Set-Off
1. Function of set-off
All European legal systems provide that, under certain circumstances, the obligations of two debtors, each of whom is the creditor of the other, are extinguished or can be extinguished by set-off. The obligations are effectively discharged by mutual performance, albeit ‘in a simpler and more efficient manner’ (Franz Philipp von Kübel). From the standpoint of those whose focus is on procedural rather than substantive law, the purpose is to avoid ‘circuity of action and multiplicity of suits’ (Hutchinson v Sturges [1741] 125 ER 1163). Set-off (Aufrechnung, verrekening, kvitting; many legal systems—mainly the Romanistic ones, but also Scotland and Austria—use a derivative of the Latin term compensatio) therefore depends, on the one hand, on practical considerations. On the other, it has always had a specific affinity with the requirements of good faith and accordingly to widely accepted requirements of fairness and natural justice: whoever demands a sum from another, to whom he is himself liable, or sues another on the basis of such a demand, acts contrary to good faith and fair dealing. Set-off is functionally both a payment and a type of self-help execution.
2. Problems to be regulated and the development of set-off
First, the prerequisites of set-off require regulation. For the most part, they are dictated by the nature of the institution and are therefore assessed in a comparatively uniform manner in all modern legal systems (including English law). Secondly, the manner in which set-off operates must be dealt with. On this second point, even the continental European legal systems differ not insubstantially from one another, despite their common Roman law heritage. Thirdly, it is recognized everywhere that set-off should be excluded in certain exceptional situations, even if the grounds of exclusion are not everywhere identical. Finally, there are two preliminary questions that have shaped the historical development of set-off: (a) Does set-off form a single legal institution or do different types of set-off exist alongside one another? (b) Is set-off procedural in nature or are we dealing here with an institution of substantive law? The two questions are closely connected to one another. Classical Roman law was a law of actions, and the procedural formulae were therefore of decisive importance. From these it is clear that the Romans knew four different types of set-off. With the disappearance of classical formulary procedure the set-off regime came to be unified; that process brought with it a shift from a procedural understanding to a substantive one. This approach still characterizes continental European legal systems today: set-off is a unitary legal institution, which, in systematic terms, belongs to the general part of the law of obligations. It also shapes the European and international model rules in ch 13 of the Principles of European Contract Law (PECL), book 3, ch 6 DCFR (Draft Common Frame of Reference) and ch 8 of the UNIDROIT Principles of International Commercial Contracts (PICC) (the latter of which, however, is limited to contract law). But these model rules also, in a way, reflect a development that can be observed in England. The importance of the conventional distinction between statutory (or independent) set-off and equitable (or transaction) set-off—both of which were at least originally institutions of procedural law—has been considerably qualified. Today set-off is in the process of casting off its procedural shell and becoming an institution with substantive effect, which depends on the same considerations as set-off in continental Europe.
3. Mode of operation
According to Art 1290 Code civil, set-off operates ‘de plein droit par la seule force de la loi, meme à l’insu des débiteurs’. French law thereby takes its lead from two texts within the Corpus Juris Civilis, according to which set-off occurs ipso iure (Inst. IV,6,30; C. 4,31,14 pr.). Similar rules are found in the legal systems which were influenced by French law (Italy and Spain) or which, like French law, are in the tradition of the ‘law of reason’ (natural law) (Austria). The Bürgerliches Gesetzbuch (BGB), on the other hand, requires a declaration of set-off to the other party (§ 388 BGB). The draftsmen of the German code, in this respect, focused their attention on a Constitution by Justinian, which appeared to indicate that set-off specifically had to be raised, or pleaded, by the defendant in the course of legal proceedings (compensationes obici iubemus; opponi compensationem; C. 4,31, 14,1). Above all, however, they based their decision on the case law of the Supreme Courts in Germany during the second half of the 19th century, where it had come to be recognized that even an extra-judicial declaration of the intention to set off two claims against each other had the effect of extinguishing these claims. The German model of set-off subsequently gained acceptance in many European countries; it has been followed in Austrian law (in spite of the fact that § 1438 ABGB appears to endorse the ipso iure effect of set-off), in Greece and in the Dutch code. It also enjoys widespread support in Italian law (in spite of Art 1242 Codice civile). French courts and legal writers have also found it impractical to implement literally the regime envisaged by Art 1290 Code civil. Following the lead provided by pandectist scholarship, they have effectively attributed decisive influence to the will of one of the parties to bring about the mutual extinction of the obligation. As a result, there may indeed be said to be a convergence avancée (Pascal Pichonnaz), which is reflected in Art 13:104 PECL, Art III.-6:105 DCFR and Art 8.3 UNIDROIT PICC.
