Although the terms “set-off” and “netting” are often used interchangeably, they each have a different legal meaning and should be used carefully when applied in finance transactions.
Set-off is the offset of competing monetary claims to produce a single amount owed by one person to another. So, for example, where two parties have mutual payment obligations, one can offset the amount it owes to the other against the credit it has in relation to the other party. As a result, one party’s liability will be reduced or extinguished.
Set-off arises in different contexts. The main types of set-off are:
- (a) legal set-off is available when two claims are liquidated or ascertainable and are due and payable when a claim is made. It is not necessary for the claims to be in respect of the same transaction or closely connected;
- (b) equitable set-off is used when two different claims arise from the same transaction or are closely connected. The claims must involve the same parties and the same right and must be for money, due and payable, or for relief based on the non-payment of money;
- (c) current account or banker’s set-off is the right of a bank to set-off amounts from different accounts owned by the same customer. A bank may combine the accounts and set-off a debit balance from one account against a credit balance from another;
- (d) contractual set-off is widely used in financial transactions in which the parties to a contract expressly agree on the right of set-off. The contractual set-off may be freely arranged by the parties except for the limitations imposed by insolvency law (see below); and
- (e) insolvency set-off is available where, in accordance with the Insolvency Rules 1986, before the liquidation of a company, "there have been mutual credits, debits or other mutual dealings" between the company and a creditor. It applies when one party to a transaction becomes insolvent and there are mutual liabilities with the other party to a transaction. Importantly, insolvency set-off is compulsory and contracting out is not permitted.
Netting is the process contractually agreed by counterparties to consolidate mutual claims into a single net balance. This involves the termination of the mutual transactions, their valuation and the replacement of the liabilities for a single payment. Netting may be particularly useful when the mutual claims do not concern debt agreements but executory agreements where, for instance, one party is required to deliver certain commodities to the other. Netting is particularly useful in reducing transaction costs.
Netting is generally used in two circumstances. First, it is used where contracting parties have mutual payment obligations. These obligations are terminated and replaced by a single payment obligation by one party to the other (unlike contractual set-off where the parties agree that, where there are mutual payment obligations, set-off may be exercised to reduce or eliminate the amount due to be paid).
Secondly, “close-out netting” can be used where an executory contract is terminated. Unlike debt contracts (where set-off is more appropriate), the obligations of the parties pursuant to an executory contract are not vested assets. A netting provision may, on termination, require the parties’ mutual obligations to be valued and the profits and losses arising from the valuation to be offset to produce a single amount payable by one party to the other.