- Is Contractual Triangular Setoff Permitted Under the Bankruptcy Code for Derivative Transactions?
- February 24, 2009 | Authors: Joshua Dorchak; Kenneth A. Kopelman; Jeffrey S. Sabin; Ronald J. Silverman; Edwin E. Smith
- Law Firms: Bingham McCutchen LLP - New York Office; Bingham McCutchen LLP - Boston Office
It is not unusual for a seller or provider of services to a group of affiliated companies to obtain by contract a right to set off payment obligations owed by the seller or provider to one member of the group against amounts owed to the seller or provider by another member of the group. Such a setoff is often referred to as a “triangular setoff,” i.e., where A, B and C agree that A may set off amounts owed by A to B against amounts owed to A by C.
The recent case of In re SemCrude, L.P. (hereinafter “SemCrude”)1 has raised the question of whether, if B were to become a debtor in a U.S. bankruptcy case, contractual triangular setoff would be enforceable in bankruptcy even though otherwise enforceable under applicable non-bankruptcy law. In SemCrude a Delaware bankruptcy court struck down bilateral contractual triangular setoff agreements among a creditor and affiliated debtors. The court concluded that Bankruptcy Code § 553(a) preserves setoff for only “mutual” debts owing between two parties and that contractual triangular setoff, by its nature encompassing three parties, does not involve mutual debts.
The case has been viewed in the derivative community as unsettling. Many parties engaged in derivative transactions have long used contractual triangular setoff clauses — so-called “cross-affiliate netting” provisions — in their master and netting agreements. The decision has cast doubt on the enforceability in bankruptcy of these provisions. Moreover, it is possible that other courts may follow the decision without critically re-examining the SemCrude court’s reasoning. Accordingly, the decision must be taken into account by any derivative counterparty seeking to rely upon or enforce a cross-affiliate netting provision.
However, the bankruptcy court’s decision is not binding in other bankruptcy courts, and its reasoning, especially as it applies to derivative transactions, may be challenged on several grounds.
First, one may question whether Bankruptcy Code § 553(a) applies at all. A contractual triangular setoff gives to A, in our example, by contract a claim or defense that A may assert as a defense on its obligation to pay B. The claim or defense is that C owes money to A and that A can reduce what it owes to B by the amount that C owes to A. A’s contractual claim or defense is not setoff in the common law sense; it is merely the assertion of a contractual claim or defense to payment under non-bankruptcy law that should be recognized by a bankruptcy court to the same extent as any other contract defense under non-bankruptcy law would be recognized. Viewed this way, Bankruptcy Code § 553(a) preserves common law setoff rights but does not limit contractual claims and defenses.
Second, even if Bankruptcy Code § 553(a) applies to contractual triangular setoff, it may be that the debts are mutual. Since A has a right by contract to reduce what it owes to B by the amount that C owes A, A has a claim against B that A can assert to reduce the amount that it owes to B. This conclusion would have been clearer to the SemCrude court if, instead of referring to their contractual arrangements as “setoff,” the parties had used the term “guaranty.” If in our example B guaranteed C’s obligations to A, there would appear to be very little doubt that A’s payment obligation to B and B’s guaranty obligations to A would be “mutual” debts. Contractual triangular setoff is in economic effect nothing more than a guaranty by B of C’s obligations to A limited to the amount that A owes to B. That the parties referred to these arrangements as effecting a “setoff” rather than a “guaranty” should not matter for purposes of the debts being mutual.
Third, even if Bankruptcy Code § 553(a) applies to limit contractual triangular setoff, it is not at all clear that the section applies to limit contractual triangular setoff of amounts owing under derivative transactions. This is because non-debtor counterparties to securities contracts, commodity contracts, forward agreements, repurchase agreements and swap agreements, as well as netting agreements covering any of these agreements, benefit from special protections in the Bankruptcy Code. These protections include the ability of a non-debtor counterparty to exercise contractual netting rights following the closeout of the derivative transactions without the exercise of those rights being limited by any other provision of the Bankruptcy Code, including presumably Bankruptcy Code § 553(a). The creditor in SemCrude arguably could have taken the position that its contractual arrangements with the affiliated debtors were forward contracts entitled to these protections, but it did not initially do so.2
Given the vulnerability of the court’s reasoning in SemCrude and that it did not address derivative transactions, parties to derivative transactions with cross-affiliate netting provisions should not assume that the provisions will now be viewed to be unenforceable under § 553(a) of the Bankruptcy Code. On the contrary, the arguments remain strong that Bankruptcy Code § 553(a) does not limit the enforceability of these provisions.
1 In re SemCrude, L.P., 2009 WL 68873 (Bankr. D. Del. January 9, 2009).
2 The creditor did later move for reconsideration. In doing so, the creditor raised the argument that the contractual arrangements were forward contracts entitled to the benefits of the Bankruptcy Code’s special provision for derivatives.