THE PROBLEM OF THE DISAPPEARING RECEIVABLE: SETOFFS IN BANKRUPTCY

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1 THE PROBLEM OF THE DISAPPEARING RECEIVABLE: SETOFFS IN BANKRUPTCY Program: Black Swans in Bankruptcy: Foreseeable Issues That Always Surprise Presented by the BASF Commercial Law and Bankruptcy Section; July 9, 2013 Shane J. Moses, McNutt Law Group LLP Introduction The situation will be easily recognizable to most bankruptcy practitioners. Perhaps you represent the debtor-in-possession, or a trustee, or even a secured creditor with a security interest in the debtor's accounts. As is often the case, the debtor has significant accounts receivable. If they are not subject to a secured lender's lien, they may represent the best opportunity for the debtor or trustee to bring some much-needed cash into the estate. If the receivables are subject to a secured lender's lien, they may be the most promising collateral. So demand letters go out. And more often than not the majority of responses will say some variation of: "So what if we owe the debtor $100, The debtor owes us $150, So you get nothing, and we have a $50, claim. Please let us know when we will get paid." So are you SOL? Is the receivable worthless? The answer, as always, is "probably, but it's complicated." With corporate debtors, one of the largest assets will often be the debtor's accounts receivable for work done or goods sold, but not yet paid for. This is particularly true in businesses such as construction, where there is often a long lead time for payment. On the other hand, these receivables often turn out to be subject to claims for setoff (or the similar theory of recoupment), that may drastically reduce or eliminate their value. Sometimes the setoff is readily apparent, and at other times it may be almost impossible to predict. In any case, it probably will not be reflected on the debtor's AR report. The Basics: Section 553 The basic principles of setoff are understood by most practitioners, and are in fact probably unconsciously accepted by almost everyone. The right of setoff, both in and out of bankruptcy, allows two parties that owe each other money to set off the mutual debts against each other, leaving only the balance. As the Supreme Court described it, this avoids "the absurdity of making A pay B when B owes A." 1 Setoff is a generally acceptable principle of commercial law, recognized in all fifty states, although there may be some meaningful differences state-to-state as to when a setoff is recognized as having been effectuated. In bankruptcy, setoff is governed by Section 553 of the Bankruptcy Code, but neither Section 553 nor any other part of the Code creates a right of setoff. Rather, Section 553 merely preserves in bankruptcy the state law right. 2 Section 553(a) supplies the basic operative provisions, and generally provides that, except for Section 362 (automatic stay) and 363 (sale or 1 Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995). 2 See e.g., Hawaii Airlines, Inc. v. United States (In re HAL, Inc.), 122 F.3d 851, 852 (9th Cir. 1997). The operative state law provision in California is Code Civ. Proc , but since setoff is so generally recognized, bankruptcy courts almost never feel the need to cite to state law. Page 1 of 10

2 use of property), the Bankruptcy Code "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." 3 A recent Ninth Circuit BAP decision summarizes when setoff is applicable: In sum, Section 553 gives a creditor the right to net out claims it has against the debtor, against any debts it owes to the debtor. Under 553 and the relevant Ninth Circuit case law, a creditor's right to offset is recognized and preserved under three conditions: (1) The creditor holds a claim against the debtor that arose before the commencement of the case; (2) The debtor owes a debt to the creditor that also arose before the commencement of the case; (3) The claim and debt are mutual, as determined by applicable nonbankruptcy law. 4 Section 553 may simply preserve a state law right, but it creates an enormous exception to the fundamental principle of bankruptcy that like creditors are treated alike. The right to setoff allows an otherwise unsecured creditor that also owes money to the debtor to get 100% of the value of its claim through setoff, where other creditors may receive a few cents on the dollar. The Code in fact provides that such a claim is not treated as unsecured, but is a secured claim "to the extent of the amount subject to setoff." 