Set-off (law)

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In law, set-off or netting (American English) are legal techniques applied between persons with mutual rights and liabilities, replacing gross positions with net positions.[1][2] It permits the rights to be used to discharge the liabilities where cross claims exist between a plaintiff and a respondent. The result being that the gross claims of mutual debt produces a single, net claim.[3] The net claim is known as a net position. In other words, a set-off is the right of a debtor to balance mutual debts with a creditor. In bookkeeping terms, set-offs are also known as reconciliations.[citation needed] To determine a set-off, simply subtract the smaller debt from the larger.

Any balance remaining due either of the parties is still owed, but the remainder of the mutual debts has been set off. The power of net positions is to reduce credit exposure, also holding regulatory capital requirement and settlement advantages, which contributes to market stability. In regard to the financial market, net positions are vital.[4]

Difference between Set off and Netting[edit]

Whilst netting and set off are often used interchangeably, the legal distinction is made between netting, which describes the procedure for and outcome of implementing a set off. By contrast set off describes the legal bases for producing net positions. Netting describes the form such as novation netting, or close-out netting, whilst set off describes judicially recognised grounds such as independent set off or insolvency set off. Therefore, a netting or setting off gross positions involves the use of offsetting positions with the same counter-party to address counter-party credit risk. This is to be differentiated from hedging which uses offsetting positions with multiple parties to mitigate risk.

Mutuality[edit]

The law does not permit counter-parties to use third party debt to set off against an un-related liability.[5] All forms of set off requires mutuality between claim and cross claim. This protects property rights both inside insolvency and out, primarily by ensuring that a non-owner cannot benefit from insolvency.

Market Effect[edit]

The primary objective of netting is to reduce systemic risk by lowering the number of claims and cross claims which may arise from multiple transactions between the same parties. This prevents credit risk exposure, and prevents liquidators or other insolvency officers from cherry-picking transactions which may be profitable for the insolvent company.[6]

Netting[edit]

At least three principle forms of netting may be distinguished in the financial markets.[7] Each is heavily relied upon to manage financial market, specifically credit, risk

Since claims are a major form of property nowadays and since creditors are often also debtors to the same counterparty, the law of set off is of paramount importance in international affairs

— P.Wood, Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995), 72

Novation Netting[edit]

Also called rolling netting, netting by novation involves amending contracts by the agreement of the parties. This extinguishes the previous claims and replaces them with new claims.

Suppose that on Monday, 'A' and 'B' enter into transaction-1, whereby A agrees to pay B £1,000,000 on Thursday. On Tuesday A and B enter into transaction-2, whereby B agrees to pay A £400,000 on Thursday. Novation netting takes effect on Tuesday to extinguish the obligations of the parties under both transaction 1 and 2, and to create in their place a new obligation on A to pay to B £600,000 on Thursday.

— Benjamin,Joanna, Financial law (2007, Oxford University Press), 267

This differs from settlement netting (outlined below) because the fusion of both claims into one, producing a single balance, occurs immediately at the conclusion of each subsequent contract. This method of netting is crucial in financial settings, particularly derivatives transactions, as it avoids cherry-picking in insolvency.[8] The effectiveness of pre-insolvency novation netting in an insolvency was discussed in British Eagle International Airlines Ltd v Compagnie Nationale Air France[1975] 1 WLR 758. Similar to settlement netting, novation netting is only possible if the obligations have the same settlement date. This means that if, in the above example, transaction-2 was to be paid on Friday, the two transactions would not offset. Novation netting further cannot consolidate obligations. This is a systems intensive process requiring tracking of obligations as they become due.

