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Insolvency Setoff

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A standard problem faced by legal systems addressing insolvency such as bankruptcy is how to handle claims of creditors against the debtor when there is also a claim of the debtor against the same creditor. One possibility would be to require the creditor to pay its debt to the debtor in full but require the debtor to pay the creditor according to the priorities of the insolvency distribution system. Often, this will mean that the creditor will get very little. The alternative, sometimes called setoff, permits the creditor to "net out" its claim against the debtor in the same way it might have done without any problem had no insolvency occurred.

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This Demonstration compares the operation of these alternative legal schemes. You select whether you wish to permit setoff or not. You also select the magnitude of the debtor's assets (aside from its claim against ), the magnitude of 's claim against the debtor, the magnitude of the debtor's claim against , and the magnitude of 's claims against the debtor. The system responds with yellow arrows showing the claims. If you elect to permit setoff, you only see the net claim. It further responds with green arrows showing the cash flow. You can choose only to show net cash flows. A notation in red at the bottom left of the figure shows the amount distributed through the insolvency system. Explore the model and see when setoff is most beneficial to and most harmful to .

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Contributed by: Seth J. Chandler (March 2011)
Open content licensed under CC BY-NC-SA

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Snapshot 1: A situation in which a debtor with $50,000 in assets owes the first creditor $70,000 and owes the second creditor $90,000 but the first creditor also owes the debtor $30,000. No setoff permitted.

Snapshot 2: A situation in which a debtor with $50,000 in assets owes the first creditor $70,000 and owes the second creditor $90,000 but the first creditor also owes the debtor $30,000. Setoff permitted.

Snapshot 3: A situation in which a debtor with $50,000 in assets owes the first creditor $10,000 and owes the second creditor $90,000 but the first creditor also owes the debtor $30,000. Setoff permitted. Only net cash flows shown.

Snapshot 4: A situation in which a debtor with $50,000 in assets owes the first creditor $70,000 and owes the second creditor $90,000 but the first creditor also owes the debtor $30,000. Setoff permitted.

Under American bankruptcy law, recoupment is a type of setoff that arises when the mutual debts arise out of the same transaction. It is generally permitted more frequently than when the mutual debts arise out of unrelated matters.

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