Consider the Setoff: Strategies for Creditors after a Bankruptcy Filing

All too often, a bankruptcy petition is met with immediate frustration. Vendors, lenders and customers are left believing that they must wait it out, often for years, until they realize even a fraction of what is owed to them by the bankrupt debtor. In reality, however, if you and the bankrupt entity end up owing each other money, you may be able to speed things along by taking advantage of what is known as a setoff.

The right of setoff was successfully applied in the 2002 Kmart bankruptcy case, in which a small cadre of creditors (most of whom were clients of mine) were able to walk out of the bankruptcy court following first-day motions with an order allowing them to “set off” cash they were holding for Kmart in various accounts totaling nearly $20 million. How is that possible, particularly in light of the automatic stay that arises when a bankruptcy petition is filed? The answer was best articulated by the U.S. Supreme Court in Citizens Bank of Maryland v. Strumpf. According to that 1995 decision, while no federal right of setoff exists, the U.S. Bankruptcy Code does not, with certain exceptions, trump the state or common law right of setoff.

But before you stop reading and rush to set off a bankrupt debtor’s accounts, I encourage you to pause and read on. When a bankruptcy case is filed, the court issues an automatic stay that prohibits creditors from taking any collection actions against the bankrupt debtor. Although relief from an automatic stay is limited, setoffs are allowed under certain circumstances. In the majority of jurisdictions, the creditor must take three steps, with the ultimate goal of permanently settling the account.

Decide to effectuate a setoff

In order to make the initial decision to effectuate a setoff, you must determine if there are mutual obligations, meaning the actual debtor (not a subsidiary or other entity) owes you money and vice versa. Recognizing the absurdity of requiring the debtor to pay the creditor, only to have the creditor turn around and pay the debtor, the law allows one debt to be applied against the other through a setoff. For example, if Kmart owed one of its banks $5 million, and the bank held $5 million in deposits from Kmart, then a mutual obligation would exist. Even if the amounts are not equal, the concept still applies and the setoff amount is adjusted.

Take some action to accomplish the setoff

In this step, the creditor places an “administrative hold” on any accounts of the bankrupt debtor, up to the amount of money the debtor owes the creditor. For example, if the debtor owes you $5 million and you owe the debtor $10 million, then you can hold only $5 million. If you instead owe the debtor $2 million, you can hold a maximum of $2 million, even though the debtor owes you an additional $3 million. The administrative hold essentially freezes the account so that the funds remain untouched until the matter can be resolved through the bankruptcy process. It is important to note that an administrative hold does not violate the automatic stay, even though it prohibits creditors from taking any action that is adverse to a bankrupt debtor or its assets. In other words, the hold on the account represents merely a promise to pay (not cash in and of itself), and suspending that promise until the issue of setoff can be sorted out has been held not to violate the automatic stay.

Record the setoff

With mutual obligations identified and the administrative hold in place, the next step is to work with bankruptcy counsel to prepare a motion to modify the automatic stay in order to allow setoff of the funds. The bankruptcy court’s order granting this motion amounts to the “recording of the setoff” required by the Supreme Court ruling in Citizens Bank of Maryland v. Strumpf. This must be done fairly quickly after the administrative hold has been placed; otherwise, the administrative hold may be construed as something more permanent, akin to setoff in and of itself. Your request for the bankruptcy court to allow the administrative hold to become a right of setoff will be grounded in sections 542, 553 and 362(a)(7) of the Bankruptcy Code, which identifies the interplay between rights of setoff, the automatic stay and the exceptions to the general rule that the automatic stay prevents just this sort of action.

Dancing between multiple sections of the Bankruptcy Code often creates a feeling of uncertainty. However, there is very little room for interpretation or chance regarding setoff issues, because the Supreme Court’s opinion in Citizens Bank of Maryland v. Strumpf sorts through the interplay of the relevant sections so plainly. Therefore, even if you are a David-type creditor up against a Goliath mega-bankruptcy case, on the first day of bankruptcy, when the deck seems to be stacked in favor of the debtor, your odds of success are very strong on a motion to allow setoff where mutuality exists with the bankrupt debtor—no matter the amount.

This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.

Kurt M CarlsonKurt M. Carlson | Creditors’ Rights, Insolvency & Bankruptcy Litigation & Resolution

Kurt’s practice concentrates on representing creditors, assignees and businesses of all sizes in a variety of ways, including complex business litigation, workouts, insolvency proceedings, bankruptcy reorganization cases and complex settlement negotiations. Kurt has extensive experience in a broad range of quasi-business and legal issues companies must address. If you need assistance with a related matter, contact Kurt.