New York Bankruptcy Court: "Defensive" Setoff Rights of Creditor that Did Not File Proof of Claim Cannot Be Extinguished Under Chapter 11 Plan

The ability of a creditor to offset any liability it may have to a debtor against the amount of the debtor's obligation to the creditor is an important right. The Bankruptcy Code expressly preserves that right, provided it exists by contract or under applicable non-bankruptcy law, and the debts are "mutual," arose pre-bankruptcy and do not fall into one of the specified exceptions or limitations. In In re SVB Fin. Grp., 662 B.R. 53 (Bankr. S.D.N.Y. 2024), notice of appeal filed, No. 23-10367(MG) (Bankr. S.D.N.Y. Aug. 9, 2024) [Doc. 1389], direct appeal certified, 2024 WL 4345730 (S.D.N.Y. Sep. 30, 2024), the U.S. Bankruptcy Court for the Southern District of New York considered an objection to confirmation of a chapter 11 plan that purported to extinguish the setoff rights of any creditor that did not timely file a proof a claim in the bankruptcy case and obtain a final order of the bankruptcy court authorizing the setoff. The court sustained the objection, ruling that a creditor need not file a proof of claim to preserve "defensive setoff rights," and that those rights could not be discharged upon confirmation of a chapter 11 plan.

Setoff in Bankruptcy

Section 553 of the Bankruptcy Code provides that, with certain exceptions, the Bankruptcy Code "does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case." Section 553 does not create setoff rights—it merely preserves certain setoff rights that otherwise would exist under contract or applicable non-bankruptcy law. See Collier on Bankruptcy ("Collier") ¶ 553.04 (16th ed. 2024) (citing Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995)); Feltman v. Noor Staffing Grp., LLC (In re Corp. Res. Servs. Inc.), 564 B.R. 196 (Bankr. S.D.N.Y. 2017) (section 553 does not create an independent federal right of setoff, but merely preserves any such right that exists under applicable non-bankruptcy law). As noted by the U.S. Supreme Court in Studley v. Boylston Nat. Bank, 229 U.S. 523 (1913), setoff avoids the "absurdity of making A pay B when B owes A." Id. at 528; see also In re Lehman Brothers Holdings Inc., 404 B.R. 752, 756 (Bankr. S.D.N.Y. 2009) (discussing the historical underpinnings of the setoff doctrine).

The Bankruptcy Code defines a "claim," in relevant part, as a "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured," and it defines a "debt" as a "liability on a claim." 11 U.S.C. § 101 (5)(A), (12). 

With certain exceptions for setoffs under "safe-harbored" financial contracts, a creditor is precluded by the automatic stay from exercising setoff rights against a debtor in bankruptcy without court approval. See 11 U.S.C. §§ 362(a)(7), (b)(6), (b)(7), (b)(17), (b)(27), and (o). Stayed setoff rights are merely suspended, however, pending an orderly examination of the parties' obligations by the court, which will generally permit a valid setoff unless it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008).

A creditor stayed from exercising a valid setoff right must be granted "adequate protection" (see 11 U.S.C. § 361) against any diminution in the value of its interest caused by the debtor's use of the creditor's property. Ealy, 392 B.R. at 414. 

Setoff is expressly prohibited by section 553 if: (i) the creditor's claim against the debtor is disallowed; (ii) the creditor acquires its claim from an entity other than the debtor either (a) after the bankruptcy filing date or (b) after 90 days before the petition date while the debtor was insolvent (with certain exceptions); or (iii) the debt owed to the debtor was incurred by the creditor (a) after 90 days before the petition date, (b) while the debtor was insolvent, and (c) for the purpose of asserting a right of setoff, except for setoff under "safe-harbored" financial contracts. See 11 U.S.C. § 553(a)(1)–(3).

Section 553(b) provides that, except for setoffs under safe-harbored financial contracts, the trustee or a chapter 11 debtor-in-possession may recover any amount offset by a non-debtor on or within 90 days before the bankruptcy petition date to the extent the non-debtor improved its position by reducing any "insufficiency." 

Thus, for a creditor to be able to exercise a setoff right in bankruptcy, section 553 requires on its face that: (i) the creditor have a right of setoff under applicable non-bankruptcy law; (ii) the debt and the claim are "mutual"; (iii) both the debt and the claim arose prepetition; and (iv) the setoff does not fall within one of the three prohibited categories specified in the provision.

