Recoupment – Is it the same transaction?

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Recoupment is an equitable remedy – not expressly addressed in the Bankruptcy Code – that permits the offset of mutual debts arising out of the same transaction or occurrence.  Unlike typical setoff, if recoupment applies, prepetition debts can be set off against postpetition debts.  A recent decision from the Delaware bankruptcy court demonstrates that the availability of recoupment often depends on how the court defines the contours of the “same transaction or occurrence” requirement. It also highlights the differences between the Second Circuit and Third Circuit in applying this doctrine.

Before its bankruptcy filing, WL Homes LLC (“WL Homes”), a homebuilder, took out an insurance policy (the Home Builders Protective Insurance Policy) with Zurich American Insurance Company (“Zurich”).  The policy covered WL Homes for damages and defense costs relating to, among other things, construction defects.  Coverage under the policy only kicked in after WL Homes itself paid a certain portion of these costs, defined under the policy as a self-insured retention (“SIR”).  Prior to the petition date, various homeowners filed claims against WL Homes for construction defect flaws, several which were large enough to implicate Zurich’s obligations under the policy.

After WL Homes filed its bankruptcy petition, Zurich performed an audit and determined that WL Homes had overpaid its premium obligations under the policy for the 2007 to 2009 term by approximately $2.2 million.  WL Homes’ chapter 7 trustee filed an adversary complaint, seeking turnover of the $2.2 premium overpayment – the “return premium” – as property of the estate.  Zurich responded that it had setoff and recoupment rights for amounts it had paid post-petition on construction defect claims covered under the policy, up to the SIR amount.

The trustee proffered two arguments as to why recoupment was unavailable.  First, the policy did not include an express contractual claim for reimbursement of the premiums that WL Homes had made, and such reimbursement obligation arose from quasi-contract principles.  Second, recoupment was unavailable to Zurich because the premium reimbursements and the amounts paid on the construction defect claims arose from discrete and independent units of the Policy.

The bankruptcy court disagreed with the trustee and concluded that recoupment was available.  In response to the trustee’s first argument, the court held that an express contractual right is not necessary to effect recoupment.  The court reasoned that the economic realities of the insurance relationship dictated that it was illogical to conclude that Zurich had deliberately waived or foregone its right to be reimbursed if it paid amounts within the SIR. Further, the insurance policy was governed by California law, and the Supreme Court of California has held that a contractual right to reimbursement is not necessary in an insurance contract.

The court also held that the trustee’s second argument was misplaced.  Specifically, the trustee was incorrectly applying Second Circuit law, where recoupment fails as a matter of law when the mutual obligations arise from “discrete and independent units” of a transaction.  In contrast, the analysis in the Third Circuit focuses on the contractual relationship between the parties and whether the debts on both sides arise from a “single integrated transactionso that it would be inequitable for a debtor to enjoy the benefits of that transaction without also meeting its obligations.  Here, the SIR and the premium charged under the insurance contract were part of an integrated transaction that formed the basis of the relationship between the WL Homes and Zurich.  The court concluded that allowing WL Homes to enjoy the benefits of the return premiums and at the same time relieving it of the burden of its SIR obligations would be inequitable.

The decision illustrates how the availability of the recoupment remedy to mutual obligations arising under a single contract may depend on a court’s view of the recoupment standard.  Courts that conclude that the obligations need not arise from discrete and independent units, and need only be components of a single integrated transaction, may be more inclined to conclude that recoupment is available.