11 U.S.C. 506(a)(1). When Does a Setoff Occur? Although this is arguably a matter of state law under Section 553, bankruptcy courts generally find a setoff to have occurred when three distinct steps have occurred: "[A] setoff has not occurred until three steps have been taken: (i) a decision to effectuate a setoff; (ii) some action accomplishing the setoff; and (iii) a recording of the setoff." 5 Only Up To a Point: Generally Applicable Limits on Setoff in Bankruptcy Section 553 does not preserve state law setoff rights entirely unfettered. The language of 553(a) itself contains two threshold requirements, beyond the basic requirement that the creditor have a right to setoff under applicable non-bankruptcy law. In addition, subsections (1), (a)(2), and (a)(3) impose timing-based limitations designed primarily to prevent creditors from seeking to improve their position through setoff on the eve of bankruptcy, or after a petition is filed. Pre-Petition Debts Only 3 11 U.S.C. 553(a). 4 In re Coast Grain Co. (Bauma Dairy v. Braun), 2006 Bankr. LEXIS 4792 (9th Cir. B.A.P. 2006) (note that this is not an officially published opinion). 5 Id. (quoting Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995)); In re United Marine Shipbuilding, Inc. (McCarty v. Natl. Bank of Alaska), 146 F.3d 739, 744 (9th Cir. 1198). The B.A.P. in In re Coast Grain notes that nothing in California law specifically requires these three steps. Page 2 of 10

3 The Bankruptcy Code only allows setoff of pre-petition debts. This is primarily an issue for Chapter 11 cases. Without this limitation, a pre-petition creditor could purchase goods from the Chapter 11 debtor, and the "pay" by a setoff against its pre-petition claim. This issue is likely to come up in converted Chapter 11 cases, when a Chapter 7 trustee starts looking at collecting both Chapter 11 and pre-petition receivables. The Meaning of Mutuality Section 553 only allows the setoff of a "mutual" debt. 6 In theory, the mutuality requirement is "strictly construed." 7 It is, however, far from a requirement that the debts stem from the same or even related contracts (but see recoupment, below). In general, the requirement that debts be "mutual" is unlikely to be an issue in simple commercial relations, but may become relevant in complicated situations involve government entities or affiliated corporations. Mutuality imposes three requirements: 8 (1) The debts must be owed "in the same right." (This basically is a redundant requirement that debts both be pre-petition). 9 A. 10 (2) Debts must be between the same parties. A can't offset its debt to B against C's debt to (3) The debts must be "in the same capacity." 11 The requirement that the debts must be between the same parties seems straightforward enough, and usually is, but gets interesting where C and B are closely affiliated, or related government entities. More on that later. The requirement that debts be in the same capacity will generally only limit offsets of amounts owed in a fiduciary, trust, or similar capacity against ordinary debts Mutuality is technically defined by state law and applied through Section 553, but federal common law generally applied by bankruptcy courts and California state law are consistent so that there is no real need to distinguish. Murphy v. Federal Deposit Insurance Corp., 38 F.3d 1490, 1504 (9th Cir. 1994). Also, bankruptcy courts more often than not only look to other federal decisions to determine mutuality. See County of Orange v. County of Orange, 183 B.R. 609, 619 (Bankr. C.D. Cal. 1995) 7 Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1399 (9th Cir. 1996). 8 See In re Visiting Home Services, Inc., 643 F.2d 1356, 1360 (9th Cir. 1981). 9 County of Orange v. County of Orange, 183 B.R. 609 (Bankr. C.D. Cal. 1995). 10 Id. It is worth noting that substantive consolidation does not necessarily make the consolidated entities the same for purposes of mutuality. In re Wade Cook Financial, 375 B.R. 580 (9th Cir. B.A.P. 2007). 11 County of Orange, 183 B.R For example, debts that are owed to a government pension fund for the benefit of its members cannot be offset against debts owed by another agency. Id. Page 3 of 10