The Bankruptcy Code does not define the term "mutual debt." Debts are generally considered mutual when they are due to and from the same persons or entities in the same capacity, but there is some confusion among the courts on this point. See In re Am. Home Mortg. Holdings, Inc., 501 B.R. 44, 56 (Bankr. D. Del. 2013); see generally Collier at ¶ 553.03[3][a] (citing cases). 

Creditors typically rely on the remedy of setoff if the mutual debts arise from separate transactions, although the issue is murky. See Collier at ¶ 553.10. By contrast, if mutual debts arise from the same transaction, the creditor may have a right of "recoupment," which has been defined as "a deduction from a money claim through a process whereby cross demands arising out of the same transaction are allowed to compensate one another and the balance only to be recovered." Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 146 (2d Cir. 2002); accord Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1399 (9th Cir. 1996); In re Matamoros, 605 B.R. 600, 610 (Bankr. S.D.N.Y. 2019) ("recoupment is in the nature of a defense and arises only out of cross demands that stem from the same transaction").

Unlike setoff, recoupment is not subject to the automatic stay (see In re Ditech Holding Corp., 606 B.R. 544, 600 (Bankr. S.D.N.Y. 2019)), and may involve both pre- and postpetition obligations. See Sims v. U.S. Dep't of Health and Human Services (In re TLC Hosps., Inc.), 224 F.3d 1008, 1011 (9th Cir. 2000) (citing Collier at ¶ 553.10).

Even though section 553 expressly refers to prepetition mutual debts and claims, many courts have held that mutual postpetition obligations may also be offset. See Zions First Nat'l Bank, N.A. v. Christiansen Bros., Inc. (In re Davidson Lumber Sales, Inc.), 66 F.3d 1560 (10th Cir. 1995); Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016).

However, setoff is available in bankruptcy only "when the opposing obligations arise on the same side of the … bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015); accord Pereira v. Urthbox Inc. (In re Try the World, Inc.), 2023 WL 5537564, at *13 (Bankr. S.D.N.Y. Aug. 28, 2023) (noting that "claims are not in the same right and between the same parties, standing in the same capacity" where the claims underlying an alleged setoff right accrued prepetition and the "liability for the fraudulent-transfer claim is held by the Trustee as a postpetition obligation") (internal quotation marks and citations omitted); In re Williams, 2018 WL 3559098, at *3 (Bankr. D.N.M. July 23, 2018) (section 553 does not permit a creditor to collect a prepetition debt by withholding payment of a postpetition debt owed to the debtor); In re Enright, 2015 WL 4875483, at *3 (Bankr. D.N.J. Aug. 13, 2015) (same); Kramer v. Sooklall (In re Singh), 434 B.R. 298, 308 (Bankr. E.D.N.Y. 2010) ("It is well established that a party will be unable to assert a setoff where the party is being sued for fraudulent transfers … because … there is no mutuality of obligations …"); In re Passafiume, 242 B.R. 630, 633 (Bankr. W.D. Ky. 1999) ("Claims which arise post-petition lack the requisite mutuality, even if they arise with regard to work performed pre-petition.").

SVB Financial

Prior to March 10, 2023, SVB Financial Group (the "debtor") owned and operated Silicon Valley Bank ("SVB"), a California-chartered bank. On March 10, 2023, the California Department of Financial Protection and Innovation closed SVB and appointed the Federal Deposit Insurance Corporation ("FDIC") as receiver. Two days later, the U.S. Department of the Treasury declared a "systemic risk exception" for SVB. At that time, the debtor had deposit accounts in Silicon Valley Bridge Bank ("Bridge Bank") with a combined balance of approximately $2.1 billion. The debtor withdrew funds from those accounts from March 13 to March 16, 2023.

On or about March 15, 2023, the FDIC, which was also acting as receiver for Bridge Bank, purported to recall the account liability from Bridge Bank to prevent the debtor from withdrawing additional funds from its accounts. It also sought reversal of the previous withdrawals by the debtor. 

On March 17, 2023, the debtor filed for chapter 11 protection in the Southern District of New York. The following month, the bankruptcy court set September 14, 2023, as the bar date for the filing of proofs of claim against the debtor by governmental entities. Although aware of the bar date, the FDIC decided not to file a proof of claim based on its view that it could assert a "defensive setoff right" for the amount of its claim without filing a proof of claim. 

