United States: Section 553 Of The Bankruptcy Code Preserves Rather Than Creates Setoff Rights

In Feltman v. Noor Staffing Grp., LLC (In re Corp. Res. Servs. Inc.), 564 B.R. 196 (Bankr. S.D.N.Y. 2017), the bankruptcy court considered whether section 553 of the Bankruptcy Code creates a right of setoff when no such right is available under applicable nonbankruptcy law. The court concluded that section 553 does not create an independent federal right of setoff, but merely preserves any such right that exists under applicable nonbankruptcy law. It ruled that, because New York law did not allow setoff of contingent claims, the defendants in an adversary proceeding could not assert a right of setoff for admittedly contingent claims as a defense.

Setoff

Section 553(a) of the Bankruptcy Code provides, subject to certain exceptions, that 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." Section 553 does not create setoff rights—it merely preserves certain setoff rights that otherwise would exist under contract or applicable nonbankruptcy law. See COLLIER ON BANKRUPTCY ¶ 553.04 (16th ed. 2017) (citing Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995)).

A "debt" is defined in section 101(12) of the Bankruptcy Code as a "liability on a claim." Section 101(5) defines "claim" to include a "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured." Under bankruptcy case law, the term "contingent" means contingent as to liability. See Grady v. A.H. Robins Co. (In re A.H. Robins Co.), 839 F.2d 198 (4th Cir. 1988), cert. dismissed, 487 U.S. 1260 (1988).

Although the Bankruptcy Code does not define "mutual," debts are generally understood to be mutual when they are due to and from the same persons or entities in the same capacity. See COLLIER ON BANKRUPTCY ¶ 553.03[3] (16th ed. 2017).

Even though section 553 expressly refers to prepetition mutual debts and claims, many courts have held that mutual postpetition obligations may also be offset. See Zions First Nat'l Bank, N.A. v. Christiansen Bros., Inc. (In re Davidson Lumber Sales, Inc.), 66 F.3d 1560 (10th Cir. 1995); Palm Beach Cty. Bd. of Pub. Instruction v. Alfar Dairy, Inc. (In re Alfar Dairy, Inc.), 458 F.2d 1258 (5th Cir. 1972); Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016).

However, setoff is available in bankruptcy only "when the opposing obligations arise on the same side of the . . . bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015). Thus, prepetition obligations may not be set off against postpetition debts and vice versa. See In re Enright, 2015 BL 261143 (Bankr. D.N.J. Aug. 13, 2015); In re Passafiume, 242 B.R. 630 (Bankr. W.D. Ky. 1999).

A creditor is precluded by the automatic stay from exercising its setoff rights with respect to a prepetition claim without bankruptcy court approval. See 11 U.S.C. § 362(a)(7). Upon application by the creditor, however, the court will generally permit a setoff if the requirements under applicable law are met, except under circumstances where it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008). By contrast, if there is a right of "recoupment" (i.e., where mutual obligations arise under the same contract), the exercise of the right does not require court authority, and the automatic stay does not apply. A creditor stayed from exercising a valid setoff right must be granted "adequate protection" (see 11 U.S.C. § 361) against any diminution in the value of its interest caused by the debtor's use of the creditor's property. Ealy, 392 B.R. at 414.

Under section 101(5)'s broad definition of "claim," contingent claims arguably would be eligible for setoff under section 553 if applicable nonbankruptcy law permitted setoff of such claims. The Feltman court addressed this issue.

Feltman

In February 2015, Noor Associates, Inc., and Noor Staffing Group, LLC (collectively, "Noor") purchased substantially all of the assets of Corporate Resource Services, Inc. ("CRS") under a purchase agreement governed by New York law. 

On July 23, 2015, CRS and certain affiliates filed for chapter 11 protection in the Southern District of New York. The bankruptcy filings occurred shortly after Noor discovered that CRS or its affiliates failed to remit more than $100 million in employee withholding taxes to the IRS and state taxing authorities. It was unclear at the time of the filing whether Noor, as the purchaser of CRS's assets and its successor, might be liable for the unpaid taxes. The taxing authorities had not asserted any claim against Noor as of the petition date. 

