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Set-Off Law and Practice - An International Handbook, 3rd Edition edited by Johnston, William; Werlen, Thomas; Link, Frederick (22nd February 2018)

1 Introduction

William Johnston, Thomas Werlen, Frederick Link

From: Set-Off Law and Practice: An International Handbook (3rd Edition)

Edited By: William Johnston, Thomas Werlen, Frederick Link

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2015. All Rights Reserved. Subscriber: null; date: 25 August 2019

Subject(s):
Customer obligations and foreign law — Debt — Money and the conflict of laws — Contractual set-off — Insolvency set-off — Judicial set-off

(p. 1) Introduction

A.  Introduction

1.01  The third edition of Set-off Law and Practice: An International Handbook provides an overview of the law of set-off in thirty-four jurisdictions that covers issues arising in the use of set-off between solvent and against insolvent parties, as well as in a cross-border context. The laws of set-off of these jurisdictions follow a broadly similar pattern when dealing with set-off between solvent parties, which is possible either as a result of statutory or common law or as contractually agreed between the parties. For set-off against insolvent parties, on the other hand, significant additional requirements apply which vary considerably across jurisdictions.

1.02  The treatment of issues arising in a cross-border context follows a similar pattern, with the rules relating to set-off against solvent parties normally following generally applicable choice-of-law rules and set-off against insolvent parties being subject to additional requirements based on the bankruptcy or insolvency code of the jurisdiction of the insolvent counterparty.

1.03  The aim of this introduction is to provide the reader with a practical overview of the different approaches by the jurisdictions covered in this book to the right of set-off where parties are solvent, where a party is insolvent, and where parties operate cross-border.

(p. 2) B.  Short Description of Set-off

1.04  Set-off is the right to reduce or fully discharge a monetary obligation owed by a debtor against a claim owed to the debtor such that only the balance remains. The right to set-off may arise as a result of a contractual arrangement between the parties or by the operation of law, including bankruptcy or insolvency laws.

1.05  Set-off may be used in a variety of contexts and has become an increasingly important tool for reducing operational and credit risk in financial services and in commercial arrangements generally.

1.06  In contractual relationships between parties with mutual obligations, set-off usually serves to reduce a variety of risks between transacting parties. It is typical, for example, for the right to set-off to be provided for in documentation governing a bank’s relationship with its customers, allowing the bank to set off a customer’s deposits with the bank against loans extended by the bank (and, frequently, vice versa). Similarly, contractual set-off arrangements between financial services firms are frequently used to reduce counterparty risk by permitting the firms to set off obligations between them, thereby reducing losses in the event of an insolvency.

1.07  Set-off may be used also as a self-help remedy in certain cases, allowing a debtor to satisfy some or all of an obligation to pay a creditor by setting off the amount of a creditor’s claim, or it may be raised as a defence to a creditor’s claim.

1.08  The remainder of this introduction provides an overview of the law of set-off in general terms and seeks to highlight areas both of commonality and of significant difference across jurisdictions that are most relevant to practitioners and businesses.

C.  Set-off between Solvent Parties

1.  Contractual set-off

1.09  Contractual set-off is the most relevant form of set-off for most financial and commercial transactions. Contractual provisions relating to set-off are typically found in many financial contracts, including the terms and conditions governing a client’s relationship with a bank, as well as derivatives and other agreements executed between financial institutions.

1.10  Contractual set-off is enforceable in all jurisdictions covered by this book, subject to some restrictions, and is the most flexible form of a set-off right.

1.11  Parties are generally free to agree to a broad range of set-off rights that might otherwise be unavailable to them under applicable laws. In many jurisdictions, (p. 3) for example, parties may agree to set off debts even where the debts are not owing between the same two parties, ie even where mutuality is lacking, or where debts have a different maturity or are of a different kind.

1.12  This flexible approach to contractual set-off is, however, subject to limitations in a number of jurisdictions. In many cases, for example, even contractual set-off is limited to mutual debts.

1.13  Finally, it should be noted that contractual set-off provisions will not be considered to be equivalent to the creation of a security interest. Therefore the creation of contractual set-off rights will not require formal steps such as the registration of a pledge and will not violate provisions of negative pledge clauses which are limited to the granting of security interests.

2.  Set-off by operation of law

1.14  In most, but not all, jurisdictions, set-off between solvent parties is provided by statute or by common law precedent in at least some circumstances. These rights to set-off by operation of law may be used as a self-help remedy in many jurisdictions without the need to obtain a court judgment. Alternatively, set-off may be raised as a defence in an action seeking to enforce the payment of a monetary claim.