In July 2023, the debtor commenced an adversary proceeding against the FDIC in the bankruptcy court seeking turnover under section 542 of the Bankruptcy Code of approximately $1.9 billion the debtor claimed was in the Bridge Bank deposit account as of the bankruptcy petition date. It also sought relief under the Declaratory Judgment Act, 28 U.S.C. § 2201 et seq., and asked the court to determine whether the FDIC could properly set off its claim against the debtor's claim for turnover of the funds. On December 13, 2023, a New York district court withdrew the reference of the adversary proceeding in December 2023, where it remained pending (the "SDNY Action"). 

In accordance with the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, the FDIC established July 10, 2023, as the claims bar date in the SVB receivership. The debtor timely filed three claims, consisting of: (i) a $1.93 billion claim based on its Bridge Bank deposit; (ii) a second claim in an unspecified amount on behalf of certain deferred compensation plan participants; and (iii) a contingent and unliquidated damages claim for the FDIC's alleged misconduct in selling SVB's assets at a discount. The FDIC denied all three claims. In its notice of disallowance, the FDIC stated that the deposit claim was not proven to its satisfaction due to the existence of the FDIC's defenses, and it was not a liability of Bridge Bank. The remaining claims it denied as being speculative, lacking support, or otherwise unproven. The notice did not identify the FDIC's defenses (including any right of setoff). 

In March 2024, the debtor sued the FDIC in a California district court (the "ND Cal. Action") asserting the same causes of action alleged in the SDNY Action. 

The debtor proposed an eighth iteration of its chapter 11 plan in July 2024. Among other things, the plan provided as follows: 

In no event will any Person or Entity be entitled to set off any Claim or Interest against any Claim or Interest, right, or Cause of Action and Defense of the Debtor … in any judicial or administrative proceeding, unless such Person or Entity has filed a Proof of Claim in this Chapter 11 Case preserving such setoff and a Final Order of the Bankruptcy Court has been entered, authorizing and approving such setoff. 

The FDIC objected to the plan, arguing that the provision would eliminate its defensive setoff rights, which were being adjudicated in the SDNY Action and the ND Cal. Action, where the courts had exclusive jurisdiction to determine those rights. The FDIC further claimed that it had consistently provided notice of and asserted its defensive setoff rights throughout the course of the chapter 11 case (including in the SDNY Action), and was not required to file a proof of claim to preserve those rights. 

The debtor countered, among other things, that: (i) the FDIC lacked standing to assert its objection; (ii) section 553 of the Bankruptcy Code did not preserve the FDIC's purported setoff rights; and (iii) the FDIC forfeited any setoff rights by failing to file a proof of claim or to seek relief from the automatic stay to assert those rights. The official unsecured creditors' committee largely echoed the debtor's arguments, adding, among other things, that the FDIC's claims were not "defensive setoff claims," but instead, "quintessential" claims against the debtor's estate. 

The Bankruptcy Court's Ruling 

The bankruptcy court sustained the FDIC's objection to the debtor's chapter 11 plan. 

Initially, Chief U.S. Bankruptcy Judge Martin Glenn concluded that the FDIC had prudential, constitutional, and "party-in-interest" standing to object to the debtor's plan because, among other things, the plan's discharge of the FDIC's defensive setoff rights impacted the FDIC's pecuniary interest, as it foreclosed one possible way to reduce its potential liability to the debtor in the SDNY Action and the ND Cal. Action. He also held that a creditor need not file a proof of claim to obtain standing in a bankruptcy case. See SVB Financial, 662 B.R. at 72 (citing In re MF Global Holdings Ltd., 469 B.R. 177, 188 (Bankr. S.D.N.Y. 2012)). 

