Recoupment and bankruptcy: how to effectuate bankruptcy policy through the same transaction test.

• Author: Thessen, Jacob

Terry v. Standard Ins. Co. (In re Terry), 687 F.3d 981 (8th Cir. 2012)

1. INTRODUCTION

   Mixing the federal Bankruptcy Code with common law claims can certainly be a precarious endeavor. The complexity of applying common law doctrines to bankruptcy cases is apparent when a defendant invokes the defense of recoupment to reduce his liability against a bankrupt plaintiff's claim.

   Recoupment has been described as a "powerful tool" in bankruptcy, capable of seriously influencing an individual's income or an organization's ability to reorganize. (1) In essence, the common law equitable doctrine of recoupment allows a "creditor's claim against a debtor to be reduced by reason of some claim the debtor has against the creditor." (2) It was first applied under the Bankruptcy Code in the 1980's and has since become well established. (3) More recently, however, a number of courts have shown a "judicial distaste" for the doctrine and have refused to allow defendants to successfully utilize the recoupment defense against bankrupt plaintiffs. (4) Some scholars would seek to abolish recoupment completely or, at the least, severely limit its scope in the context of bankruptcy. (5)

   This Note will explore the interaction between recoupment and bankruptcy by focusing on the Eighth Circuit's decision in In re Terry. (6) Terry is significant because the Eighth Circuit allowed an insurance company to recoup pre-petition overpayments from the bankrupt debtor's post-petition benefits. (7) In doing so, the Eighth Circuit refused to acknowledge a separate balancing of the equities test, independent from the traditional same transaction requirement, when determining a creditor's recoupment defense. (8)

   This discussion will center on recoupment's "same transaction" test and why it can be utilized to achieve sound bankruptcy policy by denying recoupment claims. It is this Note's contention that Terry's precedent, that the doctrine of recoupment does not include a separate equitable balancing test, will not be as devastating to bankrupt plaintiffs as initially thought by bankruptcy practitioners and judges. This is because the same transaction test is still a viable legal tool capable of denying recoupment.

2. FACTS AND HOLDING

   As an employee of the State of Missouri and member of the Missouri State Employees' Retirement System (MOSERS), Joseph Terry received a group long-term disability policy through Standard Insurance Company (Standard). (9) In the event of a disability, the Long Term Disability (LTD) policy provided eligible employees a monthly long-term benefit for the purpose of protecting the disabled employees' earning abilities and bridging the gap between the date a disability occurred and the date of recovery or retirement. (10)

   Similar to most long term disability plans," (11) Standard's policy included a setoff provision that classified Social Security benefits as "deductible income." (12) This means that Standard's obligation to pay the disabled employee was reduced, dollar-for-dollar, by any amount the employee received from social security disability insurance. (13) Under the LTD policy, it was the obligation of the disabled employee to refund Standard for any overpayment of benefits that resulted from collecting social security income. (14)

   Terry became disabled and unable to work on December 6, 2005, as the result of severe bipolar disorder with psychotic features. (15) He subsequently filed a long-term disability claim under the LTD policy. After the insurance company approved the claim, Terry began receiving benefits from Standard in August of 2006. (16) Pursuant to the deductible income provision of the LTD policy, Terry authorized Standard to automatically withdraw from his bank account any retroactive Social Security disability payments he received in order to satisfy the resulting "overpayment" of benefits obligation. (17) In July 2008, Terry received a $45,316.54 lump-sum award of Social Security disability benefits retroactively dated to June 1, 2006. (18) Consistent with Terry's prior authorization, Standard withdrew $45,316.54 from the Debtor's bank account on July 24, 2008. (19) One week later, Terry filed for bankruptcy. (20)

   On April 20, 2009, the bankruptcy trustee sent a demand letter to Standard. (21) The trustee characterized the retroactive Social Security payment as a voidable preference under section 547 of the Bankruptcy Code (22) and instructed Standard to return the $45,316.54 it withdrew from Terry's account prepetition." (23) Standard immediately complied, apparently with little or no resistance, and sent the money to the trustee. (24) After Standard transferred the $45,316.54 to the trustee, the insurance company began to deduct $430.20 each month from Terry's post-petition disability benefits in order to recover the amount of the retroactive Social Security benefits forfeited to the trustee. (25) Standard ceased these deductions and repaid Terry the benefit withholdings after the bankruptcy court voiced its concern that Standard may have violated the automatic stay. (26)

