The right to setoff is a widely recognized common law right which allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A. The claims of the mutually indebted parties are set off against each other and only the balance is recovered. A setoff is permitted regardless of whether the debt arises out of the same contract or transaction. The right to assert a setoff inside and outside of a bankruptcy is governed under state law.
A classic setoff scenario often arises for a distressed business who has borrowed money from a secured lender. The business typically grants a security interest in all assets to a lender, including cash held in a business bank account. If a business defaults under its loan documents, the lender may sweep the money in the bank account and apply it to the debt owed. Such a setoff typically results in a seizure of a company’s operating cash, thereby crippling the ability of the business debtor to operate.
The Bankruptcy Code preserves the right of parties to assert setoffs for a mutual debt that arose before the commencement of a case. A section of the Code operates as a stay of the setoff of any debt owing to the debtor that arose prior to the bankruptcy against any claim against the debtor. As a result, after a bankruptcy filing, a creditor must obtain permission from the bankruptcy court to exercise a setoff.
Recoupment is similar to a setoff, but it may only arise out of the same transaction or occurrence. To determine if a recoupment takes place, courts generally apply either the broader, logical-relationship test or the narrower integrated transaction test. Unlike with a setoff, a creditor is not required to obtain permission from the bankruptcy court to exercise the right of recoupment. Nevertheless, a creditor should seek approval from the court if there is any uncertainty over whether the creditor is exercising a right of setoff or recoupment.
The Ninth Circuit Court of Appeals recently published a decision discussing the distinction between setoffs and recoupment. Gardens Regional Hospital and Medical Center, a private nonprofit hospital in California, stopped paying a hospital quality assurance fee (HQAF), which was required to be paid to the state under California law. The hospital then filed for chapter 11 bankruptcy.
The state of California owed fee-for-service payments and “supplemental” payments to the hospital under the state’s Medicaid program. After the hospital filed for bankruptcy, the state began withholding the fee-for-service and supplemental payments owed to the hospital, and applied the payments owed to the balance of the HQAF debt owed by the hospital to the state. The hospital asserted that this action violated the automatic stay in the bankruptcy proceeding.
The Ninth Circuit ultimately held that the deductions from the supplemental payments were permissible recoupments, but that the deductions from the fee-for-service payments were impermissible setoffs. The court found that deductions from supplemental payments were logically connected to the HQAF assessments, but that the fee-for-service payments to the hospital were not made from the same segregated fund as the HQAF supplemental payments. As a result, the Ninth Circuit found that the deductions from the fee-for-service payments violated the automatic stay.
The Ninth Circuit’s recent decision demonstrates the fine line between setoff and recoupment. Distressed businesses should always be wary of a creditor’s setoff and recoupment rights. If a distressed business files for bankruptcy, a creditor must not unilaterally exercise its right to recoup without obtaining confirmation from the bankruptcy court that a creditor is properly exercising its right of recoupment, as opposed to violating the bankruptcy court rules prohibiting a setoff.
