Lenders’ security interest sent to T&B was not required. For these reasons, the bankruptcy court held that T&B’s right
of setoff did not have priority over, and was cut off by, the Lenders’ security interest.
The district court in the Wheeling and Lake Erie Ry. Co. case rejected the bankruptcy court’s holding in the Communication Dynamics case that a lender’s or its borrower’s delivery of
an authenticated noti cation of the lender’s security interest to the creditor is not necessary to cut off the creditor’s setoff rights. The district court concluded that the Communication Dynamics court had failed to take into account UCC Section 9-404(a)(2)’s clear requirement that either Wheeling or MMA had to provide an authenticated noti cation of Wheeling’s prior security interest to wipe out the Defendants’ setoff rights. This requirement ensures that account debtors, such as the Defendants, are made aware of a secured creditor’s prior rights in the account receivable that the account debtor owes the secured creditor’s borrower, and can then act accordingly to protect the account debtors’ rights.
T&B’s Right of Recoupment
T&B next argued that even if the Lenders’ prior security interest cut off T&B’s setoff rights, T&B was still entitled to recoup the credits it owed the Debtor to reduce T&B’s claim against the Debtor because the debts T&B and the Debtors owed each other both arose from the sale of equipment under the distribution agreement. It did not matter that the Lenders’ prior security interest in the Debtor’s accounts receivable cut off T&B’s setoff rights.
The Debtor countered that the credits (which T&B owed the Debtor)—generated in connection with equipment for which the Debtors had already paid T&B—were unrelated to the equipment purchases giving rise to T&B’s claim (against the Debtor). As a result, T&B was not entitled to a right of recoupment and, at most, had setoff rights that were cut off when T&B had received the D&B report that disclosed the Lenders’ security interest.
The Bankruptcy Court’s Decision
The bankruptcy court upheld T&B’s recoupment rights and granted T&B’s motion for relief from the automatic stay so that T&B could recoup the credits against the amounts the Debtor owed T&B. The court broadly interpreted recoupment rights to hold that recoupment arises when both debts arose out of a single integrated transaction such that it would
be unfair to allow the debtor to enjoy the bene ts of the transaction without also meeting its obligations under the transaction. The credits and equipment purchases were both part of a single integrated transaction. Indeed, the distribution agreement contemplated T&B’s sale of multiple pieces of
equipment to the Debtor and the parties certainly intended for the credits to be applied to all of the Debtor’s purchases of equipment from T&B. Moreover, the credits were generated only after the Debtor had sold the equipment to an end-user below the standard price, which typically occurred long after the Debtor had paid T&B for the equipment.
Conclusion
In dealing with a delinquent customer, a trade creditor should be aware of and weigh its options, including whether it can exercise setoff rights. The Wheeling & Lake Erie
Ry. Co. v. Maine Northern Ry. Co. decision is certainly a positive development for trade creditors to the extent it limits a secured lender’s ability to cut off trade creditors’ setoff rights. However, in light of the contrary holding of the Communication Dynamics court, a trade creditor receiving D&B reports or other information that disclose a security interest in its customer’s accounts receivable should be aware that the creditor’s customer’s secured lender might challenge the creditor’s setoff rights. The creditor can avoid this unfavorable outcome if it can prove that either its setoff rights arose prior to its receipt of noti cation of the lender’s security interest or the creditor has recoupment rights.
About the authors:
Bruce S. Nathan, Partner in the  rm’s Bankruptcy, Financial Reorganization & Creditors’ Rights Department, has more than 30 years experience in the bankruptcy and insolvency  eld, and is a recognized national expert on trade creditor rights and the representation of trade creditors in bankruptcy and
other legal matters. Bruce has represented trade and other unsecured creditors, unsecured creditors’ committees, secured creditors, and other interested parties in many of the larger Chapter 11 cases that have been  led, and is currently representing the liquidating trust and previously represented the creditors’ committee in the Borders Group Inc. Chapter 11 case. Bruce also negotiates and prepares letters of credit, guarantees, security, consignment, bailment, tolling, and other agreements for the credit departments of institutional clients.
Barry Bazian, Esq. is an associate in the Bankruptcy, Financial Reorganization & Creditors’ Rights Department of Lowenstein Sandler LLP. He can be reached at [email protected].
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