Set-off is a fundamental concept in today’s economy. It is particularly important in the financial markets, where it performs a crucial role in facilitating financial transactions and reducing risk. In its basic form, the concept of set-off is easy enough to apply. However, the concept becomes more difficult to apply in circumstances that involve insolvency. In such circumstances, jurisdictions often have to make difficult choices between competing interests and competing priorities.
This article outlines the concept of set-off, both in its basic form and also when it operates as an integral part of the mechanism that is called “close-out netting” (净额结算). This article begins with an explanation of set-off in its basic form and the challenges that arise in the context of insolvency. It then examines close-out netting and how this mechanism operates in various jurisdictions, including China.
What is set-off?
In its basic form, set-off occurs where two parties owe each other debts that are payable on the same date resulting in a mutual debt. Instead of each party paying the full amount of the debt that it owes to the other party, the relevant debts are set off against each other and the net amount is paid by the party whose debt is greater. For example, let’s say that Party A owes $100 to Party B and Party B owes $150 to Party A. The effect of set-off is that Party B would pay the net amount of $50 to Party A.
Set-off can occur either by operation of law (e.g. where set-off is permitted or required by law) or by contract between the parties. Set-off is recognised by the Contract Law, articles 99 and 100 of which provide as follows:
Where the parties owe mutual debts that are due and the subject matter of the debts is identical in type and quality, either party may set off its debt against the debt of the other party, except where set-off is prohibited in accordance with the provisions of law or the nature of the contract. The party asserting set-off must notify the other party. The notice becomes effective when it reaches the other party. Set-off may not be subject to any condition or time limit.
Where the parties owe debts to each other and the subject matter of the debts is not identical in type and quality, the parties may exercise set-off by mutual agreement.
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A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.