4. Retrospective effect?
Even the declaratory model of set-off applicable in Germany and the legal systems following the German approach has a peculiarity which can only be explained historically. Once set-off is invoked, the two debts are regarded as having been extinguished from the moment at which, being suitable for set-off, they first confronted each other. Nineteenth-century legal doctrine sought, by this fiction of retrospectivity, to reconcile the doctrine of ipso iure compensatio fit with the requirement, also supported by the sources, that set-off had to be invoked. In the course of time, the notion of retrospectivity became firmly entrenched in prevailing legal ideology as an essential characteristic of set-off. Yet, this notion is based on a centuries-old misunderstanding. The Roman jurists had indeed used the phrase ipso iure in a special context (that of a banker’s agere cum compensatione). But the phrase had merely been intended to indicate that this type of set-off was not one effected by the judge. The banker himself was forced, by virtue of the formula granted to him by the praetor, to reduce his claim by the amount of the other party’s counter-claim; the plaintiff was thus made ipso iure, ie by the law itself, to effect set-off. It is probable that Justinian also still attributed ex nunc effect to set-off. The decisive turn came with the glossators who reinterpreted set-off ipso iure as a form of set-off which occurred automatically, sine facto hominis. This misunderstanding still clouds the ‘construction’ of set-off, not only in France and the countries influenced by French law, but also in Germany and the countries following German law (including the new Dutch Civil Code). Only the PECL (Art 13:106) and, following them, the UNIDROIT PICC (Art 8.5) and the DCFR (Art III.-6:107) departed from it. The merely prospective effect of set-off invoked by an informal, extra-judicial declaration provided in these instruments is otherwise only found in the Scandinavian legal systems, which have apparently remained uninfluenced by Roman law in this respect.
5. Prerequisites
‘On the whole, there is little dispute about the prerequisites for set-off’. This observation by the author of the preliminary draft of the BGB (Franz Philipp von Kübel) remains true today, and it does not only apply to Germany. It is generally recognized that the creditor of one claim must be the debtor of the other (requirement of mutuality, concursus debiti et crediti, reciprocity). There are exceptions to the requirement of reciprocity in cases of assignment and suretyship. A second prerequisite, uncontested and incontestable in principle, is that both claims must be of the same kind. English law limits set-off to money claims: a limitation which is not of great practical significance since set-off also normally relates to money claims in other countries. All legal systems agree, moreover, that the active claim (ie the claim of the party declaring set-off; often referred to as cross-claim) must be enforceable: after all, set-off constitutes a form of enforcement of that claim. The passive (or principal) claim, on the other hand, does not necessarily have to be due; it is sufficient that the party declaring set-off is entitled to effect performance. Of course, that only applies where set-off by a unilateral, extrajudicial declaration is recognized, as it is in the BGB, in the PECL and the UNIDROIT PICC (as well as Art III.-6:102(a) DCFR; the rule of Art 13:101(a) PECL has been changed, but the comments make it clear that a substantive change was not intended). The UNIDROIT PICC, following the French example, contain a fifth prerequisite for set-off: the liquidity of the cross-claim (‘if at the time of set-off ... the other party’s obligation is ascertained as to its existence and amount’). In this, they go a step further than the PECL which, in turn, follow Dutch law by granting the judge discretion: if the cross-claim cannot be readily ascertained, he is empowered to adjudicate upon the principal claim without taking account of the set-off declared by the debtor, provided that the principal right is otherwise ready for adjudication. Both sets of model rules provide an exception for cases where the principal claim and cross-claim arise from the same legal relationship. There are, however, good reasons to abandon the requirement of liquidity altogether, as long as the legal system makes sure that set-off cannot be declared at a late stage in legal proceedings. In this sense, Justinian had already sought to protect the other party from ‘subterfuges admitting of delay’ (C. 4,31,14,1). The fact that the parties owe each other debts in different currencies does not hinder set-off, provided that they have not agreed that the party declaring set-off must pay in a specified currency (Art 13:103 PECL). Article 8.2 UNIDROIT PICC requires, in addition, that the two currencies be ‘freely convertible’; this is implicitly presumed in the PECL and the DCFR.
