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.
