Business Bankruptcy Issues

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Business Bankruptcy Issues

Objections To Bankruptcy Claims: Ignore Them At Your Peril

If you’re a creditor in a bankruptcy case and diligently file a proof of claim on time, often months or even years may go by before you hear anything further about your claim from the debtor, bankruptcy trustee, or any other party. In fact, the only thing you may hear about your claim for a long time is an offer to purchase it made by one or more claims buyers. 

No news is not always good news. Unfortunately, the passage of time may lead you to believe that no objection to your claim will ever be filed. However, the urgency of reorganizing a debtor’s business or liquidating its assets means that the claims objection process is typically left until near the end of the bankruptcy case, often after a plan of reorganization has been confirmed in a Chapter 11 case. As a result, an objection to your claim may be brought long after you filed it. When filed, the objection may assert that your claim amount doesn’t square with the debtor’s books and records or it may be based on any number of other grounds specific to the nature of your claim. 

Is that an objection to my claim? When an objection is filed, it may not always be obvious at first. While an objection may clearly identify that it is directed to your claim, in large cases the debtor or other estate representative has so many claims to address that the objection to your claim will most likely be combined with others. Instead of a pleading specifically mentioning your name in its title or text, the objection may have a name such as “Notice of Debtors’ Fourteenth Omnibus Objections To Claims (Substantive)” or some similarly titled document. 

  • Be careful: the format of these objections can be a trap for the unwary.  Buried within the objection’s many pages of text and attached exhibits may be a few lines, often in a list or chart, identifying that your claim is one of dozens to which an objection has been filed. 
  • Whatever the objection’s name or format, the point is the same: ignore it at your peril.  If you don’t respond to the objection timely your claim will likely be disallowed and you will recover absolutely nothing from the bankruptcy estate.

Diligence is critical. As in other legal contexts, protecting your rights in a bankruptcy case requires diligence. This can be a significant task. In major bankruptcy cases, literally thousands of pleadings can be filed during the course of a case. Many of these will be served on creditors and other parties, whether in paper or electronic form, yet only a few may be important to you or your claim. For this reason, it is critical that you or your attorney keep track of the pleadings filed in a bankruptcy case. As mentioned in an earlier post, there are often special websites designed to assist creditors in following large bankruptcy cases, in addition to the Court’s own electronic filing system. 

Protect your rights.  The bottom line is, if you see anything that looks like a claim objection, you should review all of the pages carefully, including its exhibits. If an objection to your claim is filed, a timely response will be required to protect your rights. Otherwise, you may find yourself with a disallowed and worthless claim.

Business Bankruptcy Issues

Trademark Licensor In Bankruptcy: Special Risk For Licensees

In an earlier post I discussed how a recent district court case gave trademark owners a leg up when a licensee files for bankruptcy. This begs the question: Does the advantage switch back to the licensee if the trademark owner files for bankruptcy? The answer generally, and perhaps surprisingly, is no. 

Limited protection of Section 365(n). Of course, it can be devastating for a licensee to lose access to licensed intellectual property. Often a licensee will build in licensed technology into its products or develop an entire business line or brand around a licensed trademark.  Recognizing how important in-licensed IP can be, in 1988 Congress added Section 365(n) of the Bankruptcy Code, giving licensees of certain types of intellectual property special protections in bankruptcy. These protections allow licensees to retain their rights to the licensed intellectual property – but there’s a catch. The Bankruptcy Code’s definition of “intellectual property” includes, among other things, patents, patent applications, copyrights, and trade secrets, but unfortunately for trademark licensees, it does not include trademarks.

