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Set-off as an Affirmative Defense: An Inherent Claim Against the Estate?




by:
Peter M. Friedman
Stephen M. Johnson
Cadwalader, Wickersham & Taft LLP - Washington Office

 
August 31, 2010

Previously published on August 13, 2010

Two decades ago, the Supreme Court tackled the issue of whether a third party had submitted itself to jurisdiction of the bankruptcy court. In Granfinanciera, S.A. v. Nordberg,1 the Supreme Court ruled that a party who has not filed a claim against a bankrupt's estate is not subject to the jurisdiction of the bankruptcy courts. A year later, in Langenkamp v. Culp,2 the Supreme Court expanded upon Granfinanciera, holding that a third party waives its Seventh Amendment right to a jury trial by filing a claim in a bankruptcy case and is subject to the equitable powers of the bankruptcy courts. It is therefore well-settled law that upon filing a claim, a party submits itself to the equitable jurisdiction of the bankruptcy court and waives its right to demand a jury trial.

One issue that the Supreme Court has not addressed, however, is what exactly constitutes "filing a claim" for purposes of submitting to bankruptcy court jurisdiction. A recent decision from the United States Bankruptcy Court for the District of Montana addressed that very issue. In Crum v. Blixseth (In re Big Springs Realty LLC),3 the Court held that a defendant submits itself to bankruptcy court jurisdiction and waives its right to a jury trial by asserting an affirmative defense of set-off against a trustee. Big Springs Realty underscores how a defendant in an adversary proceeding must carefully and strategically weigh the affirmative defenses it chooses to plead in response to a complaint, against the risk of losing its right to a jury trial. Given that only a United States District Court can conduct a jury trial (absent the consent of all parties) the loss of a jury trial right may force a defendant into a trial before the Bankruptcy Court - a venue the defendant may find unfavorable. Thus, Big Springs Realty teaches that the traditional litigation approach of throwing every affirmative defense against the wall in the hope one sticks is not warranted where venue considerations are critical to a defendant's strategy.

Background

In Big Springs Realty, the chapter 11 trustee commenced an adversary proceeding against Blixseth for the avoidance of alleged preference payments and wrongful distributions under state law. After unsuccessfully seeking to have the adversary proceeding heard by the district court, Blixseth filed his answer to the complaint, including a number of affirmative defenses and a demand for a jury trial. In response, the trustee filed a motion to strike Blixseth's jury demand, arguing that certain of Blixseth's affirmative defenses - indemnification, set-off and recoupment - were essentially claims against the estate, and that Blixseth thereby had submitted to bankruptcy court jurisdiction and waived his right to demand a jury trial.

Although the question raised by the trustee's argument is not a novel one, no controlling precedent existed. Courts which have previously considered the issue are split. The trustee relied upon a line of cases holding that set-off, even where raised only as a defense to a trustee-brought action, constitutes the assertion of a claim against the debtor's estate. Blixseth, meanwhile, cited to a series of cases that distinguish between a party merely asserting a defense and a party asserting a counterclaim or otherwise seeking an affirmative recovery from the estate.

Set-Off as a Claim

The trustee, relying primarily upon Commercial Financial Services, Inc. v. Jones (In re Commercial Financial Services, Inc.),4 contended that Blixseth's assertion of the affirmative defenses of set-off, indemnification and recoupment subjected him to bankruptcy court jurisdiction and waived his right to a jury trial. In Commercial Financial, a chapter 11 debtor commenced an adversary proceeding to recover on a promissory note and to compel the defendant to turn over funds. In his answer, the defendant demanded a jury trial and asserted an affirmative defense, alleging that he "may be owed money by [the debtor] which may be set-off or recouped against any amount" that he may owe the debtor.5 The debtor argued, and the bankruptcy court ultimately held, that set-off, whether asserted as a counterclaim or as a defense, is dependent upon the defendant having a valid and enforceable prepetition claim against the debtor and therefore invokes the adjustment of the debtor-creditor relationship and the claims allowance process - both core functions of the bankruptcy court.6 Having found that setoff implicates the claims process, the court held that the action was a core proceeding and therefore within the jurisdiction of the bankruptcy court.

In Big Springs Realty, the trustee argued that Blixseth similarly subjected himself to bankruptcy court jurisdiction because his affirmative defenses were the practical equivalent of asserting counterclaims or filing a proof of claim. Section 553 of the Bankruptcy Code defines set-off as a creditor's ability to "offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case. . . against a claim of such creditor against the debtor that arose before the commencement of the case . . . ."7 If set-off is predicated upon the creditor having a valid and enforceable prepetition claim against the debtor, the trustee contended, then it necessitates that the bankruptcy court exercise its equitable powers to allow or disallow the claim and administer the debtor's estate.

