Bulgaria: Contractual set-off as a quasi-security in commercial and financial transactions

Prerequisites for statutory set-off in Bulgaria

Under article 103 of the Bulgarian Contracts and Obligations Act (the "COA"), if two parties owe each other¹ money or other replaceable assets, each of the parties whose receivable is due and "liquid" (i.e. indisputable as to legal grounds and amount) may set it off against its obligation to the other party. This mechanism is characterised as "statutory set-off", since each of the parties may take recourse to it when the prerequisites under the statute (i.e. art. 103 COA) exist. As the requirement for "liquidity" under the "statutory set-off" is quite cumbersome, sophisticated creditors are attempting to avoid it via "contractual set-off", i.e. to agree with their counterparty for the effects of the set-off to occur where any or all prerequisites (and most importantly "liquidity") for "statutory set-off" do not exist.

The purpose of this newsletter is to highlight some important case law developments in Bulgaria confirming the validity of contractual set-off and to summarise its practical importance.

Validity and scope of contractual set-off, deviating from statutory set-off

As there has been some uncertainty among legal scholars and some lower instance courts around the possibility for contractual set-off, it is important that there is now a Supreme Court confirmation for the validity of contractual set-off – Judgment No. 156 of 15 November 2019 under commercial case No. 2875/2018, II-nd commercial department of the Supreme Court of Cassation, reported by judge Tatiana Varbanova (the "Judgment"). The first and second instance court in this case held that a contractual set-off invoked by the Bulgarian State Agency "Road Infrastructure" on account of a contractual penalty for delayed performance vis-à-vis a portion of a road construction price was ineffective, since the existence and amount of the penalty was disputed by the respondent Black Sea Autobans AD, i.e. it was not "liquid". The lower courts accepted the submission that contractual set-off may only be effective if the prerequisites for statutory set-off, including the requirement for "liquidity", exist.

The Supreme Court rejected this submission and overruled the lower instance court judgments. It held that contractual set-off is permissible under Bulgarian law (i) based on the concept of freedom of contract under art. 9 COA, whereby "parties are free to agree on any matter under their contract if it does not violate mandatory laws and good faith", and (ii) since the prerequisites for statutory set-off are dispositive, i.e. they apply only if the parties have not agreed otherwise.

The rationale of the Judgment was recently restated – again at Supreme Court level – in Resolution No. 197 of 14 April 2021 under commercial case No. 1170/2020, II-nd commercial department of the Supreme Court of Cassation, reported by Judge Emilia Vassileva. These developments should give comfort to creditors wishing to avail themselves of contractual set-off as a security in their commercial or financial agreements.

Practical importance of the Judgment

The Judgment is very important for parties who have so far not actively used contractual set-off due to doubts about its enforceability, e.g. investors wishing to set-off a contractual penalty (that may potentially be disputed by their contractor) against a portion of a project price due by them (i.e. on facts similar to those under the Judgment), as such players may now include contractual set-off arrangements among the tools protecting their interests. Although in theory set-off is regarded as a "quasi-security", in practice it is a "super security" compared to most traditional security interests. By invoking it creditors satisfy their debts immediately, without a formal and costly procedure and in case of insolvency they may do so prior to all other secured creditors.

The Judgment is equally important for some sophisticated players like banks and financial institutions that regularly use contractual set-off as a risk mitigation tool in case their counterparties in finance transactions are in default. Such players now have more arguments to rely on set-off, including before regulatory authorities for capital relief purposes.

However, parties wishing to invoke contractual set-off should not expect courts to easily deduce the existence of such arrangements. On the contrary, much of the older case law rejecting the permissibility of contractual set-off was premised on there being no clearly expressed intention of the parties to deviate from statutory set-off. Therefore, clear, explicit and appropriate arrangements should be in place to displace the requirements for statutory set-off and substitute them with contractual clauses.

Special attention should be paid to the potential insolvency of a Bulgarian counterparty. As opposed to some other jurisdictions that treat set-off as a non-permitted preference, Bulgarian law allows set-off in insolvency when the prerequisites for it occur. Nevertheless, to reinforce the smooth enforceability of contractual set-off in case of insolvency, some special additional arrangements need to be considered by sophisticated creditors.

¹ It is established under Bulgarian case law that "mutuality" is not restricted to one and the same relationship (i.e. one contract) but would also exist for obligations under different relationships/contracts as far as the parties to these different relations are the same.

author: Tsvetan Krumov