Trademark licensee’s special risk. With no special protection, the trademark licensee faces the risk of having its license, a form of executory contract, rejected by the trademark owner in bankruptcy. If the trademark owner decides that the license is now unfavorable and a better deal can be had under a new license agreement with someone else, the trademark owner likely will reject the existing trademark license agreement and terminate the licensee’s rights to use the mark. The enforceability of phase-out provisions, which allow a licensee to continue to use a mark for a limited time period after a license is terminated, is unclear. Regardless, the trademark licensee eventually will lose its rights to the trademark following rejection. In some cases the ability to re-license can be of great value to a trademark owner in bankruptcy, and thus to its creditors, but it puts the licensee at substantial risk.

The bundled license. What about a license covering both trademarks and other intellectual property that is protected by Section 365(n)? Often a license of software or other products that involve copyrights or patents will include a license to use an associated trademark. In that case, even if the license were rejected, the licensee would have Section 365(n) rights to retain the "bankruptcy intellectual property" — in this example the rights to the copyrighted or patented IP — but would still lose the trademark license.  One case so holding is In re Centura Software Corp., 281 B.R. 660 (Bankr. N.D. Cal. 2002).  You can read that interesting decision here.

How can trademark licensees protect themselves? There are a few, albeit limited, strategies available for trademark licensees to protect themselves. Whether you are a trademark licensee or licensor, be sure to get advice from a bankruptcy attorney on your specific situation.

  • Unbundle the payments. In negotiating bundled licenses, the licensee should anticipate the prospect of losing rights to the trademark if a bankruptcy is filed. One approach would be to separate out any royalty or license payments for the trademark from those related to the other intellectual property being licensed. This way, the licensee can avoid having to pay amounts allocable to the rejected trademark license in order to retain its other IP license rights under Section 365(n). 
  • Take ownership of the mark. Would-be licensees with enough leverage sometimes demand that the trademark and its goodwill be transferred to them, coupled with a license back to the now-former trademark owner. This is perhaps the most effective method, but also the least likely to be achieved.
  • Get a security interest. Another strategy involves taking a security interest in the mark or the licensor’s other assets to secure the damage claim that the licensee would have if the trademark owner rejects the license. Licensees pressing for a security interest do so in part hoping that a debtor licensor faced with a secured claim for rejection damages may decide against rejecting the license in the first place.
  • Oppose a rejection motion. Once a bankruptcy is filed, a trademark licensee should engage counsel right away and consider challenging a debtor or trustee’s decision to reject the trademark license. If little good would come of the rejection for the debtor or its creditors, the licensee could oppose the motion arguing that the decision to reject is an inappropriate exercise of the debtor’s business judgment. Although such objections are rarely sustained, if successful this strategy could allow the licensee to continue to use the trademark without facing the consequences of a rejected license.

Short of these approaches, there is precious little trademark licensees can do to protect themselves from this bankruptcy risk. It is a fact that gives debtor licensors clear advantages and sometimes keeps trademark licensees up at night.

Business Bankruptcy Issues

Infringement Claims: Is Bankruptcy The End Of The Line?

Defending intellectual property ("IP") litigation can be expensive and, if unsuccessful, often crippling for the defendant’s business. Sometimes an accused infringer facing IP litigation will seek bankruptcy protection to invoke the automatic stay. Unless lifted by the bankruptcy court, the automatic stay will prevent further litigation against the debtor, outside of the bankruptcy claims process, for pre-bankruptcy claims. 

The collision between infringement litigation and bankruptcy, however, raises issues beyond the automatic stay, especially with respect to continuing and past infringement claims. This post addresses these questions in the context of both corporate and individual debtors.

Continuing Infringement

What if a corporate debtor continues to infringe?

If a corporation or other business debtor in Chapter 11 is continuing to infringe intellectual property rights, the IP owner may have what’s known as an "administrative claim" in the debtor’s bankruptcy case.  Administrative claims, as the name implies, are claims that result from the administration of the bankruptcy estate and include claims for payment for products and services delivered to a debtor post-petition and for fees and expenses of bankruptcy lawyers and other professionals advising the Chapter 11 debtor in possession and creditors committee. Administrative claims are paid ahead of all pre-petition unsecured claims and almost all other priority claims, and sometimes can have a major impact on a debtor’s ability to reorganize. 

