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Contract Rejection Claims Eligible for Setoff Under Section 553: Rejecting the Delta Approach

A creditor’s ability in a bankruptcy case to exercise rights that it has under applicable law to set off an obligation it owes to the debtor against amounts owed by the debtor to it, thereby converting its unsecured claim to a secured claim to the extent of the setoff, is an important entitlement. Setoff rights are generally preserved in a bankruptcy case under section 553 of the Bankruptcy Code. The provision, however, does not create a setoff right, but provides merely that the Bankruptcy Code shall not “affect” setoff rights that exist under applicable nonbankruptcy law as of the bankruptcy petition date. A Delaware bankruptcy court recently had an opportunity to consider whether a claim arising from the rejection in bankruptcy of a prepetition contract, which the Bankruptcy Code designates a prepetition claim, can be set off against the nondebtor contract party’s prepetition obligation to the debtor. In CDI Trust v. U.S. Electronics, Inc. (In re Communication Dynamics, Inc.), the court ruled that the setoff was appropriate, adopting the majority view on the issue and repudiating a competing (and widely criticized) approach taken by a New York bankruptcy court in its 2006 ruling in In re Delta Airlines.

Setoffs and the Relation-Back Rule

Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case . . . .” A creditor is precluded by the automatic stay from exercising its setoff rights without bankruptcy court approval. The stay, however, merely suspends the exercise of setoff pending an orderly examination of the respective rights of the debtor and the creditor by the court, which will generally permit the setoff if the requirements (including mutuality) under applicable law are met, except under circumstances where it would be inequitable to do so. By contrast, if there is a right of recoupment (i.e., where mutual obligations arise under the same contract), the exercise of the right does not require court authority and the automatic stay does not apply.

By its terms, section 553 is limited to mutual obligations arising prior to a bankruptcy filing. By operation of sections 365 and 502 of the Bankruptcy Code, this would appear to include claims for damages arising from the rejection by a chapter 11 debtor-in-possession or bankruptcy trustee of any prepetition contract or agreement that qualifies as “executory.” Specifically, section 365(g) provides that the rejection of an executory contract is deemed to constitute a breach of that contract as of the date immediately prior to the filing of the bankruptcy petition. Section 502(g) provides that a claim arising from the rejection of “an executory contract or unexpired lease of the debtor that has not been assumed shall be determined, and shall be allowed . . . or disallowed . . . the same as if such claim had arisen before the date of the filing of the petition.” This concept is sometimes referred to as the “relation-back rule.”

Even so, at least one court has determined that section 553 prohibits setoffs involving executory contract rejection damage claims. In In re Delta Airlines, Inc., a New York bankruptcy court, emphasizing that section 553 expressly and unambiguously precludes any other section of the Bankruptcy Code from “affecting” the right of setoff that a creditor may have as of the petition date, concluded that sections 365(g) and 502(g) of the Bankruptcy Code cannot be considered in deciding whether a creditor may utilize a rejection damages claim for the purposes of setoff. In other words, according to the Delta court, if a setoff right does not exist under nonbankruptcy law as of the bankruptcy petition date, no setoff right is preserved or created by section 553.

This holding has been widely criticized as being contrary to the express language of the Bankruptcy Code and the principles underpinning section 553. According to some commentators, there is no sound justification for concluding that lawmakers intended to exempt from section 553 claims expressly designated as arising prepetition by operation of sections 365(g) and 502(g). The gist of the criticism is that: (i) sections 365(g) and 502(g) do not create contract rejection damage claims – such claims arise when a contract is executed, although they are “contingent” or “unmatured” until the contract is breached (such as upon rejection in a bankruptcy case); and (ii) section 553 does not require a creditor to have a right of setoff that could be exercised under state law at the time the bankruptcy case is commenced – if a creditor on the petition date holds an unmatured or contingent claim that later matures or becomes fixed such that the creditor has a right of setoff under state law, section 553 should apply to recognize the right. The bankruptcy court in Communication Dynamics also rejected the Delta court’s approach.

