Set-Off Contract: Everything You Need to Know
A set-off contract involves a set-off clause, which is a legal provision that allows a lender to seize a debtor's deposits if they default on a loan.3 min read
A set-off contract is a contract that involves a set-off clause, which is a legal provision that allows a lender to seize a debtor's deposits if they default on a loan. In general, set-off clauses are used in loan agreements between lenders and borrowers. They may also be used in other areas of industry where there may be a risk of payment default, such as in manufacturing.
In lending agreements, set-off clauses can be framed in different ways. Typically, a lender will include a set-off clause in the lending contract to ensure they will obtain a larger portion of the amount owed to them if the borrower defaults. When banks make such agreements with their customers, the terms often allow the bank to seize specific assets as predetermined by the clause.
Set-off clauses may also be employed when two parties owe each other money. Often, one of the parties will utilize set-off to lower or erase its liability to the other party. In cases like this, a set-off clause is associated with settling mutual debt between a lender (creditor) and a borrower (debtor) by offsetting exchange claims. In this way, lenders can collect a larger amount than they would be able to collect through bankruptcy proceedings.
A set-off claim is limited to money, and is a defensive claim rather than a substantive claim. Set-off, as a term itself, is both a noun and a verb. As a noun, it is equivalent to "offset," which is often used instead. "Offset," may, at times, be used as a verb, but this usage in the legal world is much less common than "set-off."
Bank Action Regarding Set-Off Clauses
Banks have a legal right to seize the funds or assets of a customer if needed to cover a defaulted loan. In order for a bank or financial institution to exercise their right of set-off, they must meet the following conditions:
- The bank must transfer funds from the customer's own account.
- The account from which the funds will be transferred and the account from which the funds would have come must be held with the same bank.
- The customer must hold both accounts in the same capacity.
- The debt must be due and payable.
Depending on the set-off clause, banks may be able to access other customer assets, including deposits in savings, checking, a certificate, or money market if the customer defaults. If these assets are held with the bank, they will be more easily available to the bank upon default.
In their set-off clause, banks or other financial institutions might also include their rights to access accounts and other assets in other institutions. These assets may be less accessible to the bank, but the contract gives the bank legal consent to seize these assets nonetheless.
Set-Off Clauses in Business Contracts
Supplier contracts may include manufacturing set-off clauses. Such a clause might be used in lieu of a letter of credit, as it provides the supplier access to funds in a predetermined lending contract should the buyer default. Often the supplier will include a clause in the contract that gives the supplier the right to access deposit accounts and other assets at a bank or financial institution upon default. In this way, a supplier will be able to acquire payment equivalent to the debt incurred through the manufacturing contract by accessing these funds in the customer's savings, checking, certificate, or money market account.
Set-off clauses are beneficial for the lender when a debtor may be at risk of defaulting on payment. The lender is legally granted access to a debtor's funds and assets at either the lender's firm or another of the debtor's financial institutions. It's important for a debtor to be aware of set-off clauses, as they may ultimately relinquish assets that they might have been able to retain if they had chosen another way of settling debt, such as bankruptcy.
Although not a direct customer advantage of set-off clauses themselves, the Truth in Lending Act prohibits set-off clauses from being applied to credit card purchases. If a customer purchases a defective product, this act will protect them from having their deposits or assets seized.
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