A recent decision by the U.S. Court of Appeals for the Sixth Circuit in the Eagle-Picher Industries Chapter 11 case held that post-petition patent infringement claims qualify as administrative claims. In that case, although the debtor faced a $20 million administrative claim related to patent infringement litigation, the court held that the claim survived confirmation of the debtor’s bankruptcy plan.

A non-debtor IP owner may also be able to get relief from the automatic stay (see my earlier post on that topic) to pursue infringement claims, including to seek injunctive relief for continuing infringement, in a court other than the bankruptcy court. It is possible that the automatic stay will not even apply to post-petition acts of infringement, but IP owners and debtors should get advice from a bankruptcy attorney about their specific situation.

Are continuing infringement claims covered by an individual’s bankruptcy discharge?

Individual debtors will generally get a discharge of their pre-bankruptcy debts. A decision from the U.S. Court of Appeals for the Federal Circuit earlier this year, however, makes clear that an individual who files bankruptcy does not get a free pass to keep on infringing a patent. In Hazelquist v. Guchi Moochie Tackle Company, Inc., 437 F.3d 1178 (Fed. Cir. 2006), the court held that the debtor’s bankruptcy discharge was only retrospective, covering claims relating to acts prior to bankruptcy, and did not immunize the debtor from claims for continuing infringement. As a result, the court ruled that the patent holder could assert claims against the debtor outside of bankruptcy court for each act of post-petition infringement.  It’s an interesting decision and the full opinion is available here.  You might also enjoy reading the Patently-O blog’s post on the decision by Dennis Crouch, who seems to like the tackle company’s name as much as I do. 

Past Infringement

What about claims for past infringement? 

An IP owner can file a proof of claim for past infringement claims, but that claim will most likely be considered an unsecured claim and may end up being paid cents on the dollar. Filing a proof of claim is certainly the less costly way to go, and with a corporate debtor may be the principal remedy available for past infringement damages. 

If the infringer is an individual, however, another question is whether claims for past infringement can be declared nondischargeable, allowing the IP owner to pursue the debt notwithstanding the bankruptcy discharge. (As discussed in an earlier post, the notion of nondischargeable debts applies only to individuals and not to corporations or other entities.) Although seeking a nondischargeability determination often doesn’t make economic sense, owners of intellectual property sometimes believe that it’s important to protect those rights through vigorous pursuit of infringers, even against those who file bankruptcy. 

So is an infringement claim nondischargeable? A recent decision from the Bankruptcy Appellate Panel (known in the trade as "the BAP") of the U.S. Court of Appeals for the Ninth Circuit said yes, at least when the claim is for truly willful copyright infringement.  Why?  Well, under the Bankruptcy Code, a debt that results from a "willful and malicious injury" is nondischargeable. In In re: Albarran, decided on July 24, 2006, the BAP held that a judgment for willful copyright infringement, which included an award of statutory damages, interest, and attorney’s fees, involved "willful and malicious injury." The BAP’s decision is available here. 

In essence, the BAP held that willful copyright infringement, involving an intent to harm or knowledge that one’s actions were substantially certain to cause harm, (1) is an injury to the copyright holder and (2) statutory damages under the Copyright Act qualify as a debt arising from this injury even though the plaintiff may not have suffered identifiable economic damage.  Willful injury under the Bankruptcy Code requires that the debtor intend the consequences of his action, generally excluding negligent or reckless conduct.  In In re: Albarran, the BAP concluded that the particularly willful nature of the copyright infringement involved satisfied this requirement.  With willfulness determined, the court was able to imply the element of malice. 

Does the answer depend on the type of IP infringed?