4 Timing: Transferred Claims and New Obligations The right to setoff in bankruptcy is also limited to the extent the right to setoff arose within the 90 days pre-petition, as provided in Sections 533(a)(2) and (a)(3). These two subsections apply, respectively, to claims against the debtor that the creditor acquired within 90 days pre-petition, and to debt owed to the debtor incurred in the same time period. 13 Sections 553(a)(2) and (a)(3) are designed to prevent creditors from acquiring new positions for purposes of setoff either after the case is filed, or within 90 days before filing, while the debtor is insolvent. (Insolvency is presumed by statute in the 90 days pre-bankruptcy). 14 Section 553(a)(2) basically prevents a party that owes the debtor money from buying up other claims at a discount in order to offset their debt to the bankruptcy estate in undiscounted dollars. This applies only to transferred claims, and intent is irrelevant. Section 553(a)(3) applies in the nearly opposite situation, where a creditor incurs debt it owes to the bankruptcy debtor within 90 days before the filing, for the purpose of setoff. The obvious scenario is where the debtor sells a fairly fungible product. A major creditor, seeing the writing on the wall, could seek to buy from the debtor, up to the amount of their claim, on credit, and then "pay" by offsetting the claim, avoiding taking the loss on a claim that might only be worth a few cents on the dollar. Because of the requirement that the new debt be incurred for the purpose of setoff, not all debts incurred to the debtor will be ineligible for setoff under Section 553(a)(3). The most obvious example would be a bank that is creditor on a loan, and also holds the debtor's bank accounts. A new deposit by the debtor shortly pre-petition would be a debt the bank owes to the debtor, but presumably this was not accepted by the bank "for the purpose of setoff." 15 Under a rule that comes close to a catch-22, since it was not incurred for the purpose of setoff, it is eligible for setoff (assuming the bank can get relief from stay see below). Avoidance: Sections 553(a)(2) and (a)(3) by their terms apply retroactively, as such, if a setoff was actually effectuated pre-petition that is invalidated by 553(a)(2) or (a)(3), it should be avoidable as a preference. 13 The pre-petition applications of Sections 553(a)(2) and (a)(3) both excepts debts "of a kind described in section 362 (b)(6), 362 (b)(7), 362 (b)(17), 362 (b)(27), 555, 556, 559, 560, or 561." In general, these relate primarily to offsetting various charges in securities, commodities, swap, and master netting transactions. 14 Insolvency in the last 90 days is specifically assumed by Section 553(c), although this assumption would be rebuttable. 15 Note that Colliers does cite at least one very old case finding that the a bank did accept a deposit for the purpose of setoff. Page 4 of 10

5 What Does it All Mean? The Priority of Setoff So the contractor who owes that big receivable is asserting a setoff, and it looks like they have a right to it. What does that mean for the estate? Does a secured creditor with a blanket lien on receivables fare any better? Generally speaking, unless the setoff can be avoided in some way, the estate is out of luck as to any receivables it has that are subject to setoff. If the setoff has already been applied, then the real amount of the receivable is less the applied setoff. If the setoff has not been effectuated, then the receivable debtor merely has to seek relief from stay, and is treated as a secured creditor until the setoff is applied. 11 U.S.C. 506(a). This includes the right to adequate protection, to the extent that relief is not granted. Secured creditors do not fare any better than a trustee or the debtor. It is important not to be fooled into thinking that because the right to setoff creates a "secured claim," it is a lien that is subject to senior liens. A prior perfected security interest in the debtor's receivables does not overcome a valid right to setoff of the party owing the receivable. 16 The short explanation is that the secured party takes its security interest subject to any defenses that might be asserted against the debtor, including setoff. 17 The slightly longer Article 9 of the UCC governs the security interest generally. Section 9-109(d)(10) of the UCC provides that Article 9 does not apply to setoff and recoupment, except for two specific sections. One of those is Section 9-404, which provides that the security interest in an account is subject to any defense the account debtor may have (including setoff). 18 The other applicable section is 9-340, which protects a bank's right to assert setoff against a deposit account that a third party has a security interest in. It is also clear that amounts subject to recoupment claims are exempt from a security interest. Recoupment against a receivable in which the secured creditor holds an interest "does not impair the security interest" because it merely serves to determine the actual amount of the receivable. 19 Don't Jump The Gun: The Automatic Stay Does Apply A creditor is generally allowed the right to setoff. But this does not trump the automatic stay, which specifically prohibits actions to effectuate a setoff. 20 Section 553 specifically notes 16 See In re U.S. Aeroteam (U.S. Aeroteam v. Delphi Automotive Systems), 327 B.R. 852, (Bankr. S. D. Ohio, 2005). 17 Id., UCC There is an exception in UCC 9-404, if the mutual debts to be offset are based on different contracts, and the party seeking to apply the offset had been notified that a third party would have a security interest before it incurred the debt that would be subject to the security interest. 19 Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392 (9th Cir. 1996) U.S.C. 362(a). Page 5 of 10

