In the Ninth Circuit, creditors can recoup prepetition discharged liabilities from post-discharge payments due to a debtor.
To apply, there must be a “logical relationship” between the benefits being withheld and the overpayments; for example, in the disability benefits context, the current benefit being reduced must be related to the disability for which an overpayment had been made.
Parties should carefully evaluate whether recoupment rights may exist that permit a creditor providing continuing services, benefits or payments under the same contract/transaction to a discharged debtor to exercise recovery rights even after a discharge is granted and consider whether it is prudent to obtain clarification of those rights before a bankruptcy case is closed to avoid post-discharge litigation.

From time to time, a debtor continues to have the right to receive benefits or payments from a non-debtor counterparty under the same contractual relationship or transaction after receiving a discharge of prepetition debt. The question then arises whether the discharge prevents the non-debtor counterparty from withholding a payment or benefit to satisfy that prepetition, now discharged, debt. A recent bankruptcy appellate panel ruling decided in the context of the recoupment of overpaid Social Security benefits suggests that under the appropriate facts, the answer is no.

In Cooper v. Social Security Administration (In re Cooper), No. 23-1098, 2024 WL 166103 (B.A.P. 9th Cir. Jan. 16, 2024), the Ninth Circuit Bankruptcy Appellate Panel (BAP) analyzed whether or not the Social Security Administration (SSA) properly invoked the equitable remedy of recoupment to recover prepetition overpayments from a debtor’s future payments/benefits. The BAP concluded that recoupment was appropriate under the Ninth Circuit’s “logical relationship test” and the agency’s withholding from the debtor’s postpetition payments was not a violation of the discharge injunction.

Darrin Cooper (Debtor) was injured at work and started receiving workers’ compensation benefits through the Washington State Department of Labor & Industries in 2007. In May 2017, the Debtor applied for Social Security Disability Insurance Benefits (SSDI) and Supplemental Security Income (SSI). The Debtor’s application stated that he had been unable to work since February 2009 and that he was not receiving benefits. The Debtor’s SSDI application was denied. The Debtor appealed and received a fully favorable decision in April 2019. The decision warned the Debtor that the “workers’ compensation offset provisions at 20 CFR 404.408 may be applicable.”

In May 2019, the Debtor responded to a workers’ compensation/public disability benefit questionnaire requested by the SSA and disclosed that he was receiving workers’ compensation from the state of Washington. The SSA’s field office, however, failed to correctly process that information. As a result, the SSA Program Service Center calculated the Debtor’s SSDI benefits based on the erroneous belief that the Debtor was not receiving any other disability compensation. The SSA determined that the Debtor was entitled to SSDI payments beginning in May 2016. In August 2019, the SSA sent the Debtor a lump sum for retroactive benefits and also began sending monthly benefits.

In July 2020, the Debtor filed for chapter 7 relief under the Bankruptcy Code. The Debtor did not schedule the SSA as a creditor, and the SSA did not receive notice of the Debtor’s bankruptcy filing. In October 2020, the Debtor received a discharge of personal liability for claims arising before the chapter 7 was filed. There were no assets available for distribution in the chapter 7 case.

In October 2022, the SSA notified the Debtor that he had been overpaid based on his receipt of workers’ compensation. The SSA stated it would be reducing the Debtor’s future benefit payments as a result. The Debtor did not appeal or request a waiver of the SSA’s decision. Instead, the Debtor moved to reopen his bankruptcy case and filed a motion to hold the SSA in contempt for violating the discharge injunction by trying to collect the amounts overpaid to him prior to the chapter 7 case filing.

The Cooper bankruptcy court denied the Debtor’s motion. The bankruptcy court held that reducing future benefits to recover overpayments made to the Debtor was a proper exercise of the SSA’s recoupment rights that violated neither the Debtor’s discharge nor the automatic stay. The Debtor appealed the decision to the BAP, which affirmed. On February 14, 2024, the Debtor appealed the BAP’s decision to the Ninth Circuit Court of Appeals, an appeal which remains pending.