The BAP’s decision involves copyrights and not patents or trademarks, so the question remains whether willful patent or trademark infringement would also be considered a nondischargeable "willful and malicious injury" under the Bankruptcy Code. The BAP’s decision did make several references to the kinship between copyright and patent law and noted that "patent infringement has historically been viewed as a tort because of its invasion of another’s rights."  In 2004, in a case called In re Trantham, a BAP from a different circuit, the Sixth Circuit, held that a claim for willful patent infringement was nondischargeable. You can read that decision here. Although the answer is not settled yet, if a debtor were found to have engaged in intentional patent or trademark infringement, the odds are that a bankruptcy court would find damages for such conduct to be nondischargeable.

Is a BAP the same as the U.S. Court of Appeals?  

Although these BAP decisions are very instructive, a word of caution is in order.  Unlike a U.S. Court of Appeals itself, a BAP is made up of bankruptcy judges only, not federal circuit judges. Given a BAP’s place in the judicial system’s hierarchy, its decisions are not given the same precedential weigh as U.S. Court of Appeals decisions.  This means that it’s possible for a U.S. Court of Appeals itself to reach a different conclusion. (In fact, an appeal to the Ninth Circuit from the BAP’s In re: Albarran decision was just filed last week.) Still, the two BAP decisions in In re: Albarran and In re Trantham are well-reasoned and may be followed by other courts. 

Impact Of Asset Sale

Can a debtor sell assets free and clear of infringement claims?

Generally, a debtor will be able to sell its assets in a Section 363 bankruptcy sale free and clear of claims (see earlier post on asset sales), including claims for past infringement.  However, if an IP owner asserts claims for continuing infringement related to the assets and how they are used, the sale will in all likelihood not be free and clear of those continuing infringement claims. Instead, the purchaser could well end up buying the defense of an infringement lawsuit along with the assets.

A Final Note

Do last year’s bankruptcy law changes have an impact?

Given the amendments to the Bankruptcy Code made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, even if an individual debtor got a discharge of a willful infringement claim, he or she would have a very hard time getting another discharge within the next eight years. The message to individual infringers in bankruptcy: discharge or not, better stop infringing.

Business Bankruptcy Issues Recent Developments

Trademark Licensees In Bankruptcy: A Leg Up For Trademark Owners?

Apparently, until last November, no court had been called upon to resolve whether a trademark licensee in bankruptcy can assume, or assume and assign, a non-exclusive trademark license without the trademark owner’s consent.  

The decision. We got the first answer to that question in a case called In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), when the U.S. District Court in Nevada held that trademark licenses are personal and nonassignable, absent a provision in the trademark license to the contrary. Click here for a copy of the N.C.P Marketing Group decision. In reaching its conclusion, the court held that under the Lanham Act, the federal trademark statute, a trademark owner has a right and duty to control the quality of goods sold under the mark:

Because the owner of the trademark has an interest in the party to whom the trademark is assigned so that it can maintain the good will, quality, and value of its products and thereby its trademark, trademark rights are personal to the assignee and not freely assignable to a third party.  

The U.S. Court of Appeals for the Ninth Circuit (which includes Nevada, California, and other western states) had previously interpreted the key Bankruptcy Code provision involved, Section 365(c)(1), to prevent a debtor from assuming an agreement when it does not have the right to assign it. (For a discussion about how bankruptcy can affect intellectual property licenses, including the impact of this earlier Ninth Circuit case, you may want to read my earlier post on the topic.) 

Building on this Ninth Circuit law, the trademark owner in the N.C.P. Marketing Group case argued that under trademark law the debtor could neither assume nor assign the non-exclusive trademark license at issue. The district court agreed, holding that the bankruptcy court correctly granted the trademark owner’s motion to compel the debtor to reject the trademark license, forcing the debtor to give up its license rights. 

