07 March 2012 Written by  Balew Mersha and Kahsay Debesu

Set off and Merger

Set off

 

Set-off is among the grounds by which a contract is extinguished. In this section we will discuss set-off as one way of extinction of obligation. The conditions in which set-off is possible and the conditions in which set-off is not legally allowed will be discussed. The role of courts in effecting set-off and the restrictions will also be the concern of this topic.

 

As you can see obligation extinguishes when set-off is made. Article 1831 of the civil code is provided to indicate the extinguishing effect of set-off as:

 

Article 1831- principle

Where two persons owe debts to one another, set off shall occur and the obligation of both persons shall be extinguished in accordance with the provisions of the following Article.

 

As of this provision, two parties in which one is a debtor in respect of one obligation while a creditor with respect of another obligation to other party may extinguish the obligation by set-off.

 

Assume that Ato Abebe owes Ato Tolosa birr 500,000 in one transaction and Tolosa owes Abebe birr 500,000 in another transaction. The two parties can then set-off their debts and extinguish their obligations. Set-off can be made upon the fulfillment of certain conditions although the contractants owe debt to one another. These conditions have been put as positive and negative conditions respectively under Articles 1832 and 1833. Article 1832 has put the positive conditions as:

 

Article 1832–positive condition

Set off shall not occur unless both debts are money debts or relate to a certain quantity of fungible things of the same species and both debts are liquidated and due.

 

The conditions that are provided in Article 1832 are.

(a) The debts shall be money debt or fungible things of the same species.

(b) The debts shall be liquidated.

(c) The debts shall be due.

 

Set-off is not possible if someone owes in item and the other owes in money. Nor is set-off possible when the debts are items unless the items are fungible things. The money debt or fungible things shall also be liquidated ones in that the parties should be certain about the debt. The parties shall not have a dispute as to the amount of the debt. If the amount claimed by the creditor and the amount accepted by the creditor is not equal, the debt requires further liquidation. In such disagreement the debt is not liquidated and hence not subjected to set-off.

 

However, although the debt is required to be liquidated so that the court can make set-off when it is required to do so, there is exception to the requirement of “liquidation” of the debt.  According to Article 1841 eventhough one of the debt is not liquidated, the court may decide that set-off has been made to the extent of the admitted amount.

 

Assume that Ato Mesfin claims to owe Ato Zeberga birr 500,000 while Ato Zeberega admitted to have owed only birr 300, 000 and denied the birr 200,000( is contested). In such a case, although birr 200,000 is contested, the debt to the extent admitted (birr 300,000) can be subject of set-off.

 

The other exception is when the debt can be liquidated without delay. A debt whose amount is contested by the parties or which is not fully liquidated can be delayed so that set-off is made with regard to the whole debt. The court may suspend judgment against the debtor whose debt is liquidated until the other debt is liquidated if the debt can be liquidated without delay. These are exceptions to the condition that the debt shall be liquidated so that set-off is made.

 

The other condition is that the debt shall be due at the time set-off is required. The time when both obligations are required to be performed shall be at the same time. If one of the debts is to be paid on September 1 and the other debt is to be paid on October 3, set-off cannot be made with regard to these two debts on September 1 since both debts are not due by then.

 

This requirement protects the debtor who can be beneficiary of time limit. The one who shall perform the obligation in October 3 is the beneficiary of time limit and refusal of set-off is not to affect such contractant adversely.

 

An exception to this requirement has been provided under Article 1834 dealing with period of grace. Granting of period of grace does not bar set-off although the time in which payment shall be made is protracted by the court order of period of grace. A debtor who is given period of grace shall not be protected against set-off like other beneficiaries of time limitation.

 

Although the debts are liquidated and due, there are also other requirements which shall be additionally fulfilled. Additional negative conditions have been provided under Article 1833.

1833 Negative conditions

Set –off shall occur regardless of the cause of either obligation except where

1)      the special nature of the obligation requires that the creditor be actually paid , as in the case of maintenance or        wages necessary for the livelihood  of the creditor and his family; or

2)      the obligation is owing to state or municipality ; or

3)      The obligation is to restore a thing of which the owner has been unjustly deprived ;or

4)      The obligation is to return a thing deposited.

 

If the special nature of the obligation harmfully affects one of the parties when set off is carried out, set off is prohibited for such kinds of obligation. Someonewho lives on a maintenance payment might be in another transaction with a debtor( the person under obligation to  pay him maintenance ); if his maintenance payment is set off he might be in a position not to live. If he is refused payment of his maintenance payment for he is debtor, his life might be endangered. Protecting such undesired consequence of set-off begs providing of exceptions to set-off.

 

An obligation owing to state or municipality is not subjected to set-off because the action by which the state or municipality become debtor and creditor can be different. In such a case set off can mess up the accounting system of the state or municipality.

 

Excluding an obligation to restore a thing unjustly taken from being subject of set-off is to deter unjust deprivation of property and recognize its immoral nature. Excluding such obligation has great social importance in deterring unjust deprivation of properties like theft. Allowing set-off with debt owing to unjust deprivation on the other hand entails negative connotation of encouraging deprivation.