Close out netting[edit]

An effective close-out netting scheme is said to be crucial for an efficient financial market.[9] Close out netting differs from novation netting in that it extends to all outstanding obligations of the party under a master agreement similar to the one used by ISDA. These traditionally only operate upon an event of default of insolvency. In the event of counterparty bankruptcy or any other relevant event of default specified in the relevant agreement if accelerated (i.e. effected), all transactions or all of a given type are netted (i.e. set off against each other) at market value or, if otherwise specified in the contract or if it is not possible to obtain a market value, at an amount equal to the loss suffered by the non-defaulting party in replacing the relevant contract. The alternative would allow the liquidator to choose which contracts to enforce and which not to (and thus potentially "cherry pick").[10] There are international jurisdictions where the enforceability of netting in bankruptcy has not been legally tested.[citation needed] The key elements of close out netting are:

  • default
  • the accretion of the time for performance of obligations to the time of default
  • conversion of non-cash obligations into debts; meaning obligations to deliver non-cash assets are converted to market price equivalents; and
  • set off[11]

Similar methods of close out netting exist to provide standardised agreements in market trading relating to derivatives and security lending such asrepos, forwards or options.[12] The effect is that the netting avoids valuation of future and contingent debt by an insolvency officer and prevents insolvency officers from disclaiming executory contract obligations, as is allowed within certain jurisdictions such as the US and UK.[13] The mitigated systemic risk which is induced by a close out scheme is protected legislatively. Other systemic challenges to netting, such as regulatory capital recognition under Basel II and other Insolvency-related matters seen in the Lamfalussy Report[14] has been resolved largely through trade association lobbying for law reform.[15] In England & Wales, the effect of British Eagle International Airlines Ltd v Compagnie Nationale Air France has largely been negated by Part VII of the Company Act 1989 which allows netting in situations which are in relation to money market contracts. In regard to the BASEL Accords, the first set of guidelines, BASEL I, was missing guidelines on netting. BASEL II introduced netting guidelines.

Settlement netting[edit]

For cash settled trades, this can be applied either bilaterally or multilaterally and on related or unrelated transactions. Obligations are not modified under settlement netting, which relates only to the manner in which obligations are discharged.[16] Unlike close-out netting, settlement netting is only possible in relation to like-obligations having the same settlement date. These dates must fall due on the same day and be in the same currency, but can be agreed in advance.[17] Claims exist but are extinguished when paid. To achieve simultaneously payment, only the act of payment extinguishes the claim on both sides. This has the disadvantage that through the life of the netting, the debts are outstanding and netting will likely not occur, the effect of this on insolvency was seen in the above mentioned British Eagle. These are routinely included within derivative transactions as they reduce the number and volume of payments and deliveries that take place but crucially does not reduce the pre-settlement exposure amount.

  • Bilateral Net Settlement System: A settlement system in which every individual bilateral combination of participants settles its net settlement position on a bilateral basis.
  • Multilateral Net Settlement System: A settlement system in which each settling participant settles its own multilateral net settlement position (typically by means of a single payment or receipt).

Set off[edit]

Set off is a legal event and therefore legal basis is required for the proposition of when two or more gross claims are netted. Of these legal bases, a common form is the legal defense of set-off, which was originally introduced to prevent the unfair situation whereby a person ("Party A") who owed money to another ("Party B") could be sent to debtors' prison, despite the fact that Party B also owed money to Party A. The law thus allows both parties to defer payment until their respective claims have been heard in court. This operated as an equitable shield, but not a sword. Upon judgment, both claims are extinguished and replaced by a single net sum owing (e.g. If Party A owes Party B 100 and Party B owes Party A 105, the two sums are set off and replaced with a single obligation of 5 from Party B to Party A). Set-off can also be incorporated by contractual agreement so that, where a party defaults, the mutual amounts owing are automatically set off and extinguished.