6 that its protection of setoff is subject to Section 362. Thus, once a debtor files for bankruptcy protection, the creditor is prohibited from acting to enforce its setoff right unless the stay is terminated or lifted. 21 The usual remedy is to seek relief from stay to effectuate a setoff. In general, this will be granted, under the usual relief from stay analysis. It is not uncommon to stipulate to relief from stay, subject to the right to dispute the amount of the setoff. The automatic stay does prohibit actually applying a setoff, but it does not prohibit placing a temporary hold on funds that are otherwise payable to the debtor but subject to setoff, for example by placing an administrative freeze on the debtor's bank account when the bank is also a creditor and has a right to setoff. 22 This is consistent with Section 542(b), which requires turnover of amounts owed to the debtor, except "except to the extent that such debt may be offset under section 553 of this title against a claim against the debtor." 23 Recoverable Insufficiency? The 90 Day "Mini-Preference" The concept of setoff and its applicability in bankruptcy may be generally known to most practitioners, but the fact that setoffs may in some cases be avoided and the setoff amounts recovered for the estate, is less well known or understood. The right to setoff may be protected generally, but setoffs that let a creditor improve its position in the 90 days before a bankruptcy filing may be avoidable, in much the same way as a preferential payment. 24 The basis for this is found in Section 553(b) where a creditor effectuates an setoff within 90 days pre-petition, the trustee or debtor may recover the amount of the setoff under limited circumstances. The setoff amount can be recovered "to the extent that any insufficiency on the date of such setoff is less than the insufficiency on the later of: (A) 90 days before the date of the filing of the petition; and (B) the first date during [the 90 period] on which there is an insufficiency." 25 This turns completely on the term "insufficiency," the meaning of which is anything but self-evident. Insufficiency is defined as "the amount, if any, by which a claim against the debtor exceeds a mutual debt owing to the debtor by the holder of such claim." 26 In other words it is the amount by which the debt creditor owes debtor is insufficient to fully offset creditor's claim against the debtor. The wording of Section 553(b) is more than a little unclear, with its use of "insufficiency." Fundamentally, 553(b) just means that if a creditor exercises its right to setoff 21 Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 19 (1995). 22 See id U.S.C. 542(b). 24 See in re Bakersfield Westar Ambulance, Inc., (Parker v. Community First Bank), 123 F.3d 1243 (9th Cir. 1997); see also, Ben Caughey, A Creditor's Right to Setoff: When Does a Creditor Impermissibly Improve Its Position? American Bankruptcy Institute, ABIJ 32 (January 2011) U.S.C. 553(b)(1) U.S.C. 553(b)(2). Page 6 of 10

7 during the 90 days pre-petition, it is not entitled to a better result than would have resulted if the setoff occurred 91 days before the petition. 27 An Example of 553(b) An example is helpful here. 28 Suppose Borrower owes Bank $15 on an unsecured loan which is in default, and at the same time, Borrower has a checking account at Bank. The amounts deposited in the checking account are basically a debt owed by Bank to Borrower, which Bank may be entitled to offset against the loan (assume the loan agreement and checking account agreement allow this). Now suppose that 90 days pre-petition Borrower's checking account balance is $10. A month later, Borrower deposits $4 in it checking account. Sometime after that deposit, Bank sees the writing on the wall and asserts its right to offset the $14 checking account balance against the $15 loan balance, leaving a balance of $1 owed to Bank. Then a Chapter 7 petition is filed, and the trustee starts looking for assets. Under Section 553(b), the trustee can recover the $4 by which Bank improved its position. Applying the terms of Section 553 to the example above, on the 90th day pre-petition, the insufficiency