Corporate Update

Pre-Petition Contractual Rights to Triangular Setoff Not Available Under Section 553(a)

Bankruptcy Court finds Pre-petition contractual rights to triangular setoff are not available under Section 553(a) of the Bankruptcy Code (In re SemGroup, L.P., Bankr., D. Del. , Case Number 08-11525, Document reference 888, January 9, 2009)

On January 9, 2009, the bankruptcy court for the District of Delaware denied a motion of a nondebtor counterparty seeking relief from the automatic stay to effect a “triangular setoff” — that is, a setoff of a creditor’s right to payment from one debtor against amounts the creditor owed to an affiliate of such debtor. The court held that the mutuality requirement of Section 553 of the Bankruptcy Code prohibited triangular setoff, even though a series of pre-existing contracts among the parties expressly permitted offsets between the parties and their affiliates. This ruling could impact a wide variety of master netting agreements, swap agreements and other agreements with cross-party setoff provisions. The court has before it a motion to reconsider its ruling. In the motion to reconsider, the creditor has raised the new argument that, because the contracts are forward contracts and/or swap agreements, setoff would be permitted notwithstanding the automatic stay and therefore the provisions of Section 553 would not apply.

Background and Decision
The decision affects four bankruptcy debtors—SemGroup L.P. and its subsidiaries SemCrude, L.P., SemFuel, L.P. and SemStream, L.P.—each of which filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. The cases are jointly administered but not substantively consolidated. Prior to the bankruptcy filings, Chevron Products Company, a division of Chevron USA, Inc., contracted with the three subsidiaries for the sale or purchase of petroleum products. The sale transactions were subject to master agreements that include netting provisions allowing a party to offset deliveries or payments due under the relevant contract or any other agreement with the counterparty and its affiliates. SemGroup, L.P. provided a parent guaranty of any indebtedness incurred by the subsidiary debtors. At the date of the bankruptcy, Chevron owed a balance to SemCrude and Chevron was owed a balance from each of SemFuel and SemStream. Chevron requested relief from the automatic stay to effect a setoff of the balances between Chevron and the SemGroup affiliates. The objection to the argument for setoff was that Section 553 of the Bankruptcy Code requires that debts be “mutual” in order for parties to setoff and that even a valid, pre-petition agreement cannot contract around the mutuality requirement.

Citing prior authorities, the court found that debts are “mutual” for purposes of Section 553 of the Bankruptcy Code only when they are due to and from the same persons in the same capacity, and that each party must own its claim in its own right, severally, with the right to collect in its own name against the debtor. The court held (i) that the mutuality required by Section 553 is not established simply because a multi-party agreement permits triangular setoff and (ii) that no exception to the mutual debt requirement in Section 553 of the Bankruptcy Code can be created by private agreement. While creditors may have the benefit of setoff rights under nonbankruptcy law, they must also meet the additional restrictions of Section 553 of the Bankruptcy Code that are imposed on a creditor seeking setoff. The court ruled that earlier cases that seemed to have permitted triangular setoffs under bankruptcy law did not actually so hold. Accordingly, the court denied Chevron’s motion to permit setoff notwithstanding the automatic stay.

The question whether the contracts in question were “forward contracts” or “swap agreements” under the Bankruptcy Code (and therefore whether the governing terms were “master netting agreements”), thus being exempt from the operation of the stay in the first instance, did not appear to have been a point of discussion in the initial ruling. The pending motion for reconsideration raises that point directly.

Implications
Multiple-party setoff or netting clauses are commonly included in executed master agreements on the forms promulgated by the International Swaps and Derivatives Association (ISDA).  Accordingly, this decision has implications for parties to the master agreements that contain cross-party setoff provisions. This decision potentially undercuts the reliability of such a provision and may well impact the efficacy of post-bankruptcy termination rights in securities contracts, swap contracts, repurchase agreements, commodity contracts and forward contracts under sections 555 through 562 of the Bankruptcy Code.