In law, set-off or netting is a legal technique applied between persons or businesses with mutual rights and liabilities, replacing gross positions with net positions.[David Southern Set off revisited (1994) NJL 1412, 1412][ Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd 1970 3 All ER 473 at 488, per Buckley LJ] It permits the rights to be used to discharge the liabilities where Crossclaim exist between a plaintiff and a respondent, the result being that the gross claims of mutual debt produce a single net claim.[Joanna Benjamin, Financial Law (2007, Oxford University Press), p264] The net claim is known as a Financial law. In other words, a set-off is the right of a debtor to balance mutual debts with a creditor.
Any balance remaining due either of the parties is still owed, but the mutual debts have been set off. The power of net positions lies in reducing credit risk, and also offers regulatory capital requirement and settlement advantages, which contribute to market stability.[Louise Gullifer, Goode and Gullifer on Legal Problems of Credit and Security, Sweet & Maxwell, 7th ed., 2017]
Difference between set-off and netting
Whilst
netting and
set-off are often used interchangeably, a 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, netting or setting off gross positions involves the use of offsetting positions with the same counter-party to address counter-party credit risk.
Mutuality
The law does not permit counter-parties to use third party debt to set off against an un-related liability.
[P Wood, Title Finance, Derivatives, Securitisation, Set-off and Netting, (London: Sweet & Maxwell, 1995), 189] All forms of set-off require 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
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.
[Finch, Milman Corporate Insolvency Law (2016, Cambridge University Press, Third edition)]
Netting
At least three principal forms of netting may be distinguished in the financial markets.
Each is heavily relied upon to manage financial market, specifically credit,
financial risk
Novation netting
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.
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.[ Commissioner for HMRC v Entin 2006 BCC 955 per Lightman J 21] 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.
Close out netting
An effective close-out netting scheme is said to be crucial for an efficient financial market.
[EFMLG The regulation of close out netting in the new member states of the European Union 2005, 3] 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 or 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").
[ISDA 2002 Master Agreement, Section 2(1)(a)(iii)] There are international jurisdictions where the enforceability of netting in bankruptcy has not been legally tested.
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
[See the Financial Collateral Directive (Directive 2002/47/EC, Art 2(1)(n)]
Similar methods of close out netting exist to provide standardised agreements in market trading relating to derivatives and security lending such as
repos, forwards or options.
[ISDA master agreement] 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.
[Cf Insolvency Rules 1986 Rule 4.90] 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[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] has been resolved largely through trade association lobbying for law reform.
[Benjamin, 269] In England and Wales, the effect of
British Eagle International Airlines Ltd v Compagnie Nationale Air France has largely been negated by Part VII of the
Companies Act 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
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.
[P Wood, Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995),153-5] 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.
[Joanna Benjamin, Financial Law (2007, Oxford University Press), p274] Claims exist but are extinguished when paid. To achieve simultaneous 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
Set-off, also sometimes "set off",
[Weatherall, I. and Ryan, S., THE BASICS: WHAT IS SET OFF AND WHEN DOES THE RIGHT TO SET OFF ARISE?, Gowling WLG, published 6 August 2019, accessed 1 October 2022] is a legal event and therefore legal basis is required for the proposition that two or more gross claims are to be 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,[Insolvency Act 1986, section 323; Insolvency Rules 1986, rule 4.90.] certain types of set-off take 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. This principle has been criticized [Riz Mokal Corporate Insolvency Law (Oxford: Oxford University Press 2005)] as an undeclared security interest which violates the principle of pari passu. The alternative, where a creditor has to pay all its debts, but receives 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.[Louise Gullifer, Goode and Gullifer on Legal Problems of Credit and Security (Sweet & Maxwell, 7th ed) 2017][Roy Goode, Principles of Corporate Insolvency (Fourth Edition, Sweet & Maxwell 2013), 278] Even 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.[Stein v Blake 1993; Halesowen Presswork] Third, managing risk, particularly systemic risk, is crucial. 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. The effect is an automatic novation, meaning all elements are internalized in current accounts. This can be in different currencies as long as they are converted during 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.