is $5 ($15 claim of Bank, minus $10 owed from Bank to Borrower). After the deposit increases the Bank's debt to Borrower to $14, the insufficiency is only $1. Section 553(b) gives the trustee the right to recover the $4 by which the insufficiency decreased from 90 days pre-petition to the setoff date. The Creditor Who Buys From the Debtor to Improve Its Position Section 553(b)(1) will also apply (in addition to 553(a)(3)) where an ordinary creditor buys products from the debtor solely for the purpose of setoff. Take for example a supplier that provides steel to the debtor, and is owed $20,000. The creditor realizes that it is unlikely to be paid, and decides to buy back $15,000 worth of steel from the debtor, and instead of paying, executes a setoff against its claim, leaving it with a $5,000 claim. Because of the dollar for dollar nature of setoff, this supplier has greatly improved its outcome in a typical bankruptcy. But if a petition is filed within 90 days, the debtor or trustee can recovery the entire $15,000 improvement in "insufficiency." See In re Bakersfield Westar Am, 123 F.3d at 1245 (9th Cir. 1997). Section 553(b) only reaches out 90 days. For example if a debtor deposits money into its accounts with creditor bank slightly more than 90 days pre-petition, and then the bank exercises the setoff within the 90 day window, the setoff cannot be avoided, because the bank's improvement in position was more than 90 days pre-petition. See In re Rehab Project Inc. (French v. Bank One), 238 B.R. 363 (Bankr. N.D. Ohio 1999). 28 This example is from In re Bakersfield Westar Am, 123 F.3d at 1245, n.2 (9th Cir. 1997), which originally pulled it from 5 Collier 55309[2][b]. 29 Loosely based on In re Lawndale Steel Co. (Lawndale Steel Co. v. Magic Steel Co.), 155 B.R. 990 (Bankr. N.D. Ill 1993). Page 7 of 10

8 Special Circumstances Recoupment Recoupment is related to setoff, but applies only to offsetting demands arising from the same transaction. 30 A basic case of recoupment would be where the trustee for a contractor debtor sues a customer of the debtor to collect amounts due on a contract, and the customer raises asserts that the balance is not really owing on the contract, because the debtor never finished the work. 31 The distinction is not that important outside of bankruptcy but can be critical in bankruptcy. This is because of three key differences: (1) the automatic stay does not apply to recoupment, (2) recoupment is not avoidable or subject to the limitations of Section 553, and (3) mutuality is not necessarily required, or it is at least relaxed. 32 The requirement of recoupment is that the claims arose from the same transaction. This is governed by a "logical relationship" test originally outlined by the Supreme Court. 33 This means that two occurrences or events, or even contracts, can be part of the same transaction, as long as there is a logical relationship between events that supports a finding that they are part of the same overall transaction. For example, where a bonding company used the debtor's equipment to finish contracts the debtor defaulted on, the bonding company could recoup the debtor's indemnity obligation to it for bond losses against rents it was obligated to pay on the equipment. 34 Recoupment does not require that the offsetting claims be pre-petition. Thus a prepetition creditor that owes a post-petition debt to the debtor can apply recoupment to net out the amounts. 35 Presumably this is most likely to come up in Chapter 11 cases, but it would apply in any circumstance where the creditor became liable post-petition to a debtor. While recoupment is not recognized directly by the Bankruptcy Code, courts have more or less universally recognized that common law recoupment rights are recognized in bankruptcy, and more importantly, that the creditor can unilaterally exercise them without Court consent. 36 The concept is that the party making a recoupment claim is not seeking to offset two debts, but 30 Newbery Corp., 95 F.3d See id. (related claims under the same contract). 32 Id. at Id. at Id. 35 In re TLC Hospitals, Inc. (Sims v. U.S.), 224 F.3d 1008 (9th Cir. 1999). The Ninth Circuit found that the Dept. of Health and Human Services could apply amounts it was owed for its pre-petition overpayment for medicare services against its post-petition obligations to a hospital that continued to provide services. 36 See Gary E. Sullivan, In Defense of Recoupment: Why "Setoff" of Prepetition Utility Deposits Against Prepetition Debt is Not Subject to The Automatic Stay, Emory Bankruptcy Developments Journal, 15 Bank. Dev. J. 63 (1999). Page 8 of 10

