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Setoffs as a Tool in Business Litigation: How They Work and Why They Can Get Complicated

Here’s a hypothetical scenario:

Anna, who owns a marketing agency, wants to sell her business and retire. She finds a buyer, Herb, who first showed an interest in the agency a while back, when he hired Anna as a consultant to his own firm. Since Herb can’t afford to pay for Anna’s agency in cash, the two parties enter into a loan agreement. Herb will make monthly payments of principal plus interest to Anna until he has paid off the debt.

Things go well for a while. But halfway through the private loan, Herb runs into financial difficulties and has a hard time making the payments to Anna. His lawyers come up with a plan to reduce the debt. Arguing that Anna, in the previous consulting agreement, overcharged Herb to the tune of $10,000, they want her to deduct $10,000 from the balance of the loan. In terms of business law, they are asking for a setoff.

Setoffs are a popular business tool. They effectively allow a creditor to collect on a debt even if the other party has declared bankruptcy. But litigation over the application of setoffs can be complicated for various reasons.

Statute of Limitations

One of them is the statute of limitations. The California Code of Civil Procedure section 337 allows a party to a written contract no more than four years to sue for breach of contract in an independent lawsuit. But the same statute of limitations does not necessarily apply to setoffs; the California Code of Civil Procedure Section 431.70 allows cross-demands for money even after four years have passed if there was a point in time where the cross-demand existed and the statute of limitations had not run out on either of the two demands.

What does that mean for Herb and Anna? Well, my hypothetical scenario lacks a timeline and other essential pieces of information. To determine whether cross-demands for money apply and to which degree, would require a detailed understanding of the underlying business relationship between the parties. I would also have to scrutinize the minutiae of every transaction and contract the two parties made. Whether Herb’s plan for a setoff will work, depends on a number of factors. They include how old the consulting contract is. The bottom line is that setoff situations can get complicated. And they generally call for the engagement of not just any attorney but of an experienced business litigator.

By Kevin J. Moore