In law, set-off or netting is a legal technique applied between persons or businesses with mutual rights and liabilities, replacing gross positions with net positions.David Southern Set off revisited (1994) NJL 1412, 1412Halesowen Presswork & Assemblies Ltd v Westminster Bank Ltd 3 All ER 473 at 488, per Buckley LJ It permits the rights to be used to discharge the liabilities where cross claims exist between a plaintiff and a respondent, the result being that the gross claims of mutual debt produce a single net claim.Joanna Benjamin, Financial Law (2007, Oxford University Press), p264 The net claim is known as a net position. In other words, a set-off is the right of a debtor to balance mutual debts with a creditor.
Any balance remaining due either of the parties is still owed, but the mutual debts have been set off. The power of net positions lies in reducing credit exposure, and also offers regulatory capital requirement and settlement advantages, which contribute to market stability.Louise Gullifer, Goode and Gullifer on Legal Problems of Credit and Security, Sweet & Maxwell, 7th ed., 2017
Difference between set-off and netting Whilst netting and set-off are often used interchangeably, a legal distinction is made between netting, which describes the procedure for and outcome of implementing a set-off. By contrast set-off describes the legal bases for producing net positions. Netting describes the form such as novation netting or close-out netting, whilst set-off describes judicially-recognised grounds such as independent set-off or insolvency set-off. Therefore, netting or setting off gross positions involves the use of offsetting positions with the same counter-party to address counter-party credit risk.
Mutuality The law does not permit counter-parties to use third party debt to set off against an un-related liability.P Wood, Title Finance, Derivatives, Securitisation, Set-off and Netting, (London: Sweet & Maxwell, 1995), 189 All forms of set-off require mutuality between claim and cross claim. This protects property rights both inside insolvency and out, primarily by ensuring that a non-owner cannot benefit from insolvency.
Market effect The primary objective of netting is to reduce systemic risk by lowering the number of claims and cross claims which may arise from multiple transactions between the same parties. This prevents credit risk exposure, and prevents liquidators or other insolvency officers from cherry-picking transactions which may be profitable for the insolvent company.Finch, Milman Corporate Insolvency Law (2016, Cambridge University Press, Third edition)
Netting At least three principal forms of netting may be distinguished in the financial markets. Each is heavily relied upon to manage financial market, specifically credit, risk
Novation netting Also called rolling netting, netting by novation involves amending contracts by the agreement of the parties. This extinguishes the previous claims and replaces them with new claims.
This differs from settlement netting (outlined below) because the fusion of both claims into one, producing a single balance, occurs immediately at the conclusion of each subsequent contract. This method of netting is crucial in financial settings, particularly derivatives transactions, as it avoids cherry-picking in insolvency.Commissioner for HMRC v Entin BCC 955 per Lightman J The effectiveness of pre-insolvency novation netting in an insolvency was discussed in British Eagle International Airlines Ltd v Compagnie Nationale Air France 1 WLR 758. Similar to settlement netting, novation netting is only possible if the obligations have the same settlement date. This means that if, in the above example, transaction-2 was to be paid on Friday, the two transactions would not offset.
Close out netting An effective close-out netting scheme is said to be crucial for an efficient financial market.EFMLG The regulation of close out netting in the new member states of the European Union 2005, 3 Close out netting differs from novation netting in that it extends to all outstanding obligations of the party under a master agreement similar to the one used by ISDA. These traditionally only operate upon an event of default or insolvency. In the event of counterparty bankruptcy or any other relevant event of default specified in the relevant agreement if accelerated (i.e. effected), all transactions or all of a given type are netted (i.e. set off against each other) at market value or, if otherwise specified in the contract or if it is not possible to obtain a market value, at an amount equal to the loss suffered by the non-defaulting party in replacing the relevant contract. The alternative would allow the liquidator to choose which contracts to enforce and which not to (and thus potentially "cherry pick").ISDA 2002 Master Agreement, Section 2(1)(a)(iii) There are international jurisdictions where the enforceability of netting in bankruptcy has not been legally tested. The key elements of close out netting are: default the accretion of the time for performance of obligations to the time of default conversion of non-cash obligations into debts; meaning obligations to deliver non-cash assets are converted to market price equivalents; and set offSee the Financial Collateral Directive (Directive 2002/47/EC, Art 2(1)(n) Similar methods of close out netting exist to provide standardised agreements in market trading relating to derivatives and security lending such asrepos, forwards or options.ISDA master agreement The effect is that the netting avoids valuation of future and contingent debt by an insolvency officer and prevents insolvency officers from disclaiming executory contract obligations, as is allowed within certain jurisdictions such as the US and UK.Cf Insolvency Rules 1986 Rule 4.90 The mitigated systemic risk which is induced by a close out scheme is protected legislatively. Other systemic challenges to netting, such as regulatory capital recognition under Basel II and other Insolvency-related matters seen in the Lamfalussy ReportEuropean Commission,Report from the Commission to the Council and European Parliament, Evaluation Report on the Financial Collateral Arrangements Directive (2002/47/EC), 2006, COM (2006) 833 final, 10 has been resolved largely through trade association lobbying for law reform.Benjamin, 269 In England and Wales, the effect of British Eagle International Airlines Ltd v Compagnie Nationale Air France has largely been negated by Part VII of the Company Act 1989 which allows netting in situations which are in relation to money market contracts. In regard to the BASEL Accords, the first set of guidelines, BASEL I, was missing guidelines on netting. BASEL II introduced netting guidelines.
