• Court Rejects Swap’s Triangular Setoff Right in Bankruptcy
  • October 18, 2011 | Authors: Hollace Topol Cohen; Brian C. Harms; John J. Leonti
  • Law Firms: Troutman Sanders LLP - New York Office ; Troutman Sanders LLP - Atlanta Office ; Troutman Sanders LLP - Irvine Office
  • In a recent decision by Judge James Peck, the presiding bankruptcy judge in the Lehman Brothers Inc., SIPA proceeding (Case No. 08-01420), he held that a cross-affiliate netting provision in a swap agreement was unenforceable under the Bankruptcy Code. This advisory explains that ruling and the eligibility requirements for a cross-affiliate netting provision.

    A cross-affiliate netting provision (often referred to as a triangular setoff provision) creates a contractual right of setoff that permits netting by multiple affiliated members of the same corporate family.

    UBS AG and Lehman Brothers Inc. had previously entered into a swap agreement pursuant to a 1992 ISDA Master Agreement under which the parties subsequently entered into numerous foreign exchange transactions. Under the swap agreement the parties agreed to a triangular setoff clause, which stated as follows:

    “upon the designation of any Early Termination Date, in addition to and not in limitation of any other right or remedy...under applicable law the Non-defaulting Party or Non-affected Party (in either case, “X”) may without prior notice to any person set off any sum or obligation (whether or not arising under this Agreement...) owed by the Defaulting Party or Affected Party (in either case, “Y”) to X or any Affiliate of X against any sum or obligation (whether or not arising under this Agreement...) owed by X or any Affiliate of X to Y....”

    Swap counterparties, among others, use triangular setoff provisions to reduce counterparty credit risks. Cross-affiliate netting extends the typical setoff right to include amounts due between the defaulting party and the non-defaulting party’s affiliates. The wider scope of the setoff provision may, for example, allow a non-defaulting financial institution to capture the defaulting party’s deposit balances held with the non-defaulting financial institution’s banking subsidiaries.

    While a triangular setoff may be enforced outside of bankruptcy, the decision by Judge Peck establishes that the same provision may no longer be enforced after the commencement of a case governed by the Bankruptcy Code (or SIPA). Judge Peck ruled that “Contractual provisions that purport to create synthetic mutuality are not a substitute for the real thing. So-called triangular setoff that lacks mutuality, therefore, is not authorized under the Bankruptcy Code....”

    To be eligible for setoff under the Bankruptcy Code, there are three requirements: (1) that the amount owed by the debt must be a prepetition debt; (2) the debtor’s claim against the creditor must also be prepetition; and (3) the debtor’s claim against the creditor and the debt owed the creditor must be mutual. The issue with the triangular setoff right under the Bankruptcy Code was whether the third requirement, the mutuality requirement, was present.

    The Bankruptcy Code does not define mutuality, but courts consistently find debts to be mutual only when they are in the same right and between the same parties, standing in the same capacity. Under the ISDA Agreement, only one UBS entity was a party to the netting or setoff agreement, and therefore lacked mutuality. In so holding, UBS was directed to return approximately $21.3 million of the collateral it held pursuant to its triangular setoff right to the SIPA Trustee, which represented amounts due from Lehman Brothers to an affiliate of UBS.

    However, since only one UBS entity was a party to the ISDA Agreement, it is still uncertain whether a Bankruptcy Judge would permit the enforcement of a triangular setoff provision if the non-defaulting party and all of its affiliates had been actual parties to the triangular setoff agreement. Arguably, the necessary mutuality would be present where all relevant entities were party to the same netting agreement (as would be the practice under master netting agreements).