A creditors state law setoff right can be a its setoff rights to - - PDF document

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BY BRUCE S. NATHAN AND SCOTT CARGILL

Failing to Adequately Assert Setoff Rights Could Jeopardize Recovery

A

creditor’s state law setoff right can be a valuable tool when confronting a debtor in

• bankruptcy. The application of setoff rights

provides a dollar-for-dollar reduction of the credi- tor’s claim against a debtor, which could be valu- able where creditor recoveries are either nonexis- tent or de minimis. The division among the courts

• ver how and when a creditor must assert its setoff

rights can play a pivotal role in enhancing a credi- tor’s recovery or reducing its exposure.1

Setoff Rights

Section 553 of the Bankruptcy Code provides that, subject to certain limited exceptions, the Bankruptcy Code recognizes a creditor’s state law setoff rights when a debtor files for bankruptcy.2 This includes codifying the requirement that setoff is only permitted in mutual pre-petition obligations between the debtor and creditor held in the same right or capacity.3

Must a Creditor File a Proof of Claim to Preserve Setoff Rights?

Most courts agree that a creditor is not required to fjle a proof of claim to preserve its setoff rights during a debtor’s bankruptcy case prior to the approval of a plan. The question of whether a creditor has waived its setoff rights by not fjling a proof of claim can arise (1) when a debtor or trust- ee attempts to collect an obligation owed by the creditor to the debtor pursuant to § 542 (b) of the Bankruptcy Code,4 and/or (2) when a creditor uses its setoff rights to reduce its claim against the debtor from the amount of its obligations to the debtor. The Tenth Circuit Court of Appeals ruled that a creditor’s setoff rights are not tied to the timely fjling of a proof of claim in the context of § 542 (b), even where the creditor had not filed a proof of claim and the claims bar date had passed.5 The Tenth Circuit reasoned that it would be unfair to deny a creditor the ability to recover its obligations to the debtor while at the same time requiring the creditor to fully satisfy its debt to the debtor.6 Similarly, the U.S. Bankruptcy Court for the Southern District of New York ruled that a defendant was entitled to raise setoff as a defense to an action brought by a trustee for breach of fjduciary duties and fraudulent transfer, notwithstanding that the defendant did not timely fjle a proof of claim.7 The court held that the “clear majority and better view … is that fjling a proof of claim is not a prerequisite to asserting an

• therwise valid setoff.”8 Conversely, two bankruptcy

court decisions that are generally cited for the proposi- tion that a creditor must fjle a proof of claim asserting its setoff rights actually involved creditors that did fjle proofs of claim, but failed to assert their setoff rights.9

Scott Cargill Lowenstein฀Sandler฀ LLP;฀Roseland,฀N.J.

1 The doctrine of “recoupment” is a related but distinct concept from setoff and generally requires that offsetting obligations must arise from the same transaction. See฀NVF฀Co.฀v.฀ New฀Castle฀County, 276 B.R. 340, 353 (D. Del. 2002), aff’d, 61 Fed. Appx. 778 (3d Cir. 2003). A body of case law has developed concerning the rights available to creditors with recoupment claims, as distinct from setoff rights, which is beyond the scope of this article. 2 11 U.S.C. § 553(a). 3 See฀Fisher฀v.฀the฀Outlet฀Co.฀(In฀re฀Denby฀Stores฀Inc.), 86 B.R. 768, 76-77 (Bankr. S.D.N.Y. 1988).

Bruce฀Nathan฀is฀a฀ partner฀in฀Lowenstein฀ Sandler฀LLP’s฀ Bankruptcy,฀Financial฀ Reorganization฀and฀ Creditors’฀Rights฀ Group฀in฀New฀York.฀ Scott฀Cargill฀is฀Of฀ Counsel฀in฀the฀fjrm’s฀ Roseland,฀N.J.,฀offjce.฀ They฀are฀both฀the฀ authors฀of฀Trade Creditor Remedies Manual: Trade Creditors’ Rights under the UCC and the Bankruptcy Code (ABI,฀2011).

4 11 U.S.C. § 542(b) states in relevant part that “an entity that owes a debt that is property

• f the estate and that is matured, payable on demand, or payable on order, shall pay

such debt to, or on the order of, the trustee, except to the extent that such debt may be

• ffset under section 553 of this title against a claim against the debtor.”

