Set-off
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Set-off
/sɛt ɒf/ (n., v.)
To square up. At its simplest, there is a “set-off” between cross-claims for money in the same currency owed on the same date between a creditor and a debtor. To set-off is to cancel out to the extent of the mutual debt: to discharge the smaller claim in full, and leave just the remaining balance of the larger claim outstanding.
Net-net, there when sorting out who owes what, there are three distinct concepts to bear in mind: close-out netting, settlement netting, and set-off. Related, but different things. Seeing how important optimising capital treatment — or just capital — can be both before and after bankruptcy, it is important to know which is which.
This page is about the general concept of set-off. There is a special page reserved for chat about the Set-off clause (Section 6(f)) of the 2002 ISDA. For reasons explored on that page, there was no set-off in the earlier versions of the ISDA Master Agreement, though frequently, people put one in.
What is set-off?
In its simplest sense, it is paying the difference. Say you owe me twenty quid from a night out last week, and I ask you to collect some dry-cleaning as you are passing the shop on your way to work. The bill is £15. When you arrive with my trousers, I give you a fiver and suggest we call it quits: we set off the £15 I owe you for the dry cleaning against the £20 I owe you for the curry, and I pay the difference. That is a “set-off”.
These also exist in various guises, in law. They are oddly controversial, misunderstood, and limited things.
Types of set-off
There are different types of set-off: some mandatory, some voluntary, some having legal effect, some being practical matters of convenience. Common to all of them, though, is that set-off is bilateral.
Contractual set-off
You are free to agree what you like in a contract (within reason and subject to overriding provisions of mandatory law, equity and public policy). You can, therefore — within those bounds, which are important when it comes to the discharge of mutual debts — agree what you like about set-off in a contract. This is called contractual set-off.
Where the parties to a transaction owe each other at the same time, they may agree that, instead of making separate payments, the party owing the larger amount should simply pay the difference.
In that it is conferred by contract, close-out netting resembles contractual set-off, but it is not the same. Exacly why is discussed in more detail in the premium content section.
Strict (non-close-out netting related) contractual set-off in master agreements is okay, but it doesn’t earn you a cigar. Set-off provisions in master agreements thus tend to have a different purpose, which is to pull in anything else between the parties that might be lurking around at the moment of bankruptcy, allowing the Non-defaulting Party to be a bit opportunistic in minimising its outstanding exposure against any liabilities of any kind it owes the Defaulting Party.
Equitable set-off
Equitable set-off is a self-help remedy available to a debtor who also has a claim arising from the same transaction (or a related transaction) to the original debt. Here the debtor simply deducts its claim from the debt it owes and tenders any balance to the creditor. The sums in question must be due or, if representing unliquidated damages, a good faith and reasonable assessment of the loss. (Contrast with set off at law, which requires the claims to be determined by judgment of the courts).
Criteria
Unlike legal set-off, in equitable set-off there is no need for claims to be fixed, or to be due and payable on the same day as long as it is fair. Equitable set-off may arise between off-setting claims when:
- Close connection: The claims are “closely connected” — arising from the same transaction or a series of related transactions — such that it would be manifestly unjust to allow one party to enforce its claim without taking into account the other party’s claim.
- No prohibition: Equitable set-off is a delicate petal and you can contract out of it, and it can be disabled by statute. Bankruptcy statutes are quite good at this.
- It must be equitable: Being equitable, you must come to the court with clean hands and satisfy the court it would be “equitable” to allow the set-off.
In Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667 the leading judgment confirmed the equitable test as being
“whether the cross-claim is ... so closely connected with the claimant’s demand that it would be manifestly unjust to allow it to enforce payment without taking into account the cross-claim.”
Bankruptcy set-off
As we have said elsewhere, bankruptcy is a strange time. The usual cast-iron certainties that accopmpany dealings amongst merchants in the financial markets give way to a spooky, primordial dreamtime, where nothing is sure. All are beset by phantoms, nightmares and the dark pantomime of the supernatural.
Lawyers do not like this, but it keeps them in employment, so do not shed too many tears.
Normally, as JC’s article about set-off describes, peace-time set-off is a sensible, self-help remedy where parties can take matters into their own hands, apply a quid against a quo of equal value, and no part of the jurisprudence of fairness will be upset. I owe you, you owe me, to save forking over equal sums, we call it quits. My claim for £100 from you is the same my liability for £100 to you, so we put the two together and they vanish in a puff of legal and mathematical logic. Simple.
