Set Off Rights: Recovering Goods or Proceeds from a Bankrupt Client

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When a client goes bankrupt, an unpaid supplier is often left with few remedies.  Generally speaking, the unpaid supplier’s recovery is limited to their proportional share of what is left of the proceeds from the bankrupt’s assets after the debts of secured creditors and trust claim have been satisfied. However, a few remedies are available to unpaid suppliers: the “thirty-day rule”, set off, express trusts and consignment.

When a party becomes bankrupt, any claims against it are stayed unless the court lifts the stay of proceedings. In circumstances where the bankrupt purchaser also has a claim against the unpaid supplier, this could lead to a situation where the purchaser, through a trustee or receiver, may enforce its own claim but the supplier is precluded from doing so.  Fortunately, the principle of set-off, governed by s. 97(3) of the Bankruptcy and Insolvency Act, may protect an unpaid supplier from the impact of this inequitable result.

Where a trustee makes a demand against an unpaid supplier for payment of a debt owed to the purchaser, the supplier may plead a defense of set-off to reduce the amounts it owes to the purchaser by the amounts the purchaser owes it for unpaid goods. The remaining reduced debt will be what the supplier owes to the trustee.

Set-off rights may be expressly provided for in a contract, but in any event, s. 97(3) of the Bankruptcy and Insolvency Act confirms that an unpaid supplier is entitled to set-off of claims made against it, provided it can satisfy the applicable test.

Legal set-off is available where an unpaid supplier can satisfy a court that the claims arise from debts owed between the parties, before the assignment into bankruptcy, and that they relate to mutual cross-obligations. Equitable set-off is available where a supplier is unable to meet the criteria for legal set-off, but there is a relationship between the parties such that it would be unjust or inequitable to deny the relief from set-off.

In the case of both legal and equitable set-off, courts will refuse the remedy where it would result in an unjust preference, such as in a case where the parties entered into an agreement when the purchaser was effectively insolvent. Debts that originated well in advance of bankruptcy and have arisen in the ordinary course of business between the parties are not likely to attract the suspicion of the courts.

Readers are reminded that bankruptcy courts are typically solutions-oriented and that the application of the above-criteria is dependent on the facts of each case.  It is recommended that readers consult an insolvency professional.