Advance commission arrangements are a common feature of the life insurance industry. In order to provide an income stream for agents as they develop and grow their book of business, life insurers frequently agree to provide advances to agents on their future commissions, with the understanding that these advances will be recovered from the future generation of new and renewal commissions.
But what happens when an agent files for personal bankruptcy with a large outstanding advance deficit? What are the rights of the insurance company? The answers to these questions could affect many millions of dollars for insurers; however, based on our experience, bankruptcy trustees may not be particularly familiar with the particular legal precedents applicable here.
This article briefly explains the process and precedents that come into play when an agent with an advance commission arrangement files for bankruptcy.
1. General Bankruptcy Principles.
Filing for bankruptcy protection triggers certain procedural rules and safeguards. A comprehensive discussion of bankruptcy procedure is beyond the scope of this article; however, there are two procedural elements of bankruptcy that we want to address briefly here: (1) the automatic stay;  and (2) the rules relating to set-off. 
The automatic stay serves to protect the debtor and put its creditors on a level playing field, by prohibiting creditors from taking most actions to enforce rights or recover property from the debtor (such as initiating litigation, enforcing judgments or creating liens) until the property is released from the estate or the proceeding is concluded.  A creditor may seek relief from the automatic stay by requesting an order from the bankruptcy court to that effect. 
Bankruptcy law does expressly preserve the right of creditors to offset mutual debts that arose before the bankruptcy filing (i.e., a deduction by the creditor of an amount owed to the debtor based on a corresponding but unrelated amount owed to the creditor by the debtor).  However, there are two important limitations on the exercise of setoff rights. First, setoff rights are expressly subject to the automatic stay described above, such that creditors must seek relief from the automatic stay before proceeding to exercise any setoff right. Second, with respect to most types of setoff, if the creditor exercises a right of setoff within the 90 days preceding the bankruptcy filing, the trustee can recover “the amount so offset to the extent that any insufficiency on the date of such setoff is less than the insufficiency on the later of— (A) 90 days before the date of the filing of the petition; and (B) the first date during the 90 days immediately preceding the date of the filing of the petition on which there is an insufficiency.” 
2. Treatment of Advance Commission Arrangements in Bankruptcy.
When an insurer contracts with a new agent, it is with the understanding that it will take that agent some period of time to develop new business and corresponding commissions on such business. In order to ensure that the agent will have a stream of income in the interim, the insurer will agree to advance commissions to the agent based on expected sales activity. In return, the insurer is contractually entitled to all commissions as they are earned (including any applicable interest rate) so that it may recover the commission payments previously advanced to the agent. Until earned commissions equal or exceed advances, the agent has been paid more in commissions than he has earned.
Based on the rules discussed above, one could conclude that a life insurer seeking to recover advanced commissions would be required to seek relief from the automatic stay to allow it to exercise a right of setoff. Specifically, that the insurer owes a debt to the agent in the form of earned commissions and the agent owes a debt to the insurer in the form of the advances (plus interest), and that these debts are subject to mutual setoff to the extent of the advance amount.
However, there is a well-developed line of precedent that establishes that these advance commission arrangements are in fact wholly outside of the bankruptcy process because of a common law principle known as recoupment.
The remedy of recoupment “exists independent of the [Bankruptcy] Code, and allows a creditor to reduce the amount of a debtor’s claim, by even keeping post-petition payments due to the debtor, due to matters arising out of the same transaction.” This is distinct from the remedy of setoff: “A setoff is C’s deduction from C’s debt to B of an amount based on B’s unrelated debt to C; a recoupment is C’s deduction from C’s debt to B based on B’s debt to C arising out of the same transaction.” 
There are two essential elements to recoupment, then: (1) there must have been some type of overpayment to the debtor by the creditor; and (2) the overpayments and the amounts sought to be recouped must arise out of the same contract or transaction. 
The recovery of advances on new or renewal commissions subsequently earned by/credited to an agent with respect to pre-petition policies will generally satisfy both of these elements. First, the advances represent an overpayment to the agent: by definition, the agent is paid advances against commissions not yet earned. To satisfy the second element, the arrangement must be part of a single agreement or transaction. For example, to the extent that a single contract provides for both the advances and the right of the insurer to recover those advances (i.e., an agency agreement), they will both arise out of a single agreement. Furthermore, to the extent that the insurer is seeking to recoup the advances by retaining earned commissions on the same pre-petition policies against which the advances were made, this constitutes part of the same transaction.  In light of these factors, this type of advance commission arrangement has consistently been recognized by courts as meeting the test for recoupment. 
