Set-off of Claims in Insolvency

What is a set-off and why is it controversial in insolvency

Once insolvency proceedings are initiated, a so-called prohibition on the individual satisfaction of creditors comes into effect. This means that no creditor can, on their own initiative, enforce a claim against the debtor outside the framework of the insolvency proceedings. However, a set-off is a form of individual satisfaction, and therefore its use in insolvency is strictly limited.

When a set-off can be used: The time aspect is decisive

The key factor for assessing the admissibility of a set-off is the moment when the eligibility for the set-off arose. According to Section 140 of the Czech Insolvency Act, the set-off of mutual claims between the debtor and a creditor is permissible after a decision on bankruptcy has been made, provided that the legal conditions for this set-off were met before the decision on the method of resolving the bankruptcy.

In practice, this means that if you had a claim eligible for set-off against the debtor before the court decided on the bankruptcy and the method of its resolution, you can also exercise the set-off during the insolvency proceedings. In contrast, claims that arose only after the decision on bankruptcy cannot usually be set off.

Basic conditions for a set-off in insolvency proceedings

For a set-off to be permissible in insolvency, the following conditions must be met simultaneously:

1. Mutuality of claims – there must be a mutual obligation where both parties can demand performance from each other.

2. Same kind – the claims must be of the same kind, typically monetary.

3. Maturity – both claims must be due, or at least one of them.

4. Eligibility for set-off – the claims must not be excluded from set-off by law or contract.

5. Creditor registration – the creditor must become a registered creditor in the insolvency proceedings.

The last condition is often overlooked but is crucial. If a creditor does not register for the insolvency proceedings, they cannot exercise a set-off. The Czech Insolvency Act requires the creditor to register their claim, and only then can they exercise the right to a set-off.

Risks and penalties for an unauthorised set-off

An unauthorised set-off can lead to serious legal consequences. If you set off a claim in violation of the Czech Insolvency Act, the insolvency administrator can file an avoidance action and demand the exclusion of such performance from the insolvency estate.

Set-off as a security instrument: A practical guide

A set-off can be a very effective security instrument if used correctly and in a timely manner. A creditor who has a set-off eligible claim against the bankrupt debtor is essentially in the position of a secured creditor, as their claim will be satisfied in full by the set-off. A set-off in insolvency is not automatic. It must be explicitly exercised and all conditions must be proven to have been met.

The practical procedure is as follows:

1. Identify mutual claims – conduct an audit of all obligations between you and the debtor.

2. Verify eligibility for set-off – check whether the claims meet the statutory conditions.

3. Register for the proceedings – become a registered creditor by filing a claim registration.

4. Exercise the set-off – you can exercise the set-off in writing to the insolvency administrator.

The lawyers at ARROWS deal with this agenda on a daily basis and know what evidence is key for the court. We will be happy to help you – just write to consultation@arws.cz. 

Why a set-off in insolvency is more complex than it seems

At first glance, a set-off may seem like a simple legal act. However, the practice is much more complicated. In the real world, we encounter dozens of hidden exceptions, procedural details, and connections to other regulations that a layperson often does not see.

For example:

• Awareness of bankruptcy – if you knew or, given the circumstances, must have known about the debtor's bankruptcy, the set-off may be ineffective.

• Incongruous performance – if your claim arose shortly before insolvency from an unusual legal act, it may be challenged by an avoidance action.

• Claims against the insolvency estate – these claims are set off under a completely different regime.

The ARROWS law firm deals with this agenda daily and knows where the dangerous pitfalls lie. Our experience from more than 150 joint-stock companies, 250 limited liability companies, and 50 municipalities and regions allows us to identify risks that others overlook. It is safer for the client to have the entire matter professionally handled – just contact our office at consultation@arws.cz. 

Bankruptcy vs. reorganisation: Different rules for set-off

Insolvency proceedings can take various forms, with bankruptcy or reorganisation being the most common. Each form has different impacts on the possibility and conditions of a set-off.

Bankruptcy is the most common path. The insolvency administrator gradually liquidates the debtor's assets and distributes the proceeds to the creditors according to the law. In bankruptcy, a set-off is applied according to Section 140 of the Czech Insolvency Act, meaning if the conditions were met before the decision on bankruptcy, the set-off is permissible.

