Creditor Setoffs in Bankruptcy Reorganizations: An Analysis of Baker v. Gold Seal Liquors, Inc.

In an action between a debtor and a creditor, the debtor may seek to reduce his liability by pleading counterclaims. A permissive counterclaim-any claim against the creditor not arising out of the transaction or occurrence that is the subject matter of the creditor’s claim–is typically termed a “setoff” to the extent that it does not involve affirmative relief. If the debtor is insolvent and seeks bankruptcy relief, setoffs may result in priorities whereby one creditor gains preference in the distribution of the debtor’s estate over other creditors of the same class or even of a superior class. For example, if Jones and Smith are each owed 1000 dollars by the bankrupt Widget Corporation, which has assets of 1000 dollars, they normally would expect to receive 500 dollars each. However, if Jones also owes Widget 1000 dollars (Widget’s sole asset is thus Jones’s obligation), and Jones sets off Widget’s claim against him with his claim against Widget, then Smith will suffer a 1000 dollar loss and Jones will be whole.