Setoffs Under Shari'a-Compliant Investment Contracts Not Safe Harbored in Bankruptcy
In In re Arcapita Bank B.S.C., 2021 WL 1603608 (Bankr. S.D.N.Y. Apr. 23, 2021), the U.S. Bankruptcy Court for the Southern District of New York addressed the interaction between purported setoff rights arising under investment agreements governed by Islamic law and the Bankruptcy Code's safe harbors protecting the exercise of non-debtors' rights under financial contracts. The court granted summary judgment to a creditors' committee on its claims that two foreign banks invalidly, and in violation of the automatic stay, exercised setoffs under Islamic Shari'a-compliant investment contracts with a Bahrain-headquartered chapter 11 debtor. In so ruling, the court concluded that the investment contracts were more akin to loans than the kinds of financial contracts that are protected by the Bankruptcy Code's safe harbors.
Enforcement of 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." Section 553 does not create setoff rights—it merely preserves certain setoff rights that otherwise would exist under contract or applicable nonbankruptcy law. See Collier on Bankruptcy ("Collier") ¶ 553.04 (16th ed. 2021) (citing Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995)). As noted by the U.S. Supreme Court in Studley v. Boylston Nat. Bank, 229 U.S. 523 (1913), setoff avoids the "absurdity of making A pay B when B owes A."
With certain exceptions for setoffs under "safe-harbored" financial contracts, a creditor is precluded by the automatic stay from exercising setoff rights against a debtor in bankruptcy without court approval. See 11 U.S.C. §§ 362(a)(7), (b)(6), (b)(7), (b)(17), (b)(27), and (o). Stayed setoff rights are merely suspended, however, pending an orderly examination of the parties' obligations by the court, which will generally permit a valid setoff unless it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008).
A creditor stayed from exercising a valid setoff right must be granted "adequate protection" (see 11 U.S.C. § 361) against any diminution in the value of its interest caused by the debtor's use of the creditor's property. Ealy, 392 B.R. at 414.
Setoff is expressly prohibited by section 553 if: (i) the creditor's claim against the debtor is disallowed; (ii) the creditor acquires its claim from an entity other than the debtor either (a) after the bankruptcy filing date or (b) after 90 days before the petition date while the debtor was insolvent (with certain exceptions); or (iii) the debt owed to the debtor was incurred by the creditor (a) after 90 days before the petition date, (b) while the debtor was insolvent, and (c) for the purpose of asserting a right of setoff, except for setoff under "safe-harbored" financial contracts (discussed below). See 11 U.S.C. § 553(a)(1)-(3).
Section 553(b) provides that, except for setoffs under safe-harbored financial contracts, the trustee or a chapter 11 debtor-in-possession ("DIP") may recover any amount offset by a non-debtor on or within 90 days before the bankruptcy petition date to the extent the non-debtor improved its position by reducing any "insufficiency."
Thus, for a creditor to be able to exercise a setoff right in bankruptcy, section 553 requires on its face that: (i) the creditor has a right of setoff under applicable non-bankruptcy law; (ii) the debt and the claim are "mutual"; (iii) both the debt and the claim arose prepetition; and (iv) the setoff does not fall within one of the three prohibited categories specified in the provision. Although some courts have permitted the setoff of mutual postpetition debts (see, e.g., Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016)), the remedy is available in bankruptcy only "when the opposing obligations arise on the same side of the … bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015).
The Bankruptcy Code does not define the term "mutual debt." Debts are generally considered mutual when they are due to and from the same persons or entities in the same capacity, but there is some confusion among the courts on this point. See generally Collier at ¶ 553.03[a] (citing cases).
Creditors typically rely on the remedy of setoff if the mutual debts arise from separate transactions, although the issue is murky. See Collier at ¶ 553.10. By contrast, if mutual debts arise from the same transaction, the creditor may have a right of "recoupment," which has been defined as "a deduction from a money claim through a process whereby cross demands arising out of the same transaction are allowed to compensate one another and the balance only to be recovered." Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 146 (2d Cir. 2002); accord Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1399 (9th Cir. 1996); In re Matamoros, 605 B.R. 600, 610 (Bankr. S.D.N.Y. 2019) ("recoupment is in the nature of a defense and arises only out of cross demands that stem from the same transaction").