5 Turner฀v.฀United฀States฀(In฀re฀G.S.฀Omni฀Corp.), 835 F.2d 1317, 1318 (10th Cir. 1987); see฀also฀Suncrete฀Corp.฀v.฀Glusman฀(In฀re฀Suncrete฀Corp.), 100 B.R. 102, 103-04 (Bankr. M.D. Fla. 1989) (creditor’s failure to file proof of claim, even after passage of claims bar date, did not prohibit creditor from raising setoff as a defense to debtor’s turnover action). 6 In฀re฀Omni฀Corp., 835 F.2d at 1318. 7 Geltzer฀v.฀Bloom฀(In฀re฀Silverman฀Laces฀Inc.), 404 B.R. 345, 365 (Bankr. S.D.N.Y. 2009). 8 Id. at 365 (citing Davidovich฀v.฀Welton฀(In฀re฀Davidovich), 901 F.2d 1533, 1539 (10th Cir. 1990); Bernstein฀v.฀IDT฀Corp.฀(In฀re฀Frigitemp฀Corp.), 76 B.R. 275, 281 (S.D.N.Y. 1987); Neal฀v.฀Golden฀Knights฀Inc., 1995 Bankr. LEXIS 2163, at **10-16 (Bankr. E.D. Va. Oct. 13, 1995), aff’d, 1996 U.S. Dist. LEXIS 15442 (E.D. Va. April 10, 1996); In฀re฀Denby฀Stores, 86 B.R.at 777 n.8; In฀re฀Bousa฀Inc., 2006 WL 2864964, at **5-6 (Sept. 29, 2006)). 9 See฀In฀re฀Britton, 83 B.R. 914 (Bankr. E.D.N.C. 1988); Tavormina฀v.฀ITT฀Commercial฀Fin.฀ Corp.฀(In฀re฀Aquasport฀Inc.), 115 B.R. 720 (Bankr. S.D. Fla. 1990), aff’d฀on฀other฀grounds, 155 B.R. 245 (S.D. Fla. 1992) (finding that creditor did not waive setoff rights), aff’d฀without฀

• pinion, 985 F.2d 579 (11th Cir. 1993); see฀also฀Bank฀of฀Dixie฀v.฀King฀(In฀re฀Honeycutt฀Grain฀

Co.฀Inc.), 41 B.R. 678 (Bankr. W.D. La. 1984) (creditor must file proof of claim asserting setoff rights before claims bar date and must file motion to exercise setoff rights).

Bruce S. Nathan Lowenstein฀Sandler฀ LLP;฀New฀York

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Must a Creditor Raise Setoff in a Proof of Claim?

Greater disagreement exists concerning whether a credi- tor must raise its setoff rights in any proof of claim that it