In certain jurisdictions (including the UK[18]), certain types of set-off takes place automatically upon the insolvency of a company. This means that, for each party which is both a creditor and debtor of the insolvent company, mutual debts are set-off against each other, and then either the bankrupt's creditor can claim the balance in the bankruptcy or the trustee in bankruptcy can ask for the balance remaining to be paid, depending on which side owed the most. The primary argument This has been criticized[19] as an undeclared security interest that violates the principle of pari passu. The alternative, where a creditor has to pay all its debts, but receive only a limited portion of the leftover moneys that other unsecured creditors get, poses the danger of 'knock-on' insolvencies, and thus a systemic market risk.[20][21] Seven still three core reasons underpin and justify the use of set-off. First, the law should uphold pre-insolvency autonomy and set-offs as parties invariably rely on the pre-insolvency commitments. This is a core policy point. Second, as a matter of fairness and efficiency both outside and inside insolvency reduces negotiation and enforcement costs.[22] Third, managing risk, particularly systemic risk is crucially. Clearing house rules offer stipulation that relationships with buyer and sellers are replaced by two relationships between buyer and clearing house and seller and clearing out. Effect is automatic novation meaning all elements are internalised in current accounts. Can be in different currencies as long as they are converted at calculation.

The right to set off is particularly important when a bank's exposures are reported to regulatory authorities, as is the case in the EU under financial collateral requirements. If a bank has to report that it has lent a large sum to a borrower and so is exposed because of the risk that the borrower might default, thereby leading to the loss of the money of the bank or its depositors, is thus replaced. The bank has taken security over shares or securities of the borrower with an exposure of the money lent, less the value of the security taken.

Set-off by Country[edit]

Two primary examples of set-off rules are outlined below. These are in addition to the financial regulations pertaining to netting set out by trade associations and the European Union through the Financial Collateral Directives.

English law set-off[edit]

Under English law, there are broadly five types of set-off which have been recognised:[23][24][25]

  1. Legal set-off. or Independent set-off[26] What is known as statutory set-off, this arises where a claim and a counterclaim in a court action are both liquidated sums or ascertained with certainty. This is wider than insolvent set-off, but the claim and cross claim must be mutual and liquidated. In such cases the court will simply set-off the amounts and award a net sum. The two claims do not need to be intrinsically connected.
  2. Equitable set-off. or Transaction set-off Outside of litigation, where two mutual claims arise out of the same matter or a sufficiently closely related matter and an injustice would be done if not enforced, the claims will set off in equity.[27] Both sums must be due and payable, but may be for liquidated or unliquidated sums. Unlike Independent set-off, this is not self-executing
  3. Contractual Set-off made by express agreement. Often netting will arise through express agreement to the parties, the ISDA master agreement is an example of this type, which is ineffective against an insolvent party but is often used to address pre-insolveny credit risk and reduce the need for collateral.
  4. Banker’s set-off. or Current Account Set-off Sometimes referred to as a banker's right to combine accounts, this is a special form of set-off which is implied into contractual agreements with bankers and allows banks to offset sums in one account against another account which is overdrawn from the same client.[28] However, the right cannot be exercised if one of the accounts is a loan account, or if the bank has agreed not to exercise the right, or if the bank has notice that the sums in the account are for a specific purpose,[29] or on trust for another party. It is said to derive from a bankers' lien, however this is misleading as it is only available where both accounts are maintained in the same capacity. Difference in currency will not prevent this right, however.[30]
  5. Insolvency set-off. It is perhaps the most expensive form of set off. Under section 323 of the Insolvency Act 1986[31] where a person goes into bankruptcy or a company goes into liquidation mutual debts are automatically set-off. This is a mandatory operation in bilateral situations. Whether the debt is liquidated or unliquidated does not matter, and the set-off will apply to future or contingent claims if the debts are provable. Insolvency set-off operates on liquidation and administration, where the administrator gives notice of his intention to make a distribution.[32]

The five types of set off are extremely important as a matter of efficiency and of mitigating risk. Contractual set offs recognised as an incident of party autonomy whereas banker right of combination is considered a fundamental implied term. It is an essential aspect for cross-claims, especially when there exits overlapping obligations. Common features of set-off are that they are confined to situations where claim and cross claim are for money or reducible to money and it requires mutuality.

