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On October 4, 2011, the United States Bankruptcy Court for the Southern District of New York (the Bankruptcy Court) overseeing the liquidation of Lehman Brothers Inc. (LBI) under the Securities Investor Protection Act (SIPA),1 held that a cross-affiliate setoff provision, otherwise known as a "triangular setoff," in a contract between UBS AG (UBS) and LBI was unenforceable in bankruptcy for lack of mutuality (the UBS Decision),2 even though the contract fell within the "safe harbor" provisions3 of Title 11 of the United States Code (the Bankruptcy Code).

Along with two other recent cases, SemCrude4 and Swedbank5, the UBS Decision completes a trilogy of cases that, taken together, holds parties may not give effect to a right to triangular setoff after the initiation of a case governed by the Bankruptcy Code. In SemCrude, the United States Bankruptcy Court for the District of Delaware (the Delaware Bankruptcy Court) held that such setoffs are unenforceable under section 553 of the Bankruptcy Code because they lack the requisite mutuality. However, the Delaware Bankruptcy Court had no occasion to consider whether triangular setoff rights are nevertheless enforceable if they are provided for by a provision of an otherwise safe-harbored contract. In Swedbank, the Bankruptcy Court suggested that the answer to that question is "no," holding that the mutuality requirement of section 553 prohibits the setoff of prepetition obligations against postpetition obligations even where the right to do so is explicitly provided for by a provision of a safe-harbored contract. The Bankruptcy Court's decision was affirmed on appeal by the United States District Court for the Southern District of New York (the District Court).

In the UBS Decision, the Bankruptcy Court extended the Swedbank logic to the context of triangular setoffs, holding that the Bankruptcy Code's safe harbor provisions do not obviate mutuality as a prerequisite to the enforcement of any setoff right. Thus, following the UBS Decision, for all practical purposes triangular setoff provisions are unenforceable in an insolvency proceeding governed by the Bankruptcy Code. Consequently, parties drafting setoff provisions should be aware of the potential difficulties involved in enforcing such provisions, even if they are contained in an otherwise safe-harbored contract.


UBS and LBI were parties to a 1992 ISDA Master Agreement (the Master Agreement). Upon the occurrence of an Event of Default under the Master Agreement, UBS exercised its contractual rights to, among other things, (1) terminate all outstanding transactions under the Master Agreement, (2) designate an Early Termination Date, (3) calculate amounts due and owing from LBI, and (4) set off those amounts against collateral posted to it by LBI. UBS then attempted to further set off its obligation to return the excess collateral it continued to hold after the first setoff against amounts due from LBI to certain affiliates of UBS pursuant to language in the Master Agreement allowing for such action (the Cross-Affiliate Setoff Provision).

In response, the trustee for LBI's liquidation under SIPA (the SIPA Trustee) filed a motion to enforce the automatic stay against UBS and sought the return of the excess collateral. Citing to the Swedbank decision, LBI argued that the mutuality requirement of section 553 of the Bankruptcy Code continued to apply in the context of transactions governed by otherwise safe-harbored contracts, and thus the exercise of triangular setoff rights of the kind being utilized by UBS was prohibited. In response, UBS filed a cross-motion for an order confirming the enforceability of the Cross-Affiliate Setoff Provision, arguing, inter alia: (i) that the Cross-Affiliate Setoff Provision was valid and enforceable as a matter of New York contract law and that the mutuality requirement of section 553 did not apply where a setoff right was contractual (as opposed to merely a right at common law); (ii) that even if section 553 did apply, the Cross-Affiliate Setoff Provision should be enforced because it did not violate the Bankruptcy Code, and the rights under the Master Agreement were not directly contradicted by the Bankruptcy Code; and (iii) UBS' contractual right of setoff was protected by the safe harbor provisions relating to "swap agreements" and "master netting agreements" contained in sections 560 and 561 of the Bankruptcy Code.

The Bankruptcy Court's decision

The Bankruptcy Court rejected each of UBS' arguments in turn, holding that to the extent a contractual right of setoff permits netting by multiple affiliated members of the same corporate family outside of bankruptcy, such a right is no longer enforceable upon the commencement of a case governed by the Bankruptcy Code.

