Importance of Insolvency Set-off in the Times of COVID-19

Insolvency set-off comes into picture when both the debtor and the creditor have a cross-claim against one another and to avoid multiplicity of proceedings for recovery, the mutual debts are cancelled against each other to the extent of the smaller debt. A set off is generally not allowed in civil law countries as it is treated as violative of the universally accepted principles of pari passu, creditors’ expectation, and predictability.[1] They also treat it as being against the legitimate expectations of the parties and commercial certainty of transactions.^[2]

On the other hand, common law jurisdictions acknowledge set-off and in cases where mutuality of debt is present, it is treated as a mandatory process.^[3] A creditor with rights of set-off becomes a super priority creditor^[4] and may even form a separate class thereby carving out a valid exception to the principle of pari-passu. The object of the set-off is to do substantial justice between the parties^[5] and therefore, its operation is treated as automatic, mandatory, and self-executing[6] and due to such fundamental nature of set-off it must be protected.

Moreover, the UNCITRAL Model Law on Cross Border Insolvency’s Legislative Guide also provides for the right of set-off as an exception to the principle of pari-passu distribution.^[7] Under the EU Insolvency Regulations (Recast) as well, set-off becomes a guarantee governed by law applicable to the insolvent debtor’s claim. This exception under Article 9 acts as an exception to the general rule of pari-passu and was inserted with an intention to protect a creditor from lack of set-off rights.^[8] India also recognizes the principle of set-off, despite not having adopted the UNCITRAL Model Law.[9]

Due to the WHO declared global pandemic, many countries are suffering from financial strain and trying to amend their Insolvency laws to protect the financial system from economic drain. Banks, as well, are required by law to maintain minimum capital requirements with themselves for preventing any crash in the economy.^[10] To maintain a minimum capital requirement in such situation, it is necessary that countries should adopt the set-off provision to relieve the country from any economic loss.

For instance, A typical transaction is that of an interest rate swap agreement between the bank and the company (Corporate Debtor).[11] In such transactions, swap agreements can be a precondition to the term loan itself[12] and if the interest rate is moved in the favour of corporate debtor such that it is substantially “in the money”, for that sum of money, bank becomes the debtor of such company. Commercial Banks view their swap activity primarily as a part of their business in providing financial services to their customers and a part of their dealing activities.[13]. One of the advantages of swaps initially perceived by bank intermediaries was that banks could offer swap financing without regard to lending limits, reserves, capital adequacy or other regulatory restraints on risk. However, swaps do involve credit risk, which is one reason why commercial banks generally regarded as the most qualified to manage credit, are so prominent in the swap market.[14]

For illustration, A bank has given a term loan of $10 million to a Company. In addition, the bank required the company to enter into a swap debt agreement as a precondition to the term loan. Since the inception, the interest rates have moved in favour of the company. As a result of the company’s insolvency, the agreement got terminated. After the calculation of the sum due upon termination, it is found out that sum of $10 million is due to the Company.

In a typical resolution process, a bank with a swap agreement with its Corporate Debtor may or may not be able to recover the full amount owed to it, however it will have to contribute to the pool of assets under the debt that it owes to the corporate debtor under transactions such as the one mentioned above.

Disapplying set-off would jeopardize and severely hinder a bank’s ability to meet its minimum capital maintenance requirements if they will be required to pool in all the money that they owe to the debtor. If set-off is not allowed, banks would get only percentage of amount of their actual claim during the resolution process in return.[15] Banks are crucial in ensuring the sustainability of a countries’ economic growth and such a precarious transaction would put banks in a more vulnerable position as a result thereby affecting the whole economy.

The incorporation of set-off provision in insolvent situation is necessary as not having one will unduly hamper the resolution process of the distressed companies in the twilight zone. This is especially important now due to the Covid-19 Pandemic which has a ravaging effect not only on companies but also on economies at.

A provision for set-off would allow such companies and banks to cancel out the mutual debts and companies would no longer go through the whole insolvency resolution process for at least one or more of the creditors and will ease the process of settlement of claims. Banks, on the other hand, depending on the value of the debt will not be required to pay anything from their reserves but only have to set-off the claims. This would help bank in maintaining its reserves by receiving the amount lent to the Corporate Debtor.  Countries, therefore should adopt set-off as an exception to the insolvency resolution process to not only prevent any injustice but also for preventing any economic breakdown and a smoother resolution process.

There are a lot of measures[16] adopted by different countries in their domestic legislations to minimise the risks faced by the companies. However, it is inevitable for some companies to face insolvency due to their legal obligations that they are required to meet.