Characterizing the recovery of advances as recoupment and not setoff is critical, because the two remedies are treated very differently under bankruptcy law. The remedy of recoupment, because it arises out of a single transaction, recognizes that it would be inequitable for a debtor to enjoy the benefits of a transaction without also meeting its obligations.  In light of this principle, recoupment “would not be affected by bankruptcy but could simply be deducted from debts owed to [the debtor] as a matter of course.”  The effect then is that the debtor, and therefore the trustee of the bankruptcy estate, has no right to the funds subject to recoupment.  Accordingly, unlike setoff, the exercise of recoupment is expressly not subject to the automatic stay provisions of the Bankruptcy Code. 
Where an advance commission arrangement is used, the agent is not entitled to further compensation until the renewal commissions exceed what he has already been paid by way of advances.  As a result, “[t]he Trustee’s rights could be no greater; he could not recover commissions that had already been paid.”  Therefore, the renewal commissions arising from the agent’s pre-petition activities, which are subject to recoupment, simply never become part of the bankruptcy estate, whether for purposes of the automatic stay or otherwise. 
The effect of the recoupment doctrine then, is that the insurer is legally permitted to recoup advances from commissions earned on pre-petition policies (including renewal commissions): (1) without seeking relief from the automatic stay; and (2) without applying the restrictions subject to the exercise of a right of setoff.
There are two takeaways from the discussion above. First, insurers should be cognizant of the recoupment doctrine when structuring their advance commission arrangements with agents. Specifically, to ensure that the insurer receives the benefit of the recoupment doctrine, the insurer should: (1) document all advance commission arrangements in a written contract that expressly identifies that the amounts paid in advance are against future commissions and that the insurer owns all rights to earned commissions that exceed the advances; (2) document the arrangement in a single written contract (or successive contracts that clearly merges the rights and obligations of the parties into the latest resulting contract); and (3) expressly identify the right of the insurer to “recoup” advance commissions.
Second, insurers should ideally document the insurer’s rights and obligations under the recoupment doctrine in a legal memorandum or other similar document, such that the insurer retains institutional memory on this issue and is prepared to mount an appropriate defense in the event of a challenge to its rights in a bankruptcy proceeding.
Third, in the event a bankruptcy trustee challenges recoupment (either as a matter of substance or as a violation of the automatic stay), the insurer should be prepared to immediately explain the applicable doctrine to the trustee.
Taking these steps will help ensure that these insurers maintain the preferential rights afforded by the recoupment doctrine and should be helpful in avoiding unnecessary litigation with bankruptcy trustees as well.
 11 U.S.C. § 362(a)(7).
 In re Public Service Co. of New Hampshire, 107 B.R. 441, 444 (D. N.H. 1989).
 In re Slater Health Center, Inc., 398 F.3d 98, 103 (1st Cir. 2005).
 See id. at 103-105; In re Public Service Co. of New Hampshire, at 444-45.
 See In re Ruiz, 146 B.R. 877, 880 (S.D. Fla 1992) (under analogous facts, concluding that “the advances of commissions and the post-petition renewal commissions involved in this case unquestionably arise from the same transaction”).
 See Matter of Kosadnar, 157 F.3d 1011 (5th Cir. 1998) (employer’s post-petition recovery from debtor’s pay of commission advances was recoupment); In re Sherman, 627 F.2d 594 (2nd Cir. 1980) (insurance company could deduct advances from renewal commissions accruing post-petition); In re Pruett, 220 B.R. 625 (E.D. Ark. 1997) (insurance company exercised recoupment, not setoff, when retaining commissions accruing post-petition in satisfaction of advances made pre-petition); In re Ruiz, (same); In re Tomer, 128 B.R. 746 (S.D. Ill. 1991) (same).
 See In re Holyoke Nursing Home, Inc., at 3 (citation omitted).
 In re Slater Health Center, Inc., 398 F.3d at 103.
 See Matter of Kosadnar, 157 F. 3d at 1016 (citations omitted).
 See, e.g., In re Holyoke Nursing Home, Inc., 372 F.3d 1, 3 (1st Cir. 2004) (“the recoupment doctrine constitutes an equitable exception to the Bankruptcy Code §362(a)(7) prohibition against offsetting reciprocal debts”); Matter of Kosadnar, 157 F.3d at 1014 (citing Holford v. Powers, 896 F.2d 176, 178 (5th Cir. 1990) (“money recouped by creditors from an amount owed to a debtor post-petition would not be subject to the automatic stay”).
 See In re Sherman, 627 F.2d at 595.
 See In re Slater Health Center, Inc., 398 F.3d at 105 (holding that overpayment recouped by Medicare need not be returned to the bankruptcy estate).