Delaware Bankruptcy Court Disallows Triangular Setoff

This post is by my Philip A. Gelston’s partners Richard Levin and Paul H. Zumbro.

The United States Bankruptcy Court for the District of Delaware, in a decision announced January 9, 2009, denied a creditor’s request for permission to effect a triangular setoff, that is a setoff of the creditor’s claim against one debtor against amounts the creditor owed to another debtor affiliate of the debtor (In re SemCrude, L.P., Case No. 08-11525, Docket No. 2754, Jan. 9, 2009). The decision, if widely followed, could substantially increase a company’s credit exposure if the company has multiple contracts with another corporate group’s affiliates and has relied on a provision in the contracts allowing the company to offset amounts owing to one affiliate against claims against another affiliate and if the other group’s affiliates later file bankruptcy. The bankruptcy court ruled that allowing such a setoff would be inconsistent with the Bankruptcy Code’s express setoff provision and with fairness to all creditors.

Chevron USA, Inc. had entered into numerous contracts for the purchase or sale of various petroleum products with three counterparties, SemCrude L.P., SemFuel L.P. and SemStream, L.P., each of which is a direct or indirect subsidiary of SemGroup, L.P. and each of which later filed bankruptcy. Bilateral master agreements governed the contracts. Each of the master agreements contained a broad version of a common cross-affiliate setoff provision:

“in the event either party fails to make a timely payment of monies due and owing to the other party, or in the event either party fails to make timely delivery of products or crude oil due and owing to the other party, the other party may offset any deliveries or payments due under this or any other Agreement between the parties and their affiliates. (emphasis added.)

As of the affiliates’ bankruptcy petition date, Chevron owed $1.4 million to SemCrude and was owed $10.2 million by SemFuel and $3.3 million by SemStream. All parties agreed that SemCrude, SemFuel and SemStream were “affiliates” as defined by the relevant master agreements. Chevron sought bankruptcy court permission to effect a “triangular setoff” of the amount owed to SemCrude against the amounts SemFuel and SemStream owed Chevron.

The bankruptcy court denied permission for the triangular setoff, holding that the Bankruptcy Code does not permit triangular setoff. The court did not question that the contracts permitted the setoff. It concluded, however, that while Bankruptcy Code section 553 preserves any setoff right existing under nonbankruptcy law, it does not create or augment a setoff right, and it imposes restrictions that might not apply under nonbankruptcy law, the most important of which is the requirement that debts to be offset must be “mutual”.

The Bankruptcy Code does not define “mutual”. Case law is clear, however, that debts are “mutual” only when “they are due to and from the same persons in the same capacity”. On its face, then, the mutuality requirement prohibits triangular setoffs of the type Chevron proposed.

Chevron relied on a line of case law to argue that a valid, prepetition contract providing for triangular setoff either satisfies section 553’s mutuality requirement or that the parties may contract around it. The court acknowledged that “at first blush”, the nearly dozen cases under the Bankruptcy Code and a smaller number of cases decided under the former Bankruptcy Act seemed to support the propositions Chevron advanced. The court found, however, that none of the cases actually had permitted a triangular setoff or addressed the merits of the purported exception, despite general discussions in the cases of a potential exception to the mutuality requirement. The court thus concluded there was a “complete absence of controlling or persuasive published case law on the issue”.

Having dismissed the prior case law as unhelpful, the court rejected the argument that debts owing among different parties are “mutual” based on contractual netting provisions. Based on the case law definition of “mutual”, the court concluded that “mutuality cannot be supplied by a multi-party agreement contemplating triangular setoff”.

The court also ruled against a “contractual exception” to section 553’s mutuality requirement. The court found “nothing in the language of the Bankruptcy Code upon which to base a conclusion that there is a contractual exception to the ‘mutual debt’ requirement” and accordingly deemed it “improper to recognize one”.

Though some may view a cross-affiliate setoff provision as a de facto guarantee, the court did not and expressly excepted guarantees from the scope of its decision. Because all of the master agreements were bilateral, the court did not address multilateral agreements at all.

Although the court’s decision rested on a strict reading of section 553, it also noted that it was “consistent with the purpose of section 553 and the broader policies of the [Bankruptcy] Code [that] similarly-situated creditors are treated fairly and enjoy an equality of distribution …. By allowing parties to contract around the mutuality requirement of section 553, one creditor or a handful of creditors could unfairly obtain payment from a debtor at the expense of other creditors, thereby upsetting the priority scheme of the Code and reducing the amount available for distribution to all creditors.” “Such a result is clearly contrary both to the text of the Code and to the principle of equitable distribution that lies at the heart of the Code.”

The Effect of the Decision
The decision contains a clear analysis of section 553 and an equally clear dismissal of the prior, somewhat unclear case law concerning triangular setoff. Although not precedential, if the decision is widely followed, it would render largely unenforceable bilateral triangular setoff provisions, cross-affiliate setoff provisions and master netting agreements that provide for setoff among different entities in corporate groups. Contract counterparties may resort instead to express cross-affiliate guarantees or to multilateral agreements, which might provide the necessary mutuality.

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