Next, the bankruptcy court determined that the FDIC held defensive setoff rights and that those rights were preserved by section 553 of the Bankruptcy Code. In so ruling, the court rejected the committee's argument that the FDIC's defensive setoff rights were merely claims that could be discharged under the debtor's chapter 11 plan. Judge Glenn agreed with other courts that have concluded that a defensive setoff is substantively different from a "claim," as defined in section 101(5) of the Bankruptcy Code generally as a "right to payment" or a "right to an equitable remedy for breach of performance," because the assertion of a defensive setoff does not involve any "affirmative recovery" from the estate that could be characterized as a "claim." Id. at 67 (discussing Turner v. U.S. (In re G.S. Omni Corp.), 835 F.2d 1317, 1319 (19th Cir. 1987); Styler v. Jean Bob Inc. (In re Concept Clubs, Inc.), 154 B.R. 581 (D. Utah 1993)). He acknowledged that some courts have disagreed with this approach but concluded that "there is a material difference between a defensive claims for setoff and a claim that seeks similar relief on an affirmative basis against a debtor or its estate." Id.  

The bankruptcy court also rejected the argument that the FDIC's defensive setoff was precluded by section 553 of the Bankruptcy Code, finding that: (i) section 553(a) preserved the FDIC's setoff rights under applicable non-bankruptcy law—here, 12 U.S.C. § 1822(d), which provides in substance that the FDIC may withhold payments to any depositor in a defaulted bank as required to pay any liability of a depositor to the defaulting bank or its receiver; (ii) the debtor owed a debt to the FDIC in its capacity as receiver for, and successor in interest to, SVB and that debt arose prepetition when the debtor commenced the N.D. Cal. Action, even though the FDIC had not yet formally asserted its setoff rights in that litigation, so that the rights were contingent and unliquidated; (iii) the debtor's claims against the FDIC also arose prepetition when the FDIC, as receiver, transferred all of SVB's assets to Bridge Bank, after which they were purportedly transferred back to the FDIC; and (iv) the required mutuality existed between the debtor and the FDIC and was not defeated by the debtor's unsupported argument that section 553(a)(3) barred the FDIC's setoff rights because the FDIC incurred deposit liability to the debtor two days before its bankruptcy filing for the purpose of obtaining setoff rights. 

The bankruptcy court ruled that that the FDIC was not required to file a proof of claim to preserve its defensive setoff rights, noting that "case law in this district expressly state that a defensive right to setoff can be preserved in the absence of a proof of claim." Id. at 71 (citing cases). According to Judge Glenn, cases in which the courts have required the party seeking to assert a setoff to file a timely proof of claim or otherwise take affirmative action to preserve its setoff rights are either unpersuasive or distinguishable. 

Finally, the bankruptcy court held that the FDIC's setoff rights could not be discharged under the debtor's chapter 11 plan pursuant to section 1141 of the Bankruptcy Code, which, with certain exceptions, "discharges the debtor from any debt that arose before the date of … [plan] confirmation." According to Judge Glenn, those rights were expressly preserved in section 553(a), and the FDIC, in exercising defensive setoff rights, was not required to file a proof of claim because it was not attempting to assert a claim against the estate, but to reduce any liability it might have to the debtor in the SDNY Action and the ND Cal. Action.

Outlook 

SVB Financial is not groundbreaking, but it represents a significant ruling for creditors with setoff rights, especially creditors who choose for strategic purposes not to participate in a bankruptcy case (e.g., by filing a proof of claim) but want to preserve their right to reduce or eliminate any liability to a debtor by setting off that debt against the amount owed by the debtor. 

Key takeaways from the decision include: 

• If a creditor with setoff rights seeks no affirmative recovery from the bankruptcy estate, but merely wants to preserve its ability to exercise a "defensive" setoff, the creditor need not file a proof of claim or otherwise participate in the bankruptcy case;
• Section 553 of the Bankruptcy Code does not create a right of setoff, but merely preserves any such rights that exist under contract or applicable non-bankruptcy law;
• A defensive setoff right is not a "claim" under the Bankruptcy Code; and
• Defensive setoff rights preserved under section 553 cannot be extinguished under a chapter 11 plan.

As noted previously, not all courts agree with the approach adopted by the bankruptcy court in SVB Financial, so it is important to be aware of the approach to this question applied in any particular district. 

The debtor and the official creditors' committee filed a notice of appeal of the bankruptcy court's ruling on August 9, 2024. On September 30, 2024, the U.S. District Court for the Southern District of New York granted the debtor's motion to certify a direct appeal of the ruling to the U.S. Court of Appeals for the Second Circuit, finding that "a decision on appeal calls for the resolution of a question of law that the Second Circuit has yet to settle." In re SVB Financial Group, 2024 WL 4345730, at *2 (S.D.N.Y. Sept. 30, 2024).