• fjles. The courts following the majority view use a nuanced

approach in deciding whether a creditor waived its setoff rights on equitable grounds (e.g., estoppel, laches, waiver, election).10 These courts recognize that there is no specifjc bankruptcy statute or procedural rule requiring a creditor to assert setoff rights in a proof of claim.11 A creditor will generally not be deemed to have waived its setoff rights if it failed to assert them during the early stages of a bankruptcy case (e.g., it failed to raise setoff in a proof of claim). Instead, the court will look to whether a creditor expressly waived its setoff rights through, for instance, a written statement that the creditor will not pursue its rights or the statements of its counsel in court,12 or by tak- ing actions that are inconsistent with an intent to exercise a setoff right (e.g., making a voluntary payment to the debtor without any reservation of setoff rights).13 The First Circuit Court of Appeals held that a creditor seeking relief from the automatic stay to exercise its setoff rights had not previously waived its rights by failing to object to a fjnancing order that granted the lender a fjrst-priority security interest in the debtor’s accounts receivable, includ- ing the accounts owed by the creditor holding the alleged setoff claim.14 The court reasoned that the fjnancing order did not eliminate the creditor’s setoff rights.15 Had the proposed fjnancing order set a date by which creditors must assert their setoff rights, a creditor’s failure to fjle an objection could have been viewed as being inconsistent with the creditor’s intent to assert its setoff rights.16 The court also did not fjnd any waiver of setoff rights based on the limited factual record before the court where the creditor had failed to raise setoff rights in certain of its proofs of claim and had disclaimed its setoff rights in certain of the claims.17 A minority of courts adopt a strict per se rule that a credi- tor’s failure to assert setoff in its proof of claim results in a waiver of its setoff rights.18 The U.S. Bankruptcy Court for the Eastern District of North Carolina ruled that in chapter 11 and 12 cases, a creditor must timely fjle a proof of claim, assert its setoff rights and seek to have the automatic stay lifted in order to allow the setoff. The court reasoned that § 506 of the Bankruptcy Code provides that an “allowed claim” of a creditor that is subject to setoff is a “secured claim” to the extent of the setoff. Accordingly, if the credi- tor does not timely fjle a proof of claim asserting its setoff rights, the creditor will lose its “allowed claim” status under § 506 and will therefore be stripped of its secured status and setoff rights.19 The court further held that the creditor could not amend its original proof of claim to assert its setoff rights because in chapter 11 and 12 cases, a debtor will generally be prejudiced by a creditor that fails to assert setoff rights in its original claim.20 Another court adopting the minority view stated in dic- tum that “a creditor will generally be deemed to have waived his right of setoff if he fjles a proof of claim in bankruptcy without asserting the right.”21 However, the court ruled that the creditor maintained its setoff rights because the credi- tor did not fjle a proof of claim.22 Similarly, another court ruled that a creditor lost its setoff rights because its late-fjled proof of claim had been disallowed. The court recognized that other courts have permitted creditors to assert setoff rights when no proof of claim was fjled.23 These cases raise the counterintuitive proposition that in certain circumstances, setoff rights may be preserved if a creditor does not fjle a proof of claim, but a creditor may lose them if it fjles a claim without any assertion of setoff rights.

Impact of Plan Confirmation on Setoff Rights

As a bankruptcy case continues toward conclusion, creditors face a substantially greater risk that they will lose their unasserted setoff rights. This risk becomes particularly acute when a debtor’s plan is confjrmed and/or the debtor receives a discharge. Courts have noted the tension between § 553, which provides that absent limited circumstances, the Bankruptcy Code does not affect a creditor’s setoff rights, and the discharge of claims pursuant to § 1141 and other plan provisions that adversely affect setoff rights. Courts have been divided on the issue of whether set-

• ff rights under § 553 or the discharge provisions of § 1141

should take precedence for plans that make no provision for the treatment of setoff rights. The Tenth Circuit Court of Appeals has ruled that a creditor’s setoff right against the debtor survives a discharge, reasoning that it would not be fair for the law to deny a creditor the right to recover an obli- gation while requiring the creditor to fully satisfy its debt to the debtor.24 Similarly, the Ninth Circuit Court of Appeals ruled that § 553 must take precedence over § 1141 because if § 1141 controlled, only setoff rights that are dealt with and allowed in a chapter 11 plan would be allowed in chapter 11 cases, making § 553 largely superfmuous.25 By comparison, the Third Circuit Court of Appeals in In re Continental Airlines26 ruled that a creditor loses its setoff rights once a debtor’s plan is confjrmed unless the creditor asserts its setoff rights in a proof of claim or otherwise pros- ecutes its rights.27 In this case, the creditor had timely fjled a proof of claim but did not raise its setoff rights until it had fjled an amended claim after the plan (which did not address setoff rights) was confjrmed.28 The Third Circuit ruled that a creditor’s setoff rights must be timely exercised.29 There is greater consensus among the courts that a credi- tor’s setoff rights are waived when a debtor’s confjrmed plan

