Set-off (law)

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In law, a set-off is a statutory defence 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 recognised in equity. Such a defence 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 defence 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 addition, in certain jurisdictions (including the UK), set-off takes place automatically upon the insolvency of a company. This means that parties who are both creditors and debtors of an insolvent company will be paid in full (because their debt to the insolvent company is reduced by the amount that it is owed by the insolvent company). This has been criticised 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.

In many countries, where a debtor goes into bankruptcy mutual debts are set-off as against each other, and then either the bankrupt's creditor can prove for the balance in the bankruptcy or the trustee in bankruptcy can ask for the balance remaining to be paid.

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 1,000,000,000 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-the value of the security taken.