Finally, the trustee argued that recognizing a distinction between set-off as an affirmative defense and as a counterclaim would only serve to elevate form over function and impermissibly allow defendants to circumvent the claims process and its attendant consequences (i.e., submitting to bankruptcy court jurisdiction and waiving a jury trial). As claims are property of the estate, a diminution of any potential recovery effectively decreases the estate's value and the total distribution available to creditors.

Defense Versus Affirmative Recovery

Unsurprisingly, Blixseth viewed things differently. He asserted that he was not seeking any affirmative recovery from the estate, but was only defending himself against the action brought by the trustee. In support of his objection to the motion to strike the jury demand, Blixseth cited a number of cases that distinguished between defendants who sought some affirmative recovery via set-off and those who merely raised set-off as a defense in hopes of reducing or eliminating the damages, if any, to be awarded to the plaintiff.

Blixseth argued that some cases, particularly Container Recycling Alliance v. Lassman,8 expressly rejected the reasoning in Commercial Financial that the assertion of an affirmative defense or counterclaim is equivalent to filing a proof of claim. Although other courts had also discussed the distinction between compulsory and permissive counterclaims when considering the issue, Container Recycling observed that the primary concern of the courts (including the Commercial Financial court) had been "whether the counterclaimant was seeking to achieve an affirmative recovery from the estate by circumventing the bankruptcy court's formal claims allowance procedure."9 In considering that issue, the Container Recycling court emphasized that the defendant had disavowed any affirmative recovery based on its counterclaims.

Container Recycling also addressed the significance of the defendant's "understandable but nonetheless infelicitous use of the term 'set-off.'"10 The court distinguished between set-off and recoupment, stating that "[r]ecoupment, [unlike setoff], is not a mechanism which reduces mutual debts 'for the sake of convenience,' but rather is 'in the nature of a defense' and is intended to 'permit . . . judgment to be rendered that does justice in view of the one transaction as a whole.'"11 While recoupment may technically reduce the amount of the estate's potential recovery, it "is more properly seen as part of the process of ascertaining the true value of the estate, not as an attempt to obtain a distribution from it."12 In any event, defending against the trustee's claim on its merits would have the same effect vis-à-vis the value of the estate's claim and it could potentially be problematic for courts to consider any defense in an adversary proceeding as an invocation of the claims allowance process and the equitable powers of the bankruptcy court.

Relying on Container Recycling, Blixseth disputed the trustee's characterization of the affirmative defenses in this case as "claims" that invoked equitable powers of the bankruptcy court to allow or disallow claims and restructure the debtor-creditor relationship. Blixseth contended that because he only sought to ascertain the validity and true value of the trustee's claim, rather than any affirmative recovery, his affirmative defenses, whether termed set-off or recoupment, did not qualify as "claims" under Granfinanciera, Langenkamp, or their progeny. Blixseth also cited Styler v. Jean Bob Inc. (In re Concept Clubs, Inc.)13 for the proposition that an affirmative defense offered only to reduce or extinguish the original claim, rather than seek some affirmative recovery, does not invoke the bankruptcy court's equitable jurisdiction.

The Court's Analysis

The Court disagreed with Blixseth's reading of Container Recycling and Concept Clubs. Although Blixseth never filed a formal proof of claim, the Court found that he "sought more than a fair accounting" of the value of the trustee's claims.14 The "affirmative defenses [were] an attempt to assert independent, affirmative claims against the Debtor and Debtor's bankruptcy estate"15 and were "akin to an informal proof of claim . . . [that] would directly impact the administration of the Debtor's bankruptcy estate."16 Having so found, the Court ruled that Blixseth had submitted himself to bankruptcy court jurisdiction and therefore waived his Seventh Amendment right to a jury trial.

Conclusion

While Granfinanciera and Langenkamp established that a third party submits itself to the equitable jurisdiction of the bankruptcy court and thereby waives its right to a jury trial when it files a claim against the debtor's estate, what constitutes filing a claim remains an open question. The decision in Big Springs Realty endorses those decisions that favor an expansive view of bankruptcy court jurisdiction, but, in the end, does not settle the controversy.

1 Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989).
2 Langenkamp v. Culp, 498 U.S. 42, 44-45 (1990).
3 Adv. No. 09-00065, 2010 WL 2244682 (Bankr. D. Mont. May 28, 2010).
4 251 B.R. 397 (Bankr. N.D. Okla. 2000).
5 Commercial Fin. Servs., Inc., 251 B.R. at 400.
6 Id. at 404, 406.
7 11 U.S.C. § 553(a) (emphasis added).
8 359 B.R. 358 (D. Mass. 2007).
9 Id. at 362.
10 Id. at 363.
11 Id. at 364.
12 Id.
13 154 B.R. 581 (D. Utah 1993).
14 In re Big Springs Realty LLC, 2010 WL 2244682 at *5.
15 Id.
16 Id. at *4.



 

The views expressed in this document are solely the views of the author and not Martindale-Hubbell. This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
 

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