Spotlighting the need for elaborate set-off provisions in commercial contracts

• Overview

  A set-off provision in a contract allows a debtor to reduce (in whole or in part) its debt to a counterparty by the amount that the counterparty owes to the debtor. Such provisions are relatively common in some commercial contracts, for example, loan agreements, investment documents, hire-purchase agreements, property lease documentation, forward purchase agreements, hedging/swap contracts, and service/employment agreements.

  However, many types of commercial contracts that could benefit from a set-off provision tend to lack such provisions, and often complex commercial contracts include a limited set-off clause, which does not fully account for the various nuances of the underlying deal. This is likely because the rules of equity would support a party’s right to set-off receivables against payables in most circumstances, even in the absence of an express contractual arrangement to that effect.

  Generally, outside of specific contracts such as futures or hedging contracts where ‘net settlement’ is standard, parties tend to consider set-off rights primarily in situations of insolvency or disputes over contractual obligations. In most commercial contracts, when parties assess the viability of set-offs (contractual or equitable), they are usually evaluating this in the context of such challenging circumstances.

  This article focuses on set-off rights in insolvency situations and analyses the need for instituting express and comprehensive set-off provisions.

• Set-off in insolvency under the Insolvency and Bankruptcy Code, 2016

  Under India’s Insolvency and Bankruptcy Code, 2016 (IBC), insolvency is broadly a two-phased process: (a) the corporate insolvency resolution process (CIRP); and (b) liquidation. In the CIRP phase, the creditors of an insolvent entity attempt to devise a plan to revive and rescue the entity, and during this process the insolvent entity (i.e., the corporate debtor) benefits from certain statutory protections, such as a moratorium on:

  The provisions of the IBC dealing with the CIRP do not expressly mention (or suspend or override) contractual set-off rights of debtors of the insolvent entity.

  • termination of leases of the property in possession of the corporate debtor;
  • disruption of supply of essential utility services to the corporate debtor; and
  • institution/continuation of suits or execution of any judgments against the corporate debtor.

  The provisions of the IBC dealing with the CIRP do not expressly mention (or suspend or override) contractual set-off rights of debtors of the insolvent entity. On the other hand, in the second phase (i.e., liquidation), the set-off rights of persons dealing with an entity in liquidation are expressly recognised under Section 173 (mutual credit and set-off) of the IBC and Regulation 29 (mutual credit and set-off) of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016.

  Following these provisions of the IBC, parties to commercial contracts have generally assumed that set-off rights (both contractual and equitable) would also be available during the CIRP process. Given that the CIRP process can be long-drawn and time-consuming, the absence of a set-off right during this phase could ultimately defeat its utility in practice.

  However, a recent Supreme Court decision has provided much-needed clarity on the applicability of set-off in insolvency proceedings. While assessing the enforceability of set-off rights against an entity undergoing CIRP, the Court concluded that contractual set-off rights are enforceable, but the enforceability of equitable set-off rights depends on the facts and circumstances.¹ The relevant extract is reproduced below:

  “The foundation of contractual set-off is based on the same ground as in the case of equitable set-off, which is impeachment of title, albeit contractual set-off is a result of mutual agreement that permits set-off and adjustment………………………The Resolution Professional takes the debtor’s property subject to all clogs and fetters affecting it in the hands of the debtor.”

  The observations of the Supreme Court in this decision have triggered a heightened focus on set-off provisions, both on their inclusion and their import in commercial contracts.

• Takeaways for commercial contracts

  In light of the decision of the Supreme Court, it is advisable to include strong, effective, and automatic set-off provisions in commercial contracts going forward, depending on the commercial considerations in each deal. To this end, the following key considerations must be kept in mind while negotiating and drafting such provisions.

  In light of the Supreme Court's decision, it is advisable to include strong, effective, and automatic set-off provisions in commercial contracts going forward, depending on the commercial considerations in each deal.

  • Express inclusion of set-off provisions: Set-off provisions must be expressly included when contracting with an Indian entity, including a clear acknowledgement by the contracting parties on such set-off provisions being fair and reasonable.
  • Requirements for execution: Set-off provisions should contain all the necessary mechanical requirements to be capable of execution without the need for further consent/agreement between the parties (for instance, where contracts involve multiple currencies). Additionally, contracts should clearly differentiate between a set-off right and a counter-claim, as this distinction can streamline the dispute resolution process for the parties.
  • Coverage at individual and group levels: Set-off provisions should extend beyond individual parties to include group-level considerations, where needed. For instance, where contracting parties are special purpose vehicles. This broader coverage ensures that set-off rights are preserved even when dealing with complex corporate structures, providing a safety net for financial obligations across related entities.
  • No separate notice for set-off rights: There should be no requirement for a separate notice or a separate action to trigger set-off rights. While the notice requirement follows from the need for legal certainty and the autonomy of the parties to decide if, when, and to what extent reciprocal claims should be set-off against one another, in certain scenarios, such as an Event of Default (EoD) or a termination event, parties may agree to a set-off provision without a notice requirement.
  • Cross-contract set-off provisions: In arrangements involving multiple contracts, such as an acquisition coupled with a distribution or procurement agreement, set-off provisions should be applicable across all related contracts to ensure seamless financial reconciliation.
  • Composite set-off in multiple dealings: For parties engaged in multiple inter-se dealings, like numerous sale and purchase orders, set-off provisions should operate in a composite manner across all transactions.
  • Applicability to indemnity/damages claims: Set-off rights should explicitly extend to compensation, damages, and indemnity claims, just as they apply to other payables and receivables, with clear understanding on any temporary limitations applicable to such rights.
  • Non-contingency of set-off rights: The applicability of set-off rights should not be hindered by the monetary liability being 'contingent' or not yet matured; they should be enforceable regardless of the claim's status.
  • Set-off across different capacities: When an individual contracts with an entity in various capacities, such as a contractor and a borrower, set-off rights should be applicable to inter-se claims across all such capacities, ensuring equitable financial treatment.
  • Unconditional set-off provisions: Set-off provisions should be absolute, without the necessity to demonstrate the inadequacy of any other collateral or rights, affirming the robustness of set-off as a financial safeguard.

  In M&A transactions with staggered payments, purchasers should consider incorporating set-off rights to adjust indemnity claims against any deferred or withheld consideration, while ensuring compliance with exchange control regulations. Similarly, in private equity or venture capital deals, where investors and founders/promoters share profits, including set-off rights for indemnity claims against founders/promoters can be beneficial, particularly if the founders/promoters undergo CIRP.

  Several commercial contracts, such as International Swaps and Derivatives Association (ISDA) agreements, have historically had robust set-off provisions and the decision of the Supreme Court validates/supports the approach of including such provisions resulting in a rich set of forms/precedents for set-off provisions.

^[1] Bharti Airtel Limited and Another v Vijaykumar V. Iyer and Others Civil Appeal nos. 3088-3089 of 2020

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