Bankruptcy changes all this. When, as a going concern, you face a bankrupt, your claim for £100 is not worth £100. It may be worth nothing. You must take your place in the queue of creditors and find out. And if, at the same time, you have a liability to that very same bankrupt for the very same £100 it is still worth £100. The bankrupt can make you pay the whole lot. This seems unfair, but this is the game of cosmic chicken we play by extending credit.
So, you see, an enforceable set-off is a highly attractive proposition — for you. For the bankrupt’s administrator, on the other hand, at least as far as the bankrupt’s other creditors are concerned, avoiding that set off is a highly attractive proposition.
This is the palaver that close-out netting and the vaunted Single Agreement concept addresses. The trick it tries to pull is to work like an enforceable set-off, without actually being a set-off, precisely because in bankruptcy, set-offs are notoriously unreliable.[1]
We have seen wishful game-playing in insolvency scenarios. This is unlikely to work, but the fact that it has occurred to people to try it will give you a glimpse into the venal minds that operate in the capital markets.
A large Texan Energy conglomerate has gone titten hoch, leaving behind it, in that smoking crater, a portfolio of energy swaps it bought from you — Debtor A — which, against all the odds, are heavily in the money to the bankrupt. You owe, let’s say, a couple of hundred million. Reports in the market suggest that a number of your competitors — Creditors B, C and D — are in the opposite position — they are all owed a lot of money and the bankrupt, being a blackened stump in the middle of said crater, is not going to be able to pay them. Their combined claims against the bankrupt add up to roughly $200m. Indications are that these contracts will pay 10 cents on the dollar. If your counterparties are lucky they’ll get $20m between them, and that will take 5 years and God knows how much time, resources and legal fees.
There is a trade to be done here: Debtor A buys the claims of Creditors B, C and D for $25 million dollars. The Creditors all avoid five years of the swamp, and get out for more money than they were expecting. This is a great outcome. Debtor A acquires $200m of notional claims against Bankrupt E for 12.5 cents on the dollar, and then sets off that £200m claim against the $200m it already owes Bankrupt E under the portfolio of energy swaps. Creditor A has paid $25m to avoid a certain £200m loss.
Now, let’s be clear: while bankruptcy laws differ wildly this would not work in a jurisdiction with sophisticated bankruptcy regime: though the bankrupt is not involved — so it would not be directly voidable, bankruptcy administrators tend to have wide discretionary powers, and courts generally will take a dim view of actions that usurp the function of the administrator, as this clearly would do. Whether it might hold up if engineered before a bankruptcy, however, is another question. It would make a great play.
Banker’s set-off (banker’s right to combine accounts)
The banker’s right to combine accounts arises where a customer has multiple bank accounts, usually where some are in debit and some in credit. This stands to reason, obviously — unless there are multiple accounts, all overdrawn, but only some of them benefit from a security interest — though see also the rules about bailment. It is sometimes called a Banker’s set-off but, in 1972’s (still leading) case National Westminster Bank Ltd v Halesowen, Lord Buckley noted it isn’t a set off right so much as a function of accounting:
“Nor is it a set-off situation, which postulates mutual but independent obligations between the two parties. It is an accounting situation, in which the existence and amount of one party’s liability to the other can only be ascertained by discovering the ultimate balance of their mutual dealing.”
Cross-affiliate set-off
Not a thing: the founding principle of set-off is that there must be a mutuality of debts and parties: specifically, set-off is a bilateral thing. As between you, your counterparty, and your counterparty’s European energy trading affiliate, there is no mutuality of parties. See triangular set-off (which is also not a thing).
When to use set-off
You do not exercise a set-off right willy nilly. Unless you are, mutually, settlement netting (this happens a lot less in practice than you might thing), set-off is a drastic unilateral remedy which indicates a lack of trust in your counterparty and will be seen as enemy action.
You would not do it, without agreement, to any client you expected to keep.
So, generally, keep your powder dry. Use set-off as a remedy only following an event of default.
See, for example, Set-off in the 2002 ISDA under Section 6(f). So you don’t just do it for the hell of it.
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See also
- Set-off (ISDA)
- Set-off (2010 GMSLA)
- There is no general right of set-off in a 2010 GMRA
- Triangular set-off
- Netting
References
- ↑ Not so in an English insolvency, as it happens. See the premium content section for more.