In a recent decision, In re Black Diamond Mining Company, LLC,[1] the United States Court of Appeals for the Sixth Circuit held that a netting provision contained in a contract was enforceable against an assignee from one of the parties to the contract.  The decision is sound, and is worth noting by parties to contracts and by those parties that succeed to their rights.

Background

In 2006, Constellation Energy Commodities Group and Black Diamond Mining Company entered into a contract whereby they agreed to buy and sell coal to one another.  The contract contained an express provision that allowed the parties to net payments to each other, so that only the party that owed the greater amount had to make a payment, and only in the amount of the difference owed after subtracting the amount owed to it.

Black Diamond then assigned its receivables arising under the contract to The CIT Group pursuant to a factoring agreement.

In 2007, Commodities had purchased $10 million worth of coal from Black Diamond, for which it did not tender payment to Black Diamond or CIT. In early 2008, CIT and several other creditors filed an involuntary bankruptcy petition against Black Diamond, and the bankruptcy court entered an order for relief.  Black Diamond’s bankruptcy constituted a breach of its contract with Commodities that permitted Commodities to terminate the coal contract, and Commodities incurred $90 million of damages as a result.

CIT sued Commodities for the $10 million payment.  The bankruptcy court granted Commodities’ motion for summary judgment, and the district court affirmed.  CIT then appealed to the Sixth Circuit.

The Sixth Circuit applied New York law, and affirmed. The Sixth Circuit held that CIT had stepped into Black Diamond’s shoes and was subject to the same defenses to payment as would have been applicable to Black Diamond if no assignment had occurred.

Analysis

Section 9-404(a)(1) of the Uniform Commercial Code provides that, unless an account debtor[2] has made an enforceable agreement not to assert defenses or claims, the rights of an assignee of payment rights under an agreement are subject to “all terms of the agreement between the account debtor and assignor  . . . .”  In this case, the terms of the agreement clearly permitted Commodities to set off amounts that Black Diamond owed to it against payments it owed to Black Diamond.  That meant that Commodities was entitled to not pay the $10 million amount to CIT, and was entitled to offset such amount against the larger amount owing from Black Diamond to it on account of the damages claim.  It further meant that, because CIT was an assignee of Black Diamond, CIT was subject to the contractual setoff provision to the same extent that Black Diamond had been.

Observations

As a general rule, an assignee of a contract takes the assignment subject to all defenses and claims of the account debtor,[3] and the holding in the Black Diamond case is a straightforward application of this rule.  Lenders and other assignees of payment rights under contracts should be aware that setoff rights may exist under such contracts and that assignees may be subject to such setoff rights.  Persons taking by assignment should perform due diligence of important contracts to determine whether such contracts contain express setoff provisions.

Setoff questions can be tricky, and it is helpful to go over some of the basic rules with respect to the way that setoff rules apply to assignees.  Section 9-404(a) of the UCC essentially refers to three types of defenses to payment or provisions that an assignee is subject to:

  1. the terms of the assigned contract;
  2. defenses or claims in recoupment arising from the transaction that gave rise to the assigned contract; and
  3. other defenses or claims (such as claims arising from transactions unrelated to the assigned contract).

Importantly, with respect to the third type (claims and defenses not arising from the terms of the assigned contract and not involving recoupment), an assignee can cut off the ability of the account debtor to raise such a defense by providing notice[4] to the account debtor of the assignment.  Such a notice would cut off defenses to payment on the part of the account debtor that accrued[5] after the account debtor received the notice, but not before.  The right of an assignee to cut off defenses by providing notice does not apply to the other two types of defenses.  Thus, assignees (which may include secured parties) may have better rights as against account debtors than did their assignors under Section 9-404(a), but only as to defenses not arising from the terms of the assigned contract and not involving claims arising out of the same transaction.

Many contracts include express setoff provisions, as was the case in Black Diamond, in order to give the parties rights that they would not have if they simply relied on common law setoff rights, or to make the setoff rights more explicit.  By way of example, such contractual provisions often expressly allow offset for transactions between the parties under transactions unrelated to the contract at issue, and often permit a party to offset obligations owing to affiliates of its counterparty, as is often the case in swap or loan documentation.  For a contracting party, one of the benefits to including such a provision in a contract is to avoid the possibility of having its defenses to payment being cut off by a creditor to the other party by giving notice under UCC §9-404(a).

Lenders and purchasers of payment rights under contracts often negotiate with account debtors to get such account debtors to waive their rights to assert defenses against assignees. [6]  In some instances, an account debtor may be receptive to granting such a waiver, particularly if it views the ability of its contractual counterparty to obtain financing as important.  The Sixth Circuit noted that CIT could have negotiated an agreement with Commodities to the effect that the contractual setoff provision did not apply to CIT, but did not do so.  Absent such an agreement, the court held that CIT was in no better position than its assignor had been, and took its interest in the receivables subject to the contractual setoff provision.