Bankruptcy Court Holds That Debtors May Use Their Setoff or Recoupment Rights (Whether Pre- or Post-Petition) to Reduce, At Their Election, A Creditor’s Secured, Administrative, or General Unsecured Claims

In re ADI Liquidation, Inc., (f/k/a AWI Delaware, Inc.), No. 14-12092 (KJC) (Bankr. D. Del. May 5, 2015)

In this Memorandum, Judge Carey answered an important legal question in the affirmative: whether a debtor can use its setoff or recoupment rights (whether pre- or post-petition) to reduce—at its election—the amount of a creditor’s allowed secured, administrative, or general unsecured claim.  In other words, a debtor may choose to apply a receivable against a creditor’s allowed administrative claim, which is entitled to full payment under a plan, and to preserve the creditor’s general unsecured claim, which may only receive partial payment under a plan.

At the outset, the Court held that section 558, which preserves a debtor’s personal defenses (including setoff), requires a transaction to be analyzed as if a bankruptcy proceeding has not been commenced.  Accordingly, unlike section 553, which restricts a creditor from exercising its prepetition setoff rights against post-petition debts and obligations, such a rule does not apply to debtors.  See also In re Prince Sports, Inc., 2013 WL 6906717, at *2 (Bankr. D. Del. Dec. 11, 2013).  Whether a debtor’s setoff or recoupment right arose pre- or post-petition makes no difference.  Moreover, despite arguments that Congress intended for administrative claims such as section 503(b)(9) claims to receive priority payment over general unsecured claims, the Court noted that this priority preference does not “provide a basis for stripping a debtor’s defenses in determining the allowed amount of [such claim].”  Op. at 9 (emphasis in original).  And finally, the Court agreed with the Bankruptcy Court for the Eastern District of Virginia, which has held that creditors are not harmed if a debtor elects to reduce administrative claims by its setoff rights (even if prepetition) rather than general unsecured claims.  In re Circuit City Stores, Inc., 2009 WL 4755253, at *2 (E.D. Va. Dec. 3, 2009).  In such a scenario, creditor claims against the estate are satisfied dollar-by-dollar by the extinguishment of debt otherwise owed to the estate.  While it seems unfair to allow a debtor to satisfy a claim otherwise required to be paid in full and leave a general unsecured claim to be partially paid, the result, as highlighted by the case law, allows a debtor to maximize its assets in a manner that could further distributions to all creditors.  A contrary ruling, other the other hand, would provide specific creditors with a windfall to the detriment of creditors as a whole.  Id. at *4.

The Bankruptcy Court’s ruling was supplemented by a companion Memorandum Order.  For substantially the reasons discussed above, the Court denied a creditor’s setoff motion, stating that “[a]t its core, the dispute between the parties is a race to determine which party can exercise its setoff rights first” and holding that there is no basis “to conclude that a claimant’s setoff rights should trump a debtor’s setoff rights.”  Mem. Order at 3.