Do you think that set-off and netting are important for the effective functioning of the international finance?

I found this old article from my files and thought that I share this as it brigs to my mind good memories from Oxford times and lectures with amazing Philip Wood of Allen & Overy. I had fun writing this and hope you enjoy (reading with your own discretion and no guarantees on substance, and mistakes are all attributable to the undersigned).

There are three general types of set-off and netting. To begin with, there is insolvency set-off in which case the party sets-off his claim against his insolvent counter party. The second type is close-out netting in which case the parties cancel and set-off open executory contracts. Finally, in settlement netting debts or fungible claims under executory contracts are set-off provided that they fall due or are delivered during the same day. I first focus on general policies underlying set-off and netting in different jurisdictions and then analyse these different aspects in connection with the above-mentioned classification. I then turn to the question whether or not set-off and netting are important for functioning of the international finance.

One of the most fundamental distinctions in this question can be illustrated with reference to different approaches to ‘cherry-picking’. Term cherry-picking itself means the question whether or not the solvent party has the right to cancel and set-off the losses and gains in its open executory contracts or whether the insolvency administrator may choose selective performance. Jurisdictions can be roughly divided into two categories on the basis of how they approach this issue in other words to those which consider cherry-picking as unjust and those which think that it is justified. The former approach can be classified as pro-creditor, which allows insolvency set-off, or like in the case of England, it even mandatory. In addition, pro-creditor view considers rescission clauses valid in the event of insolvency. The latter approach on the other hand tries to maximise the debtor’s estate by allowing selective performance. Rescission clauses having an effect on insolvency are usually expressly nullified. This latter approach could be said to apply in Napoleonic countries while the former in Anglo-American and Roman-Germanic legal families.

As already mentioned above, in insolvency set-off the parties may set-off mutual claims. If the solvent party is not allowed to set-off, his exposure to insolvent party will increase. Naturally this risk is taken into account in the risk assessment of the bank increasing the cost of credit. Controversially, it could be argued that set-off itself make rehabilitations process more difficult because it diminishes the debtor’s assets generally, which may be needed not only for future business but also as a security in the process itself. At least in some circumstances, the rehabilitation process might maximise the creditor income and in addition to that provide some other positive externalities like saved jobs. In financial terms this issue is extremely difficult whether pro-creditor or pro-debtor approach should be preferred and it will become even more difficult if the effects of set-off on systemic risk are taken into consideration.

On the other hand, it can be argued that set-off violates creditor equality, because only one creditor is paid at the expense of the others. From this respect this is a question whether creditors should be treated pari passu. The Napoleonic pro-debtor system sees this issue from the perspective of quasi-security and deems set-off as an unpublished security interest. At the end of the day the question of equality issue turns to the issue what is considered as just. Should the creditor have the right to set-off or should the debtor or her successor have the right to selective performance for example in close-out netting depends on moral value-judgements connected with the socio-economical culture of the legal system in question.

In the third type, the parties agree that monetary obligations in the same currency or the same type are netted provided that they fall due or delivery on the same day in order to reduce settlement risk. The actual conflicting policies are already explained above, but it should be borne in mind that in this case both approaches purport to protect the same underlying interest: reduce transaction costs not only trough legislation and carve-out arrangement but also trough voluntary agreement-based system like ISDA.

Set-off and netting are important especially due to their financial effects, but what is the best way to implement and organise the whole system remains to be the key question. When comparing these two categories one faces with the problem of finding appropriate measures for measuring the financial effects of insolvency set-off in pro-debtor and pro-creditor systems or to prioritise different values behind these financial choices. This distinction is however merely a question of effectiveness since it is conceivable to argue that both systems facilitate the objectives of the international finance.