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. For instance, if the debtor owes a prepetition debt to a particular creditor, and that creditor also owes a prepetition debt to the debtor, the creditor can setoff the debt which is owed to the debtor. The Bankruptcy Code is not an independent source of law that authorizes a setoff; it recognizes and preserves rights that exist under non-bankruptcy law. Therefore, a creditor seeking to setoff a debt must establish a claim and a right to do so under state or federal law. A setoff can be an affirmative defenses or a counterclaim. Setoff is available in bankruptcy only when both the opposing claims arise on the same side of the time line according to the filing of the petition. The claims must both be either prepetition claims or postpetition claims.
Setoff is only available when the obligations between debtor and creditor are mutual. Both obligations must be held by the same parties in the same right or capacity, and both must arise either prepetition or postpetition. Where the parties are identical, but they stand in different relationships in various transactions, mutuality does not exist.
Prepetition or Postpetition Claims
For setoff to be permitted, both debts must arise prepetition or postpetition. Thus, a claim which arises prepetition may be setoff only against a credit which also arises prepetition. Claims “arise” for bankruptcy purposes when (1) all “transactions” or acts necessary for liability occur, and for government claims, (2) there is some prepetition relationship, such as contact, exposure, impact, or privity between the United States and the debtor such that the Government is able to fairly contemplate that it might have a claim against the debtor.
Setoff and Equity
Bankruptcy courts lack a statutory predicate to disallow setoff for “equitable” reasons. Generally, courts have only disallowed otherwise valid setoffs in two categories of cases:
where the creditor committed an inequitable, illegal, or fraudulent act, or the setoff is against public policy; and
where the setoff would significantly harm or destroy the debtor’s ability to reorganize.
Recovery of Setoffs
Setoffs made within 90 days of the debtor filing for bankruptcy relief may be recovered by the trustee. The trustee applies recovered property to pay the debts owed unsecured creditors.