What Is a Right of Set off?

Right of set off is a type of financial arrangement between two parties that owe each other money in two separate accounts or debts. With this strategy, the amount owed by one of the parties is offset by subtracting that figure from the amount of the debt owed by the other party. The end result is that both parties are able to partially or completely settle an outstanding debt without actually making use of the proceeds from any income or revenue stream that either party generates.

One of the more common applications of a right of set off is found when two companies choose to lend each other money at different periods of time. For example, if Company A loans Company B a total of $1 million US dollars, the plan will normally call for structuring a series of payments to be tendered at specific dates over a period of time. If two years down the road, Company B has occasion to lend Company A $500,000 USD in a separate loan situation, that contract will often include what is known as a right of set off clause. That clause will essentially provide Company A with the right to deduct any remaining balance from that first loan from the amount it owes to Company B as part of that second loan, if Company B should default on that first loan for any reason.

Other uses of the right of set off do not necessarily depend on the need for either party to default on their obligations. At times, the two entities may determine at some point that in order to more effectively organize their debt obligations, they will agree to use the balance owed in one loan to offset the balance owed on another loan. This approach usually results in one loan being completely settled, a move that helps to improve the overall financial position of both companies. Both entities effectively reduce the amount of debt they carry, which in turn enhances the bottom line for both companies.

A version of right of set off can also be used to secure business services. In this scenario, two vendors agree to provide goods and services to each other at agreed-upon pricing that is documented in full between the two parties. Both vendors bill for products provided according to those pricing schedules, while allowing the invoiced amount on one account to offset the balance in the other vendor account.

For example, a teleconference firm may covenant to provide conference call services to a courier, while that courier also agrees to provide services to the teleconference firm. The balance owed on the monthly conference call invoice is reduced, subtracting the balance of the invoice for courier services for the same monthly period, and sometimes appearing as a line item or documented in the form of a credit memo. The arrangement allows both companies to obtain services they require while also making sure that each is compensated fairly for the products provided to each partner in the arrangement.