Delaware Bankruptcy Court Rejects Triangular Setoff
In a recent decision, a Delaware bankruptcy court ruled on the permissibility of “triangular setoffs” pursuant to section 553 of the Bankruptcy Code. In In re SemCrude, L.P., the court held that triangular setoffs do not meet the mutuality requirements of section 553, such that a creditor could not effect a triangular setoff of the amounts owed among it and three affiliated debtors, despite pre-petition contracts that expressly contemplated multiparty setoff.
Setoff Rights in Bankruptcy
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 such a 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 under applicable law are met, except under circumstances where it would be inequitable to do so.
As articulated by the U.S. Supreme Court as early as 1913, setoff avoids the “absurdity of making A pay B when B owes A.” Debts are considered mutual when they are due to and from the same persons in the same capacity. An exception to this strict mutuality requirement may exist in cases involving “triangular setoff,” the provenance of which is commonly traced (rightly or wrongly) to a 1964 ruling construing section 68(a) of the former Bankruptcy Act of 1898 by the Seventh Circuit Court of Appeals in Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.). In this situation, A might have a relationship with B and C, where B and C are related parties. Triangular setoff occurs when A owes B, and A attempts to set off such amount with amounts C owes to A. The validity of triangular setoff in the bankruptcy context, as distinguished from under state contract or common law, is subject to debate, given the lack of mutuality involved. A Delaware bankruptcy court had an opportunity to consider this controversial issue in SemCrude.
Energy-industry services company SemCrude, L.P. (“SemCrude”), and various direct and indirect subsidiaries (collectively, the “debtors”), including SemFuel, L.P. (“SemFuel”), and SemStream, L.P. (“SemStream”), filed voluntary petitions for chapter 11 protection in Delaware in 2008. Prior to the petition date, Chevron USA Inc. (“Chevron”) entered into separate contracts with SemCrude, SemFuel, and SemStream, respectively. The contracts provided for the purchase of crude oil, gasoline, butane, isobutene, and propane. The three contracts contained or were governed by identical netting provisions that provided:
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 product 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.
On the petition date, Chevron owed a balance of $1.4 million to SemCrude, while SemFuel owed Chevron $10.2 million and SemStream owed Chevron $3.3 million. Chevron claimed that pursuant to the terms of the contracts, the amount it owed could be set off, and it sought relief from the automatic stay to effect the setoff. The debtors, the official committee of unsecured creditors, and a number of individual creditors objected, citing the requirement of section 553 of the Bankruptcy Code that debts must be “mutual” in order to be set off. Chevron countered that either its pre-petition contracts with the debtors satisfied the mutuality requirement or the Bankruptcy Code allowed the parties to contract around the mutuality requirement by providing for setoffs across affiliates.
In determining whether an agreement that contemplates triangular setoff can create mutuality under section 553, the bankruptcy court scrutinized the meaning of the term “mutual debt.” Finding that the nature of mutuality under section 553 is well settled, the court concluded that “debts are considered ‘mutual’ only when they are due to and from the same persons in the same capacity.” “Put another way,” the court explained, “mutuality requires that each party must own his claim in his own right severally, with the right to collect in his own name against the debtor in his own right and severally.” In light of this definition, the court concluded that “mutuality cannot be supplied by a multi-party agreement contemplating a triangular setoff.”
The bankruptcy court rejected Chevron’s contention that parties could contract around section 553’s mutuality requirement. In its motion, Chevron cited a line of cases decided under both the Bankruptcy Code and the Bankruptcy Act of 1898 that appeared to support the proposition that section 553 could be circumvented by a pre-petition contract. Each case cited by Chevron to support triangular setoff could be traced either directly or indirectly to the Seventh Circuit’s ruling in Berger Steel. In Berger Steel, a party sought to satisfy the mutuality requirement by means of an alleged oral agreement for triangular setoff. The court, upholding the bankruptcy referee’s ruling that no agreement existed, rejected the setoff. Acknowledging that some previous cases allowed a triangular setoff to be taken pursuant to a valid contract, the court emphasized that each of these cases was decided under state law or the common law of equitable receivership, not under the restrictive language of the Bankruptcy Act. However, by factually distinguishing its ruling from other instances where triangular setoff was allowed, the Seventh Circuit invited later courts to cite Berger Steel as precedent for circumvention of section 553’s mutuality requirement by contract.
In SemCrude, the court rejected Berger Steel as authority for the proposition that nonmutual setoff provisions in a contract can be enforced against a debtor. Addressing other decisions that rely on Berger Steel, the court noted that none of these cases actually upheld or enforced an agreement for a triangular setoff. Rather, the rulings simply recognized the possibility of an exception for pre-petition contracts contemplating triangular setoff in the course of denying setoff or finding mutuality.
Finding no actual precedent for enforcing nonmutual setoff, the court focused on the plain language of section 553(a), which in its view clearly and unambiguously requires mutuality. Furthermore, the court found that nonmutual setoff would be contrary “to the principle of equitable distribution that lies at the heart of the Code,” because “one creditor or a handful of creditors could unfairly obtain payment from a debtor at the expense of the debtor’s other creditors, thereby upsetting the priority scheme of the Code and reducing the amount available for distribution to all creditors.”
The court distinguished setoff from a guarantee relationship, explaining that, unlike in a guarantee situation, setoff does not give rise to a debt that is due from one party to the other, nor a right to collect. When a setoff right is exercised, the court emphasized, the parties’ receivables are merely reduced or eliminated as between the same parties. As such, the court concluded, although Chevron might retain privity of contract by reason of its agreements with SemCrude, SemFuel, and SemStream, the outstanding obligations under such contracts were not mutual for purposes of section 553.
According to SemCrude, absent piercing of the corporate veil or substantive consolidation of affiliated debtors’ estates, the mutuality requirement precludes triangular setoffs in bankruptcy. However, the legitimacy of a triangular setoff even in cases of substantive consolidation or veil piercing is open to debate, at least in Delaware, given the Delaware district court’s December 2008 ruling in In re Garden Ridge Corp. In Garden Ridge, the court affirmed a decision of the bankruptcy court refusing to permit a creditor to invoke a triangular-setoff right despite the prior substantive consolidation of affiliated debtors’ bankruptcy estates, remarking that “substantive consolidation cannot create mutuality where it did not otherwise exist.” Thus, parties seeking to avoid the setoff problem in transactions involving multiple related obligors may be better served by relying on cross-collateralization and/or guarantees.
If followed, SemCrude would eliminate triangular setoff, at least where the contracts at issue are not subject to a Bankruptcy Code safe-harbor provision, such as those that apply to financial contracts. The safe-harbor provisions of the Bankruptcy Code suggest that where triangular setoff is being exercised under a contract that is protected by the safe harbor, the mutuality requirement of section 553(a) does not apply. In fact, on January 20, 2009, Chevron asked the bankruptcy court to reconsider its order denying triangular setoff, arguing that the contracts at issue are “forward contacts” and/or “swap agreements” and are therefore entitled to the protections of the safe-harbor provisions of the Bankruptcy Code. On March 20, the bankruptcy court denied the motion to reconsider, based on Chevron’s failure to raise the safe-harbor provisions in its initial moving papers. Chevron thereafter appealed the bankruptcy court’s initial ruling. Thus, the fate of triangular setoff in bankruptcy may rest in the hands of the Delaware district court or perhaps even the Third Circuit Court of Appeals.
In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009).
Studley v. Boylston Nat. Bank, 229 U.S. 523 (1913).
Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.), 327 F.2d 401 (7th Cir. 1964).
In re Garden Ridge Corp., 399 B.R. 135 (D. Del. 2008).