This practice note discusses the use of setoff by creditors as a mechanism to limit loss when a debtor has filed bankruptcy. In bankruptcy, setoff is governed by and subject to the limitations imposed by Section 553 of the Bankruptcy Code.

Section 553 of the Bankruptcy Code recognizes a creditor’s right to offset a pre-petition obligation it owes to the debtor against a pre-petition obligation the debtor owes to it. This setoff right, which permits the parties to cancel mutual debts, effectively shields a creditor from being obligated to pay its debt in full to a debtor and then needing to stand in line to collect only a pro-rata share of the debt owed by the debtor to that creditor. Thus, a creditor with a right to setoff receives priority over other creditors (after obtaining relief from the stay to exercise the setoff right).

Originally published on October 12, 2022, as a LexisNexis Practical Guidance® Practice Note.