Set-Off Right against a Company in Liquidation

July 3, 2018
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The article was published in Afik News 260 04.07.2018

Trade relations between two companies take place, in which they offset one another’s debts on a regular basis and transfer only the difference. However, when a company enters into insolvency proceedings, the rules of the game change and a situation can arise where one has to pay the debt to the other, but wait in line with the other creditors in order to hope and see at least part of its money back at the end of the road. So when can offset claims be made when entering insolvency proceedings?
A fundamental principle in insolvency proceedings is the principle of equality. In general, one must not discriminate between creditors and the law sets the priorities among the various creditors. For example, employees, state debts and rent are high priority debts in comparison to ordinary creditors and creditors with liens will come before other. The right of set-off undermines these principles because we allow a “lucky” creditor who happens to also owe money to the insolvent company, to take advantage of the fact that it is obligated in order to circumvent the other creditors.
The Courts referred to the right of set-off as a “de facto” guarantee, because the debt of a creditor, who also happened to owe money to the insolvent company, is paid (by way of offsetting) in full while other creditors will, in many cases, have to wait for the end of the liquidation process with hopes of receiving at least a small part of the debt towards them.
For this reason, the Israeli Bankruptcy Ordinance states that a person contending a right of set-off must meet five cumulative conditions that are to be construed in a precise manner. Thus, for example, it is necessary to show that this is a mutual debt between the same parties and mainly – that the person claiming the offset did not know in advance that the other party is about to enter insolvency and “created” the right to set-off for this purpose.
The new insolvency law, which date of entry into effect is yearend of 2019, creates a new offsetting mechanism that allows (in addition to the right of the state to offset tax debts) offset under two possible circumstance: (1) when the obligations of the debtor and the creditor are interrelated; or (2) the assumption of reciprocal obligations and the reliance on the right of set-off are part of the ordinary course of business of the debtor or creditor, and the creditor’s past debt, which the creditor wishes to offset, was made in the course of the mutual business with the debtor. This is an innovative approach that leaves much room for the interpretation of the Courts, which usually interpret new laws in light of the previous case law, but in this case, as this is an innovative law replacing a mandatory ordinance over 70 years old, it is difficult to predict how these provisions will be interpreted. In light of the aforesaid, even as long as the new law does not come into force (and here, too, the Courts generally interpret an existing law in the light of a law that will take effect in the foreseeable future), it is very important to consult an attorney specializing in the field in any case of open transactions with a company that has entered insolvency proceedings.