9 simply establishing that the amount owing on one debt is lower. See Newbery, 95 F.3d 1392, Government Agencies The IRS is a very frequent creditor in bankruptcy cases. At the same time, various other agencies of the U.S. Government may owe money to the debtor. Attempts by the U.S. to setoff the respective debts raise the question of mutuality, since mutuality requires that the obligations be between the same parties. While it might on its face seem like the IRS and, for example, the Forest Service are not the same party, the law is very clear that they are for purposes of setoff. Federal government agencies are collectively a single entity for purposes of setoff under Section It is worth noting that by filing a claim, any governmental entity with sovereign immunity waives immunity with respect to not just counterclaims arising from the same transaction, but as to any potential setoff. 38 The law is less clear on state agencies, but it appears that local government entities (e.g., a county and its school district) will generally be viewed as separate for purposes of setoff. 39 Discretionary Denial Although the right to setoff is generally applied, it is in fact discretionary. While setoff is generally favored, its application does rest in the "discretion of [the] court, which exercises that discretion under the general principles of equity." 40 The bankruptcy court may deny setoff where there is clear evidence that the conduct of the creditor seeking to exercise its setoff rights was egregious. 41 This has been applied, for example, to preclude setoff against tax debt where the Forest Service used a long series of delaying tactics to avoid paying a judgment to a contractor, where evidence showed the Forest Service knew it was in the wrong from the beginning. 42 Post-Petition Setoff While Section 553 only recognizes setoffs of mutual pre-petition debts, Courts will generally allow set-off of mutual post-petition debts In re HAL, Inc. (HAL, Inc. v. U.S.), 196 B.R. 159, 165 (9th Cir. B.A.P. 1996). This case, involving Hawaiian Airlines happens to be the reverse of the usual, in that the IRS sought to setoff amounts the debtor owed to the FAA against a tax refund it owed to the debtor. 38 See Doe v. U.S., 58 F.3d 494 (9th Cir. 1995). This case involved an FBI informant who was pursuing claims against the FBI for revealing his identity to a drug cartel. In his bankruptcy case, he sought the right to assert these claims as a setoff against his tax debt. 39 County of Orange v. County of Orange, 183 B.R. 609, 619 (Bankr. C.D. Cal. 1995). 40 In re Cascade Roads, Inc. (U.S. v. Arkison), 34 F.3d 756, 763 (9th Cir. 1994). 41 Id. 42 Id. at See 5 Collier on Bankruptcy (15th ed.) [6]. Page 9 of 10

10 Mutuality: Assignment and Subrogation When A pays the debtor's obligation to B, and acquires B's rights against the debtor, A can then setoff the claim it acquired against amounts it owes the debtor. 44 This is subject to Section 553(a)(2)'s 90-day rule. For purposes of 553(a)(2), if A agreed to pay B, and received an assignment of B's claim, the transaction is complete, even if A does not actually pay B until within the 90 day period the issue is when A received the assignment of the claim against the debtor. 45 In general, an assigned right is subject to setoff regardless of whether the assignment was voluntary or involuntary as the result of the doctrine of subrogation. Setoff Against Fraudulent Conveyances Setoff is not a good defense against a fraudulent conveyance turnover order. There is a general rule that the court should apply its discretion to deny setoff against amounts owed for return of a fraudulent conveyance. 46 Setoff Following Confirmed Plan It appears that the right to setoff is not precluded by confirmation of a Chapter 11 plan, even where that plan does not address any right to setoff. 47 This may also be true regarding a discharged Chapter 7 debt. 48 Waiver and Unintentional Release If a creditor inadvertently releases to the debtor funds it claims a right to setoff in, that release does not waive the right to setoff. 49 Where the creditor released funds without having first asserted a right to setoff, however, it appears that most courts find the right to setoff waived See In re U.S. Aeroteam, 327 B.R. at Id. at In re Acequia, Inc. (Acequia Inc. v. Clinton), 34 F.3d 800, 817 (9th Cir. 1994). 47 In re De Laurentiis Entertainment Group (Carolco Television Inc. v NBC), 963 F.2d 1269 (9th Cir. 1992). 48 See id., noting that the majority view is that 553 overcomes the 524 discharge (even that 524 specifically mentions setoff). 49 In re United Marine Shipbuilding, Inc. (McCarty v. Natl. Bank of Alaska), 146 F.3d 739, 745 (9th Cir. 1198). 50 Id. Page 10 of 10