David M. Perlman and Shoam D. Naik, Bracewell & Giuliani |
Published December 7, 2011 at 2:42 PM ET
In a recent decision in the Lehman Brothers Holdings Inc. bankruptcy cases, In re Lehman Brothers Inc., decided in October, the New York bankruptcy court denied the enforcement of a cross-affiliate, or "triangular," setoff provision contained in a swap agreement, casting further doubt on the enforceability of these provisions in bankruptcy. The decision is significant in that triangular setoff provisions are a common feature in agreements that govern derivative and commodity trading transactions.
Lehman follows the decision in In re SemCrude, in which the Delaware bankruptcy court found no contract exception to the "mutuality" requirement of Section 553 of the Bankruptcy Code, which governs the enforceability of setoff rights in bankruptcy. In addition, while SemCrude did not address the safe-harbor provisions for derivatives contracts under the Bankruptcy Code, Lehman makes clear that the safe harbors cannot circumvent the mutuality requirement. These decisions do not limit the enforcement of triangular setoffs outside of bankruptcy, but they increase the risk that such setoffs cannot be enforced in bankruptcy by a creditor seeking to obtain priority over general unsecured claims.
In Lehman, Lehman Brothers Inc. entered into a 1992 International Swap Dealers Association Inc. Master Agreement with UBS. A schedule to the Master Agreement included a triangular setoff provision as follows: "upon the designation of any Early Termination Date ... the Non-defaulting Party or Non-affected Party (in either case, 'X') may without prior notice to any person set off any sum or obligation (whether or not arising under this Agreement ...) owed by the Defaulting Party or Affected Party (in either case, 'Y') to X or any Affiliate of X against any sum or obligation (whether or not arising under this Agreement ...) owed by X or any Affiliate of X to Y."
Following Lehman's bankruptcy, UBS sought to set off amounts posted as collateral under the Master Agreement against amounts owed by Lehman to affiliates of UBS under separate swaps agreements.
Although Section 553 does not create a right of setoff, subject to certain exceptions, the section preserves "any right of a creditor to offset a mutual debt owing by such creditor to the debtor" that arose prior to the commencement of the debtor's bankruptcy case. Debts are considered "mutual" only when "they are due to and from the same persons in the same capacity." As a result, triangular setoffs generally do not satisfy the mutuality requirement.
In response to the lack of mutuality with respect to triangular setoffs generally, UBS appealed to both the contract language in the Master Agreement and the safe-harbor provisions of the Bankruptcy Code.
First, UBS contended that there is a contract exception to the mutuality requirement in that the parties contracted for the triangular setoff rights and that the court should honor the agreement of the parties under New York law. In the alternative, UBS contended that the express contract provision satisfied the mutuality requirement because the provision allowed UBS to offset amounts owed to affiliates, notwithstanding that the affiliates were not party to the agreement. However, following the precedent established by SemCrude, the court rejected UBS' appeal to the contract language and found that the parties cannot contract around the requirements of Section 553(a). Moreover, the court held that attempts to contractually aggregate all of UBS' affiliates as a single corporate counterparty through a general setoff provision could not satisfy the required mutuality and that mutuality is "tied to the identity of a particular creditor that owes an offsetting debt. The right is personal."
Second, UBS argued that even if no contract exception exists, the triangular setoff right should still be enforced under Section 561 of the Bankruptcy Code. Section 561, in conjunction with Sections 555, 556, 559 and 560 of Bankruptcy Code, are safe-harbor provisions that allow the exercise of "any contractual right" to terminate, and setoff amounts under securities contracts, commodities contracts, forward contracts, repurchase agreements, swap agreements and master netting agreements, notwithstanding the automatic stay or any other provision under the Bankruptcy Code that could operate to stay, avoid or otherwise limit such contractual right. UBS reasoned that the safe-harbor provisions permit it to exercise the contractual setoff right in the Master Agreement notwithstanding the lack of mutuality.
However, the court, relying on its previous decision in Swedbank, disagreed and found that the safe-harbor provisions do not eliminate the mutuality requirement. Swedbank addressed whether a bank can set off postpetition deposits in the debtor's bank account against prepetition amounts owed by the debtor to the bank and held that the setoff of postpetition deposits against prepetition obligations does not satisfy mutuality. Importantly, Swedbank further held that the safe-harbor provisions of the Bankruptcy Code can't nullify the mutuality requirement. Following Swedbank, Lehman held that the central purpose of the safe-harbor provisions is to permit the contractual right of setoff of a derivatives contract despite the automatic stay, but that such safe harbors do not eliminate the requirement of mutuality under Section 553(a).
Together, Lehman and SemCrude hold that there are no exceptions to the mutuality requirement of Section 553(a) and represent adverse precedent regarding the enforceability of triangular setoff from the two leading bankruptcy jurisdictions of New York and Delaware. As such, the continuing viability of triangular setoff in bankruptcy is likely tied to the ability to satisfy the mutuality requirement. One possible means of satisfying mutuality may be through the use of guarantees. Although Lehman did not address this issue, the SemCrude court noted that under a guarantee of debt, the guarantor is liable for making a payment on the debt it has guaranteed. The reasoning is that a guarantee creates indebtedness from one party to another in a way that a triangular setoff does not. However, the court left open whether a guarantee satisfies the mutuality required under Section 553(a).
Prior courts that have addressed whether a guarantee creates mutuality are divided on the issue. For instance, in a case decided prior to the Bankruptcy Act, the court found that a guarantee can satisfy mutuality and allowed a guarantor to set off claims of its affiliates against the debtor against the guarantor's guarantee of the affiliates' obligations to the debtor. Nevertheless, in In re Ingersoll, the court held that a triangular setoff involving a guarantor did not satisfy mutuality because the guarantee did "not change the fact that the debts are between different parties in different capacities."
Ultimately, whether a guarantee can satisfy mutuality is still an open issue and may depend on the facts of the case. In addition, use of guarantees may not be applicable in every instance, such as in Lehman where UBS was attempting to use its position as an oversecured creditor to set off amounts owed by Lehman to affiliates of UBS. In that scenario, UBS needed to cross-collateralize the obligations owed by Lehman to its affiliates to ensure success. Accordingly, in light of the complexities associated with enforcing triangular setoffs in bankruptcy, creditors are encouraged to examine additional credit support structures such as the use of guarantees and cross-collateralization in addition to their reliance on contractual setoff rights to facilitate cross-entity netting transactions.David M. Perlman is a partner in the energy and commodity trading practice at Bracewell & Giuliani LLP in Washington. Soham D. Naik is an associate in the finance and financial restructuring practices at the firm in New York.