An opinion issued earlier this year by the Delaware Bankruptcy Court in In re SemCrude, L.P., et al. (Bankr. Del., No. 08-11525; January 9, 2009) may end much of the practice of so-called “triangular setoffs” by creditors in bankruptcy cases. The Court in SemCrude found that creditors violate section 553 of the Bankruptcy Code by setting off amounts among multiple debtors, even when exercising contractual assignment rights. This ruling is likely to have far-reaching impact given the dearth of case law on this fairly common contractual provision. However, SemCrude may not disturb setoff provisions in contracts protected by the Bankruptcy Code’s “safe harbor” provisions applicable to certain financial agreements.

In a triangular setoff, a creditor offsets its exposure to one debtor with amounts owed to it by a separate co-debtor by enforcing a contractual provision agreed upon in advance by the parties. The creditor in SemCrude, Chevron Products Company (Chevron), filed a motion seeking relief from the automatic stay to enforce its setoff rights under oil and gas supply and purchase contracts with several co-debtors. Chevron wanted to offset its debt to one debtor with unsecured amounts owed to it by a co-debtor. A successful setoff would have allowed Chevron to fully recover the offset portion of its unsecured claim through the elimination of its liability to a different entity.

The SemCrude debtors and a number of other creditors objected to Chevron’s motion, arguing that the setoff was unfair and would violate the section 553 requirement that offsetting debts be “mutual.” In response, Chevron argued that the Bankruptcy Code allows parties to contract around this mutuality requirement, citing a line of cases in which courts favorably addressed setoff provisions.

The Bankruptcy Code is not itself a source of setoff rights; it merely permits creditors to exercise existing nonbankruptcy setoff rights, and then only as long as certain conditions are met. Section 553 provides that a creditor may set off enforceable debts when (i) the creditor’s debt arose before the bankruptcy, (ii) the amount owing from the debtor to the creditor arose before the bankruptcy and (iii) the debts were “mutual.” 11 U.S.C. § 553(a).

Nowhere in the Bankruptcy Code is “mutuality” defined, although courts generally accept that mutual debts are those “due to and from the same persons in the same capacity.” Westinghouse Credit Corp. v. D’Urso, 278 F.2d 138, 149 (2d Cir. 2002) (citing Scherline v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181 B.R. 730, 740 (Bankr. S.D.N.Y. 1995)). Because its contracts were with multiple debtor parties, Chevron clearly did not meet this definition of the mutuality requirement. Furthermore, section 553 explicitly prevents Chevron from creating mutuality by transferring a claim within 90 days of the debtor’s bankruptcy petition. 11 U.S.C. § 553(a)(2)(B)(i).

Chevron’s argument relied on a long line of cases that had recognized that a contractual exception to mutuality may exist. But the Court disagreed, determining that none of the courts in the earlier cases had actually upheld a triangular setoff provision and all had been decided on other grounds. The Court further found that the wording of section 553 is sufficiently precise to prohibit contractual workarounds of mutuality. The description of debts owing to and from such creditor suggests an intention that the parties at the time of the setoff must be the same as when the debts were incurred. Chevron could not offset its debts because of the multiple debtor parties involved, and it could not override this clear intent by creating mutuality by operation of contract.

Chevron’s motion did not invoke any of the various safe harbor provisions found in sections 555, 556, 559, 560 and 561 of the Bankruptcy Code, although its contracts with SemCrude and its affiliates may have been covered, as later case law developments have indicated. See, e.g., Hutson v. E.I. du Pont de Nemours & Co. (In re Nat'l Gas Distribs., LLC), 556 F.3d 247 (4th Cir. N.C. 2009). These provisions allow nondebtors to continue to enforce the terms of specific types of financial agreements, such as securities contracts and commodities contracts, counter to the normal operation of the automatic stay.

This preserves the rights of nondefaulting, nondebtor parties, presumably including any rights to engage in triangular setoffs, by removing safe harbor-covered agreements from the applicability of section 553, although no court has yet directly addressed this issue. Chevron’s appeal of the SemCrude decision is currently pending, and Chevron has addressed safe harbor issues in its appeal.

Given that the case law is still developing in this area, it will not be surprising to see triangular setoff issues litigated soon in other cases. In the meantime, it appears that parties should still incorporate setoff provisions in contracts, particularly in financial agreements that might qualify for safe harbor protection. While triangular setoff provisions in noncovered contracts clearly seem to be affected by SemCrude, safe-harbored contracts in particular appear to be safe for now.