Good news for trademark owners.  The decision is good news for trademark owners. Many have have long worried that if a licensee files bankruptcy it might be able to use the Bankruptcy Code’s general power to assume and assign executory contracts to assign trademark licenses to third parties over the trademark owner’s objection. The N.C.P. Marketing Group decision extends to trademark owners protections already recognized by many courts for patent and copyright holders. The case does not address whether the same rule would apply to exclusive trademark licenses, but given the trademark owner’s similar rights and duties to control the quality of goods sold under a licensed mark, the result could be the same. 

Bad news for debtor licensees. The decision, of course, is bad news for trademark licensees that file bankruptcy.  If the decision is followed by other courts, trademark licensees in bankruptcy will be unable to assign their rights to third parties or even to keep those rights for themselves without the trademark owner’s consent.  The value of these debtors, and their ability to repay creditors, could suffer as well.

On appeal. The district court’s decision may not be the last word. The debtor has appealed to the Ninth Circuit, although a ruling could be a number of months away.  I will report on the Ninth Circuit’s decision when it comes down.  In the meantime, this is only one district court decision, applying Ninth Circuit law, so its full impact has yet to be determined.

Just for kicks. Finally, for those interested, the trademarks involve the Billy Blanks® Tae Bo® fitness program.  At least until the Ninth Circuit rules on appeal, the district court’s decision will give trademark owners like Billy Blanks a "leg up" in their efforts to control their marks. 

Business Bankruptcy Issues

Selling A Bankruptcy Claim: Opportunity And Risk

At one time or another just about every creditor in a large corporate Chapter 11 bankruptcy case will receive an offer to purchase the creditor’s claim.  These offers typically come from professional claims traders, most of which are in the business of buying claims at a discount to what they believe will be the claims’ ultimate value.  Some claims buyers, including hedge funds and other distressed debt investors, may buy claims with the strategic objective of controlling the direction of the Chapter 11 case by owing a substantial percentage of one or more classes of creditors. 

How do claims buyers find out about your claim? Within the first few weeks after a bankruptcy is filed, the debtor must file schedules of its assets and liabilities.  Creditors holding secured claims are listed on Schedule D and those with unsecured claims are listed on Schedule F.  These schedules show the amount the debtor believes it owes each creditor and whether it thinks the claim is disputed, contingent, or unliquidated.  Claims buyers will often first contact creditors with claims listed as being undisputed, not contingent, and liquidated because those claims are less likely to be subject to litigation later in the bankruptcy case. 

If you express interest in selling your claim, you may be sent a "confirmation" document with key terms such the percentage on the dollar to be paid and the amount of the claim to be purchased.  The actual document that transfers the claim, however, is usually a separate "claim assignment agreement."  You should carefully review all of the documentation, including the claim assignment agreement, before committing to sell your claim.

Selling a claim can sometimes be beneficial, but there are also risks.  When evaluating whether to sell your claim, here are some of the key points to keep in mind:

