navy not same entity for setoff), appeal pending, (N.D. Ill.); In re Ionosphere Clubs, Inc., 164 B.R. 839 (Bankr. S.D.N.Y. 1994); In re Hancock, 137 B.R. 835 (Bankr. N.D. Okla. 1992). Compare In re Lakeside Community Hosp., 139 B.R. 886 (Bankr. N.D. Ill. 1992) (state agencies not one entity for setoff purposes), aff'd, 151 B.R. 887 (N.D. Ill. 1993) with Wallach v. New York (In re Bison Heating & Equipment, Inc.), 177 B.R. 785 (Bankr. W.D.N.Y. 1995) (State agencies as "creatures of the State" are a "single entity capable of holding mutual credits and debts;" distinguishing Lakeside based on N.Y. statute permitting offset between state agencies and noting that this right required a "similar application when offset works to its detriment.") and In re Bennett Co., 118 B.R. 564 (M.D. Tenn. 1990) (mutuality existed to setoff taxes owed to state agency against contractual debt owed by state agency).
(c) Capacity. The parties must be standing in the same capacity. Where the parties are identical, but they stand in different relationships in various transactions, mutuality does not exist. For example, the prepetition debtor is treated differently from the debtor-in-possession or the debtor's estate for some setoff purposes. See, e.g., Reich v. Davidson Lumber Sales Emp. Ret. Plan, 154 B.R. 324, 335 (D. Utah 1993); In re Express Freight Lines, 130 B.R. 288, 291 (Bankr. E.D. Wis. 1991); In re OPM Leasing Serv., 68 B.R. 979, 983 (Bankr. S.D.N.Y. 1987) (While the postpetition estate is not a wholly new entity distinct from the prepetition debtor, a definite cleavage separates the two upon the filing of a bankruptcy petition.); 4 Collier on Bankruptcy ¶ 553.08 (the lack of mutuality results from the new fiduciary capacity of the debtor-in-possession/trustee rather than from the existence of a new entity). But see In re Mohar, 140 B.R. 273, 279 (Bankr. D. Mont. 1992) (postpetition debtor same as prepetition debtor for offset purposes). Where a bank holds the debtor's money in the capacity of a trustee, mutuality does not exist, In re Knedlik, 192 B.R. 559, 561 (Bankr. D. Kan. 1995) (Court refused setoff where "a debtor-creditor relationship gave rise to the first obligation and a fiduciary relationship gave rise to the other;" "[b]ecause they were not standing in the same capacities, there is no mutuality of obligations."); accord In re Anton, 146 B.R. 509, 513 (Bankr. E.D.N.Y. 1992); In re Mastroeni, 57 B.R. 191 (S.D.N.Y. 1986), nor does mutuality exist where the creditor holds property of the debtor as a bailment, In re Bevill, Bresler & Schulman Asset Mgmt., 896 F.2d 54, 57 (3d Cir. 1990); cf. United States v. Jones, 607 F.2d 687, 688 (5th Cir. 1979) (US has no right of setoff against cash bail bond held by clerk of court). Finally, mutuality does not exist where the creditor's debt to the debtor is based on the recovery of a fraudulent conveyance 11 U.S.C. § 544(b). In re Acequia, Inc., 34 F.3d 800, 817 (9th Cir. 1994).
(a) For setoff to be permitted, both debts must arise prepetition or postpetition. In other words, a claim which arises prepetition may be setoff only against a credit which also arises prepetition. Braniff Airways v. Exxon, 814 F.2d 1030 (5th Cir. 1987); Reich v. Davidson Lumber Sales Emp. Ret. Plan, 154 B.R. 324, 335 (D. Utah 1993) (mutuality requires that both debts be prepetition; mutuality is determined with reference to the time the underlying debt arose, not with reference to the time the petition was filed); In re OPM Leasing Serv., 68 B.R. 979 (Bankr. S.D.N.Y. 1987). Compare In re Weissman, 126 B.R. 889, 894 (Bankr. N.D. Ill. 1991) (claim liquidated by litigation during the bankruptcy case is a prepetition claim if the events giving rise to the cause of action occurred before bankruptcy) with Cooper-Jarrett, Inc. v. Central Transp., 726 F.2d 93 (3d Cir. 1984) (prepetition contract obligation supplanted by postpetition settlement; hence, no right to setoff prepetition claims against postpetition settlement debt). While the Code specifically allows prepetition setoff, it is silent regarding the offset of postpetition claims against postpetition credits. However, courts have allowed the parties to offset claims postpetition in the same manner as prepetition. In re Alfar Dairy, 458 F.2d 1258 (5th Cir.), cert. denied, 409 U.S. 1048 (1972); In re Seal, 192 B.R. 442, 457 (Bankr. W.D. Mich. 1996); In re Mohawk Indus., 82 B.R. 174 (Bankr. D. Mass. 1987); In re Fordson Eng'g, 25 B.R. 506 (Bankr. E.D. Mich. 1982). Contra In re Sherry & O'Leary, Inc., 148 B.R. 248, 253 (Bankr. W.D. Pa. 1992) (only prepetition debts can be set off).B. Character Of The Claim. The debt and the claim need not arise from the same transaction nor must they be of the same character. See, e.g., In re Bevill, Bresler & Schulman Asset Mgmt., 896 F.2d 54 (3d Cir. 1990) (contractual obligations are debts for purposes of setoff); Braniff Airways v. Exxon, 814 F.2d 1030 (5th Cir. 1987); In re Bay State York Co., 140 B.R. 608 (Bankr. D. Mass. 1992) (obligations which arise from differing surety relationships satisfy mutuality requirement); In re Thurston, 139 B.R. 14 (Bankr. W.D. Mo. 1992) (contract claims may be setoff against tort based claims); In re Denby Stores, 86 B.R. 768, 777 (Bankr. S.D.N.Y. 1988); In re Elsinore Shore Assoc., 67 B.R. 926 (Bankr. D. N.J. 1986). However, if the creditor's debt to the debtor is based on the recovery of a fraudulent conveyance under 11 U.S.C. § 544(b), setoff is generally denied. In re Acequia, Inc., 34 F.3d 800, 817 (9th Cir. 1994).