In March 2016, a chapter 11 trustee appointed in the case commenced an adversary proceeding against Noor, alleging, among other things, that Noor breached the sale agreement. The trustee also sought to avoid the sale as a constructive fraudulent transfer under section 548 of the Bankruptcy Code because, allegedly, the value of CRS's assets substantially exceeded the sale price and CRS was insolvent at the time of the transaction.

In its answer and a proof of claim filed in December 2016, Noor asserted, among other things, that it had a right to set off contingent liabilities to taxing authorities or CRS customers in the amount of approximately $8.4 million against any liability to the trustee in the avoidance and breach of contract litigation. As noted, no claims for those liabilities had been asserted against Noor. 

The trustee moved to strike the setoff defense and to disallow the proof of claim to the extent it asserted a right to set off contingent claims.

The Bankruptcy Court's Ruling

The bankruptcy court ruled in favor of the trustee.

The court explained that "in order to establish a right to setoff under section 553, a creditor must first demonstrate a preexisting right of setoff under nonbankruptcy or state law." It rejected Noor's argument that the Bankruptcy Code creates a federal right of setoff. According to the court, the U.S. Supreme Court's ruling in Strumpf "definitively resolved that the Bankruptcy Code does not create a right of setoff," but merely "preserves a right to setoff created by state law or federal nonbankruptcy law." As a consequence, the bankruptcy court in Feltman noted, pre-Strumpf rulings cited by Noor to the contrary were inapposite or no longer good law, and a post-Strumpf decision relied on by Noor—In re Comm'n Dynamics, Inc., 382 B.R. 219 (Bankr. D. Del. 2008)—was distinguishable.

In Comm'n Dynamics, the court held that, for purposes of section 553, a contract rejection damages claim under section 365(g) is a prepetition claim that qualifies for setoff. In so holding, the court identified an ambiguity in section 553, in that it does not identify the sources of a setoff right, but speaks only of not "affect[ing]" such a right. Thus, the court reasoned, section 553 should not prevent setoff of a claim arising under another section of the Bankruptcy Code—in that case, section 365(g). The Feltman court, however, did not view the existence of this ambiguity as support for the proposition that there is a federal right of setoff. 

Nor did the Feltman court agree with the argument that a federal right of setoff exists because section 101(5) broadly defines "claim" to include contingent claims. According to the court, reading sections 101(5) and 553 together as creating a federal right of setoff, when no such right exists under applicable nonbankruptcy law, would result in elevating contingent "unsecured claims to secured status to the disadvantage of all other unsecured creditors, a result contrary to the Code's policy promoting a distribution to unsecured creditors in pari passu."

The Feltman court explained that section 151 of the New York Debtor and Creditor Law, which codifies equitable and common law setoff rights, provides that a debtor has the right "to set off and apply against any indebtedness, whether matured or unmatured," any amount owing from the debtor to the creditor. However, the provision does not permit setoff of contingent claims. 

Without any setoff right under state law, the court ruled, Noor could not use its contingent claim to offset liability to the trustee under section 553. 

Outlook

Feltman reinforces the settled proposition that section 553 preserves setoff rights under applicable nonbankruptcy law but does not create such rights. This principle of preservation, but not creation of rights for creditors, is reflected in other provisions of the Bankruptcy Code. For example, section 546(c) of the Bankruptcy Code, which addresses a creditor's right to reclamation of goods supplied to a debtor prepetition, does not create a new "federal right of reclamation," nor does it create a comprehensive federal scheme for reclamation, but rather, preserves a seller's reclamation rights under applicable nonbankruptcy law. In re Dana Corp., 367 B.R. 409 (Bankr. S.D.N.Y. 2007).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Mark G. Douglas
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.