Legal Blog

Setoff

Setoff is a wonderful concept. Simply put, it means that a defendant in an action may owe money to the plaintiff, but claim that, because the plaintiff owes it money, it can set off the two debts against each other and either reduce or eliminate the plaintiff’s claim. However, setoff is not always available. Usually, if it is unavailable, it is more of a timing problem because, sooner or later, the defendant will commence its own action or counterclaim against the plaintiff. However, in a bankruptcy context, the inability to set off can be devastating (i.e. no setoff availability means that a claim against a bankrupt gets lumped in with the claims of all other unsecured creditors, but the requirement to pay the bankrupt’s trustee remains for the full amount owing). This issue was front and centre in King Insurance Finance (Wines) Inc. v. 1557359 Ontario Inc., a 2012 Ontario Superior Court of Justice decision.

 

Debt

A creditor commenced an action against a bankrupt’s corporation and the bankrupt – before he made an assignment into bankruptcy. The creditor claimed against the corporation for repayment of its debt and against the bankrupt on his personal guarantee of the corporation’s indebtedness. After the bankruptcy, the creditor obtained an order lifting the automatic stay of its action against the bankrupt. In order to do so, the creditor claimed that the bankrupt was liable to it not only as a guarantor, which would have resulted in a meaningless judgment in view of the bankruptcy, but also on the grounds of fraud, conversion, and breach of trust (collectively, the “Fraud Claim”). Success against the bankrupt on these grounds may have entitled the creditor to obtain a judgment against the bankrupt that would survive his bankruptcy.

 

At the trial of the action, the creditor was successful against the corporation and the bankrupt on the guarantee, but its claim against the bankrupt for the nasty allegations in the Fraud Claim was dismissed. Consequently, the trial judge awarded full costs of the action against the creditor – $93,000 – even though the creditor had established its claim of $416,000 against the bankrupt. An allegation of fraud is a serious matter that, if ultimately unproven, will often result, as in this action, in an adverse costs order.

 

Subject to another twist that we will discuss later, the bankrupt’s trustee claimed the costs of $93,000 from the creditor. The creditor claimed setoff against the trustee for the $416,000 that the bankrupt was adjudged to have owed to the creditor.

 

Legal Setoff

There are two types of setoff: legal and equitable. A legal setoff arises when there are two offsetting debts. Without the bankruptcy, the creditor would have had a legal setoff against the bankrupt. By virtue of the judgment, there were two judgment debts. However, bankruptcy changes the usual dynamic.

 

“So long as there is a debt owed to the defendant by the plaintiff before the date of bankruptcy and a corresponding debt from the defendant to the plaintiff, that satisfies the mutual and cross obligation condition notwithstanding one of the debts was not actually payable at that time.”

 

In this case, however, the debt for costs arose by virtue of the judgment for costs awarded after the bankruptcy and, therefore, there were no mutual and cross obligations at the inception of bankruptcy. Further, the creditor owed its debt of costs to the bankrupt personally, subject to the bankruptcy rules for after-acquired property, but the judgment debt due by the bankrupt was a debt that the bankrupt’s estate owed. Accordingly, for both reasons, legal setoff did not apply.

 

Equitable Setoff

Equitable setoff does not need two debts. Normally, a claim for damages may be set off against a debt only if there is a sufficient relationship between the claims of the parties that it would be unconscionable or inequitable not to permit a setoff. As an example, a creditor may be owed money arising out of the purchase of a business; however, the debtor may claim that it ought not to have to pay the money due because the creditor misrepresented the assets of the business. The claim for damages arises out of the same transaction as the claim for debt and it would be inequitable to allow the creditor to collect its debt while the debtor’s claim for damages is being litigated.

 

The creditor argued that it could set off the costs award because the award arose out of the same contract or series of events giving rise to the creditor’s claim against the bankrupt. Does bankruptcy change the ordinary situation? Again, yes. The judge stated, “The creditor claiming an equitable set-off must as of the date of the bankruptcy have an entitlement to a remedy in its own right. Otherwise, the effect of giving the set-off would be to defeat the intent of the BIA by giving one creditor a preference over other unsecured creditors.”

 

The judge decided to disallow the claim for equitable setoff for two reasons:

 

1. The Fraud Claim, out of which the costs award arose, was a discrete claim, unrelated to the guarantee claim against the bankrupt – even though the two claims related to the same factual background of the business relationship among the bankrupt, the bankrupt’s corporation, and the creditor. The judge held that the Fraud Claim was not sufficiently connected to the contractual relationship; rather, the Fraud Claim related to intentional tortious conduct alleged against the bankrupt.

 

2. The creditor had no entitlement to the tortious remedies at the date of bankruptcy; it had at most a speculative cause of action.

 

Policy

There are two competing policy objectives relating to setoff in a bankruptcy. The first is to avoid the perceived injustice to a person, having mutual dealings with a party who becomes a bankrupt, being forced to pay in full what that person owes to the bankrupt, but receiving a dividend from the bankruptcy that is only a portion of what the bankrupt owed to the person. The second is to attempt to ensure that all unsecured creditors are treated the same. Accordingly, the limits of setoff are narrowly confined.

 

In this case, the second policy prevailed and the judge denied the creditor the right to set off its debt against the money it owed to the bankrupt’s estate.

 

Lien

There was, however, another claimant to the $93,000 costs award: the lawyer who acted for the bankrupt in the action. The costs that the creditor had to pay to the bankrupt represented the lawyer’s unpaid fees and disbursements in defending the bankrupt.

 

The Solicitors Act authorises a judge to declare that a lawyer is entitled to a charge on property recovered or preserved due to the lawyer’s efforts. The bankrupt’s lawyer therefore requested a charging order against the costs award because the costs award arose only because of his efforts.

 

The bankrupt’s trustee consented to the lawyer’s request for a charging order and the judge agreed. Accordingly, the lawyer was treated as a secured creditor in the bankruptcy to the extent of the $93,000, with priority over all unsecured creditors.

 

It was a happy ending for everyone – except, of course, the creditor.

 

Written by Jonathan Speigel Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.