With the existence and continuance of this pandemic, it is the correct time for the Countries either to adopt set-off in their domestic legislations or to provide the provision for set-off in the commercial contracts and facility agreements itself. Irrespective of any financial emergency that may be declared or economic fallout as a result of the pandemic; set-off will continue to help the situation.

If set-off is allowed amidst the Covid-19, the developing and the under-developed countries facing the strained financial condition will benefit the most. In the prevalent lockdown situation and numerous guidelines for movement of persons and goods, the businesses are drying up reserves and will soon file for insolvency. This is going to adversely affect the lending institutions such as the banks because in most cases they will be the financial creditors and with loss of value of the businesses of the corporate debtors, the recovery will not be maximised and thus will severely hinder Bank’s capability to maintain any of the capital requirements or the Ratios as mandated by the RBI.

[1] Philip R Wood, Set-off and Netting, Derivatives, Clearing system (2nd edn, Sweet & Maxwell 2009) [2-052].

[2] Regulation (EU) 2015/848 on Insolvency Proceedings (Recast), Recitals 67 and 70.

[3] Ian F Fletcher, Insolvency in Private International Law (Oxford Private International Law Series, 2007), [7.97].

[4] Philip R Wood, Principle of International Insolvency vol 1 (2nd edn, Sweet and Maxwell 2009) [15-019].

[5] Forster v Wilson (1843) 12 M & W 191, 203.

[6] Stein v Blake [1996] AC 243, 245.

[7] United Nations, Legislative Guide on Insolvency Law (United Nations Office 2005) 86 [35].

[8] Miguel Virgos & Etienne Schmit, ‘Report on the Convention on Insolvency Proceedings’ (EU Council Doc 6500/96, 1996) [109].

[9] Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations 2016, Schedule; Bank of Maharashtra v Official Liquidator, Navjivan 1999 96 CompCas 234 Guj.

[10] Basel Committee on Banking Supervision, Basel III (Rev Ed 2011), [3]– [4]; Reserve Bank of India, ‘Guidelines on Implementation of Basel III Capital Regulations in India’ <https://rbidocs.rbi.org.in/rdocs/content/pdfs/FBSEIII020512_I.pdf&gt; accessed 12 May 2020; Alastair Holt, ‘Banking Regulation, 2020 United Kingdom’ (Global Legal Insights, 2020) <https://www.globallegalinsights.com/practice-areas/banking-and-finance-laws-and-regulations/united-kingdom#chaptercontent5&gt; accessed 12 May 2020.

[11] Schuyler K Henderson, ‘Swap Credit Risk: A Multi-Perspective Analysis’ (1989) 44 (2) The Business Lawyer 365.

[12] How interest rate swaps work (and why they’re worth it) (Commerce Bank, 24 May 2018) <https://www.commercebank.com/business/trenf44ds-and-insights/2018/interest-rate-swaps&gt; accessed 13 May 2020.

[13] Schuyler K Henderson, n (11).

[14] Study Group established by the Central Banks of the Group of Ten Countries, Recent Innovations in International Bank (1986)

[15]Bank of Maharashtra, n (10).

[16]‘Congress Passes Largest Ever Economic Stimulus Package: Key Provisions Of Cares Act’ (Shearman & Sterling, 27 March 2020) <https://www.shearman.com/perspectives/2020/03/congress-passes-largest-ever-economic-stimulus-package-key-provisions-of-cares-act-covid-19&gt; accessed 12 May 2020; ‘UK Suspends Wrongful Trading Rules for Company Directors Amid Coronavirus Disease 2019’ (Greenberg Traurug, 2 April 2020) <https://www.gtlaw.com/en/insights/2020/4/uk-suspends-wrongful-trading-rules-for-company-directors-amid-coronavirus-disease-2019>accessed 12 May 2020 ; ‘Singapore introduces COVID-19 (Temporary Measures) Act 2020’ (Norton Rose Fulbright, April 2020) <https://www.nortonrosefulbright.com/en/knowledge/publications/782929df/singapore-introduces-covid-19-temporary-measures-act-2020&gt; accessed 12 May 2020; Cyril Shroff & Dhananjay Kumar, ‘Indian Insolvency Law responds to the COVID-19 Pandemic’ (India Corporate Law, 25 March 2020) <https://corporate.cyrilamarchandblogs.com/2020/03/indian-insolvency-law-responds-to-the-covid-19-pandemic/&gt; accessed 12 May 2020.