10 See฀Denby฀Stores, 86 B.R. at 777; United฀States฀v.฀Peterson฀(In฀re฀Peterson), 2004 WL 1397575, at *2 (Bankr. M.D. Ga. June 3, 2004); Weems฀v.฀U.S.฀(In฀re฀Custom฀Center฀Inc.), 163 B.R. 309, 316-17 (Bankr. E.D. Tenn. 1994); In฀re฀Northeastern฀Int’l฀Airways฀Inc., 99 B.R. 487, 489 (Bankr. S.D. Fla. 1989); United฀ States฀v.฀Krause฀(In฀re฀Krause), 261 B.R. 218, 223 (B.A.P. 8th Cir. 2001). 11 See฀In฀re฀Custom฀Center, 163 B.R. at 317. 12 See฀In฀re฀Calore฀Express฀Co., 288 F.3d 22, 38 (1st Cir. 2002). 13 Id. at 38. 14 Id. at 40. 15 Id. 16 Id. 17 Id. at 42-43. 18 See฀In฀re฀Lykes฀Bros.฀Steamship฀Co.฀Inc., 217 B.R. 304, 312 (Bankr. M.D. Fla. 1997). 19 In฀re฀Britton, 83 B.R. at 918. 20 Id. at 920 (opinion did not state whether claims bar date had passed when creditor amended its claim to add setoff rights). 21 In฀re฀Butler, 61, B.R. 790, 791 (Bankr. S.D. Fla. 1986). 22 Id. at 791. 23 Aureal฀Inc.฀v.฀I/O฀Magic฀Corp.฀(In฀re฀Aureal฀Inc.), 279 B.R. 573, 579-80 (Bankr. N.D. Cal. 2002). 24 See฀Davidovich฀v.฀Welton฀(In฀re฀Davidovich), 901 F.2d 1533, 1539 (10th Cir. 1990). 25 See฀Carolco฀Television฀Inc.฀v.฀Nat’l.฀Broadcasting฀Co.฀(In฀re฀De฀Laurentiis฀Entertainment฀Group฀Inc.), 963 F.2d 1269, 1276-77 (9th Cir. 1992). 26 United฀States฀v.฀Continental฀Airlines฀(In฀re฀Continental฀Airlines), 134 F.3d 536 (3d Cir. 1998). 27 See฀id. at 542. 28 See฀id. at 537-38. 29 See฀id. at 541.

66฀Canal฀Center฀Plaza,฀Suite฀600฀฀•฀฀Alexandria,฀VA฀22314฀฀•฀฀(703)฀739-0800฀฀•฀฀Fax฀(703)฀739-1060฀฀•฀฀www.abi.org expressly abridges or abrogates setoff rights. For example, in a case before the U.S. District Court for the Southern District

• f New York, the debtor’s plan expressly barred creditors

from asserting setoff rights post-confirmation. The court ruled that the creditor’s setoff rights were deemed waived because the creditor had failed to object to the plan, so there was no need to resolve the conflict between §§ 553 and 1141.30 Another court similarly held that a creditor lost its setoff rights when it did not raise them in its proof of claim and had also failed to object to a plan barring them. The court ruled that the creditor lost its rights both under § 1141 and because the confjrmation order is a fjnal judgment entitled to res judicata effect against the creditor.31

Conclusion

While a creditor may hold valid and enforceable setoff rights prior to the commencement of a bankruptcy case, those rights can be jeopardized thereafter if they are not timely asserted and pursued during the case. Although various courts have reached differing conclusions regarding exactly what actions or omissions will result in a creditor waiving its setoff rights, the one consistent theme is that a creditor should be proactive in asserting its rights. Depending on the circumstances of the case, this may mean expeditiously seek- ing to lift the automatic stay to effectuate the setoff, or, at a minimum, timely fjling a proof of claim that articulates the facts giving rise to the setoff right and indicates that the cred- itor has a secured claim equal to the amount subject to setoff. A creditor should also be especially diligent in reviewing pleadings, such as an order approving chapter 11 fjnancing and use of cash collateral, as well as a debtor’s plan and the proposed confjrmation order, and be prepared to interpose an

• bjection to any pleading that abridges or abrogates a credi-

tor’s setoff right. abi Reprinted฀with฀permission฀from฀the฀ABI฀Journal,฀Vol.฀XXXII,฀No.฀9,฀ October฀2013. The฀American฀Bankruptcy฀Institute฀is฀a฀multi-disciplinary,฀non- partisan฀organization฀devoted฀to฀bankruptcy฀issues.฀ABI฀has฀ more฀than฀13,000฀members,฀representing฀all฀facets฀of฀the฀ insolvency฀fjeld.฀For฀more฀information,฀visit฀ABI฀World฀at฀www. abiworld.org.

30 See฀Daewoo฀Int’l฀(America)฀Corp.฀Creditor฀Trust฀v.฀SSTS฀America฀Corp., 2003 WL 21355214, at *5 (S.D.N.Y. June 11, 2003); see฀also฀In฀re฀Lykes฀Bros.฀Steamship฀Co., 217 B.R. at 312. 31 See฀In฀re฀Twins฀Inc., 318 B.R. 90, 96 (Bankr. D.S.C. 2004).