There are financial regulations pertaining to netting set out by certain trade associations. The British International Freight Association (BIFA) standard trading conditions do not permit set-off.[BIFA standard trading condition 21(A), which refers to payment being due "without reduction or deferment on account of any claim, counterclaim or set-off", quoted in Court of Appeal (Civil Division), Röhlig (UK) Ltd v Rock Unique Ltd, EWCA Civ 18 (20 January 2011), accessed 23 September 2022]
Set-off by jurisdiction
Canadian law
Canadian law in relation to set-off in construction contracts includes:
-
Swagger Construction Ltd v. University of British Columbia (2000): the British Columbia Supreme Court ruled that "when a claim is made by a Contractor for the price of work and labour done, the Owner is entitled, in the absence of a provision in the Contract to the contrary, to set-off against the amount claimed any damages which he has suffered as a result of the Contractor's breach of the Contract".
[Quoted by Vetsch, P. A. K. in Canada: Effect Of Consultant Certifying Application For Progress Payment, published 27 August 2008, accessed 9 December 2020]
-
Armenia Rugs/Tapis v. Axor Construction Canada, an Ontario case relating to sub-contracted work on the RCMP building in Ottawa.
[Superior Court of Justice of Ontario, Armenia Rugs v. Axor Construction, 2006 O.T.C. 261 (SC), 20 March 2006] The judge's ruling made reference to both statutory or legal set-off, and equitable set-off, which apply under Canadian law.[ Withholding of progress payment by general contractor deemed unfair, Daily Commercial News, published 1 January 2006, accessed 14 November 2022]
English law
Under
English law, there are broadly five types of set-off which have been recognised:
[Roy Goode, Principles of Corporate Insolvency (Fourth Edition, Sweet & Maxwell 2013), 278][Joanna Benjamin, Financial Law (2007, Oxford University Press), p274]
-
Legal set-off or Independent set-off,
-
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, the claims will set off in equity,
[Sweigart, R. L. and Farmer, S. P., Equitable Set Off of Claims in England: When Separate Contracts May Be Close Enough, Pillsbury Advisory, published 3 August 2010, accessed 13 September 2022] Both sums must be due and payable, but may be for liquidated or unliquidated sums. Unlike Independent set-off, this is not self-executing. Rawson v Samuel (1848) was an established leading case which held that equitable set-off was available as a defence when "the title of the Plaintiff to his demand is impeached", for example when a contractual claim for payment is made but the debtor makes a claim for unliquidated damages.[1848 CR and TH 161, 41][Glover, J., Cross-contract set-off, Fenwick Elliott: Annual Review 2011/12, accessed 14 November 2022] The 2010 Court of Appeal case involving Geldof Mettalconstructie NV and Simon Carves looked at claims by two companies in relation to two contracts between them, one to supply goods, and the other to install them, which had been separately awarded. The court found sufficient connection between the two contracts to allow the claim under the installation contract to be set off against the claim under the supply contract.
-
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-insolvency credit risk and reduce the need for collateral.
-
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.
[ National Westminster Bank Ltd v Halesowen Presswork & Assemblies Ltd 1972 AC 785] 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,[ Miliangos v George Frank Ltd 1976 AC 443]
-
Insolvency set-off: perhaps the most expensive form of set off. Under section 323 of the Insolvency Act 1986
[Rule 4.90 of the Insolvency Rules 1986 for companies] 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.[Rules 14.25 and 14.25 of the Insolvency Rules 1986]
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.
European Union law
European Union law governs set-off through the Financial Collateral Directive 2002/47/EC.
[European Commission, Financial collateral - Directive 2002/47/EC, accessed 9 December 2020]
US law
The Statute of Limitations prevents court action to recover overpayment after 6 years, but legislation enacted in 1983 allows overpayments to be recovered by "administrative setoff" for up to ten years.
[U.S. Comptroller General, B-211213: The Department of Labor -- Request for Advance Decision, page 4, published 21 April 1983, accessed 1 September 2022]
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).
Acknowledgment