Unlike setoff, recoupment is not subject to the automatic stay (see In re Ditech Holding Corp., 606 B.R. 544, 600 (Bankr. S.D.N.Y. 2019)) and may involve both pre- and postpetition obligations. See Sims v. U.S. Dep't of Health and Human Services (In re TLC Hosps., Inc.), 224 F.3d 1008, 1011 (9th Cir. 2000) (citing Collier at ¶ 553.10).
Setoffs Permitted Under Safe-Harbored Financial Contracts
As noted, setoffs under safe-harbored financial contracts are permitted without court permission by the Bankruptcy Code. Specifically, section 362(b)(6) provides that, notwithstanding the general prohibition of postpetition setoffs without court authority, a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency may exercise any contractual right under any commodity contract, forward contract, or securities contract "to offset or net out any termination value, payment amount, or other transfer obligation" arising under the contract. Subsections 362(b)(7), (b)(17), and (b)(27) give the same setoff rights to participants under repurchase agreements, swap agreements, and master netting agreements, respectively.
Unless a pre-bankruptcy transfer under these types of agreements was made with the intent to defraud creditors, a trustee or DIP may not avoid such a transfer under the safe harbors set forth in sections 546(e), 546(f), 546(g), and 546(j) of the Bankruptcy Code. The rights of participants under these financial contracts to liquidate, terminate, accelerate or offset obligations under such contracts unfettered by the automatic stay or a trustee's avoidance powers are reiterated in sections 555, 556, and 559 through 561. Those provisions also protect the exercise under such contracts of "a right, whether or not in writing, arising under common law, under law merchant, or by reason of normal business practice."
Finally, section 362(o) provides that the exercise of rights not subject to the automatic stay (such as offset rights under safe-harbored financial contracts) "shall not be stayed by any order of a court or administrative agency" in a bankruptcy case.
In 2012, Arcapita Bank B.S.C.(C) ("Arcapita"), a Bahrain-headquartered investment bank and global manager of Shari'a-compliant alternative investments, entered into short-term investment agreements with two commercial banks—Bahrain Islamic Bank ("BisB") and Tadhamon Capital B.S.C. ("Tadhamon") ("defendants")—headquartered in Bahrain and Yemen, respectively. The agreements were negotiated and signed in Bahrain and provided that Bahraini law would govern any disputes, except to the extent that such laws conflicted with the principles of Islamic Shari'a, in which case Shari'a law would prevail.
In accordance with Islamic banking and finance practice, the transactions were structured as investments rather than traditional lending transactions.
In "murabaha" investments, the defendants invested approximately $28 million ($9.8 million from BisB and $18 million from Tadhamon) with Arcapita for the purchase of commodities from a third party in the defendants' names, with Arcapita then repurchasing those same commodities from the defendants for the original investment amount plus an agreed-upon return to be paid on an agreed-upon maturity date.
Arcapita then made $30 million in reciprocal murabaha investments with BisB. Arcapita funded the investments by transferring $30 million on or about March 15, 2012, from its U.S. bank account to a U.S. bank account maintained by BisB.
Arcapita also made $20 million in "wakala" investments with Tadhamon. Under these transactions, instead of offering to sell commodities, Tadhamon invested on Arcapita's behalf in Shari'a-compliant investment products such as debt instruments, murabaha and wakala placements, and bridge financing products, which provided an expected (but not guaranteed) investment return to be paid on a specified date.
Arcapita filed for chapter 11 protection in the Southern District of New York on March 19, 2012.