 

When the obligation is to return a thing deposited, it is not again subject of extinction by set-off. The basic reason for this is actually to give protection and encourage the trust built among parties. It is a confidence that makes a party deposit something with some one. Such special confidence is required to be created and protected for the sake of smooth social relationship. Obligation to return a deposited thing is excluded from being extinguished by set-off to achieve the said purpose.

 

Be that as it may, set-off cannot be made in the absence of intention to do so. Article 1838 provides that if the debtor fails to inform the creditor his intention to effect set-off, set-off does not occur. Knowing intention can be difficult as there is no proof of mental element of the parties. Circumstances from which the mental element of the parties can be inferred should be considered.  Set-off cannot be made upon the proposition of the court. The court is strictly prohibited from making set-off unless it is raised.

 

Parties do have freedom of contract about set-off with regarded to obligation they assumed reciprocally. Parties may wave their legally permitted right to require set-off. Article 1839 to this effect has provided that the debtor may in advance waive his right to make set- off. Freedom to wave set off encourages further transaction between parties who have unsettled obligation.

 

 

Assume that Ato Tillahun is a debtor of Ato Fitsume in one transaction. Ato Tillahun may not enter into a contract with Ato Fitsume for fear that Ato Fitsume may make set-off to Ato Tillahun’s claim in their future transaction. Although Ato Fitsume may promise not to make set-off for he needs the transaction with Ato Tillahun, Ato Tillahun may not rely on the promise of Ato Fitsume unless the law recognizes and gives effect for such contracts. There can be such binding effect of law if the other party can wave set-off. The rationale behind giving a legal effect for waiving of set-off in advance is to encourage furtherance business transaction and smooth furtherance of economic and social advancement.

 

Freedom of the parties is not only to wave their right to set off but also to extend set-off beyond the legally possible ones and set aside certain conditions. Article 1840 permits occurrence of set-off eventhough it is not provided by law if the parties agree. Legally it is money debts or tangible things, which are subject of set off. However, parties can specify conditions of set-off, otherwise setting aside the legally provided conditions.


For example Henok and Biniyam may agree to make set-off to their debt, which they owe each other though it is not due. They may also agree to effect set-off though the debts are neither money debts nor fungible things. Since freedom of agreement made under the umbrella of public and social policies are guiding principles of contract, agreement of the parties as to either exclusion or inclusion of set-off has legal effect.

 

As it is known we are discussing set-off under extinction of obligation. The effect of set-off is then extinction of obligation. Although set-off extinguishes obligation, its extinction effect is limited to the lesser amount regarding debts subject of set-off. Article 1836 has been provided connoting this effect as:

Art.1836__Effect of set-off

The debts shall extinguish each other as from the day when both exist and to the amount of the lesser debt.

 

In its effect set-off extinguishes obligation to the lesser extent as it is illustrated below. Assume A owes B 500 Birr and B owes A 1000 Birr. Set-off does not extinguish obligation of paying the whole birr of 1000. Here set-off can take place up to Birr 500 only and the rest (500) remains as a debt of B against A.

 

This might cast doubt if the right to refuse part payment might not be applied in the case of set-off in light with the extinction effect of set-off to the extent of the smaller debt because if set-off is effective to the lesser amount, the one who is entitled to a greater amount might not refuse set-off although part of his claim is to be extinguished. He can, however, refuse part payment.

 

Assume for example Abebe is a creditor of Hanna to the extent of 1000 Birr. If Hanna provides to pay 500 of the debt as a part payment, Abebe may refuse to receive pursuant to Article 1746 (1). What if Hanna requires set-off to the extent of 500 as she is creditor of Abebe to that extent? Actually Abebe cannot refuse set-off on the ground of its being part of the debt.

 

 

Set-off and payments are not the same although both are grounds of extinction of obligation. Set-off is not mode of payment. This can be exemplified by the validity of set-off made with an incapable person and invalid nature of payment made to incapable person unless it is proved that the incapable benefited.

 

Contracting parties are not allowed to set-off their debts if it is going to affect the rights of third parties. Extinction of obligation by set-off “shall not affect rights which third parties have on one of the debts.” Extinction of obligation has effect only between the parties whomake  set-off.

 

Assume that Ato Yeselam owes to Solomon and Ato Stiffo Birr 1000 each. In another transaction Solomon owes Stiffo Birr 1000. If Yeselam and Solomon make set–off, the right of Stiffo to recover his money form Yeselam’s receivables may be at stake.  Therefore, Stiff can protest set-off, as it is detrimental to him. At least its effect on third parties shall be protected.

 

A bit of perplexity might be created with regard to appropriation of payments. Appropriation of payment in the case of set-off has been provided in Article 1835 of the civil code in its wording as: “Where several debts liable to set-off are owing from the same person, the set- off shall be made in accordance with the provisions of chapter 2 of this Title relating to appropriation of payments” (Art. 1752-1754 of the C.C).

