Delaware Bankruptcy Court Denies Multi-Party Setoff

As of the date of the bankruptcy filing, Chevron owed approximately $1.4 million to SemCrude and nothing to SemFuel, SemStream or SemGroup. SemFuel and SemStream owed Chevron approximately $10.2 million and $3.3 million, respectively. Chevron filed a motion to vacate the automatic stay to effect a multi-party setoff of the $1.4 million it owed to SemCrude against the amounts due to Chevron from SemFuel and SemStream.

Summary of the Applicable Law

Setoff allows entities that owe each other money to apply the mutual debts against one another to “avoid the absurdity of making A pay B when B owes A.” Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995) (quoting Studley v. Boylston Nat. Bank of Boston, 229 U.S. 523, 528 (1913)). The existence of the right of setoff is determined under applicable non-bankruptcy law. Once an independent right of setoff is determined to exist, ' 553 of the Bankruptcy Code preserves such right in bankruptcy but imposes additional restrictions. 11 U.S.C. ' 553(a); Packaging Indus. Group Inc. v. Dennison Mfg. Co. Inc. (In re Sentinel Prod. Corp. Inc.), 192 B.R. 41, 45 (N.D.N.Y. 1996). Such restrictions include, among others, a requirement that the debts to be offset are mutual. See, e.g., Scherling v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181 B.R. 730, 738-39 (Bankr. S.D.N.Y.1995). To be mutual, the debts must be due and owing from the same parties standing in the same capacity. Id. at 739.

Analysis

In evaluating whether mutuality existed, the court reviewed a long line of cases spanning several decades, including cases decided under the Bankruptcy Act, that acknowledge a contractual right of multi-party setoff in bankruptcy. In reliance on these cases, commentators, practitioners and judges have long presumed the existence of such a right. The court observed, however, that each of the cases cited for this proposition are based on those decided under non-bankruptcy law. Such cases interpreted the often more liberal non-bankruptcy law standard for setoff and not the more restrictive bankruptcy law standard. Moreover, none of the bankruptcy cases acknowledging the existence of a contractual right of setoff actually upheld or enforced such right. These cases only recognized the right in non-binding dicta and ultimately denied the setoff or found mutuality independent of the contract. See, e.g., In re Garden Ridge Corp., 338 B.R. 627, 634 (Bankr. D. Del. 2006); Bloor v. Shapiro, 32 B.R. 993, 1001-02 (S.D.N.Y. 1983).

Undertaking its own analysis of ' 553, the court reasoned that mutuality requires each party to own the claim in its own right severally, with the right to collect in its own name. Otherwise stated, debts can be mutual only if they are due to and from the same entity standing in the same capacity. In this case, Chevron owed $1.4 million to SemCrude; however, SemCrude owed nothing to Chevron. Chevron sought to offset the money it owed to SemCrude against the money that SemFuel and/or SemStream, two affiliates of SemCrude, owed to Chevron. Accordingly, the mutuality requirement was not satisfied.

In considering whether a contractual exception to the mutuality requirement exists, the court found that the express language of ' 553 requires the debts be mutual. Based on the statute's plain language, and the absence of any exception, the court declined to recognize one.

Procedural Posture

Chevron has moved for reconsideration of the decision based on a manifest error of law or fact and to permit the court to make additional findings of fact. In the reconsideration motion, Chevron argues for the first time that the underlying agreements are entitled to the protections of the “safe harbor” provisions of the Bankruptcy Code because the agreements are “forward contracts” and/or “swap agreements” and Chevron is a “forward contract merchant” and/or “swap participant.” See 11 U.S.C. ” 556 and 560. As such, the setoff is not subject to the automatic stay or the “mutuality” requirement of ' 553 of the Bankruptcy Code. It is unclear from the record why Chevron did not raise this position in the original motion to vacate the stay.

Impact of the SemCrude Decision

Since the SemCrude decision was rendered by a bankruptcy court, it is not binding on other courts in Delaware or other jurisdictions, including New York. See, e.g., Marcus Montgomery Wolfson & Burton P.C. v. AM Int'l, Inc. (In re AM Int'l, Inc.), 203 B.R. 898, 905 (D. Del. 1996); In re Suburban Motor Freight, 134 B.R. 617, 626 (Bankr. S.D. Ohio 1991). The SemCrude decision, however, will probably be given deference by courts in Delaware and other jurisdictions because the decision addresses an issue of first impression and is based on an extensive review of the law. As such, notwithstanding the lack of precedential value and an acknowledgement, albeit through non-binding dicta, of the existence of the right to multi-party setoff in other reported decisions, courts confronted with a similar issue in the future may look to the SemCrude decision for guidance.

