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The telecommunications industry is making headlines — fundamentally different headlines than this same industry made only a few years ago. By now, the stories have become all too familiar. A company (for example, “Telecom A”) develops a form of technology that it believes will revolutionize the way people communicate. In order to bring this technology to the masses, an extraordinarily complex and expensive infrastructure is required to be erected. However, these costs greatly exceed Telecom A’s projected revenues for many years. In an effort to finance this construction and maintenance, Telecom A borrows large sums of money, issues bonds and attracts third-party investors. Precipitously, the investments stop and the loans reach their capacity. It quickly becomes apparent that Telecom A may soon collapse under the weight of its own debt burden. While the names of the companies continue to change, the above fact pattern has been repeated numerous times over the past 18 months. [FOOTNOTE 1]Going forward, this pattern is likely to continue and, perhaps, even be accelerated by the fact that many telecommunications companies are interdependent upon each other for the use of the other’s networks and to serve as the other’s suppliers, distributors and purchasers. As such, when one company struggles, it puts other companies within the industry in jeopardy as well. In short, the recent flood of telecommunications companies filing for relief under the Bankruptcy Code is not likely to ebb anytime soon. Two doctrines that will continue to play a prominent role in these bankruptcy cases are those of setoff and recoupment. A recent decision by a Delaware bankruptcy court in In re Telephone Warehouse Inc. [FOOTNOTE 2]illustrates the applicability of those doctrines in a Chapter 11 case. SETOFF AND RECOUPMENT Section 553 of the Bankruptcy Code preserves a creditor’s common-law right of setoff in bankruptcy cases, with certain limitations, in connection with “a mutual debt owing by such creditor to the debtor that arose before the commencement of the case . . . . “ As such, the first component of a setoff claim is the requirement that the debts be “mutual.” Mutual debts have been described as debts in the same right between the same parties standing in the same capacity. For example, the debt of a lender to a debtor arising out of a deposit account maintained by the debtor with the lender may not be offset against the debt of the debtor to a separate corporate affiliate of the lender because the debt is not owed directly to the lender. The requirement that the debts be mutual does not mean, however, that the debts must have arisen from the same transaction. The second requirement for setoff is that the debts must have arisen before the bankruptcy petition was filed. A pre-petition debt cannot offset a post petition debt. It is also important to note that the exercise of the right of setoff is subject to the automatic stay imposed by �362 of the Bankruptcy Code. Recoupment is an equitable remedy that permits the offset of mutual debts when obligations are based on the same transaction or occurrence. Many courts have used this doctrine to achieve equity when setoff was unavailable. Under the doctrine of recoupment, the claims owed by the creditor to the debtor can be reduced by the amount of the claims owed by the debtor to the creditor, as long as the mutual claims arise from the same transaction. Thus, recoupment is essentially a defense to a debtor’s claim against a creditor and is a matter of determining the correct amount of liability. There is no independent claim to set off. Accordingly, recoupment is not a claim and gives no right to actual payment. For this reason, most courts have held that the automatic stay is not a bar to recoupment. The mere fact that the same parties may owe debts to each other is insufficient to trigger the doctrine of recoupment; recoupment is limited solely to a single integrated transaction. However, some courts have permitted recoupment, even if part of the debt arose prepetition and the other part arose post-petition, as long as the entire debt arose from the same transaction. ‘IN RE TELEPHONE WAREHOUSE’ Debtors in Telephone Warehousewere among the largest independent specialty retailers of cellular and wireless products in the U.S. Prepetition, the debtors entered into agreements with Voicestream Wireless Corp., Omnipoint Communications and Aerial Communications (collectively, the service providers). Under the agreements with the debtors, the service providers sold cellular phones to the debtors for resale to the public. When the debtors sold a cellular phone, they also sold cellular service to be provided by one of the service providers. Depending on the number of sales, the debtors could become entitled to commissions, bonuses, reimbursement for advertising the service providers’ products or discounts on the price of cellular phones in the future. When the debtors filed for bankruptcy, there were various amounts due between the debtors and the service