Setoff in bankruptcy: two balances do not automatically cancel each other

Identify the right outside bankruptcy

Section 553 generally preserves certain rights of setoff, subject to its exceptions and other Code provisions. It does not create a right simply because two businesses owe each other money. The starting point is the applicable nonbankruptcy law and the agreements governing each obligation.

The statute's central framework concerns mutual prepetition debts and claims. The identity of the parties, the capacities in which they act, and when the obligations arose can be decisive. A consolidated accounting report may combine balances that do not satisfy the legal mutuality requirement.

Separate the debtor entities and time periods

An illustrative group may include a company that owes a supplier and an affiliate that is owed a rebate by that supplier. Commercially, the balances appear connected. Legally, the separate entities and contractual rights require analysis. Do not assume that a netting clause or common ownership resolves the issue.

Build two ledgers with the underlying contracts, dates of performance, credits, and payment history. Identify any acquisition or transfer of a claim. Section 553 contains restrictions addressing certain claims acquired or debts incurred near bankruptcy, as well as a rule concerning an improvement in position from specified prepetition setoffs.

A preserved right is not immediate permission to exercise it

The automatic stay in section 362 expressly addresses setoff of certain prepetition debts. A creditor must therefore evaluate both whether a right exists and whether it may be exercised at the proposed time. Taking a bookkeeping shortcut can create a legal problem even when the underlying setoff argument is substantial.

Discuss the necessary process with counsel before netting, withholding, or treating an account as settled. Setoff and recoupment are also distinct doctrines; using one label for every deduction can obscure the applicable rules. This guide does not resolve a recoupment claim.

A useful setoff file includes

• The source of the asserted right and both contracts.
• The exact entities and capacities on each side.
• Dates and evidence for each obligation.
• The applicable stay order or other authority for the proposed action.