Impact on 'Safe Harbor' Contracts

The SemCrude decision does not address the right of multi-party setoff under master netting agreements governing contracts entitled to the safe harbor protections of the Bankruptcy Code. Although there is very little case law in this area, it is clear that parties to protected agreements, such as securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements and master netting agreements, are entitled to special protections under the Bankruptcy Code. See, e.g., 11 U.S.C. ” 555, 556, 559, 560, and 561. Generally, the protections include broader rights of setoff pursuant to master netting agreements without regard to the limitations of other provisions of the Bankruptcy Code. For example, a forward contract merchant is permitted to enforce contractual rights to terminate, liquidate and setoff under a safe harbor agreement without first filing a motion to vacate the automatic stay. See, e.g., 11 U.S.C. ” 362(b)(6), (7), (17) and (27). The contracts at issue in the SemCrude decision were characterized as regular purchase and supply agreements and there was no master netting agreement signed by the relevant parties. While Chevron has raised the applicability of the safe harbor provisions in its reconsideration motion, the provisions were not raised in the original pleadings, and the court did not address whether the contracts at issue were entitled to the safe harbor protections.

Before 2005, the Bankruptcy Code's safe harbor provisions did not address master netting agreements. Effective October 2005, the Bankruptcy Code was amended to expressly allow cross-product setoff among parties to master netting agreements for transactions under safe harbor contracts. In 2006, the Bankruptcy Code was amended again to omit a reference to “mutuality” as a condition of setoff under such contracts. Compare 11 U.S.C. ' 362(b)(27) under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8 with 11 U.S.C. 362(b)(27), as amended by the Financial Netting Improvement Act of 2006, Pub. L. No. 109-360.

Impact on Cross-Affiliate Guarantees

Provided a cross-affiliate guarantee is otherwise enforceable, the SemCrude decision also left open the possibility that a guarantee could create mutuality for setoff under ' 553. The impact of guarantees on mutuality is in dispute; some courts find mutuality exists and others do not. Compare Bloor, 32 B.R. at 1001-02 with In re Ingersoll, 90 B.R. 168, 171 72 (Bankr. W.D. N.C. 1987). Under the facts of the SemCrude decision, SemGroup guaranteed SemStream's and SemFuel's debts to Chevron; however, Chevron did not owe any money to SemGroup. In turn, Chevron owed money to SemCrude but SemCrude did not guarantee any debts to Chevron. The court observed that, unlike a guarantee of a debt where the guarantor is liable for making payment on the debt it has guaranteed, an agreement to setoff does not create an actual indebtedness from one party to another for purposes of mutuality. The court implied that if SemCrude guaranteed SemStream's and SemFuel's debts to Chevron, the outcome may have been different.

Conclusion

The SemCrude decision addresses only setoff under ' 553 of the Bankruptcy Code. It does not address setoff under master netting agreements that govern contracts entitled to protection under the safe harbor provisions of the Bankruptcy Code. As mentioned above, such provisions give broader setoff rights than those provided under ' 553. While there is a dearth of case law interpreting the Bankruptcy Code's safe harbor provisions, parties entitled to the protections of such provisions should not be concerned with the SemCrude decision provided each underlying agreement governed by the master netting agreement is a protected agreement. The SemCrude decision also did not address the situation where each setoff participant is directly liable for the debt to be offset or the situation involving cross-affiliate guarantees.

To mitigate the uncertainty caused by the SemCrude decision, parties doing business in reliance on multi-party, cross-netting agreements should consider taking one or more of the following steps:

• structure transactions to qualify for the protections of the Bankruptcy Code's safe harbor provisions;
• have each party, including affiliates, sign the master netting agreement or document containing the applicable netting provisions; and
• obtain cross-affiliate guarantees and include provisions in the transaction documents that may increase the likelihood that a subsequent court will enforce such agreements, such as providing for joint and several liability.

Implementing one or more of these measures may reduce, but certainly will not eliminate, the risk that contractually agreed multi-party, cross-netting agreements will be enforced.

James S. Carr, Chair of the Bankruptcy Department, and Eric R. Wilson are partners at Kelley Drye & Warren LLP, resident in the New York office. Their practices focus on corporate restructuring, bankruptcy and creditors' rights. The authors acknowledge the assistance of associate Benjamin Blaustein in the preparation of this article.

On Jan. 9, 2009, the United States Bankruptcy Court for the District of Delaware, in the SemCrude, L.P., et al. bankruptcy cases, refused to enforce the terms of a valid, pre-bankruptcy agreement that provided for cross-affiliate, multi-party setoff ' a setoff by a creditor holding funds belonging to one or more debtors ' based on a lack of “mutuality” under ' 553 of the Bankruptcy Code (the “SemCrude decision”). The decision, In re SemCrude, L.P., Case No. 08-11525 (BLS), 2009 WL 68873 (Bankr. D. Del. Jan. 9, 2009), is a departure from the long-standing assumption that a multi-party netting agreement among affiliates would be upheld in bankruptcy if enforceable under applicable non-bankruptcy law. This article provides an analysis of the decision, the procedural status and its potential impact, and recommendations for minimizing the potential negative implications.