On March 26 and 27, 2012, BisB repaid $20 million of Arcapita's matured murabaha investments but withheld approximately $10 million in investment proceeds on the March 29, 2012, maturity date. On March 28 and April 15, 2012, Arcapita agreed to "roll over" its $20 million in wakala investments with Tadhamon to later maturity dates. The new rollover contracts matured on April 30, 2012, and May 16, 2012, after which Tadhamon was obligated to remit in excess of $20 million in investment proceeds to Arcapita.
The defendants' $28 million in investments with Arcapita matured (either originally or via rollover) after Arcapita filed for bankruptcy.
Both defendants claimed that they were entitled under Bahraini law to retain the withheld proceeds ("transaction proceeds") as a valid setoff against Arcapita's obligations to them. However, the Central Bank of Bahrain ("CBB"), which oversees all banks doing business in the country, directed both BisB and Tadhamon either immediately to return the transaction proceeds to Arcapita or to seek permission from the bankruptcy court to effect the offset, failing which they should remit the funds to Arcapita. The defendants did not comply with the CBB directive.
The bankruptcy court authorized Arcapita's official committee of unsecured creditors to commence adversary proceedings against the defendants, seeking, among other things, turnover of the transaction proceeds under section 542 of the Bankruptcy Code, avoidance and recovery of the $30 million paid by Arcapita to BisB as a preferential transfer under sections 547 and 550, disallowance of the defendants' claims under section 502(d) (because the defendants retained voidable transfers), and a determination that the defendants' purported setoff transactions violated the automatic stay under section 362.
After unsuccessfully challenging the lawsuits on the basis of lack of personal jurisdiction, the defendants moved to dismiss the complaints. They contended that the turnover, avoidance, and automatic stay violation claims were precluded by the "presumption against extraterritoriality" and that the court should dismiss the litigation under the principle of international comity.
In 2017, Bankruptcy Judge Sean H. Lane denied the motions to dismiss. Among other things, he rejected the defendants' extraterritoriality defense because the committee's claims were either based on domestic conduct—the U.S. bank transfers were at the "heart" of the transactions—or based on statutes that apply extraterritorially. See In re Arcapita Bank B.S.C.(C)), 575 B.R. 229 (Bankr. S.D.N.Y. 2017). On the latter point, he ruled that the committee's claims under sections 362 (the automatic stay) and 542 (turnover of property to the estate) were independent of the avoidance claims, and that those provisions applied extraterritorially because it was clear from their language that Congress intended for them to apply outside of the United States.
The committee and the defendants then cross-moved for summary judgment.
The Bankruptcy Court's Ruling
Judge Lane granted summary judgment in favor of the committee.
First, he held that Tadhamon could not offset its obligations against Arcapita's obligations because the obligations were not "mutual"—Arcapita's debt arose prepetition, whereas Tadhamon's rollover debt arose and matured postpetition. In so ruling, Judge Lane rejected Tadhamon's argument that the Bankruptcy Code's safe harbors eliminate section 553's mutuality requirement for financial contracts.
This argument, Judge Lane noted, was expressly rejected by Bankruptcy Judge James M. Peck in In re Lehman Bros. Holdings Inc., 433 B.R. 101, 109 (Bankr. S.D.N.Y. 2010). In Lehman, Judge Lane explained, the court wrote that "[f]or purposes of any right to setoff permitted under section 553, mutuality is baked into the very definition of setoff," reasoning that technical amendments to the language of the safe harbors as part of the Financial Netting Improvements Act of 2006 did not alter this principle.
Judge Lane also ruled that setoff was not permitted under Bahraini law because the applicable contracts with Arcapita did not expressly provide for setoff and the defendants did not comply with the directive of the CBB before effecting a setoff.
According to Judge Lane, setoff was also precluded by section 553(a)(3)(C) because the evidence established as a matter of law that the defendants incurred their debt to Arcapita for the purpose of obtaining a setoff right against it.
Among other things, he noted that: (i) the investments made by Arcapita with the defendants were outside the regular course of business for the parties; (ii) the defendants were aware of Arcapita's financial difficulties in the months prior to its bankruptcy filing; and (iii) extensive correspondence between the defendants and Arcapita immediately before and after the bankruptcy filing reflected that Arcapita and the defendants were trying to find a way for the defendants' investments, unlike the claims of Arcapita's other unsecured creditors, to be fully protected.