  • Liquidity.  The main advantage of selling your claim is getting some cash for it now.  Although creditors often believe that selling their claim will also eliminate any further risk of loss, for the reasons discussed below claim assignment agreements usually keep you at risk even after you sell your claim.  If you’re willing to accept those risks, you can get immediate liquidity by selling your claim instead of having to wait months or years to receive whatever payment — which sometimes is in the form of stock or debt instead of cash — the bankruptcy estate ultimately distributes.
  • Price.  Given the claims buyer’s usual objective of buying at a discount, coupled with the time value of money, the price you are offered could end up being lower than the value you could recover if you held your claim and waited for distributions to be made later in the case. The price offered for claims can also rise or fall over time as more information about creditors’ likely recovery becomes available.  
  • Read the fine print.  Occasionally, claims buyers add detailed provisions and representations to the claim assignment agreement that operate to give the buyer an option to "put" or sell all, or the disputed part, of the claim back to you upon the mere filing of an objection or other challenge to the claim — even if the objection is ultimately defeated. Why? Well, if the price paid for your claim later turns out to have been too high, the claims buyer might use the filing of a claim challenge to get its money back, plus interest. Since commonplace events such as claim objections and preference actions may be classified as triggering "challenges," it’s important to watch out for these provisions.
  • Defending the claim.  Often the claims buyer will put a provision in the claim assignment agreement requiring you to defend the claim against any objection at your own expense, and to pay the claims buyer back for any portion of the claim that might be disallowed.  If a portion of your claim is disputed, however, you may well want the right to defend the claim so you can keep what you’ve been paid. Either way, you may incur costs in the bankruptcy case after you sell your claim.
  • Setoff or other special claims.  Claim assignment agreements may also include provisions limiting your right to assert a setoff or recoupment against the debtor (concepts discussed in an earlier post) or requiring you to pay back all or a portion of the purchase price if you do.  If you have significant setoff rights, be careful to preserve those rights if you sell your claim. Likewise, if you have an administrative claim or reclamation claim (which could be paid at 100 cents on the dollar), be sure it’s clear how those valuable rights will be treated.
  • Creditors’ committee.  If you’re serving on the official committee of unsecured creditors in a Chapter 11 case, you should get legal advice on whether, or under what conditions, you may sell your claim.  You likely will have received confidential information about the debtor while on the creditors’ committee, and this could restrict your ability to sell your claim.  Generally, you will also have to resign from the committee if you sell your claim.  
  • Court-ordered restrictions.  In some cases, bankruptcy courts may restrict creditors — especially those with very large claims — from selling their claims.  This is done to preserve the tax benefits of a debtor’s net operating losses or NOLs, which can be lost if ownership of a large amount of claims or equity interests changes.  As this example shows, these orders can be very complicated and you may want to consult with a bankruptcy attorney to determine whether any restrictions apply to you.

If you sell your claim, you will often be required to sign an additional document with a name such as "Evidence of Transfer of Claim," which does not mention the price paid and which will be filed with the bankruptcy court.  Thereafter, you may receive a notice from the bankruptcy court that the claims buyer has filed the Evidence of Transfer of Claim document and giving you 20 days to object to the transfer.  This notice is designed to prevent unscrupulous individuals from fraudulently assigning claims to themselves and is only a formality in a legitimate claims sale.

Claims buyers can provide creditors with a ready market for their claims, generating liquidity months or years before creditors otherwise would receive a distribution from the bankruptcy estate.  Selling a claim is not risk free, however, so be sure to consult with a bankruptcy attorney for specific advice on how best to protect your rights if you do choose to sell.

Business Bankruptcy Issues

Intellectual Property Licenses: What Happens In Bankruptcy?

The major role intellectual property, or "IP," plays in our economy makes intellectual property licenses an especially significant type of executory contract.  Whether you are a licensor or licensee, it’s important to know what can happen to IP licenses when a bankruptcy is filed.

Licensor in bankruptcy.  A licensor in bankruptcy (or its bankruptcy trustee) has the option of assuming or rejecting a license. Generally, a debtor licensor can assume a license if it meets the same tests (cures defaults and provides adequate assurance of future performance) required to assume other executory contracts.  Many licensees will not have a problem with assumption of their license as long as the debtor can actually continue to perform. Instead, the real concern for licensees is the fear of losing their rights to the licensed IP, which often can be mission critical technology, if the license is rejected.

  • Special protections. Recognizing this concern, the Bankruptcy Code, in Section 365(n), provides licensees with special protections.  If the debtor or trustee rejects a license, under Section 365(n) a licensee can elect to retain its rights to the licensed intellectual property, including even a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payments. The licensee also can retain rights under any agreement supplementary to the license, which includes source code or other forms of technology escrow agreements.  Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
  • Watch out for trademarks. While many people would expect intellectual property to include trademarks, the Bankruptcy Code has its own limited definition of "intellectual property." The bankruptcy definition includes trade secrets, patents and patent applications, copyrights, and mask works.  Importantly, however, it does not include trademarks. This distinction means that trademark licensees enjoy none of Section 365(n)’s special protections and those licensees are at risk of losing their trademark rights in a bankruptcy.