While observing that as a general matter parties can agree to include in a contract whatever provisions they choose so long as they are not contrary to law or public policy, the Bankruptcy Court held that with respect to setoff, the mutuality requirement embodied in section 553 is absolute and that by the explicit terms of the statute no setoff provision that lacks mutuality can survive a bankruptcy filing. The court reasoned that "[t]he identity of the named counterparty to a contract is an essential aspect of settling mutual accounts, and to disregard this most basic of corporate formalities and treat subsidiaries as if they have the same standing as their parent for purpose of setoff rights is to ignore the separate nature of these entities to the obvious detriment of other creditors. For that reason, mutuality is an essential, definitional element of the right to setoff that must be strictly observed."6

Concluding that UBS' affiliates, against whose claims UBS sought to setoff the collateral, were not named parties to the Master Agreement and that as a result mutuality was lacking between the parties, the Bankruptcy Court went on to flatly reject the theory promoted by UBS that the requisite mutuality had been created by contract. UBS argued that a contract can supply the required mutuality by collecting all affiliates under the same corporate umbrella and treating them as if they were a single counterparty. With respect to that argument the Bankruptcy Court followed SemCrude, which as noted above rejected the notion that the requisite mutuality for triangular setoff can be created by contract. To the extent that UBS identified other cases suggesting that a so-called "contract exception" exists, the Bankruptcy Court held that those cases were incorrectly decided.

Finally, turning to UBS' argument that the Cross-Affiliate Setoff Provision was protected by the safe harbor provisions of the Bankruptcy Code, the Bankruptcy Court merely reaffirmed its decision in Swedbank, reiterating that while safe harbors permit the exercise of a contractual right of setoff in connection with swap agreements, such right must exist in the first place, and any setoff right lacking mutuality ceases to exist upon the initiation of an insolvency proceeding governed by the Bankruptcy Code.

Criticism of the UBS Decision

At least one party to the LBI SIPA insolvency proceeding has subsequently challenged the Bankruptcy Court's reasoning in the UBS Decision. In a separate adversary proceeding, brought by the SIPA Trustee against The Royal Bank of Scotland N.V. (RBS) involving another triangular setoff provision, RBS has filed a supplemental memorandum (the RBS Memorandum)7 to address the impact of the UBS Decision. RBS raises the following key points.

First, RBS argues that because the Bankruptcy Court concluded in the UBS Decision that a contractual right to triangular setoff is without question valid and enforceable under New York law, it follows that such a provision "renders all the debts mutual and eligible for set off under Bankruptcy Code section 553."8 Essentially, RBS' position is that because LBI contractually agreed that UBS could setoff amounts owed by itself and its affiliates, UBS held a direct claim against LBI for any breach of that contract, which satisfies the Bankruptcy Code's mutuality requirement.9

The SemCrude court rejected that precise argument on the basis that a contractual right to triangular setoff is not a claim and thus cannot serve as a basis for mutuality. RBS argues that the SemCrude court's holding on that point is a "glaring statutory and logical error," given the broad formulation of "claim" under the Bankruptcy Code.

Second, RBS argues that the plain language of the Bankruptcy Code's safe harbor provisions provide that safe-harbored transactions are not required to meet the mutuality requirements of section 553. Essentially, RBS suggests that Swedbank was improperly decided because the court relied on "legislative silence" to hold that sections 560 and 561 should not be read so broadly as to remove the mutuality requirement of section 553. In so doing, RBS suggests that the District Court did not follow the United States Supreme Court's instruction that where statutory language is clear and not absurd, there can be no resort to legislative history, let alone legislative silence.10

While these arguments may not resonate with the Bankruptcy Court, RBS notes that it needs to preserve all of its arguments for an appeal, which indicates that the UBS Decision may not be the last word in this area.


The Bankruptcy Court's UBS Decision makes it clear that the mutuality requirement for setoff rights under section 553 of the Bankruptcy Code will be read strictly in all instances, applying with full force to triangular setoff rights regardless of whether those rights are contractual, and regardless of whether the contract in which they appear is otherwise safe-harbored. However, as can be seen from the RBS Memorandum, these decisions may not be the last word and parties may seek further appellate review of the issues.