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Court Rules Against Cross-Entity (Triangular) Setoff Rights in Bankruptcy: At Least With Respect to Non-Safe-Harbor Contracts

February 2, 2009

In an opinion issued on January 9, 2009, the Bankruptcy Court for the District of Delaware held that at least with respect to non-safe-harbor contracts, there is no exception to the "mutual debt" requirement for effectuating setoffs in bankruptcy; and denied the non-debtor counterparty's attempt to exercise cross-entity or triangular setoff rights. In re SemCrude, L.P., No. 08-11525, 2009 Bankr. LEXIS 21 (Bankr. D. Del. Jan. 9, 2009).  In its ruling, the SemCrude court held that: (1) triangular setoffs are not permitted in bankruptcy as long as the debt is not mutual; and (2) there is no contractual exception to the "mutual debt" requirement. Id. In issuing its opinion, however, the court did not appear to consider the safe-harbor provisions which apply to certain qualified contracts including, forward contracts, swap agreements, and master netting agreements involving these qualified contracts. The non-debtor counterparty has recently requested the SemCrude court to reconsider its opinion, claiming that its contract is a forward contract and/or swap agreement and its setoff rights are protected under the safe-harbor provisions; setting the stage for a possible ruling on the enforceability of cross-entity netting provisions under the safe harbor provisions of the Bankruptcy Code as recently amended by Congress.

The circumstances giving rise to this opinion arose in the bankruptcy cases of SemCrude and several of its affiliates, including SemFuel, L.P. ("SemFuel"), and SemStream, L.P. ("SemStream"). Chevron Products Company ("Chevron") filed a motion for relief from the automatic stay with the bankruptcy court asking permission to effectuate its contractual right of setoff. Chevron wanted to offset its obligation to pay SemCrude by the amounts that SemFuel and SemStream were obligated to pay Chevron. Chevron based its right to setoff on contractual netting provisions that permitted a party to offset payments between the parties and their affiliates in the event either party failed to make a timely payment.  Id. at *5.  Because the setoff contemplated by Chevron involved multiple parties, the setoff is termed a "cross-entity" or "triangular" setoff.

With respect to non-safe-harbor contracts, the Bankruptcy Code permits, with some limitations, parties that have a contractual right to setoff to enforce that right in bankruptcy as long as they first seek relief from the automatic stay to do so. One of the primary limitations on setoff rights under non-safe-harbor contracts is that the debts must be mutual. See 11 U.S.C. § 553(a). Chevron originally argued that it was permitted to effectuate its contemplated triangular setoff because: (1) mutuality is created by the contractual netting agreements between the parties; and (2) triangular setoffs are permitted as an exception to the mutuality requirement as long as there is a contractual right for such a setoff that is established prior to the bankruptcy filing. The bankruptcy court rejected both of these arguments.

First, the court held that debts owing between different parties cannot be considered mutual simply because there are contractual netting provisions governing all the parties' business relationship. Id. at *19. Next, the bankruptcy court held that there is no exception to the "mutual debt" requirement and rejected the argument that case law established a contractual exception to the mutuality requirement.

It is important to note that SemCrude did not guaranty the debts of its affiliates.  If it had, the results may have been different. The court did not foreclose the possibility that a guaranty could confer mutuality by virtue of creating the necessary right to payment between all the parties. It is for this reason we have always advised (and continue to advise) our clients to obtain guarantees as a necessary component of any cross-entity or triangular setoff arrangement.

It is also important to note that in rendering its ruling, the SemCrude court did not consider any of the safe harbor provisions of the Bankruptcy Code. In an effort to change the court's ruling, Chevron now argues that its contractual netting agreement is a safe harbor contract under the Bankruptcy Code and therefore not subject to either the automatic stay or any mutuality requirement.

The safe harbor provisions exempt certain qualified contracts and parties from the automatic stay and certain avoidance powers under the Bankruptcy Code and authorize the non-debtor counterparty to exercise its contractual rights terminate, liquidate and setoff upon the debtor's bankruptcy filing.  The purpose of these safe harbor provisions is to protect against the ripple effect caused by the insolvency of one firm, threatening the collapse of the affected market.

In 2005, the Bankruptcy Code was amended to expand the types of qualified contracts protected to include master netting agreements which authorize cross-product netting. However, the 2005 amendments limited the exemption from the automatic stay to "the setoff by a master netting agreement participant of a mutual debt and claim under or in connection with one or more master netting agreements..." 11 U.S.C. § 362(b)(27) (2005) (emphasis added). The provisions exempting setoffs under other qualified contracts (such as forward contracts and swap agreements) from the automatic stay similarly included a mutuality requirement, bringing into question the enforceability of cross-entity netting. In 2006, all of these provisions were further amended to delete any mutuality requirement. However, there have been no published opinions on the effect of the 2006 amendments on cross-entity netting. The SemCrude court may be the first court to do so.

No party in the SemCrude bankruptcy case has yet responded to Chevron's new "safe harbor" argument. The court will hear arguments in connection with Chevron's motion to reconsider on March 12, 2009. In the meantime, parties wishing to effectuate cross-entity netting in bankruptcy should continue to include cross guarantees for all parties to the netting agreements. We will also continue to monitor Chevron's motion to reconsider as well as any subsequent appeals to see if the courts finally weigh in on the effect of the 2006 amendments on cross-entity netting.