A usual query that arises in Spain in almost any single reinsurance transaction or contract where some money is advanced or handed over between the parties is whether it is possible to set-off mutual debts within an insolvency proceedings.
Set-off is an equitable right that allows the parties to a contract to cancel or offset mutual debts to each other by asserting the amounts owed, subtracting one from the other and paying only the balance. In particular, the right of set-off is used in day-to-day business transactions between reinsurers and cedants (reinsured). Balances due to the reinsured for paid losses and earned premiums due from the reinsured to the reinsurer are netted out between the reinsured and the reinsurer through periodic accounting reports.
Besides this net accounting, the right of set-off can be secured as an express contractual right to protect the paying party towards the other party when the latter ceases to pay the amounts due under the reinsurance agreement.
The interest of the parties to set-off amounts arises, for example, in VIF (Value in Force) transactions, which imply monetizing the value in force of an insurer's individual life risk portfolio to allow such insurer to exchange the expectation of future cashflows for an upfront amount of capital. These VIF transactions, quite frequent in Spain during the last crisis, are structured through a reinsurance treaty whereby the cedant cedes the defined book to the reinsurer in exchange of an upfront reinsurance commission reflecting the assessment of the future profits expected to arise from such defined book of business. At the signing date of a VIF, the reinsurer shall pay a (usually) very high reinsurance commission, whereas the cedant pays an initial premium.
The right of set-off is particularly relevant in those cases where the cedant transfers the reserves to the reinsurer to enable the reinsurer to pay the reinsured claims. In these cases, the reinsurer is usually interested in being able to offset the reserves against amounts due by the cedant, especially in case of insolvency of the cedant.
This same problem arises in those cases where a reinsurance treaty provides for a premium withheld account, whereby the insurer withholds the periodic premiums collected from the policyholders up to the end of the period foreseen in the reinsurance contract in order to guarantee the fulfillment of the reinsurer's obligations. In such case, it is the cedant who needs to be entitled to offset the infringements of the reinsurer (unpaid reinsured claims) with the funds withheld.
The possibility of offsetting payments is expressly regulated under articles 1195 to 1202 of the Spanish Civil Code. According to these articles, set-off is permitted when two persons or entities are reciprocally creditors and debtors of each other, provided that the following requirements (set out under article 1196 of the Civil Code) are met:
- Each of the persons is a creditor of the other.
- Both debts consist of a sum of money or, when things owed are fungible, that they are of the same kind and also of the same quality, if the quality has been designated.
- Both debts must have matured.
- They are liquidated and enforceable.
- None of them is subject to any retention or dispute brought by a third party and of which due notice has been given to the debtor.
In light of the aforesaid, as a general rule set-off is permitted under Spanish law, provided that certain requirements are met. However, the problem arises when one of the parties to the contract becomes insolvent.
The insolvency of the cedant does not imply the automatic termination of the reinsurance contract. In fact, the general rule (according to article 61.2 of the Insolvency Act) is that the ''the opening of the insolvency proceedings itself shall not affect the effectiveness of those contracts with reciprocal obligations pending to be fulfilled by both parties to the contract (…)''. Nevertheless, in accordance with the second paragraph of article 61.2 of the Insolvency Act, the Mercantile Court (or the Insurance Compensation Consortium –"Consorcio de Compensación de Seguros" or "CCS"-, as the case may be, because this public entity can be entrusted with the liquidation of an insurance company) could decide the termination of the reinsurance contract if they consider it appropriate for the interest of the insolvency proceedings, in which case the Court or the CCS would have to determine the indemnities to be paid to the reinsurer (solvent party) as a result of the early termination.
Obviously, the insolvency of the cedant will not release the reinsurer of its obligation to pay all the amounts owed to
the insurer as a consequence of the reinsurance contract (the insurer could ask for the fulfilment of the contract and for the payment of the pending indemnities).
So, in general terms, the reinsurance contracts will remain in force in case of insolvency of any of the contracting parties.
Under the Insolvency Act, the general rule is that it is not possible to set-off obligations once the insolvency of a contractual party is declared. In this sense, article 58 of the Insolvency Act states the following:
''Article 58. Prohibition of set-off.
Without prejudice to the provisions established in article 205, once insolvency proceedings are declared open, it shall not be possible to set-off the claims and debts of the insolvent debtor, but a set-off whose requirements were fulfilled prior to the declaration shall take effect.
In the event of controversy over this particular issue, it shall be resolved through the channels of insolvency procedural plea''.
As stated in aforementioned article 58 of the Insolvency Act, set-off would only be possible if the requirements for the set-off, established under article 1196 of the Civil Code, are complied with before the insolvency proceedings are declared open.
Nevertheless, a large number of Scholars consider that the prohibition established under article 58 of the Insolvency Act does not apply (and, thus, set-off is permitted upon the insolvency of one of the contracting parties) when the credits and debts to be offset have the same origin or cause (''ex eadem causa''). That is, when the credits and debts derive from the same contract which foresees such set-off. According to this interpretation, the set-off that is carried out in those cases is not the general legal set-off of credits and debts of the insolvent company due to the whole number of contracts in which it is a party (situation to which article 58 of the Insolvency Act refers, according to the aforesaid Scholars) but instead, the set-off is the way of performance of the contract agreed by the parties.
On the contrary, there are also some Scholars (a minority) who understand that there shall be no exceptions to the general rule set out under article 58 of the Insolvency Act: set-off is not possible upon the opening of the insolvency proceedings. These Scholars understand that if the legislator had intended to exclude from the set-off prohibition credits ''ex eadem causa'', he would have expressly stated in article 58 of the Insolvency Act.
As it can be deduced from the above, the possibility of setting-off debts and credits deriving from the same contract is quite controversial. The Supreme Court has given some light on this issue very recently. In its Ruling of 13 March 2017 it says:
"Actually, we are not before a compensation per se (…). We find ourselves before a liquidation scenario of one single contractual relationship where obligations have arisen for both parties involved. In the rulings 188/2014, of 15 April, and 428/2014 of 24 July we have considered that in scenarios like this one, even in the case where the loans arise amongst a bankruptcy procedure, we are before a contract liquidation mechanism and not before compensations where Section 58 of the Bankruptcy Act is applicable".
This position of the Supreme Court has been held by the Barcelona High Court of Appeal in several judgments (for instance, rulings of 9 October 2014, 26 March 2014 and 6 March 2014), where it is expressly concluded that the set-off of mutual debts arising from the same contract shall be permitted upon the insolvency of one of the parties to such contract. However, other courts (for example, the Madrid High Court of Appeal –judgment of 8 July 2008-) defend the opposite interpretation: upon insolvency set-off is only permitted if the requirements established under article 1196 of the Civil Code are met, regardless of whether the debts to be offset derive from the same title or contract. According to the High Court of Madrid, if the possibility to set-off is extended, the principle ''par condition creditorum'' (equal treatment of creditors) would be infringed.
Therefore, although the issue is controversial, we understand there are solid grounds (based on the position of most Scholars and some case law) to defend that the general prohibition established under article 58 of the Insolvency Act (which prohibits set-off upon the opening of insolvency proceedings) does not apply when the mutual debts to be offset derive from a single contract with bilateral and reciprocal obligations between the parties (like a reinsurance contract). Therefore, in our opinion, it is possible to agree a set-off regime in a reinsurance transaction and this would be valid even in the case of the insolvency of the cedant.