The Semcrude Decision

Prior to the bankruptcy filing of SemCrude, L.P., et al., Chevron Products Company entered into various contracts for the purchase and sale of petroleum products with three debtors: SemCrude, L.P., SemFuel, L.P. and SemStream, L.P. SemGroup L.P. guaranteed the debts of each debtor to Chevron. The contracts incorporated certain terms and conditions, including netting provisions that provided a right of setoff between the parties and their affiliates. Only SemCrude signed the netting agreement and none of the three debtors signed the terms and conditions.

As of the date of the bankruptcy filing, Chevron owed approximately $1.4 million to SemCrude and nothing to SemFuel, SemStream or SemGroup. SemFuel and SemStream owed Chevron approximately $10.2 million and $3.3 million, respectively. Chevron filed a motion to vacate the automatic stay to effect a multi-party setoff of the $1.4 million it owed to SemCrude against the amounts due to Chevron from SemFuel and SemStream.

Summary of the Applicable Law

Setoff allows entities that owe each other money to apply the mutual debts against one another to “avoid the absurdity of making A pay B when B owes A.” Citizens Bank of Maryland v. Strumpf , 516 U.S. 16, 18 (1995) (quoting Studley v. Boylston Nat. Bank of Boston , 229 U.S. 523, 528 (1913)). The existence of the right of setoff is determined under applicable non-bankruptcy law. Once an independent right of setoff is determined to exist, ' 553 of the Bankruptcy Code preserves such right in bankruptcy but imposes additional restrictions. 11 U.S.C. ' 553(a); Packaging Indus. Group Inc. v. Dennison Mfg. Co. Inc. (In re Sentinel Prod. Corp. Inc.), 192 B.R. 41, 45 (N.D.N.Y. 1996). Such restrictions include, among others, a requirement that the debts to be offset are mutual. See, e.g., Scherling v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181 B.R. 730, 738-39 (Bankr. S.D.N.Y.1995). To be mutual, the debts must be due and owing from the same parties standing in the same capacity. Id. at 739.

Analysis

In evaluating whether mutuality existed, the court reviewed a long line of cases spanning several decades, including cases decided under the Bankruptcy Act, that acknowledge a contractual right of multi-party setoff in bankruptcy. In reliance on these cases, commentators, practitioners and judges have long presumed the existence of such a right. The court observed, however, that each of the cases cited for this proposition are based on those decided under non-bankruptcy law. Such cases interpreted the often more liberal non-bankruptcy law standard for setoff and not the more restrictive bankruptcy law standard. Moreover, none of the bankruptcy cases acknowledging the existence of a contractual right of setoff actually upheld or enforced such right. These cases only recognized the right in non-binding dicta and ultimately denied the setoff or found mutuality independent of the contract. See, e.g., In re Garden Ridge Corp., 338 B.R. 627, 634 (Bankr. D. Del. 2006); Bloor v. Shapiro , 32 B.R. 993, 1001-02 (S.D.N.Y. 1983).

Undertaking its own analysis of ' 553, the court reasoned that mutuality requires each party to own the claim in its own right severally, with the right to collect in its own name. Otherwise stated, debts can be mutual only if they are due to and from the same entity standing in the same capacity. In this case, Chevron owed $1.4 million to SemCrude; however, SemCrude owed nothing to Chevron. Chevron sought to offset the money it owed to SemCrude against the money that SemFuel and/or SemStream, two affiliates of SemCrude, owed to Chevron. Accordingly, the mutuality requirement was not satisfied.

In considering whether a contractual exception to the mutuality requirement exists, the court found that the express language of ' 553 requires the debts be mutual. Based on the statute's plain language, and the absence of any exception, the court declined to recognize one.

Procedural Posture

Chevron has moved for reconsideration of the decision based on a manifest error of law or fact and to permit the court to make additional findings of fact. In the reconsideration motion, Chevron argues for the first time that the underlying agreements are entitled to the protections of the “safe harbor” provisions of the Bankruptcy Code because the agreements are “forward contracts” and/or “swap agreements” and Chevron is a “forward contract merchant” and/or “swap participant.” See 11 U.S.C. ” 556 and 560. As such, the setoff is not subject to the automatic stay or the “mutuality” requirement of ' 553 of the Bankruptcy Code. It is unclear from the record why Chevron did not raise this position in the original motion to vacate the stay.