A creditor with initiative and knowledge of the procedure can thus achieve a situation where they are satisfied in full, while other unsecured creditors receive only a few percent. This is precisely why the insolvency administrator tends to challenge set-offs. There is a risk that the set-off will remove an asset from the insolvency estate that could have satisfied other creditors.

Reorganisation is a recovery method where the debtor (or creditors) prepares a plan to keep the business alive and get it back on its feet. Here, a set-off is more complicated. The publication of a proposal to permit reorganisation in the insolvency register automatically prohibits the set-off of claims – this is a strong tool to protect the liquidity of the reorganised company. 

Therefore, a creditor cannot individually set off claims during the preparation of the reorganisation plan to get rid of their obligation to the debtor; it would be a total sabotage of the plan. However, this prohibition can be broken by a court's preliminary injunction – if it were a set-off that threatens the company's liquidity in a particularly serious way.

What are the practical differences? In bankruptcy, a creditor with mutual claims has a realistic chance to benefit from the insolvency dispute with their initiative and knowledge of the law. In reorganisation, it is the opposite; the creditor is motivated to cooperate with the debtor and their creditors for the plan to succeed. The lawyers at ARROWS will understand your specific situation and advise on the optimal strategy for you. Let's see what solution your insolvency position opens up for you – contact us at consultation@arws.cz. 

Preventive strategies: How to protect yourself against avoidance actions

The best defence is good prevention. If you are a creditor and you realise that your business partner is in trouble, it is time to clarify your legal position. An avoidance action by the administrator can come up to three years after you have made the set-off, which is a long time when you might think everything is fine, and then the court decides to overturn your transaction.

The basis is documentation proving your good faith. If you are performing a set-off, keep evidence that you did not know and could not have known about the debtor's bankruptcy. Usual communication, standard business procedures, absence of warnings. All this will help later if the insolvency administrator claims you should have known. ARROWS will help you structure your documentation and communication so that your good faith is proven to be watertight.

Ensure the demonstrable legality of the transaction. If you want your claim to be eligible for a set-off, do not do anything suspicious. Do not buy assets below market price, do not inflate invoices, do not create artificial situations. The set-off must be a consequence of a normal business relationship. If you are not sure, consult a lawyer before you perform the set-off.

Monitor the possible initiation of insolvency proceedings. As soon as you notice that the debtor is in trouble and an insolvency process is possible, immediately find out if it has already been initiated, and if so, register without delay. Missing the deadline for registration means you cannot exercise the set-off at all. ARROWS has experience with managing deadlines and never misses them – just give us the instruction at consultation@arws.cz. 

Assess the pros and cons of this set-off and, before setting off, verify what your actual benefit from this set-off is. If you have a sufficiently low level of risk in your claim (e.g., it is covered by security) and, on the other hand, a high risk that your set-off would be challenged, you might prefer to avoid the set-off and have the matter resolved in the regular insolvency proceedings.

The international aspect of set-off in insolvency

In today's interconnected economy, we often encounter situations where the debtor or creditor is based in another country. Cross-border set-offs bring another layer of complications – different legal regulations, conflict-of-law rules, and regulations on cross-border insolvency.

Thanks to the ARROWS International network built over ten years, the ARROWS law firm deals with cases with an international element on a daily basis. We can coordinate procedures in several jurisdictions simultaneously, work with document translations, and communicate with foreign insolvency administrators. If your case has an international dimension, leave it to us – contact us at consultation@arws.cz. 

Conclusion: Why entrust your set-off to ARROWS

The set-off of claims in insolvency is, both legally and procedurally, one of the most complex institutes of commercial law. Individual steps that seem simple hide dozens of hidden exceptions, procedural details, and risks that a layperson often does not see. A mistake in timing, a formal deficiency in the registration, or an incorrect assessment of mutuality can lead to you losing your claim entirely.

The ARROWS law firm deals with the agenda of set-offs in insolvency daily and can therefore significantly shorten the time and minimise the risk of errors for clients. Our firm is insured against damages up to CZK 500,000,000, which represents a guarantee of a safe solution for the client. We are common partners for corporate lawyers in resolving special matters.

If you do not want to risk mistakes, damages, or fines, you can safely leave the entire matter to ARROWS – just contact the office at consultation@arws.cz.