Settlement netting For cash settled trades, this can be applied either bilaterally or multilaterally and on related or unrelated transactions. Obligations are not modified under settlement netting, which relates only to the manner in which obligations are discharged.P Wood, Title Finance, Derivatives, Securitisation, Set off and Netting, (London: Sweet & Maxwell, 1995),153-5 Unlike close-out netting, settlement netting is only possible in relation to like-obligations having the same settlement date. These dates must fall due on the same day and be in the same currency, but can be agreed in advance.Joanna Benjamin, Financial Law (2007, Oxford University Press), p274 Claims exist but are extinguished when paid. To achieve simultaneous payment, only the act of payment extinguishes the claim on both sides. This has the disadvantage that through the life of the netting, the debts are outstanding and netting will likely not occur, the effect of this on insolvency was seen in the above-mentioned British Eagle. These are routinely included within derivative transactions as they reduce the number and volume of payments and deliveries that take place but crucially does not reduce the pre-settlement exposure amount.
Bilateral Net Settlement System: A settlement system in which every individual bilateral combination of participants settles its net settlement position on a bilateral basis.
Multilateral Net Settlement System: A settlement system in which each settling participant settles its own multilateral net settlement position (typically by means of a single payment or receipt).
Set-off Set-off, also sometimes "set off",Weatherall, I. and Ryan, S., THE BASICS: WHAT IS SET OFF AND WHEN DOES THE RIGHT TO SET OFF ARISE?, Gowling WLG, published 6 August 2019, accessed 1 October 2022 is a legal event and therefore legal basis is required for the proposition that two or more gross claims are to be netted. Of these legal bases, a common form is the legal defense of set-off, which was originally introduced to prevent the unfair situation whereby a person ("Party A") who owed money to another ("Party B") could be sent to debtors' prison, despite the fact that Party B also owed money to Party A. The law thus allows both parties to defer payment until their respective claims have been heard in court. This operated as an equitable shield, but not a sword. Upon judgment, both claims are extinguished and replaced by a single net sum owing (e.g. If Party A owes Party B 100 and Party B owes Party A 105, the two sums are set off and replaced with a single obligation of 5 from Party B to Party A). Set-off can also be incorporated by contractual agreement so that, where a party defaults, the mutual amounts owing are automatically set off and extinguished.
In certain jurisdictions, including the UK,Insolvency Act 1986, section 323; Insolvency Rules 1986, rule 4.90. certain types of set-off take place automatically upon the insolvency of a company. This means that, for each party which is both a creditor and debtor of the insolvent company, mutual debts are set-off against each other, and then either the bankrupt's creditor can claim the balance in the bankruptcy or the trustee in bankruptcy can ask for the balance remaining to be paid, depending on which side owed the most. This principle has been criticized Riz Mokal Corporate Insolvency Law (Oxford: Oxford University Press 2005) as an undeclared security interest which violates the principle of pari passu. The alternative, where a creditor has to pay all its debts, but receives only a limited portion of the leftover moneys that other unsecured creditors get, poses the danger of 'knock-on' insolvencies, and thus a systemic market risk.Louise Gullifer, Goode and Gullifer on Legal Problems of Credit and Security (Sweet & Maxwell, 7th ed) 2017Roy Goode, Principles of Corporate Insolvency (Fourth Edition, Sweet & Maxwell 2013), 278 Even still, three core reasons underpin and justify the use of set-off. First, the law should uphold pre-insolvency autonomy and set-offs as parties invariably rely on the pre-insolvency commitments. This is a core policy point. Second, as a matter of fairness and efficiency both outside and inside insolvency reduces negotiation and enforcement costs.Stein v Blake ; Halesowen Presswork Third, managing risk, particularly systemic risk, is crucial. Clearing house rules offer stipulation that relationships with buyer and sellers are replaced by two relationships between buyer and clearing house, and seller and clearing out. The effect is an automatic novation, meaning all elements are internalized in current accounts. This can be in different currencies as long as they are converted during calculation.