Impact of the SemCrude Decision

Since the SemCrude decision was rendered by a bankruptcy court, it is not binding on other courts in Delaware or other jurisdictions, including New York. See, e.g., Marcus Montgomery Wolfson & Burton P.C. v. AM Int'l, Inc. (In re AM Int'l, Inc.), 203 B.R. 898, 905 (D. Del. 1996); In re Suburban Motor Freight, 134 B.R. 617, 626 (Bankr. S.D. Ohio 1991). The SemCrude decision, however, will probably be given deference by courts in Delaware and other jurisdictions because the decision addresses an issue of first impression and is based on an extensive review of the law. As such, notwithstanding the lack of precedential value and an acknowledgement, albeit through non-binding dicta, of the existence of the right to multi-party setoff in other reported decisions, courts confronted with a similar issue in the future may look to the SemCrude decision for guidance.

Impact on 'Safe Harbor' Contracts

The SemCrude decision does not address the right of multi-party setoff under master netting agreements governing contracts entitled to the safe harbor protections of the Bankruptcy Code. Although there is very little case law in this area, it is clear that parties to protected agreements, such as securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements and master netting agreements, are entitled to special protections under the Bankruptcy Code. See, e.g., 11 U.S.C. ” 555, 556, 559, 560, and 561. Generally, the protections include broader rights of setoff pursuant to master netting agreements without regard to the limitations of other provisions of the Bankruptcy Code. For example, a forward contract merchant is permitted to enforce contractual rights to terminate, liquidate and setoff under a safe harbor agreement without first filing a motion to vacate the automatic stay. See, e.g., 11 U.S.C. ” 362(b)(6), (7), (17) and (27). The contracts at issue in the SemCrude decision were characterized as regular purchase and supply agreements and there was no master netting agreement signed by the relevant parties. While Chevron has raised the applicability of the safe harbor provisions in its reconsideration motion, the provisions were not raised in the original pleadings, and the court did not address whether the contracts at issue were entitled to the safe harbor protections.

Before 2005, the Bankruptcy Code's safe harbor provisions did not address master netting agreements. Effective October 2005, the Bankruptcy Code was amended to expressly allow cross-product setoff among parties to master netting agreements for transactions under safe harbor contracts. In 2006, the Bankruptcy Code was amended again to omit a reference to “mutuality” as a condition of setoff under such contracts. Compare 11 U.S.C. ' 362(b)(27) under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8 with 11 U.S.C. 362(b)(27), as amended by the Financial Netting Improvement Act of 2006, Pub. L. No. 109-360.

Impact on Cross-Affiliate Guarantees

Provided a cross-affiliate guarantee is otherwise enforceable, the SemCrude decision also left open the possibility that a guarantee could create mutuality for setoff under ' 553. The impact of guarantees on mutuality is in dispute; some courts find mutuality exists and others do not. Compare Bloor, 32 B.R. at 1001-02 with In re Ingersoll, 90 B.R. 168, 171 72 (Bankr. W.D. N.C. 1987). Under the facts of the SemCrude decision, SemGroup guaranteed SemStream's and SemFuel's debts to Chevron; however, Chevron did not owe any money to SemGroup. In turn, Chevron owed money to SemCrude but SemCrude did not guarantee any debts to Chevron. The court observed that, unlike a guarantee of a debt where the guarantor is liable for making payment on the debt it has guaranteed, an agreement to setoff does not create an actual indebtedness from one party to another for purposes of mutuality. The court implied that if SemCrude guaranteed SemStream's and SemFuel's debts to Chevron, the outcome may have been different.

Conclusion

The SemCrude decision addresses only setoff under ' 553 of the Bankruptcy Code. It does not address setoff under master netting agreements that govern contracts entitled to protection under the safe harbor provisions of the Bankruptcy Code. As mentioned above, such provisions give broader setoff rights than those provided under ' 553. While there is a dearth of case law interpreting the Bankruptcy Code's safe harbor provisions, parties entitled to the protections of such provisions should not be concerned with the SemCrude decision provided each underlying agreement governed by the master netting agreement is a protected agreement. The SemCrude decision also did not address the situation where each setoff participant is directly liable for the debt to be offset or the situation involving cross-affiliate guarantees.

To mitigate the uncertainty caused by the SemCrude decision, parties doing business in reliance on multi-party, cross-netting agreements should consider taking one or more of the following steps:

• structure transactions to qualify for the protections of the Bankruptcy Code's safe harbor provisions;
• have each party, including affiliates, sign the master netting agreement or document containing the applicable netting provisions; and
• obtain cross-affiliate guarantees and include provisions in the transaction documents that may increase the likelihood that a subsequent court will enforce such agreements, such as providing for joint and several liability.

Implementing one or more of these measures may reduce, but certainly will not eliminate, the risk that contractually agreed multi-party, cross-netting agreements will be enforced.

James S. Carr, Chair of the Bankruptcy Department, and Eric R. Wilson are partners at Kelley Drye & Warren LLP, resident in the New York office. Their practices focus on corporate restructuring, bankruptcy and creditors' rights. The authors acknowledge the assistance of associate Benjamin Blaustein in the preparation of this article.