Communication Dynamics

On May 8, 2002, Communication Dynamics, Inc. (“CDI”), the parent of the cable television products distributor TVC Communications Inc. (“TVC”), and its subsidiary, US Electronics, Inc. (“USE”), entered into an asset purchase agreement with USE Acquisition, LLC (now referred to as “ICX”). Under the asset purchase agreement, ICX purchased certain business assets of USE for which it paid $20 million in cash and delivered two notes (the “USE Notes”) in the aggregate face amount of $5 million. Twelve days later, ICX, CDI, and TVC executed a distribution agreement whereby TVC obtained the exclusive right to market and committed to purchase a minimum amount of the product manufactured by ICX. Under the same distribution agreement and the USE Notes, ICX gave TVC a 25-cent discount for each unit it sold. This discount was credited against the principal owed by ICX under the USE Notes.

Four months afterward, CDI and six of its affiliates, including TVC (collectively, the “debtors”), filed for chapter 11 protection in Delaware. ICX expressed concern about TVC’s ability to comply with the distribution agreement. Due to the size of the cure payment necessary to satisfy TVC’s anticipated obligations under the distribution agreement (approximately $1.3 million), the debtors decided to reject the agreement. ICX subsequently asserted a secured proof of claim in the amount of approximately $4.8 million and an unsecured claim in the amount of approximately $10.1 million. According to ICX, the secured claim represented the portion of its rejection damages subject to setoff against the sums it owed the debtors under the USE Notes.

The bankruptcy court confirmed the debtors’ joint chapter 11 plan in May 2004. The plan called for the debtors to transfer certain property and rights, including the USE Notes, to a liquidating trust (the “Trust”) created for the benefit of creditors. The trustee sued ICX for amounts allegedly due under the USE Notes, seeking, among other things, a declaratory judgment that ICX had no right of setoff based upon its contract rejection claim.

The Bankruptcy Court’s Ruling

The bankruptcy court ruled in favor of ICX. In doing so, the court expressly rejected the approach articulated in Delta. At the outset, the court noted that because the bankruptcy court in Delta determined that the obligation asserted to give rise to a right of setoff did not even constitute a debt, such that it could not be a claim in bankruptcy, the court’s conclusion with respect to the setoff issue was nothing more than dicta. Still, the bankruptcy court rejected as unpersuasive the Delta court’s basic premise regarding section 553’s preclusion of offset rights from extending to rejection damages claims. According to the court in Communication Dynamics, a literal interpretation of the term “affecting,” as used by the Delta court, could lead to absurd and unintended results, such as: (i) the elevation of rejection damages to administrative-expense status, in direct contravention of congressional will as expressed in section 365(g); and (ii) precluding a landlord from setting off a prepetition security deposit against its rejection damages claim.

The bankruptcy court in Communication Dynamics generally agreed with ICX’s reasoning, holding that the language of section 553 is ambiguous and must be considered together with other provisions of the Bankruptcy Code, such as sections 365(g), 502(g), and 101 (the last defining “debt” and “claim” broadly to include unmatured, contingent, disputed, and unliquidated claims). Viewed in conjunction, the court concluded, these provisions mandate that a rejection damages claim is a prepetition claim subject to setoff against any prepetition debt owed by the creditor to the debtor. It also articulated a second rationale for its conclusion – namely, that section 553 references the Bankruptcy Code for determining when a claim arises, but the Bankruptcy Code looks to state law to determine the substance of that claim. Sections 365(g) and 502(g), the court emphasized, do not actually affect the substance of a claim, but only specify when a given rejection damages claim arises. Therefore, the court concluded, section 553’s preclusion of any Bankruptcy Code provision “affecting” a setoff right under applicable nonbankruptcy law is not meant to apply to sections 365(g) and 502(g).

Outlook

No other court has followed Delta’s pronouncements concerning the invalidity of setoffs involving contract rejection claims. The reasoning of Communication Dynamics is more consistent with the application of section 553. For now, the Delta court’s approach on section 553 and rejection damage claims is in the distinct minority.
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CDI Trust v. U.S. Elec., Inc. (In re Commun. Dynamics, Inc.), 382 B.R. 219 (Bankr. D. Del. 2008).

In re Delta Airlines, Inc., 341 B.R. 439 (Bankr. S.D.N.Y. 2006).
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