6. Exclusion of set-off
According to Art 13:107 PECL and Art III.-6:108 DCFR, set-off cannot be effected (a) where it is excluded by agreement; (b) against a claim to the extent that that claim is not capable of attachment; and (c) against a claim arising from a deliberate wrongful act (law of torts/delict, general and lex Aquilia). In all these cases, the model rules reflect the approach either explicitly adopted, or implicit, in the vast majority of national legal systems in Europe. (A corresponding provision is lacking in the UNIDROIT PICC.)
7. Set-off by agreement
Set-off by agreement is of great practical importance in commercial dealings (above all in international commerce). It is, of course, permitted as a result of the general recognition of freedom of contract. Thus, in particular, the parties can derogate from the requirements of unilateral set-off; usually, in fact, the parties resort to set-off by agreement if one or other of the normal requirements for set-off is not met. The terminology applied with regard to set-off by agreement is varied and confusing. In particular, ‘netting’ and ‘clearing’ are used as general terms for many different types of balancing of accounts and set-off procedures. Two of the most important forms of set-off by agreement are the current account (the debits and credits are set off against each other at each balancing of the account) and settlement clearing (Skontration), the paradigm of a multilateral settlement of claims relevant in the business of banking. Settlement clauses concerning groups of affiliated companies (Konzernverrechnungsklauseln), on the other hand, are designed to establish a unilateral right of set-off and thus, in the terminology of Klaus Peter Berger, they constitute an ‘agreement concerning set-off’ and not a ‘set-off by agreement’. The legal effects of set-off by agreement depend on the will of the parties. Insofar as the parties have not agreed otherwise, the normal requirements of unilateral set-off will be applicable (either by analogy or directly).
8. Protection of reliance?
The power to set off can have the effect of a security right in a number of situations. Thus legal systems that follow the model of set-off by declaration generally allow a set-off with cross-claims which have prescribed, at least in those cases where the claim had not yet prescribed at the moment when set-off became possible. (In those legal systems where set-off operates ipso iure, this kind of rule is not required.) This is normally said to be necessary in order to protect a party’s reliance on a legal position in which it is able to effect set-off. However, this argument is hardly convincing in view of the fact that by being granted the opportunity to give notice of set-off at any time, any party entitled to set off its claim against that of the other party has a very simple and convenient means of avoiding any conceivable disadvantage that the other party’s delay might bring about. The law should, therefore, rather provide an incentive for a party entitled to set off to give notice of set-off as soon as possible in order to bring to an end the existing state of pendency. The aforementioned rules, which also thwart the fundamental policy considerations underlying the law of prescription, have therefore been criticized repeatedly. The European and international model rules do not contain such protection of reliance (Art 14:503 PECL, Art III.-7:503 DCFR, Art 10.10 UNIDROIT PICC).