1.15  The requirements for statutory or common law set-off rights vary (sometimes significantly) among jurisdictions. In this sense, there is far less uniformity across the thirty-four jurisdictions contained in this book than is the case with contractual set-off rights.

1.16  Nevertheless, set-off rights provided by law do contain certain common elements:

  • •  Mutuality: claims must be mutual in order to be eligible for set-off. Mutuality of claims typically requires that they are owed between the same two parties, acting in the same capacity. As a result, set-off will typically not be possible where the claims are related to affiliated, but legally separate, entities.

  • •  Maturity: claims must also typically be matured in order to be eligible for statutory or common law set-off requirements. Therefore mutual obligations may only be able to be set off against one another if they have the same maturity or if they are already matured.

  • •  Type of claim: claims should generally be of the same type in order to be eligible for set-off. As a result, an obligation to pay money may not typically be set off against an obligation to deliver goods or provide services. In some circumstances, obligations to make payments in different currencies may also not be eligible for set-off by the operation of law because they are not of the same type.

  • •  Determination of amount: in many cases, the amount of each of the claims must have been determined in order to be eligible for set-off. For this reason, (p. 4) damages claims are then not eligible for set-off until the amount of the claim has been determined.

  • •  Excluded obligations: certain types of claims, such as tax obligations, personal injury compensation claims, and alimony payments, are often excluded from set-off by the operation of law.

1.17  Many common law jurisdictions also differentiate between legal and equitable set-off. Legal set-off refers to set-off rights defined in a statute, which often contains some or all of the above requirements for obligations to be eligible for set-off.

1.18  Equitable set-off, on the other hand, relates to the set-off of closely connected debts in circumstances where it would be inequitable for one party to be required to perform its obligation to pay as a result of a breach of the other party’s obligation. Equitable set-off is typically a self-help or procedural remedy.

1.19  It is important to note that in many circumstances the application of these rules is not mandatory and a contractual agreement to opt out of or otherwise change these rules would be effective. These rules are therefore important to keep in mind when drafting a contract where set-off rights are not desired. It is thus common for lending contracts, in particular, to contain provisions disapplying set-off rights which may otherwise be available to a borrower.

D.  Set-off against Insolvent Parties

1.20  The rules relating to the set-off of claims against insolvent parties are subject to the provisions of the bankruptcy or insolvency law governing the liquidation of restructuring of the insolvent parties and vary significantly across the thirty-four jurisdictions covered in this book—even more so than set-off by the operation of law. Such insolvency laws may create a right of set-off in insolvency that is independent of the relevant requirements for set-off against a solvent party prior to a declaration of insolvency, they may preserve existing rights of set-off established prior to bankruptcy subject to additional restrictions, or they may do both.

1.21  In addition, bankruptcy or insolvency laws in each of the jurisdictions covered by this book subject the right of set-off to look-back or clawback provisions relating to the exercise of the right of set-off and often include automatic stays or other provisions limiting the ability to exercise the right of set-off against an insolvent party.

1.  Rights of set-off

1.22  Rights of set-off established by relevant bankruptcy or insolvency laws which do not depend on the existence of a pre-insolvency set-off right will more likely permit the set-off of mutual debts existing prior to the declaration, often irrespective (p. 5) of their maturity or the type of obligation. In some cases, such set-off rights may be mandatory, automatic, or both.

1.23  It should be noted, however, that rights of set-off established by insolvency laws contain requirements beyond the mutuality of debts. Depending on the jurisdiction, obligations which are unmatured, contingent, or of different kinds may be excluded from set-off provisions established by the relevant bankruptcy or insolvency laws.

1.24  Provisions of bankruptcy or insolvency laws which act to preserve rights of set-off established prior to bankruptcy are also common. In these cases, important restrictions on such rights of set-off are typically imposed. For example, there are no jurisdictions covered in this book which permit the set-off of non-mutual debts against an insolvent party. In addition, many jurisdictions require that some or all of the requirements for set-off be satisfied prior to the declaration of insolvency. This may be particularly important in the case of unmatured debts, where a failure to demand payment pursuant to an event of default or an early termination clause may result in the right of set-off being unavailable against an insolvent party.

2.  Automatic stays

1.25  Bankruptcy or insolvency laws in many jurisdictions also restrict the ability of a creditor to effect set-off against debtors once insolvency has been declared without the consent of the court. Such automatic stays or similar provisions may cause significant delays in exercising set-off rights.

3.  Look-back periods

1.26  The bankruptcy or insolvency laws of nearly every jurisdiction covered in this book contain rules relating to unfair preference which limit the ability of a creditor to exercise its right to set-off against an insolvent debtor and may permit an insolvency trustee to avoid the application of set-off which had been executed prior to the declaration of insolvency.

