Set-off is simply put a reduction or discharge of a debt by setting against it a claim in favour of the debtor (or the person otherwise having to pay).

The applicability of the principle of set-off under the Insolvency and Bankruptcy Code, 2016 (IB Code) is no longer res integra and the draconian view of the inapplicability of set-off under insolvency proceedings has not found Thankfully, judicial favour.

The National Company Law Tribunals (NCLT) have applied the principles of set-off under liquidation and have also applied this principle in case of pre-Corporate Insolvency Resolution Process (CIRP).

In Bharti Airtel Limited and Anr. v. Vijay Kumar Iyer and Ors., the Supreme Court of India while referring to the decision of High Court of Republic of Singapore (BP Singapore Pte Ltd v. Jurong Aromatics Corp Pte Ltd and Others), recognised that there can be five types of set-off:

Statutory or Legal set-off [codified under the existing statute];

Common Law set-off [Equitable set-off is allowed in common law, as distinguished from legal set-off, which is allowed by the court only for an ascertained sum of money and is a statutory right];

Equitable set-off [i.e., in respect of an unascertained sum of money payable as damages. Equitable set-off can also be claimed in respect of an ascertained sum of money];

Contractual set-off [i.e., is a matter of agreement, rather than a separate application of set-off]; and

Insolvency set-off [i.e., when there are mutual debts, mutual credits and other mutual dealings between the parties at the relevant cut-off time, which is essentially the stage of commencement of the liquidation process].

The Supreme Court of India noted that Insolvency set-off gives primacy and an overriding effect to the creditor who is entitled to set-off mutual credits. It also noted that when cross demands are set-off, the assets available for distribution amongst the general body of creditors, would be depleted in favour of a single creditor (with the set-off entitlement). The court also took into account Insolvency set-off as a proposition mitigates against common law the doctrine of pari passu and anti-deprivation. that aims at conservation of the insolvency estate for the benefit of the creditors.

The Supreme Court whilst considering the intricacies of set-off (and common law principes) held:

1. Pre CIRP –

Contractual set-off i.e., a result of mutual agreement that permits set-off and adjustment.

Equitable set-off, described as Transactional set-off by the Supreme Court i.e., claim and counter claim in the form of set-off that are linked and connected on account of one or more transactions, can be treated as one.

Contractual and Transactional set-off entered into by the parties prior to the initiation of CIRP does not breach the moratorium under the IB Code, as it does not amount to recovery of any property or enforcement of any security interest or legal proceeding against the corporate debtor (post commencement of CIRP). NCLAT has also allowed Set off/ adjustment/ Counterclaim be at the stage of CIRP admission under Section 9 of IB Code after noting that the set-off which has been used was with respect to business transactions between the appellant and respondent, which was more of adjustment of accounting entries. Instead of exchanging physical money, accounting adjustments were made. (Khushbu Dye Chem Pvt. Ltd. Vs. Chemical Suppliers India Pvt. Ltd.)

2. Post CIRP - In absence of any provision akin to Liquidation Regulations, the Supreme Court clarified that the application of set-off is limited to only one circumstance, i.e., during the admission of the claim by the Resolution Professional. The means that while the creditor cannot directly exercise set-off, the claims filed have to be after giving (notional) effect to set-off.

Set off as Preferential Transaction?

NCLT Mumbai has held that transaction of set off receivables from wholly owned subsidiary of stepdown subsidiaries of Corporate Debtor with payable to stepdown subsidiaries in the books of Corporate Debtor does not fall in section 43 of IBC as Preferential Transactions (Dr. Mamta Binani RP Vs. Rolta Middle East FZ LLC and Others)

Liquidation

Set off remains unaffected during liquidation. This principle continues to be codified from the old insolvency regime to the provision of winding up under the Companies Act upto the present IB Code. A conjoint reading of IB Code with the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016, provides the exclusion of the claim, subject to mutual set-offs from the liquidation estate of the creditor. And the devil can lie in the details or rather the process and this applies even as regards “crown debts”! Recently, the NCLAT held that NCLT was partially correct in allowing the principle of set-off in the liquidation proceedings but partially incorrect in allowing the suo-motu set-off without the claims having been filed by the Income Tax Department before the Liquidator in terms of the Liquidation Regulations (Avil Menezes (Liquidator) v. Principal Chief Commissioner of Income Tax, Mumbai). NCLAT has recently also held that a party who has made a categorical averment in its FORM B that “details of any mutual credits, mutual debts, or other mutual dealings between the Corporate Debtor and the Operational Creditor which may be set off against the claim – NIL” cannot be permitted to claim set off benefit under Liquidation Regulation 29 during liquidation process (Ritu Tandon Vs. M/s Rain Automotive India Pvt. Ltd.).

Why set-off?

Application of set-off was never alien to the insolvency regime in India. Yet, given the drafting lacunae in the IBC, doubts were expressed. The recent pronouncements by the Supreme Court of India coupled with by NCLAT have cleared the air. This includes pre-CIRP set-off, which was exercised with respect to the business transactions between Corporate Debtor and the operational creditor It was held that such set off was merely an adjustment of accounting entries, since instead of exchanging physical money, accounting adjustments were made.

Conclusion

We believe that there will still be many a challenges made to exercise of pre-CIRP set-off even though such challenges should not succeed. The incongruity of seeking to challenge pre-CIRP set-off on grounds of preferential treatment (of creditor exercising set-off) is still lost on many. Such (and many other challenges) can be avoided by appropriate statutory drafting.

Juris Corp - Smrithi Nair and Palak Nenwani