Suppose you have a savings account at a bank with $100 in it. Suppose that you also get a $500 loan from the same bank. In this case, both you and the bank are both creditor and debtor to each other. You owe the bank $500 and the bank owes you $100 that is in your savings account. In most jurisdictions, if you were slow in paying your debt or you file for bankruptcy, the bank would have the right to reduce its loan to you by the $100 in your savings account by simply taking the money. The bank doesn't have to go court, obtain your permission, or even give you advance notice. However, if you file for bankruptcy, the bank would have to get permission to lift the automatic stay before it could take your money.

A setoff (aka offset) is the right for a creditor to reduce its loan to a debtor by subtracting what the creditor owes the debtor. Hence, each party is both a creditor and a debtor to the other party. If a party fails to pay its debt or if a party goes into bankruptcy, then the other party can offset the debt owed by the credit given.

Although states may have laws concerning setoffs, the right to a setoff is not based on statute or even on a contractual provision. The right of setoff is based on equity, since it is the most effective and immediate remedy for collecting a debt. And, as illustrated by the bank example above, the setoff right exists even if the mutual debts are based on different transactions.

However, if the mutual debts are based on the same transaction, then the right to offset mutual debts in what is known as recoupment is even greater. A common example of recoupment is when a writer receives an advance for a book from the book publisher, who then collects the royalties and uses it to repay the advance. In this case, the right to recoupment allows the publisher to apply postpetition earnings of the book to the prepetition advance, which would not be allowed in a setoff, since a setoff right in bankruptcy requires that both debts to have arisen prior to bankruptcy.

While the right to a setoff is not created by bankruptcy law, it is available to a creditor of a debtor in bankruptcy if nonbankruptcy law allows it. However, the Supreme Court has ruled[i] that a setoff is only achieved by the actual debiting of the debtor's account — not by freezing or putting a hold on it. In bankruptcy, a setoff is bifurcated into a secured claim, up to the amount of the setoff, and an unsecured claim for the remaining portion.

Section 553 governs setoffs and recoupments in bankruptcy. Generally, a setoff gives a creditor a much greater payment on its debt than it would otherwise be entitled to under bankruptcy. For instance, if a creditor, such as a bank, extended a $1,000 loan to the debtor and the debtor has $900 in a savings account, then the bank can reduce the debt to $100 by taking the $900 in the savings account and paying down the loan.

However, since the automatic stay applies to setoffs §362(a)(7), if the debtor is already in bankruptcy, then the creditor must apply to the court to get relief from the automatic stay before it can use a setoff. In most cases involving a setoff, the creditor has cash collateral, which is given special protection in bankruptcy. A trustee or debtor-in-possession (DIP) cannot use the collateral unless they can show the court that the collateral has adequate protection.

Restrictions and Limitation on Setoff in Bankruptcy

To close possible loopholes in the setoff right, §553 stipulates various requirements and restrictions for the setoff:

The mutuality requirement means the creditor must owe the debtor and vice versa. However, different courts have treated different creditors of some groups or affiliations as separate creditors while treating others as a single creditor — setoff is only allowed if the entity owing the debtor and the entity that is a creditor to the debtor are treated as a single entity. For instance, different agencies of the United States government are treated as a single creditor by most courts, and so the debt owed to the debtor by an agency may be offset by a debt that the debtor owes to a different government agency. However, most courts have treated affiliates of a corporation as separate creditors.

A setoff deficiency exists when the debtor owes the creditor more than what the creditor owes the debtor. For instance, if a bank lends the debtor $10,000 and the debtor has a savings account at the bank with an account balance of $3,000, the bank has a setoff deficiency of $7,000. If a creditor sets off its loan during the 90 days before the debtor files for bankruptcy, and if the setoff deficiency at the time of the setoff is less than what it was at the beginning of the 90-day period or when a deficiency first arose, whichever is later, then the bankruptcy trustee can recover the difference in deficiencies between the time of the setoff and the beginning of the 90-day period or the date when a deficiency first arose. Continuing the above example, suppose the debtor deposited another $4.000 during the 90-day period, but then the bank paid down its loan with the $7.000 balance in the savings account. Since the deficiency at the time of the setoff was only $3.000, but was $7,000 at the beginning of the 90-day period, the trustee will be able to recover the $4,000 difference as a preference payment. The purpose of this requirement is to dissuade creditors from pressuring the debtor to lessen the setoff deficiency by making payments to the creditor that the debtor can ill afford.

[i] Citizens Bank v. Strumpf, 516 U.S. 16 (1995)