Judge Lane rejected the defendants' argument that the transactions were protected by the safe harbors for "securities contracts" set forth in sections 362(b)(6), 546(e), 555, and 561(a) of the Bankruptcy Code. According to Judge Lane, the agreements between the defendants and Arcapita "are like loans as they explicitly provide for a creditor to recoup its investment with a specific rate of return." Moreover, the parties consistently referred to the prepetition debts owed by Arcapita as "loans," and the agreements did "not bear the hallmarks of debt securities such as bonds, debentures, notes, or other instruments that are considered securities under Section 101(49) of the Bankruptcy Code."
Guided by the Second Circuit's decision in In re Lehman Brothers Holdings Inc., 855 F.3d 459, 474-75 (2d Cir. 2017), Judge Lane explained that, of most significance in this context, neither the defendants nor Arcapita assumed "the same risk and benefit expectations as shareholders" as a result of their investments. Instead, he wrote, "The only risk the investing party assumed was the risk of non-payment by its counterparty; its only expectation was timely payment of a fixed amount." Judge Lane acknowledged that, in a wakala transaction, the return to the investor is expected but not guaranteed, but he emphasized that "the expected return is paid to the depositor in 99% of cases."
Judge Lane concluded that the murabaha agreements did not qualify as safe-harbored "forward contracts" because: (i) the primary purpose of the agreements was not risk-shifting; and (ii) the agreements specified maturity dates less than two days after the contracting date, rather than the date of delivery of the underlying commodity. He also determined that the agreements were not "swap agreements" because, among other things, the "transactions do not provide for the 'swap' of financial instruments and are therefore not similar to any of the examples specified in Section 101(53B) [of the Bankruptcy Code]."
In addition, Judge Lane rejected the defendants' contention that the setoffs constituted rights under "law merchant" and "normal business practice" in Bahrain and within Islamic finance generally, and therefore qualified as "contractual rights" under the "rarely invoked" safe harbor provisions in sections 555, 556, 559, and 560. According to Judge Lane, the defendants cited no authority for the proposition that a setoff right "is a recognized practice of law merchant" or that setoff under Shari'a law and Islamic finance is a "long standing custom among merchants." Moreover, he noted, the CBB's directive to the defendants to seek court authority for the setoffs indicated that they were not a "normal course of action in these circumstances."
Having rejected the defendants' various defenses, the bankruptcy court addressed the merits of the committee's claims. Because the setoffs were invalid, Judge Lane granted summary judgment to the committee on its claims for breach of contract arising from the defendants' failure to remit the investment proceeds to Arcapita. He also ruled that the proceeds were subject to turnover under section 542 of the Bankruptcy Code and that, by withholding the proceeds, the defendants violated the automatic stay. However, he denied the committee's request for sanction under section 362(k) for the defendants' willful violation of the stay, noting that "under established Second Circuit law, the requested relief is limited to natural persons and is not available to corporate debtors."
In light of its turnover ruling, the court did not address the committee's request that the defendants' claims be disallowed under section 502(d).
The court's meticulous analysis of the agreements in Arcapita and the mechanics of the Bankruptcy Code's safe harbors for financial contracts are emblematic of the exacting scrutiny that many courts have directed recently toward transactions that purportedly qualify for protection. The scope of the safe harbors has been litigated extensively in the last few years, and that trend will likely continue.
Arcapita is unusual because it involved principles of foreign contract law and practice that were not readily susceptible to analysis under U.S. law. Nevertheless, the decision is instructive regarding setoff rights in bankruptcy and, most notably, the circumstances under which a purported setoff right will be denied because it either does not exist or is invalid under applicable non-bankruptcy law, or the non-debtor party seeking to exercise a setoff was motivated by a desire to obtain an unfair advantage over other creditors.
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