Right of setoff definition
/What is the Right of Setoff?
The right of setoff is a legal right by a debtor to reduce the amount owed to a creditor by offsetting against it any amounts owed by the creditor to the debtor. For example, a bank can seize the amount in a customer’s bank account to offset the amount of an unpaid loan. It is a useful legal right when a borrower goes bankrupt, since the creditor will likely obtain more asset value by seizing assets than by gaining a lesser amount through the bankruptcy process. Therefore, set-off clauses are most frequently found in lending arrangements where the lender suspects that the borrower may not be able to continue as a going concern.
Another good use for the right of setoff is when a seller of goods is selling to a buyer that has questionable credit. In this case, the seller will want to retrieve its goods if the buyer is unable to make payment within the agreed-upon credit terms. It can do so by including a right of setoff clause in its sale agreement with the buyer.
In addition, this right allows businesses to avoid situations where the party owed more money is still obligated to pay an amount due to the other party.
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Examples of the Right of Setoff
Here are three examples of the right of setoff within a bankruptcy setting:
Bank offsets customer deposits against a loan. A business takes out a $500,000 loan from its bank but later files for bankruptcy while still having $100,000 in a checking account with the same bank. The bank exercises its right of setoff by applying the $100,000 balance toward the outstanding loan, reducing the remaining debt to $400,000. This allows the bank to recover part of its loan without waiting for the bankruptcy proceedings to distribute assets.
Supplier offsets outstanding payments against receivables. A manufacturing company files for bankruptcy while owing $200,000 to a supplier for raw materials. At the same time, the supplier owes the bankrupt company $50,000 for a prior business transaction. The supplier exercises the right of setoff and deducts the $50,000 from the amount owed, reducing the claim in the bankruptcy proceedings to $150,000.
Insurance company offsets claims against premiums owed. A construction company declares bankruptcy while having an active insurance policy but still owes $30,000 in unpaid premiums. The company previously filed a $20,000 claim with the insurer for property damage. The insurance company exercises its right of setoff by reducing the unpaid premium balance to $10,000, effectively settling part of the debt through the pending insurance payout.