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In law, a set-off is a statutory defense to the whole or to a portion of a plaintiff's claim. It had no existence under the English common law, being created by 2 Geo. II c. 22 for the relief of insolvent debtors, although set-off was recognized in equity. Such a defense could be pleaded only in respect of mutual debts of a definite character, and did not apply to cases in which damages were claimed, nor to equitable claims or demands. By the rules of the Supreme Court (O. XIX. r. 3) a defendant in an action may set off or set up any right or claim by way of counterclaim against the claims of a plaintiff, and such set-off or counterclaim has the same effect as a statement of claim in a cross-action.
- The legal defense of set-off (above) was originally introduced to prevent the unfair situation whereby a person ("Party A") who owed money to another ("Party B") could be sent to debtors prison, despite the fact that Party B also owed money to Party A. The law thus allows both parties to defer payment until their respective claims have been heard in court. Upon judgment, both claims are extinguished and replaced by a single net sum owing (e.g. If Party A owes Party B 100 and Party B owes Party A 105, the two sums are set off and replaced with a single obligation of 5 from Party B to Party A).
- Set-off can also be incorporated by contractual agreement so that, where a party defaults, the mutual amounts owing are automatically set off and extinguished.
- In certain jurisdictions (including the UK), set-off takes place automatically upon the insolvency of a company. This means that, for each party which is both a creditor and debtor of the insolvent company, mutual debts are set-off against each other, and then either the bankrupt's creditor can claim the balance in the bankruptcy or the trustee in bankruptcy can ask for the balance remaining to be paid, depending on which side owed the most. This has been criticized as an undeclared security interest that violates the principle of pari passu. The alternative, where a creditor has to pay all its debts, but receive only a limited portion of the leftover moneys that other unsecured creditors get, poses the danger of 'knock-on' insolvencies.
The right to set off is particularly important when reporting a bank's exposures to regulatory authorities. The situation where a bank has to report that it has lent a large sum to a borrower (and is therefore exposed, because there is a risk that the borrower might default thereby leading to the loss of the bank's or its depositors' money) is thus replaced (where the bank has taken security over shares or securities of the borrower) with an exposure of the money lent minus the value of the security taken.
US law set-off
See De Magno v. United States, 636 F.2d 714, 727 (D.C. Cir. 1980) (district court had jurisdiction over claim involving VA’s “affirmative action against an individual whether by bringing an action to recover on an asserted claim or by proceeding on its common-law right of set-off”) (discussing similar language of predecessor statute, 38 U.S.C. § 211)
See, e.g., United States v. Munsey Trust Co., 332 U.S. 234, 239, 67 S.Ct. 1599, 1601, 91 L.Ed. 2022 (1947) ("government has the same right 'which belongs to every creditor, to apply the unappropriated moneys of his debtor, in his hands, in extinguishment of the debts due to him' " (quoting Gratiot v. United States, 40 U.S. (15 Pet.) 336, 370, 10 L.Ed. 759 (1841))); see also Tatelbaum v. United States, 10 Cl.Ct. 207, 210 (1986) (set-off right is inherent in the United States government and grounded on common law right of every creditor to set off debts)
United States Court of Appeals for the Federal Circuit
H. T. Johnson, ACTING SECRETARY OF THE NAVY,
ALL-STATE CONSTRUCTION, INC.,
The Secretary of the Navy ("the Navy") appeals the decision of the Armed Services Board of Contract Appeals ("Board") in favor of All-State Construction ("All-State" or "the contractor"). All-State Constr., Inc., ASBCA No. 50,586, 02-1 B.C.A. (CCH) 31,794, at 157,019-21 (Feb. 21, 2002). This case presents the question of whether the Navy was entitled to withhold progress payments from All-State. The Navy offers two justifications for the withholding: (1) that the government is entitled to withhold progress payments when a default termination is imminent; and (2) that the government is entitled to withhold progress payments pursuant to its common-law right of set-off and also pursuant to section 1.12.2.b. of the contract. We disagree with the Navy's first theory, but agree with the second. Accordingly, we reverse the Board's decision and remand.