providers. The debtors sought the payments due under the agreements from the service providers and the service providers refused, asserting the rights of recoupment and setoff. Due to the refusal to make payment, the debtors removed all of the service providers’ product from their stores. Thereafter, the debtors moved to compel performance from each of the service providers. In response, the service providers moved the Bankruptcy Court for a determination of their right of recoupment and setoff. The Bankruptcy Court held that the service providers were entitled to assert recoupment as a defense to the debtors’ motion to compel. In so holding, the court rejected the debtors’ arguments that the earned but unpaid commissions arose from a different transaction than the sales of the cellular phones. The debtors contended that the majority of the financial obligations owed by it to the service providers arose from the purchase of cellular phones and related equipment. However, a majority of the debt owed to it by the service providers represented commissions due for the activation of telephone service and was not directly attributable to the sale of cellular phones. In this sense, according to the debtors, the obligations did not arise from the same transaction. Judge Walrath rejected the debtors’ position on the ground that the sale of the cellular phones were “part and parcel” of the sale of cellular service. After all, the debtors apparently could not activate the service providers’ service via any equipment other than the service providers’ equipment. Conversely, it appears that the service providers’ cellular phones could only be activated via the service providers’ service. As a result of the nexus between the agreement to sell the cellular phones and the agreement to pay an activation commission, the court concluded that all the sums due between the parties comprised a single integrated business transaction subject to the right of recoupment. The Telephone Warehousecourt further held that the service providers were entitled to setoff. The service providers had argued in favor of setoff, not just as alternative relief to recoupment, but because OmniPoint was seeking an affirmative recovery from the debtors. Recoupment is exclusively a defensive doctrine and cannot lead to an affirmative recovery for a creditor. DEBTORS ARGUMENTS The debtors had argued against setoff on the ground that most of the monies owed to them by the service providers were not due until after the petitions were filed, while the majority of the debtors’ obligations to the service providers arose prepetition. Based upon their agreements with the debtors, the service providers were not obligated to pay any commission until 45 to 60 days after activation. The debtors contended that since, by statute, setoff is limited to “amounts that arose before the commencement of the case,” the service providers were not entitled to setoff the post-petition amounts owed by them. The court rejected this argument, holding that the commissions were not, in fact, post-petition obligations. The court reasoned that the obligation to pay the commissions actually arose prepetition when the cellular phones were activated. The fact that payment was not due for several weeks thereafter did not affect the determination of when the obligation arose. As such, the court concluded that the service providers were entitled to setoff the amounts due to the debtor. In their final argument against the application of recoupment and setoff, the debtors contended the doctrines were inapplicable because the debtor’s prepetition lenders had a perfected security interest in all of the debtors’ accounts receivable, including those due from the service providers. Essentially asserting the rights of these lenders, the debtors argued that, under applicable state law, a holder of a perfected security interest in accounts receivable has priority over a creditor with only setoff rights. Again, the court rejected the debtors’ argument, holding that such an argument violates the plain language of �9-318 of the U.C.C., which provides that the rights of an assignee are subject to “all the terms of the contract between the account debtor and assignor and any defense or claim arising therefrom . . . . ” Since the service providers expressly preserved their right to assert any setoff rights in the subject agreements, the service providers’ setoff rights were deemed to have a priority over any lien held by the prepetition lenders. As a result of the exercise of the service providers’ recoupment and setoff rights, the court found that the debtors owed Omnipoint $520,238, while Aerial only owed the debtors $104,246 and Voicestream only owed the debtors $56,408. ANALYSIS The Telephone Warehousedecision is a timely reminder of the continuing importance of the doctrines of recoupment and setoff. The decision also offers some insight into how these doctrines may become as prominent in the telecommunications industry as they have already become in connection with another financially troubled industry, namely, the health care