In bankruptcy cases, creditors have the powerful right of “setoff,” i.e., the right to “net” or cancel payments. The right to set off usually arises in cases of mutual debt obligations where a debtor owes a debt to a creditor who in turn owes a unilateral debt back to the same debtor. The rationale for the right to setoff it obvious, as it allows the parties to apply their mutual debt obligations against each other, “thereby avoiding the absurdity of making A pay B when B owes A.” In other words, the court will reduce the two competing judgments into a single judgment to arrive at a balance due or net figure. Additionally, the right to setoff preserves creditor value by insulating the creditor from being forced to pay its debtor while it waits to recover a pro rata share of the debtor’s debt via the debtor’s plan.
The Bankruptcy Code does not create an explicit right of setoff; rather, section 553 of the Bankruptcy Code preserves, with certain exceptions, whatever right of setoff that exists outside of bankruptcy. Generally, once a debtor files for bankruptcy, the creditor may only seek to setoff the debt after being granted relief from the automatic stay; any attempt to setoff without first obtaining relief from the automatic stay will be void. Once the bankruptcy court grants relief from the automatic stay, the creditor may assert its right to setoff, so long as section 553 of the Bankruptcy Code is satisfied.