C. Setoff And Equity.
1. Bankruptcy courts lack a statutory predicate to disallow setoff for "equitable" reasons. Unlike other Code provisions, § 553 does not expressly confer a power to disallow setoff for equitable reasons. Compare 11 U.S.C. § 553(a) with 11 U.S.C. § 552(b) (specific instruction that courts consider the "equities of the case" in evaluating postpetition effect of security interests); see also In re Elcona Homes Corp., 863 F.2d 483 (7th Cir. 1988) (questioning limits of bankruptcy court's discretion to disallow setoff); Melamed v. Lake County Nat'l Bank, 727 F.2d 1399 (4th Cir. 1984) (set offs are generally favored); In re Applied Logic Corp., 576 F.2d 952 (2d Cir. 1978) ("The rule allowing setoff ... is not one that courts are free to ignore when they think application would be unjust."); In re IML Freight, Inc., 65 B.R. 788, 792 (Bankr. D. Utah 1986) (judicial preference favors allowance of setoff). However, many courts assume wide discretion to disallow setoff. See, e.g., In re Securities Group 1980, 74 F.3d 1103, 1114 (11th Cir. 1996) ("[S]etoff under § 553 is merely permissive and subject to the discretion of the bankruptcy court."); In re Cascade Roads, Inc., 34 F.3d 756 (9th Cir. 1994) (same); In re Southern Indus. Banking, 809 F.2d 329 (6th Cir. 1987) ("when justice dictates, setoff must be denied"); In re Cabrillo, 101 B.R. 443 (Bankr. E.D. Pa. 1989) (setoff denied when creditor asserts a security interest in property it seeks to offset and creditor fails to meet its burden under § 362(d)).
2. At the least, we can argue that compelling circumstances are required to disallow setoff. See In re NWFX, Inc., 864 F.2d 593 (8th Cir. 1989) (compelling reasons required to disallow setoff); Bohack Corp. v. Borden, Inc., 599 F.2d 1160 (2d Cir. 1979); In re Buckenmaier, 127 B.R. 233 (Bankr. 9th Cir. 1991) (setoff enforced absent compelling circumstances); In re Tilston Roberts Corp., 75 B.R. 76 (S.D.N.Y. 1987); In re Utica Floor Maintenance, Inc., 41 B.R. 941 (N.D.N.Y. 1984); In re Springfield Casket Co., 21 B.R. 223 (Bankr. S.D. Ohio 1982) (setoff permitted absent compelling circumstances).
3. Generally, courts have only disallowed otherwise valid setoff in two categories of cases: (a) where the creditor committed an inequitable, illegal, or fraudulent act, or the setoff is against public policy, see In re Cascade Roads, Inc., 34 F.3d 756 (9th Cir. 1994) (IRS setoff denied because Government's conduct was inequitable); In re Blanton, 105 B.R. 321, 337 (Bankr. E.D. Va. 1989) and cases cited therein, and (b) where the setoff would significantly harm or destroy the debtor's ability to reorganize, see, e.g., In re Lincoln, 144 B.R. 498 (Bankr. D. Mont. 1992) (setoff denied where payments necessary for chapter 12 reorganization); In re Cloverleaf Farmers Co-op, 114 B.R. 1010 (Bankr. D.S.D. 1990) (setoff denied because inconsistent with purpose of chapter 12 and the rehabilitation of American farmers); In re IML Freight, 65 B.R. 788, 792 (Bankr. D. Utah 1986) (legislative history shows setoff only appropriately denied in reorganization cases; not appropriate in liquidation cases); In re Penn Cent. Transp., 315 F. Supp. 1281 (E.D. Pa. 1970) (setoff denied because it would frustrate railroad reorganization process), aff'd, 453 F.2d 520 (3d Cir.), cert. denied, 408 U.S. 923 (1972); but see generally Matter of Rash, 31 F.3d 325, 330 (5th Cir. 1994) ("[W]hile reorganization is an important goal, this goal cannot be pursued by exterminating a secured creditor's property interest. Reorganization is not a Holy Grail to be pursued at any length.").
4. In reorganization cases where the debtor argues that setoff affects the opportunity to reorganize, we should argue as a backup that setoff be deferred rather than denied, see, e.g., In re Allen, 135 B.R. 856, 871 (Bankr. N.D. Iowa 1992); Blanton, 105 B.R. at 321 and cases cited therein; Utica Floor, 41 B.R. at 945-46, and that the debtor must provide a "substantial explanation of the factual basis" for their assertion, see Allen, 135 B.R. at 871; Utica Floor, 41 B.R. at 945 and cases cited therein.
5. Bankruptcy courts may grant setoff on equitable grounds even if no mutuality. Gray v. Rollo, 85 U.S. 629 (1873); In re Sherman Plastering Corp., 346 F.2d 492 (2d Cir. 1965); Modern Setting v. Prudential-Bache Sec., 109 B.R. 605 (S.D.N.Y. 1989). Contra In re NWFX, Inc., 864 F.2d 593 (8th Cir. 1989) (no reason for enlarging the right to setoff beyond that allowed in the Code); Boston & Maine Corp. v. Chicago Pacific Corp., 785 F.2d 562 (7th Cir. 1986).