In In re Rogers Morris, 2020 WL 1321894 (Bankr. N.D. Miss. Mar. 16, 2020), the U.S. Bankruptcy Court for the Northern District of Mississippi contributed to an existing split among the courts by joining the majority view in holding that a creditor may exercise setoff rights after the confirmation of a plan in a bankruptcy case. In a chapter 12 case, the court found that the creditor did not waive its setoff rights or engage in inequitable conduct justifying equitable subordination of its claim, and it granted the creditor's post-confirmation motion for relief from the automatic stay to offset mutual prepetition obligations.
Setoff in Bankruptcy
Section 553(a) of the Bankruptcy Code provides that, with certain exceptions, 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." With this language, the Bankruptcy Code preserves an otherwise existing right of setoff, but it does not create one. Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 18 (1995); accord In Feltman v. Noor Staffing Grp., LLC (In re Corp. Res. Servs. Inc.), 564 B.R. 196 (Bankr. S.D.N.Y. 2017) (section 553 does not create an independent federal right of setoff, but merely preserves any such right that exists under applicable nonbankruptcy law).
The Bankruptcy Code defines a "claim," in relevant part, as 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," and it defines a "debt" as a "liability on a claim." 11 U.S.C. § 101 (5)(A), (12). 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.), cert. dismissed, 487 U.S. 1260 (1988). Although the Bankruptcy Code does not define "mutual debt," courts typically find that the mutuality requirement is satisfied when the debt and the claim are between the same parties acting in the same capacity. See Collier on Bankruptcy ¶ 553.03 (16th ed. 2020).
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); 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 Williams, 2018 WL 3559098 (Bankr. D.N.M. July 23, 2018); In re Enright, 2015 WL 4875483 (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 debt 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" (generally, 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.
Courts disagree over whether setoff rights survive confirmation of a plan. The bankruptcy court weighed in on this issue in Rogers Morris.
In March 2018, family farmer Rogers Morris ("Morris") filed a chapter 12 petition in the Northern District of Mississippi. Prior to filing for bankruptcy, Morris entered into a contract with the Commodity Credit Corporation ("CCC"), an agency within the U.S. Department of Agriculture ("USDA"), for risk and price loss crop coverage. The contract provided in part that "[o]ffsets for debts owed to agencies of the U.S. Government shall be made prior to making any payments to participants or their assignees."
The USDA was obligated under the contract to pay approximately $3,500 to Morris for the 2017 program year. The USDA duly issued a check, but withheld the payment because Morris had payments due under an outstanding prepetition secured debt to the CCC in the amount of approximately $31,000 and a partially secured debt in the amount of approximately $240,000 to the Farm Services Agency ("FSA"), also an agency within the USDA.
The U.S. government ("government") timely submitted proofs of claim on behalf of the CCC, the FSA, and the USDA in the bankruptcy court asserting a setoff right (expressly or by reference to attached documentation) under the contract and otherwise participated in the case. After resolving objections filed by the CCC, the FSA, and the USDA, among others, the bankruptcy court confirmed a chapter 12 plan for Morris in December 2018. The plan provided for reinstatement of the CCC, FSA, and certain other secured loans under altered terms, but provided for no distribution to unsecured creditors. The plan was silent as to the effect of confirmation on setoff rights.
In October 2019—10 months after confirmation of Morris's chapter 12 plan—the government petitioned the bankruptcy court for relief from the automatic stay to exercise its setoff right. In opposing the setoff motion, Morris argued that: (i) a creditor may not assert a setoff right after confirmation of a plan; (ii) the government waived its setoff right by waiting 10 months after confirmation to file its setoff motion; and (iii) the government engaged in inequitable conduct warranting the equitable subordination of its claim by asserting its setoff right post-confirmation and thereby attempting to gain an unfair advantage over other creditors.
The Bankruptcy Court's Ruling
The bankruptcy court rejected Morris's arguments and granted the government's motion for relief from the automatic stay to exercise the right of setoff.
Initially, the court found that the government possessed a valid setoff right under the contract with Morris, that both obligations arose pre-bankruptcy, and that the mutuality requirement was satisfied.