 

When set-off is made with a person who has claims related to costs, interests and principal debt, set-off extinguishes first the cost, then the interest and finally the principal debt pursuant to Article 1752. When set-off is made against a creditor who has several claims, the debtor who wants to effect set-off may specify the debt which is extinguished by set-off. However, if the debtor, who effects set-off, does not exercise his right of specifying the subject of set-off, the person who has several claims may specify the subject of set-off among his several claims according to Article 1753.

 

When both parties do not specify the subject of set-off among the several claims, the law fills the gap as provided under Article 1754. Accordingly, the debt which is due or where none of them is due, the debt which shall first become due shall be subject of set-off. When there are several debts which become due at the same time, the debt which is of greater advantage to the debtor shall be extinguished by set-off. As far as debts which are of the same advantage to the creditor are concerned, such several debts shall be extinguished proportionally.

 

Rene David illustrates this well. Assume A owes B 1000 and B owes A 1000. B also owes another 1000 because of another transaction. All these debts are liquidated and due. Both debts extinguish reciprocally immediately when they exist simultaneously up to the amount of the level of the two debts.

 

Merger

 

Among the grounds of extinction of obligation, merger is also one. Merger in extinguishing the contractually created obligation has certain peculiar effects on the contracting parties and the third parties. This section will, accordingly, discuss merger, along with its peculiar characteristics.

 

 

Merger is another method by which obligation extinguishes. Merger happens when the position of creditor and debtor becomes one and the same. There are different reasons for merger between debtor and creditor. Successions, formation of partnership are among the juridical acts which result in merger. Merger makes the debtor and creditor the same person.

 

If we see Article 1842 of the Ethiopian civil code the principle of merger in extinction of obligation has been put verbally as:

 

Art.1842__ Principle

Merger shall occur and the obligation shall be extinguished where the position of creditor and debtor are merged in the same person.

 

Performance of obligation after merger is not actually realistic once the creditor and debtor become the same since performing certain obligation towards one self is actually absurd.

 

Assume Ato Haile borrowed 25,000 birr from his father, Ato Aklilu; however his father died before collecting the debt from his son, Ato Haile. The later is the only successor of his father, Ato Aklilu. Here we can say that Ato Haile becomes the owner of the property of his father including the 25,000 Birr. It is not feasible for Ato Haile making payment to himself. The position of Ato Haile merged with that of his father. The obligation to pay his debt is then said to be extinguished by merger.

 

Extinction of obligation on the account of merger has certain limitations in its effect of extinction of obligation. The limitation is when it affects the right of third parties. Merger shall not be made to the prejudice of the interest of third parties, which have a right on the debt. Article 1843 of the civil code is provided in a way such rights of third parties are enshrined.

 

Art.1843.__Rights of third parties

Merger shall not affect the rights which third parties may have in respect of the obligation.

 

The protection of the right of the third party gets its strong support from the privity principle provided in the definitional provision of Article 1675, 1731 (1) and 1952 (1). Third parties may have a right on the credit which is subjected for extinction by merger.  The right of third parties shall be protected to avoid the externality effect of merger. When third parties who have usufruct right or pledge on the credit, such right is not subject of extinction though the main obligation on which such right depends could be extinguished by merger.

 

For example, Ato Yidnekachew is a creditor of Ato Zinabu, his only son, for the extent of 1,000,000 Birr.  Kemal is entitled to get the interest of the debt of Zinabu by dint of another transaction with Ato Yidnekachew. If Ato Yidnekachew dies Zinabu will succeed him and the obligation of paying 1,000,000 extinguishes, as there is merger. However, the merger, which extinguishes the principal obligation, does not extinguish the obligation to pay interest pursuant to Article 1843.

 

Merger has certain peculiar characteristics, as obligation extinguished by merger might revive in certain circumstances. The circumstance which results in revival of obligation extinguished by merger is when the merger comes to an end. Article 1844 of the civil code has been put incorporating this connotation.

 

Art.1844__End of merger

The obligation shall revive where merger comes to an end.

 

 

Assume that Misganaw has borrowed 50,000 Birr from his father, Ato Alebachew. In the mean time, Ato Alebachew disappeares and his absence is declared by court. Since Misganaw is the only successor of his father, he becomes the owner of his father’s property and his obligation is extinguished by merger. After 3 years of declaration of absence, Ato Alebachew returns. In this case Ato Alebachew can claim all his properties along the credits he has with his son, which he could have claimed before the declaration of absence and before the extinction of obligation. Here the obligation of Misganaw to pay Birr 50,000 to his father is said to be relieved.

 

His son may not claim that his obligation to pay the money has extinguished by merger as coming of merger to an end results in revival of the extinguished obligation according to Article 1844 of the Civil Code.

 

Another illustration in which obligation extinguished by merger could be revived is for instance, if company X lent company Y Birr 2,000,000 but if the two companies merged into one before company Y paid its debt (merged). However, if the two companies split back to their original position, merger is said to cease and the obligation will revive on the debtor.

Last modified on Tuesday, 12 June 2012 23:44