Equitable Doctrine of Recoupment
Recoupment is an equitable doctrine. It permits a party to reduce amounts due to a debtor by amounts owed by the debtor that arise out of the “same transaction” or occurrence or agreement. Courts have applied different approaches in determining whether the “same transaction” test is met. The leading case in the Ninth Circuit is Newbery Corp. v. Fireman’s Fund Insurance Co., 95 F.3d 1392 (9th Cir. 1996) (applying the “logical relationship test” and requiring only that the obligations be sufficiently interconnected). Other circuits construe the “same transaction” test more narrowly. See University Medical Center v. Sullivan (In re University Medical Center), 973 F.2d 1065 (3d Cir. 1992) (applying the more restrictive “integrated transaction test” and requiring that the obligations arise out of a single integrated transaction).

The BAP observed that recoupment is used defensively in bankruptcy proceedings. Because recoupment only reduces a debt, rather than constituting an independent basis for a debt, there is no claim against estate property. As a result, recoupment is not subject to the automatic stay or the discharge injunction.

The Ninth Circuit “Logical Relationship” Test
The Ninth Circuit applies the “logical relationship test” to determine whether a creditor’s claim arises out of the same aggregate set of operative facts as the debtor’s claim to support recoupment.

In describing the “logical relationship test,” the BAP reviewed a state retirement benefits case, In re Williamson, 2018 WL 4926430 (B.A.P. 9th Cir. 2018), aff'd, 795 F. App’x 537 (9th Cir. 2020), which satisfied the “logical relationship test” because the plan administrator’s obligation to pay the debtor’s pension benefits, and the debtor’s debt for prior overpayments, both arose from the debtor’s pension plan.

The BAP also reviewed a disability benefits case, In re Madigan, 270 B.R. 749 (B.A.P. 9th Cir. 2001), in which the “logical relationship test” was not met because the debtor had two different reimbursement agreements, two disability periods, and two claims separated by a two-year period of employment. The BAP panel in Madigan reasoned that, even if the claims for benefits arose from the same injury or recurring illness, the two disability periods were not logically related, and therefore the insurer’s postpetition reduction in payments violated the debtor’s discharge injunction.

BAP’s Analysis and Holding
The BAP grounded its analysis in Ninth Circuit precedent that previously held equitable recoupment applies in cases involving the overpayments of both federal and state Medicaid and state retirement benefits, as well as other circumstances, which guided the totality of its decision.

Against this overarching observation, the BAP then rejected the substantive legal arguments made by the Debtor as follows:

First, the BAP rejected the Debtor’s position that his current right to benefits was not related to the prior overpayment, nor part of the same transaction or occurrence, because his on-going entitlement to SSDI payments required periodic renewed findings by the SSA that he is disabled. The BAP distinguished Madigan and found that there were no facts to suggest that the Debtor’s disability payments arose from multiple disability periods, and no intervening period of time in which the Debtor returned to work and was no longer considered disabled.

Second, the BAP disagreed with the Debtor’s argument that it was inequitable to make the Debtor pay for the SSA’s mistake of paying him too much, and it would not offend equitable principles if he retained the overpayment. The BAP acknowledged that the Debtor’s equity argument resonated, but held it was bound by contrary Ninth Circuit law and by the Debtor’s failure to utilize the remedies afforded by the Social Security Act. The Debtor could have appealed the SSA overpayment ruling but did not. The BAP also found that the Bankruptcy Court had, contrary to the Debtor’s argument, considered his equity arguments.

Third, the BAP rejected the Debtor’s argument, relying on the Third Circuit’s holding in Lee v. Schweiker, 739 F.2d 870 (3d Cir. 1984), that statutory entitlements are not contracts or transactions subject to recoupment. The BAP noted that the Ninth Circuit previously considered and rejected Lee, which applies a narrower interpretation of what constitutes the “same transaction” than the Ninth Circuit.

Finally, the BAP explained that allowing the SSA to recoup was a fair result because the reduced future payments simply reflect an adjustment to pay the Debtor in the aggregate the amounts actually due to him.

Under the appropriate facts, a discharge likely does not prevent the withholding of a future payment or benefit to satisfy a discharged, prepetition debt. A creditor providing continuing services, benefits or payments under the same or a related contractual relationship or transaction with a discharged debtor should, however, carefully evaluate whether recoupment is available without running afoul of the discharge injunction. The creditor may also wish to obtain clarification from the bankruptcy court regarding its recoupment rights before the debtor’s case is closed, in order to avoid unnecessary post-discharge litigation.

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