Eighth Circuit Holds that the "Equities" Do Not Need to Weigh in Favor of a Creditor Seeking Recoupment

Contributed by Cristine Pirro
The Eighth Circuit recently considered whether a creditor that meets the same transaction requirement of recoupment otherwise may be denied recoupment if a separate balancing of the equities weighs against allowing recoupment.  The Eighth Circuit held that, while recoupment is an equitable principle such that equity may influence whether two claims arise from the same transaction, courts should not impose an additional balancing of the equities requirement once a party meets the same transaction test.
The case before the court involved an individual debtor, Joseph Terry, who became disabled and unable to work in December of 2005.  Terry filed a claim under a long-term disability insurance policy issued by Standard Insurance Company and began receiving benefits in August of 2006.  The policy provided that benefits payable to a disabled employee would be reduced by the amount of any benefits such disabled employee received under the Social Security Act.  To satisfy any overpayment, Terry authorized Standard to automatically withdraw any retroactive Social Security disability benefits received.
In July of 2008, Terry received a $45,316.54 lump sum award of Social Security disability benefits retroactive to June of 2006.  Standard subsequently withdrew that amount from Terry’s bank account.  A week after Standard withdrew the overpayment, Terry filed a chapter 7 case.  The chapter 7 trustee demanded turnover of the payment on the basis that it was a preferential transfer under section 547 of the Bankruptcy Code.  Although Standard complied, Standard also began reducing its monthly payments to the debtor to slowly recover the $45,316.54.  Shortly thereafter, the bankruptcy court commented that the deductions might be in violation of the automatic stay, at which point Standard ceased making the monthly reductions.  Standard then attempted to decrease its future payments to the debtor through the equitable right of recoupment, which permits a defendant to reduce or extinguish a plaintiff’s claim by reason of a claim the defendant has against the plaintiff.  Recoupment requires the claims to have arisen out of the same transaction, but, unlike a setoff right under section 553(a) of the Bankruptcy Code, does not require mutuality with respect to the timing of the obligations.  Thus, one obligation may have occurred prepetition and the other postpetition.
The bankruptcy court ruled that Standard could not recoup the payments because section 502(h) of the Bankruptcy Code limited Standard to filing a general unsecured claim against the estate.  That section provides that certain claims arising from the recovery of property are allowed or disallowed as if they arose prepetition.  The bankruptcy court explained that, once the trustee avoided the preferential transfer, Standard received a claim against the estate (not the debtor) by virtue of section 502(h) of the Bankruptcy Code.  The issue then became whether section 502(h) permitted a claim for recoupment, and the bankruptcy court determined it did not.
The Bankruptcy Appellate Panel for the Eighth Circuit reversed and remanded, finding that nothing in section 502(h) limited Standard to a claim against the estate or otherwise changed Standard’s right to recovery.  The BAP additionally found that recoupment is an equitable remedy, and the bankruptcy court should have considered whether the equities weighed in favor of recoupment.  The BAP thus reversed and remanded to the bankruptcy court to determine whether the equities weighed in favor of allowing Standard to recoup the overpayment from Terry’s postpetition benefits.
On remand, the bankruptcy court found that the equities weighed in favor of denying Standard’s request for recoupment.  While the bankruptcy court explicitly stated that it could not find “any generic equitable factors to consider in determining whether to permit recoupment,” the factors listed by the BAP (which included, inter alia, whether allowing recoupment would compromise the debtor’s fresh start and whether recoupment would be particularly inequitable given that the debtor was permanently disabled) weighed against recoupment.
The Eighth Circuit acknowledged that recoupment is, indeed, an equitable principle that requires that the claims to be offset arise out of the same transaction or subject matter.  This requirement, often referred to as the “same-transaction” requirement, “acts as a mechanism to ensure that equitable reasons for recoupment are present before a creditor may attain priority through the doctrine of recoupment.”  Analysis of the same-transaction requirement, the Eighth Circuit reasoned, requires the court to consider the equities of the case only to the extent that it would be inequitable for a debtor to enjoy the benefits of a transaction without also meeting its obligations.  Because the same-transaction requirement incorporates equitable principles to some extent, a separate balancing of the equities test should not be introduced into the doctrine of recoupment.  The Eighth Circuit found that the BAP erred by introducing equity as a separate reason to deny Standard the right of recoupment after finding that the same-transaction requirement was met.  Thus, although “[f]airness and equity may influence whether two competing claims arise from the same transaction . . . a court should not impose an additional ‘balancing of the equities’ requirement once a party meets the same-transaction test.”  The Eighth Circuit accordingly remanded to the bankruptcy court for yet another round of review.
Interestingly, the Eighth Circuit’s focus on “equitable principles” in the context of recoupment seems directed at the debtor and whether the debtor is unfairly denying the non-debtor the benefits of its bargain by attempting to separate into two transactions what was intended to be a single transaction under which the parties would net out amounts owed.  This approach is the opposite of the approach taken by the Eighth Circuit BAP, which seemed interested in focusing on the fairness to the debtor of characterizing a transaction as recoupment instead of setoff.  Although cloaking its decision in the rubric of “equitable principles,” though, the Eighth Circuit did not elaborate on how such principles actually would affect the determination of whether two offsetting obligations arose out of the same transaction.