Term definition and general explanation of compensation
The term compensation refers in a legal context to the set-off or balancing of mutual claims between two parties. The term derives from the Latin ‘compensatio’ and is particularly used in civil law. In the international context, the term is often used to describe the set-off of mutual obligations (‘set-off’). In Germany and Austria, the term ‘Aufrechnung’ is typically used, while in other legal systems—such as Anglo-American law—’compensation’ is common.
The legal treatment of compensation is comprehensively regulated in various national and international legal systems, with differing requirements, effects, and limitations. In principle, compensation serves to efficiently balance claims and avoid unnecessary cash transactions.
Legal basis and statutory regulations
Germany
In Germany, set-off as a legal instrument is regulated in the German Civil Code (BGB) (§§ 387 to 396 BGB). Compensation arises by operation of law if the statutory requirements are met and a declaration of set-off has been made.Key requirements:
- Mutuality of claims (§ 387 BGB)
- Similarity of claims
- Due date and enforceability of the counterclaim
- No existence of set-off exclusions pursuant to § 393 BGB (for example, in the case of claims arising from tortious acts)
Through set-off (compensation), mutual claims expire to the extent that they correspond, pursuant to § 389 BGB.
Austria
In Austrian law, compensation is referred to as “Kompensation” and is regulated in the General Civil Code (ABGB), §§ 1438 et seq. ABGB. The requirements essentially correspond to those of German law, with a focus on the offsetting of similar claims.
Switzerland
In Switzerland, set-off is regulated in Articles 120 to 126 of the Code of Obligations (OR). Here, too, the basic requirements are mutuality, similarity, and due date of the relevant claims.
Private international law and EU law
In the international context, the applicability and effectiveness of compensation can depend on the relevant legal system. The determination of the applicable law is governed by international agreement rules or, for contractual obligations, by the Rome I Regulation (EU).
Types and areas of application of compensation
Statutory compensation
Statutory compensation refers to set-off as provided by law. It takes effect when the requirements under the relevant national law are met and a declaration of set-off has been made.
Contractual compensation
Parties may also contractually determine under what conditions compensation (set-off) is possible or excluded. Such clauses are particularly common in banking and finance to minimize economic risk.
Automatic compensation
In certain situations—such as insolvency proceedings—automatic compensation may apply, provided that the claims were suitable for set-off before the commencement of the proceedings.
Requirements, legal consequences, and limitations of compensation
Mutuality and similarity
In all relevant legal systems, valid compensation requires that the claims are mutual and of the same kind (e.g., monetary claims).
Due date and enforceability
The claim to be set off must generally be due and enforceable, while the counterclaim must at least be performable.
Effects of compensation
Through compensation, claims cease to exist to the extent that they correspond to each other. The effect generally applies retroactively to the moment when the prerequisites for set-off were first met.
Restrictions and prohibitions
Compensation is legally restricted, such as for non-attachable claims, maintenance claims, or where excluded by law or contract. Special restrictions and exceptions apply in insolvency proceedings.
Compensation in international trade
In international commercial law, compensation is of particular importance. It enables business partners to balance mutual obligations within short periods, which is beneficial especially in the case of payment problems or differing legal systems. The structure of compensation in international contract law is the subject of various model contracts (such as CISG/UN Sales Law) and is often supplemented by arbitration agreements.
Relevance in special areas of law
Insolvency law
In insolvency law, compensation is a key tool for avoiding disadvantages. Claims eligible for set-off before the opening of insolvency proceedings can generally still be set off. However, the acquisition of claims after insolvency opening for the purpose of set-off to prevent abuse is prohibited.
Tax law
In tax law, compensation plays a role in the form of the balancing of debts when mutual tax claims exist between the taxpayer and the tax authorities.
Procedural law
In civil procedure, compensation may be asserted as a defense by way of a set-off in order to balance or at least reduce a claim asserted in a lawsuit.
Summary
Compensation is a central concept of the law of obligations, recognized and comprehensively regulated in almost all legal systems. It serves the efficient settlement of mutual claims and helps avoid unnecessary payment transactions. The particularities of compensation lie above all in the wide variety of clause-specific and statutory provisions that affect both national and international matters. Detailed knowledge of the requirements, effects, and limitations is of great importance for the application of compensation in legal and commercial dealings.