industry. Recoupment and setoff are critically important in health care bankruptcies due to the relationship between the government and the health care providers themselves. Under the Medicare statute, the federal government is obligated to make certain reimbursement payments to various health care providers on account of services performed for elderly or disabled patients. In practice, the health care provider is generally paid periodic interim payments that are estimates of its actual expenditures. Actual expenditures are audited annually to determine whether the provider has been over or underpaid for that cost-year. Depending upon the results of the audit, future payments are either increased or decreased. This dynamic has a profound impact upon the administration of health care bankruptcy cases. After all, when a health care provider files for bankruptcy, there is a distinct possibility that it has already been overpaid under Medicare. However, assuming that the provider has continued to render services to covered individuals, the provider would be still owed money from the federal government for these current services. This situation, where each party to a transaction simultaneously owes a debt and is owed a debt in connection with that same transaction, is likely to breed numerous claims for setoff and recoupment, which has already occurred in the health care field. In fact, in many instances these claims for offset or recoupment are critical to the success or failure of a health care reorganization and have thus generated much litigation. For example, there is currently a split in the circuits in connection with a specific recoupment issue. As set forth above, in order to be entitled to recoupment, the two debts must have arisen from the same transaction. Several courts, including the 3rd U.S. Circuit Court of Appeals in University Medical Center v. Sullivan( In re University Medical Center), [FOOTNOTE 3]have held that the right of recoupment is limited to debts that arose in the same Medicare cost-year. In contrast, other courts, including the 9th Circuit in Sims v. H.H.S.( In re TLC Hospitals, Inc.), [FOOTNOTE 4]have held that recoupment is applicable even to debts that span more than one cost-year, provided that both debts arose from a single integrated transaction. The telecommunications industry is analogous to the health care industry in that it also presents the distinct possibility that many debtors will owe a debt to a particular creditor, and will be simultaneously owed a debt from that same creditor. This relationship is not the result of any particular statute, but the product of the numerous interrelationships among parties in this industry. For example, in order to provide telecommunication service to their clients, smaller companies will often enter into an interconnection agreement with a larger, more-established telephone company. These interconnection agreements will permit the customers of both companies to access the other’s infrastructure in order to place a call. Generally, payments are calculated under these interconnection agreements based upon actual usage. At any given time, both parties to an interconnection agreement may owe a debt to the other party, and may be owed a debt from the other party. This dynamic is ripe for the prevalence of setoff and recoupment issues. CONCLUSION As telecommunications companies continue to falter, the issues of recoupment and setoff may assume a more central role in an even greater number of bankruptcies. Additionally, based upon the interconnections within the industry, the chances of each of the parties to a telecommunications contract becoming a debtor in bankruptcy increases, which may, of course, require further refinement of these concepts. Against this backdrop, the Telephone Warehousedecision presents a faithful and consistent application of the doctrines of setoff and recoupment, which are important creditors’ rights and which must be considered before a creditor makes any post-petition payments to a debtor. The decision also presents a cautionary tale to debtors to consider the doctrines of recoupment and setoff before seeking payment from a creditor to whom a financial obligation may be owed. John J. Rapisardi is a partner in the Business, Finance and Restructuring Department of Weil, Gotshal & Mangesand is an adjunct professor of law at Pace University School of Law. Timothy Graulich, an associate at the firm, assisted in the preparation of this article. ::::FOOTNOTES:::: FN1For example, WinStar Communications, Inc., Viatel, Inc., Advanced Radio Telecom, ICG Communications, Inc., Convergent Communications, Inc. and NorthPoint Communications have all filed for bankruptcy protection with the last 18 months. For a timely discussion of the current plight facing the telecommunications industry, see Gregory Zuckerman and Deborah Solomon, Telecom Industry Faces Reckoning, WALL ST. J., May 11, 2001, at A1. FN2259 B.R. 64 (Bankr. D. Del. 2001). FN3973 F.2d 1065 (3d Cir. 1992). FN4224 F.3d 1008 (9th Cir. 2000).

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