Licensee in bankruptcy.  The law is different when an IP licensee files bankruptcy.  The Bankruptcy Code, in Section 365(c)(1), contains an exception to the general rule that executory contracts can be assumed and assigned to third parties if defaults are cured and adequate assurance of future performance is demonstrated. The exception kicks in when "applicable law" precludes such an assignment absent consent of the nondebtor party. 

  • Restrictions on assignment. Case law from several United States Courts of Appeals holds that "applicable law" — here patent and copyright law (and perhaps trademark law) — in fact precludes an assignment of rights under an intellectual property license unless the IP owner has consented.  These courts have ruled that non-exclusive patent and copyright licenses are personal and nonassignable. As a result, a patent or copyright holder can prevent a debtor licensee from assuming and assigning a non-exclusive license to a third party without the licensor’s consent. 
  • License at risk. In the Ninth Circuit, which includes California, a licensor not only can stop a debtor from assigning the license to a third party, it can even prevent a debtor from keeping the license for itself.  Although the reason is technical, stemming from how the Ninth Circuit has interpreted Section 365(c)(1) of the Bankruptcy Code, the impact can be very real. For those interested, the landmark Ninth Circuit decision on this point is In re Catapult Entertainment, Inc.,165 F.3d 747 (9th Cir. 1999). 

Get advice. The interplay between bankruptcy and intellectual property law is complex.  Whether you are a licensor or licensee, you should get legal advice about your specific license agreement and the ways you may be able to protect your rights if a bankruptcy is filed.  Likewise, companies that anticipate having to file bankruptcy should pay careful attention to their IP licenses before they file.

Business Bankruptcy Issues The Financially Troubled Company

Setoffs And Bankruptcy

Many businesses not only sell products or services to another company, they also buy products and services from that company.  If you do business with a customer or vendor and you each end up owing the other money, you may have the right to "set off" the amount the other company owes you against the amount you owe it.  

Setoff. When a complete setoff is made, no cash changes hands but each side’s debt to the other is canceled. In some business relationships, including in the telecommunications industry, these kinds of cross-debts occur frequently and setoffs can be an important part of the payment structure. In others, setoffs only come up if one side fails to pay what it owes.  The term is also used to describe a bank’s right to sweep or set off the amounts owed on a loan against amounts the borrower has on deposit at the bank. 

Recoupment. A related concept called "recoupment" is similar to a setoff but it applies only when the offsetting amount or other defense to payment arises from the same contract or transaction that gives rise to your debt to the other company.

Impact of bankruptcy. The U.S. Bankruptcy Code does not create any setoff rights, but with certain limitations it does recognize the rights that exist under other applicable law.  However, with a bankruptcy filing comes a new risk that is similar to the preference risk that arises when you receive a direct payment before a bankruptcy.

  • If you made a setoff within 90 days before the bankruptcy filing, the debtor company (or its bankruptcy trustee, if one has been appointed) may have a right to sue you to recover the amount of that pre-bankruptcy setoff.  
  • Be sure to maintain detailed records of any setoffs made, along with the amounts each side owed the other during the business relationship. These records can be very helpful to your defense if such a claim is ever brought.

Setoff after bankruptcy. Making a setoff after a bankruptcy is filed — also known as a "post-petition" setoff — is allowed only in narrow circumstances.  Among other technical requirements, the debts have to be mutual between you and the actual debtor (not with one of its subsidiaries, for example) and they have to have arisen before the bankruptcy was filed.  Another very important point to remember is that you cannot make a setoff unless the bankruptcy court first grants you relief from the automatic stay that arises as soon as a company files for bankruptcy.

Get legal advice. This is a complex area of bankruptcy law and neither setoffs nor recoupments should be attempted after a bankruptcy has been filed without the advice of a bankruptcy attorney.  The old adage “Don’t try this at home” definitely applies.