1.27  Typically, these unfair-preference provisions establish a suspect period of between three months and two years (with longer periods being possible in some cases). Obligations of the insolvent debtor to the creditor established during this suspect period may be deemed not to qualify for set-off against an insolvent party if no set-off has been exercised prior to the declaration of insolvency and any set-off which occurred during the suspect period may be avoided by the insolvency trustee, especially if the obligation was incurred in order to provide for the repayment of a debt which would otherwise be subject to clawback under the unfair-preference provision of the relevant bankruptcy or insolvency code.

(p. 6) E.  Conflict of Laws and Cross-border Issues

1.28  Cross-border financial and commercial transactions often raise important conflict-of-laws issues as the diversity of approaches to set-off described above may result in different results depending on the applicable law. As with the substantive rules relating to set-off described above, the applicable law in cross-border financial and commercial relationships will likely vary according to whether set-off is asserted against a solvent or an insolvent party.

1.  Set-off between solvent parties

1.29  In relation to set-off against solvent parties, contractual set-off rights are typically determined by the governing law of the contract. Should there be no contractual choice-of-law provision, then the courts will apply generally applicable conflict-of-laws principles to determine what law to apply. In many cases, this will involve a multi-factor analysis to determine the jurisdiction which is most closely connected to the relationship between the parties.

1.30  By contrast, courts in EU Member States (with the exception of Denmark) faced with the same conflict-of-laws question must look no further than to Rome I regulation to determine the applicable law.1

1.31  A more difficult analysis applies if the set-off involves obligations with different governing laws. The question then arises whether the set-off should be governed by the law applicable to the obligation which is being set off against or by the law applicable to the obligation that is being satisfied, in whole or in part, through the exercise of the set-off right. Unfortunately, the answer to this question is uncertain in most of the thirty-four jurisdictions covered by this book.

1.32  The law applicable to set-off rights resulting from the operation of law will similarly be determined by generally applicable conflict-of-laws principles. These principles often distinguish between substantive and procedural law. While the applicable substantive law will be determined either by an agreement between the parties or by generally applicable choice-of-laws principles, the applicable procedural rules will be those of the court or tribunal adjudicating a dispute. Where set-off is considered to be a procedural right, the applicable law will be that of the tribunal hearing a dispute and may differ from the substantive law governing the matter before such tribunal.

(p. 7) 1.33  There is no consensus among the thirty-four jurisdictions covered by this book as to whether the law of set-off is substantive or procedural, with some countries taking each view and others distinguishing among set-off in different contexts.

2.  Set-off between insolvent parties

1.34  Set-off rights against an insolvent party will generally be determined by the law of the jurisdiction of the insolvent party. Where the applicable set-off right against an insolvent party is established independently of set-off rights existing prior to insolvency, the applicable law will be that of the jurisdiction of the insolvent party.

1.35  Where the bankruptcy or insolvency laws applicable to the insolvent party preserve set-off rights existing prior to insolvency, the applicable law relevant for determining the existence of the right of set-off may be determined by reference to the rights of set-off against solvent parties. The provisions relating to automatic stays and look-back provisions will, however, likely be determined by the laws of the jurisdiction of the insolvent debtor.

1.36  Finally, in many cases, recovery of an asset held outside the jurisdiction of the main bankruptcy or insolvency proceeding may be sought through the opening of an ancillary proceeding in the jurisdiction where the asset, such as a bank account, is located. These proceedings generally allow for the enforcement of security interests and other rights in assets subject to the ancillary proceeding to be determined by the insolvency courts in the jurisdiction where the assets are located. As a result, the application of set-off to such an asset will be determined by the rules of the ancillary proceeding. These ancillary proceedings take different approaches to the question of whether set-off rights against the assets subject to the ancillary proceeding should be adjudicated prior to returning the assets to the insolvency trustee. In some jurisdictions, set-off will be permitted against bank accounts or other monetary claims, while in others the assets will be returned to the insolvency trustee prior to the exercise of any set-off rights. In the latter case, set-off rights would then be governed according to the rules relating to the main insolvency proceeding as described above.

1.37  In summary, whereas the treatment of the contractual right to set-off between solvent parties is relatively homogeneous across the jurisdictions, various approaches are used in dealing with set-off by the operation of law and set-off against insolvent parties. In cross-border contexts, choice-of-law issues relating to cross-border set-off regimes are similarly homogeneous, while a more complicated, and often less certain, analysis applies to the application of set-off by the operation of law or set-off against insolvent parties.(p. 8)

Footnotes:

1  Regulation (EC) No 593/2008 of the European Parliament and of the Council of 17 June 2008 on the law applicable to contractual obligations (Rome I).