Set-off (law)

In law, set-off or netting are legal techniques applied between persons or businesses with mutual rights and liabilities, replacing gross positions with net positions. 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 produce a single net claim. 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.
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 exposure, and also offers regulatory capital requirement and settlement advantages, which contribute to market stability.
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. This is to be differentiated from hedging which uses offsetting positions with multiple parties to mitigate risk.
Mutuality.
The law does not permit counter-parties to use third party debt to set off against an un-related liability. 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.
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, 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. 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. 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"). There are international jurisdictions where the enforceability of netting in bankruptcy has not been legally tested.
The key elements of close out netting are:
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. 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. 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" has been resolved largely through trade association lobbying for law reform. 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.
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. 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. 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.
Set off.
Set off 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, 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 as an undeclared security interest which violates the principle of pari passu. The alternative, where a creditor has to pay all its debts, but receivse 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. 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. 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.
Set-off by jurisdiction.
Canadian law.
For Canadian case-law in relation to set-off in construction contracts, see
English law.
Under English law, there are broadly five types of set-off which have been recognised:
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.
US law.
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).