Frequently asked questions
When is compensation (set-off) permissible under German law?
Set-off is basically regulated in §§ 387 et seq. BGB in German law. It is permissible when both parties owe each other similar, due, and enforceable claims. The claim to be set off against (the principal claim) must be due, and the claim of the person setting off (the counterclaim) must be performable and enforceable. Set-off is excluded, among other things, if it is contractually prohibited, if the claim arises from a willfully committed unlawful act, or if the claim in question is subject to attachment (§ 393 and § 394 BGB). In addition, statutory exclusions or the nature of the obligation can bar set-off (e.g., for highly personal services such as maintenance or wages for especially protected employee groups). In court or insolvency proceedings, special restrictions apply, for example, the rule that after the opening of insolvency proceedings no new claims can be set off (§ 96 InsO).
What formal requirements exist for legal compensation?
According to German law, exercising set-off under § 388 BGB does not generally require any special form. It may be made orally, in writing, or even implicitly (by conduct). However, where specific formal requirements are agreed upon in particular contractual arrangements (e.g., in commercial law or company agreements), these must be observed. For the effectiveness of the set-off, it is required that it is clearly declared to the contractual partner; i.e., it must be clear which claims and to what extent the set-off is being made. In complex claim situations, a written declaration is sometimes recommended for evidential purposes.
What are the legal consequences of effective compensation?
Through valid set-off, the claims concerned, to the extent that they match, are extinguished retroactively to the point when they first became available for set-off (§ 389 BGB, retroactivity). This means that the claims in the corresponding amount are extinguished, even if the declaration of set-off is made later. There is then neither any payment obligation regarding the balanced amount nor can a payment already made be reclaimed to that extent, as the obligation has ceased to exist. However, the extinguishing event may lapse retroactively, for example if it is later revealed that the prerequisites for set-off were not met.
Can future claims also be set off?
As a rule, set-off is only permitted against already existing and performable claims. Future claims can therefore not be set off until they have arisen, become due, and are enforceable. In individual cases, however, it may be contractually agreed that the debtor may also set off future claims, which must, however, be explicitly agreed upon. Claims that will arise in the future, such as interest not yet due, can only be set off when the relevant claim becomes due.
Are there legal exclusions or restrictions on compensation?
The law provides for various exceptions and restrictions on set-off. For example, according to § 393 BGB, set-off against a claim arising from an intentionally committed unlawful act is excluded. Furthermore, pursuant to § 394 BGB, set-off may not be made against non-attachable claims (such as certain wage and maintenance claims) to safeguard debtor protection. In insolvency law (§ 96 InsO), set-off after the opening of insolvency proceedings is generally not permitted, unless the requirements for set-off already existed prior to commencement. Contractual or statutory set-off prohibitions may be provided for, especially in general terms and conditions or special statutes (e.g., in labor law to protect employees).
How does set-off work in insolvency proceedings?
In German insolvency proceedings, set-off is strictly regulated. According to § 96 InsO, set-off with claims that arise only after the insolvency is opened against the insolvency debtor is not permitted. Claims that existed and were eligible for set-off before the opening of proceedings remain subject to set-off (§ 94 InsO). This serves to protect creditors and to ensure the equal satisfaction of all insolvency creditors. If a creditor seeks to gain preferential satisfaction for their claim through set-off, such set-off is ineffective under § 96 InsO and the insolvency proceedings protect the total assets from individual enforcement by such creditors.
Must compensation be asserted in court?
Set-off may generally be declared outside court proceedings. However, it can also be used as a defense in litigation, especially if a creditor brings a claim and the debtor asserts set-off as a defense. In such cases, the debtor must declare the set-off in court and prove the relevant requirements (§§ 387 et seq. BGB, in conjunction with the ZPO). Judicial consideration of set-off has the result that the plaintiff’s claim is deemed settled to the extent of the set-off amount and the claim is dismissed accordingly. The competent court depends on the subject matter of the dispute and the rules of civil procedure.
