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.
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 (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.
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.
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).
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.