In cases with multiple mutual transactions (e.g. where a bank has obligations under deposits and receivables under credits with a same counterparty) a contractual arrangement is needed so that the creditor under one transaction, e.g. under the bank deposit above, retains payment in case its counterparty is in default under another transaction, e.g. under the bank credit above. Such arrangements effectively extend the Statutory Retention Right (limited to retention under the same transaction) to the whole spectrum of the parties' mutual dealings ("Contractual Retention Right").
Practical importance: Standalone quasi-security
Contractual Retention Rights as a standalone security are popular among financial institutions that normally have multiple transactions with the same counterparty. Apart from the bank deposit-credit scenario above, they are typically employed by financial institutions with multiple derivatives transactions with a single counterparty where mutual payment obligations on recurring future dates occur. Making performance of all payment obligations under various transactions dependent on there being no event of default under any of them serves as a powerful security for the non-defaulting party, as it may validly refuse performance under another transaction, thus reducing its exposure.
Practical importance (cont.): Quasi-security supporting contractual set-off/netting
Contractual Retention Rights may be an important supporting mechanism for a pre-agreed contractual set-off1 or close-out netting, the latter being in turn also quasi-securities for creditors. In such contexts it grants sufficient waiting time between the moment of default – when contractual set-off/netting may be exercised – and the moment when they are actually exercised.
Why is such waiting time important? Bulgarian courts construe contractual set-off with no accompanying rule on the timing when it should be exercised as one that should be exercised "with no delay" upon occurrence of default. The argument is to avoid unjust enrichment for the non-defaulting party that may prefer delaying set-off to allow the default interest rate or liquidated damages (agreed as due for each day in default) to accrue. However, if a prior contractual arrangement allows the non-defaulting party to wait before exercising set-off, the above "no delay" rule is overridden, ensuring that all contractual default compensations, including default interest on top of the unpaid amount, may be exercised2. Contractual Retention Rights are the most suitable tool to implement a sufficient waiting time and thus guarantee a non-defaulting party's full compensation in the said sense.
In a more sophisticated scenario, such as multiple derivatives transactions, retention of payment is necessary to postpone set-off/netting, where relevant market indices (interest rates, FX rates, etc.) underlying the respective derivatives are excessively unfavourable for the non-defaulting party at the time of default. Otherwise, immediate set-off/netting at the initial moment when the right has occurred may result in the non-defaulting party having to pay an excessive close-out amount. Contractual Retention Rights in such a case would postpone set-off/netting through retention of payments until market indices revert to normal and are favourable to the non-defaulting party.
Operation of Contractual Retention Rights under Bulgarian case law
The operation of Contractual Retention Rights was clarified in judgment No. 227 of 29 October 2018 under civil case No. 431/2018, IV – the civil department of the Supreme Court of Cassation, chaired by judge Veska Richeva (the "Judgment"). It dealt with an unjust enrichment claim for repayment of sums under a terminated transaction, where the respondent refused payment of these restitution amounts by invoking a Contractual Retention Right on account of a contractual liquidated damages arrangement. The court ruled that the Contractual Retention Right could be exercised up to the moment when set-off may be invoked in court proceedings. So, determining that moment is important, and parties should pay attention to it.
What is the moment until which set-off may be invoked?
The moment is different depending on whether the claim of the party invoking set-off (active claim) is "liquid" (i.e. indisputable as to legal grounds and amount).
Under Bulgarian law, for an out-of-court statutory set-off to occur the active claim should always be liquid (i.e. undisputed) unless the parties have made a contractual set-off arrangement and have contractually modified or displaced the liquidity requirement for the active claim3. If the active claim is illiquid (i.e. disputed) statutory set-off may be invoked only in court proceedings (where the said dispute would be solved with res judicata) and in such an illiquid-active-claim scenario set-off should be invoked very early in the proceedings – with the response to the initial claim before the first court instance. Conversely, a liquid-active-claim-set-off may be invoked before a court even if the case is pending before the second-instance court.
Practical importance of the Judgment
The Judgment indicates that depending on the type of set-off at stake, parties should pay attention to the time until which it is available, as they may avail of a Contractual Retention Right no later than this time. Otherwise, if the timeline is exceeded, the set-off itself may be compromised (e.g. in the case of an unjust enrichment claim as per the Judgment).
To avoid this, parties should make appropriate arrangements, especially in the context of insolvency proceedings.
The above reasoning regarding set-off also applies to the Contractual Retention Right when it is a corollary to close-out netting. Although close-out netting in certain scenarios is subject to strong protection in insolvency under various EU laws, those laws arguably do not protect supporting legal mechanisms as the Contractual Retention Right discussed here (or the "flawed-assets" arrangements typical for financial documentation under English law). Therefore, as with set-off above, special arrangements taking account of the restrictions under Bulgarian law are crucial for the close-out netting supporting mechanisms, too.
1 For statutory and contractual set-off in Bulgaria see here
2 In that case the Supreme Court held that as per the parties' arrangements set-off was possible only after termination of the contract, and as there was no such termination, waiting for a sufficient default interest rate to accrue and exercising set-off on account of both unpaid amount and accrued default interest over it was not tantamount to unjust enrichment.
3 See the case law in this respect cited in here