US law set-off[edit]

See De Magno v. United States, 636 F.2d 714, 727 (D.C. Cir. 1980) (district court had jurisdiction over claim involving VA’s “affirmative action against an individual whether by bringing an action to recover on an asserted claim or by proceeding on its common-law right of set-off”) (discussing similar language of predecessor statute, 38 U.S.C. § 211)

See, e.g., United States v. Munsey Trust Co., 332 U.S. 234, 239, 67 S.Ct. 1599, 1601, 91 L.Ed. 2022 (1947) ("government has the same right 'which belongs to every creditor, to apply the unappropriated moneys of his debtor, in his hands, in extinguishment of the debts due to him' " (quoting Gratiot v. United States, 40 U.S. (15 Pet.) 336, 370, 10 L.Ed. 759 (1841))); see also Tatelbaum v. United States, 10 Cl.Ct. 207, 210 (1986) (set-off right is inherent in the United States government and grounded on common law right of every creditor to set off debts).

References[edit]

  1. ^ David Southern Set off revisited (1994) NJL 1412, 1412
  2. ^ Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd [1970] 3 All ER 473 at 488, per Buckley LJ
  3. ^ Joanna Benjamin, Financial Law (2007, Oxford University Press), p264
  4. ^ Louise Gullifer, Goode and Gullifer on Legal Problems of Credit and Security (Sweet & Maxwell, 7th ed 2017
  5. ^ P Wood Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995), 189
  6. ^ Finch, Milman Corporate Insolvency Law (2016, Cambridge University Press, Third edition)
  7. ^ Jan Woltjer (March 2002). "Risk Management in Netting schemes for settlement of securities transactions" (PDF). World Bank. 
  8. ^ Commissioner for HMRC v Entin [2006] BCC 955 per Lightman J [21]
  9. ^ EFMLG The regulation of close out netting in the new member states of the European Union 2005, 3
  10. ^ ISDA 2002 Master Agreement, Section 2(1)(a)(iii)
  11. ^ See the Financial Collateral Directive (Directive 2002/47/EC, Art 2(1)(n)
  12. ^ ISDA master agreement
  13. ^ Cf Insolvency Rules 1986 Rule 4.90
  14. ^ European Commission,Report from the Commission to the Council and European Parliament, Evaluation Report on the Financial Collateral Arrangements Directive (2002/47/EC), 2006, COM (2006) 833 final, 10
  15. ^ Benjamin, 269
  16. ^ P Wood, Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995),153-5
  17. ^ Joanna Benjamin, Financial Law (2007, Oxford University Press), p274
  18. ^ Insolvency Act 1986, section 323; Insolvency Rules 1986, rule 4.90.
  19. ^ Mokal Corporate Insolvency Law (Oxford: Oxford University Press 2005)
  20. ^ Louise Gullifer, Goode and Gullifer on Legal Problems of Credit and Security (Sweet & Maxwell, 7th ed) 2017
  21. ^ Roy Goode, Principles of Corporate Insolvency (Fourth Edition, Sweet & Maxwell 2013), 278
  22. ^ Stein v Blake [1993]; Halesowen Presswork
  23. ^ "Practical Law: set-off". Thompson Reuters. Retrieved 11 May 2016. 
  24. ^ Roy Goode, Principles of Corporate Insolvency (Fourth Edition, Sweet & Maxwell 2013), 278
  25. ^ Joanna Benjamin, Financial Law (2007, Oxford University Press), p274
  26. ^ P Wood Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995), 189
  27. ^ P Wood Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995), 189
  28. ^ National Westminster Bank Ltd v Halesowen Presswork & Assemblies Ltd [1972] AC 785
  29. ^ Barclays Bank Ltd v Quistclose Investments Ltd [1968] UKHL 4
  30. ^ Miliangos v George Frank Ltd [1976] AC 443
  31. ^ Rule 4.90 of the Insolvency Rules 1986 for companies.
  32. ^ Rules 14.25 and 14.25 of the Insolvency Rules 1986