Turning to the validity of post-confirmation setoff, the court acknowledged that no controlling Fifth Circuit precedent exists on this point. Looking to case law in other circuits, the bankruptcy court noted that the U.S. Court of Appeals for the Third Circuit and some lower courts in other circuits have concluded that setoff rights terminate upon plan confirmation (citing In re Continental Airlines, 134 F.3d 536, 540-42 (3d Cir. 1998) ("[T]he right of a creditor to set-off in a bankruptcy reorganization proceeding must be duly exercised in the bankruptcy court before the plan of reorganization is confirmed; the failure to do so extinguishes the claim" because section 553 is trumped by sections 1141(b) and 1141(c), which vest all property of the estate in the debtor free and clear of liens upon confirmation); In re Lykes Bros. S.S. Co. Inc., 217 B.R. 304, 310 (M.D. Florida 1997) (once an order confirming a plan becomes final, the doctrine of res judicata precludes a creditor from asserting setoff rights post-confirmation)).
However, the bankruptcy court in Rogers Morris explained, this is the minority view. The majority rule, exemplified by the Ninth Circuit's decision in In re De Laurentiis Entertainment Group, Inc., 963 F.2d 1269 (9th Cir. 1992), is that post-confirmation setoff is permitted in accordance with the plain language of section 553. In De Laurentiis, the Ninth Circuit wrote that:
[A] contrary conclusion essentially would nullify section 553. Section 553 does not by itself create a right of setoff. Instead, it merely allows setoffs in bankruptcy to the same extent they are allowed under state law. If section 1141 were to take precedence over section 553, setoffs would be allowed under Chapter 11 only where they were written into a plan of reorganization. Section 553 would then be largely superfluous, since a setoff could be written into the reorganization plan even without section 553. A reading of section 553 which renders it meaningless should be highly suspect.
963 F.2d at 1277; accord In re Davidovitch, 901 F.2d 1533 (10th Cir. 1990); In re BOUSA Inc., 2006 WL 2864964 (Bankr. S.D.N.Y. Sept. 29, 2006); In re Ronnie Dowdy, Inc., 314 B.R. 182 (Bankr. E.D. Ark 2005); In re Whitaker, 173 B.R. 359 (Bankr. S.D. Ohio 1994).
The bankruptcy court in Rogers Morris was persuaded by this reasoning and opted for the De Laurentiis court's approach on this issue. The court echoed the Ninth Circuit's view that setoffs are usually favored, presumptively enforced, and essential to the equitable treatment of creditors—otherwise, a creditor would have to pay its full debt to the debtor while receiving only a portion of what the debtor owes to it.
The bankruptcy court rejected Morris's argument that the government waived its setoff right by waiting until after confirmation to assert the right. According to the court, by withholding the check and asserting the setoff right in its proofs of claim, the government never intentionally relinquished its right, and the confirmed chapter 12 plan did not address this issue. In addition, the court did not find that the government engaged in any misconduct or gained an unfair advantage that would warrant the equitable subordination of its claims. Finally, the court characterized as "absurd" Morris's argument that prohibiting the government from exercising its setoff right was consistent with section 553, given that the provision "expressly protects a creditor's setoff rights."
Setoff rights created by contract or applicable non-bankruptcy law are important creditor protections. The Bankruptcy Code preserves those rights and permits creditors to exercise them under appropriate circumstances. As illustrated by the ruling in Rogers Morris, however, courts disagree as to whether confirmation of a plan extinguishes setoff rights. Even though Rogers Morris involved a chapter 12 case, the court's reasoning should apply with equal force to post-confirmation setoffs in chapter 9, 11, and 13 cases.
However, it bears observation that, as noted in the chapter 11 context by the Third Circuit in Continental Airlines, chapters 11, 12, and 13 each provide that, unless provided otherwise in the plan or the confirmation order, confirmation of a plan vests all property of the estate in the debtor free and clear of any claim or interest of any creditor. See 11 U.S.C. §§ 1141, 1227, and 1327. The courts have disagreed regarding the impact of these provisions on post-confirmation setoff rights. Given the uncertain state of the law on this issue, creditors seeking to exercise setoff rights should be aware of the courts' views on the question in the jurisdiction of any debtor's bankruptcy filing and would be well-advised to assert setoff rights prior to plan confirmation or, in all events, at the earliest opportunity.
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