In In re ADI Liquidation, No. 14-12092, 2015 Bankr. LEXIS 1611 (Bankr. D. Del. May 5, 2015), the debtors filed a joint motion with a creditors' committee to reduce the allowed amounts of claims under 11 U.S.C. Section 503(b)(9), by asserting defenses of setoff and recoupment. A number of holders of Section 503(b)(9) claims objected to the joint motion, arguing that, among other things, the debtors' right of setoff should be asserted against prepetition general unsecured claims prior to being asserted against administrative expense claims. U.S. Bankruptcy Judge Kevin J. Carey of the District of Delaware rejected the creditors' claims in an opinion that explores many of the parameters of setoff and recoupment in the Chapter 11 context.

As many creditors are disappointed to learn, the Bankruptcy Code does not create a level playing field. With regard to setoff, a debtor has broad rights under 11 U.S.C. Section 558, which preserves for the estate all defenses that a debtor may have to a claim. As Carey noted, "Because Section 558 preserves to the debtor the defenses it would have had prepetition, the court must examine the transaction as though the bankruptcy had not been filed," citing In re Papercraft, 127 B.R. 346, 350 (Bankr. W.D. Pa. 1991). As a corollary, "The prepetition/post-petition distinction is not relevant under Section 558," he said, citing In re PSA, 277 B.R. 51, 53 (Bankr. D. Del. 2002). By contrast, a creditor's setoff rights are preserved under 11 U.S.C. Section 553, which "restricts the exercise of a creditor's rights so that prepetition setoff rights can be applied only to prepetition debts and obligations." This disparate treatment of setoff rights serves the Bankruptcy Code's goal of maximizing estate assets for ultimate distribution to creditors. However, this fulfillment of legislative goals is undoubtedly of little comfort to creditors who find that the debtor's prepetition setoff rights may eliminate 100 percent dollars, while a creditor's prepetition setoff rights may only eliminate proportional dollars.

The Internal Revenue Service enjoys an exception to this rule. Some courts have permitted the IRS to set off tax refunds against general unsecured claims before applying setoff to priority claims. However, the Tax Code provides a basis for this treatment; see 26 U.S.C. Section 6402(a). In the ADI Liquidation case, the objecting creditors could identify no statutory basis that would permit them to avoid the restrictive application of setoff under Section 553 of the Bankruptcy Code.

The ADI Liquidation creditors argued that, because setoff claims are secured claims under 11 U.S.C. Section 506, the creditors were entitled to adequate protection of their secured claims to the extent that those claims were reduced by setoff. Carey rejected this argument, citing to the decision in In re Circuit City Stores, No. 08-35653, 2009 Bankr. LEXIS 4011 (Bankr. E.D. Va. Dec. 3, 2009). In that decision, the court held that the debtor's assertion of setoff against an administrative expense claim does not "erode the value" of that claim. Rather, "the claimant gets the benefits of the extinguishment of the debt it owes dollar for dollar." It would not be unreasonable for creditors to read the Circuit City decision and wonder whether the court was speaking "tongue in cheek," since the court almost seemed to imply that creditors should be grateful for a dollar-for-dollar reduction of their claims.

The ADI Liquidation creditors argued that their course of dealings with the debtors and/or their contracts with the debtors restricted the application of setoff or recoupment. Carey had already rejected that argument in In re Prince Sports, No. 12-11439, 2013 Bankr. LEXIS 5334 (Bankr. D. Del. Dec. 11, 2013), where he held that "setoff and recoupment are not dependent on the parties' contract; rather they are equitable remedies available independent of any contractual remedy." However, his opinion gives the ADI Liquidation creditors the opportunity to argue that course of dealing or contract provisions limit setoff, so long as there is a "good-faith basis" for doing so.

Finally, Carey rejected the argument that holders of claims under Section 503(b)(9) are entitled to interest on their claims, noting that there is no authority in the Bankruptcy Code or elsewhere to support such a claim.

In sum, the Bankruptcy Code creates an uneven playing field, which is tilted in the debtors' favor. A debtor may set off its prepetition claims against a creditor's administrative expense claims. Creditors, on the other hand, are bound by a doctrine of parallelism where only post-petition creditor claims may be set off against a debtor's post-petition claims against that creditor.

Michael R. Lastowski is a member of Duane Morris and the head of its Wilmington office. Licensed to practice in Delaware, Pennsylvania and New York, he primarily represents Chapter 11 debtors.

Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.