9. Insolvency set-off
Above all, it is in cases of insolvency that a right of set-off operates like a security right. A considerable number of European legal systems, therefore, have rules according to which the initiation of insolvency proceedings is not supposed to deprive a creditor of his right to give notice of set-off; these rules are mostly part of the insolvency regimes of the respective countries. In England, insolvency set-off actually forms an independent legal institution, while in Germany, Austria, Greece, Italy, Portugal (since 2004), the Netherlands and Scandinavia, it presents itself as a modification of ‘normal’ set-off. France, Belgium and Spain limit opportunities to set-off in insolvency proceedings to connected claims, in Portugal it was totally excluded until 2004. The justification for this preference in insolvency proceedings of a creditor who is in a position to declare set-off is doubtful. It constitutes a serious encroachment on the par conditio creditorum, a central principle of insolvency law: as a result of set-off, the assets available for satisfaction of all creditors are reduced despite the fact that the party entitled to set-off did not have a security right that is easily recognizable by third parties. Once again, therefore, the question arises why the law should grant protection to a creditor who has a particularly convenient means of (self-) execution in comparison with other creditors (protection of reliance, general considerations of equity?). Nevertheless § 9.3 of the Principles of European Insolvency Law confirms the insolvency preference for set-off that has been established for a long time in many EU Member States; concern for the protection of reliance also underlies Art 6 of the EU Insolvency Regulation (Reg 1346/2000): it is the reliance of an insolvency creditor on the applicable law and on the right to declare set-off granted under that law that is protected by this rule. The Financial Collateral Directive (Dir 2002/47) (financial collateral) also provides for a preference in insolvency proceedings for the so-called ‘close out netting’, ie a provision of a financial collateral agreement by which, under certain circumstances, the obligations of the parties are accelerated so as to be immediately due and expressed as an obligation to pay an amount representing their estimated current value, or are terminated and replaced by an obligation to pay such an amount and/or an account is taken as to what is due from each party to the other in respect of such obligations, and a net sum equal to the balance of the account is payable (Art 7 read with Art 2(1)(n)).
10. Set-off and European civil procedure
A set-off declared extrajudicially can, of course, be raised as a defence in litigation concerning the passive claim. Sometimes, however, the defendant will declare the set-off for the first time in the course of litigation; some national legal systems even make the operation of set-off dependent on it being invoked by the defendant in the course of litigation. In such cases the question arises whether the court dealing with the passive claim must also have jurisdiction over the active claim. This question has primarily acquired importance within European procedural law (European civil procedure). The existence of jurisdiction for connected active claims is not in dispute; this follows a fortiori from Art 6(3) of the Brussels I Regulation (Reg 44/2001). Apart from that, according to the ECJ (Case C-341/93 – Danvaern v Otterbeck [1995] ECR I-2053), the applicable national procedural law determines whether and under what circumstances the defence of set-off will be permitted; the rules on jurisdiction in Arts 2 ff of the Brussels I Regulation do not apply in this respect.
Literature
Wilhelm Haudek, ‘Kompensation (Aufrechnung)’ in F Schlegelberger (ed), Rechtsvergleichendes Handwörterbuch für das Zivil- und Handelsrecht des In- und Auslandes, vol V (1936) 58; Gerhard Kegel, Probleme der Aufrechnung: Gegenseitigkeit und Liquidität rechtsvergleichend dargestellt (1938); Philip R Wood, English and International Set-Off (1989); Klaus Peter Berger, Der Aufrechnungsvertrag (1996); Matthias N Kannengießer, Die Aufrechnung im internationalen Privat- und Verfahrensrecht (1998); Pascal Pichonnaz, La Compensation— Analyse historique et comparative des modes de compenser non conventionnels (2001); Reinhard Zimmermann, Comparative Foundations of a European Law of Set-Off and Prescription (2002); Christoph Jeremias, Internationale Insolvenzaufrechnung (2005); William Johnston and Thomas Werlen (eds), Set-Off Law and Practice—An International Handbook (2006); Reinhard Zimmermann, ‘§§ 387–396. Aufrechnung’ in Mathias Schmoeckel, Joachim Rückert and Reinhard Zimmermann (eds), Historisch-kritischer Kommentar zum BGB, vol II/2 (2007); Max Pluta, Insolvenzaufrechnung und der Grundsatz der par conditio creditorum (2009).