   On July 30, 2009, Terry commenced an action against Standard in the United States Bankruptcy Court of Western Missouri seeking, in relevant part, a declaratory judgment requiring Standard to pay, without any deductions based on Social Security payments, all of his future disability benefits as provided under the MOSERS LTD plan. (27) Standard asserted the right of recoupment as a defense against Terry's claim for post-petition insurance payments, arguing that Terry owed the company $45,316.54 for pre-petition overpayments under the insurance policy. (28)

   The bankruptcy court granted Terry's declaratory judgment and found that Standard did not have the right to recoup $45,316.54 from Terry's claim for future benefits. (29) Because there was, in fact, a transfer of $45,316.54 from the debtor to the creditor before the bankruptcy filing in this case, the court concluded that Terry's overpayment obligation was already satisfied. (30) The dispositive issue, therefore, was whether Standard could assert a claim through section 502(h) of the Bankruptcy Code. (31) According to the court's interpretation, the statutory language of section 502(h) and the Eighth Circuit's decision in U.S. Postal Service v. Dewey Freight System, Inc. (32) did not permit recoupment. (33) The court further justified its holding, denying Standard's recoupment claim, as being consistent with the purpose of the Bankruptcy Code to facilitate equal distribution among creditors. (34)

   Standard appealed the adverse decision to the Eighth Circuit's Bankruptcy Appellate Panel (BAP), (35) which found some major flaws in the legal analysis of the bankruptcy court's opinion. (36) The BAP stated that the bankruptcy court erred in holding that section 502(h) of the Bankruptcy Code precluded Standard from recouping the overpayment from Terry. (37) Additionally, the BAP concluded Dewey's precedent was inapplicable to the present case. (38)

   Since both parties' rights and obligations arose under the LTD plan and Terry did not adequately argue that the parties' obligations were not sufficiently distinct, the BAP determined that Standard's recoupment claim met the requirement that both debts arise from the same transaction. (39) The BAP went on to emphasize the equitable nature of recoupment and how the doctrine should be narrowly construed in bankruptcy. (40) The case was remanded back to the bankruptcy court so it could properly balance the equities to determine if recoupment was appropriate. (41) The BAP's opinion concluded by offering some relevant considerations the bankruptcy court should examine when balancing the equities. (42) This guidance was highly preferential to Terry. (43)

   On remand, the bankruptcy court employed a balancing approach and found that the equities weighed in favor of Terry for two reasons. (44) The first was transactions based: allowing Standard's recoupment claim would essentially force Terry to repay his debt a second time, and, not to mention, Standard failed to put up any sort of fight when it immediately sent the money to the bankruptcy trustee. (45) The second rationale centered on Terry's medical prognosis, bleak employment prospects and minute income. (46) In the end, the court felt that the hardship imposed on Terry by the recoupment claim was too severe and held that "Standard [wa]s simply in a better position to sustain this loss." (47)

   The Eighth Circuit reversed and held that Standard was entitled to invoke the common law equitable defense of recoupment because the obligations of both Terry and Standard arose under the same transaction, the LTD plan. (48) Thus, Standard would be able to offset the $45,316.54 in "overpayments" Terry owed it under the deductible income provision of the LTD plan against Terry's claim for future benefits. (49) Of crucial importance, the Eighth Circuit made clear that an equitable balancing test was unnecessary because the singular requirement for recoupment, that both party's claims arise from the same transaction, already incorporates elements of "[f]airness and equity" into the doctrinal analysis. (50)

3. LEGAL BACKGROUND

   1. The Doctrine of Recoupment and Its Application in Bankruptcy

      The common law defenses of recoupment and its more familiar colleague, setoff, are ostensibly similar. As put by the bankruptcy court in Terry, both doctrines are defenses employed by "a defendant to reduce or extinguish a plaintiffs claim by reason of a claim the defendant has against the plaintiff." (51) However, significant distinctions between the two remedies do exist and are significant for purposes of the Bankruptcy Code.

      First, the Bankruptcy Code's automatic stay enjoins "the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor." (52) In contrast, the automatic stay provision does not expressly apply to recoupment, and...