The U.S. Bankruptcy Court for the District of Delaware recently issued a decision addressing triangular set-off provisions, which potentially has very far-reaching implications for the enforceability of contractual set-off rights under U.S. law.

It is not uncommon to find in trading agreements triangular set-off provisions, also commonly referred to as “cross-affiliates” set-off clauses. Such provisions are intended to allow a nondefaulting party to apply against the amount owed as a result of an agreement termination, any amounts owing between the nondefaulting party and affiliates of the defaulting party. Such clauses generally do not appear as standard in industry-wide contracts (e.g., the ISDA Master Agreement), but commonly are added by mutual agreement of the parties, most often in contracts that are governed by U.S. laws.

On January 9, 2009, the federal bankruptcy court in Delaware, presiding over the jointly administered chapter 11 bankruptcy cases of In re SemCrude L.P., et al., 399 B.R. 388 (Bankr. D. Del. Jan. 9, 2009), held that triangular set-offs are impermissible under section 553 of the U.S. Bankruptcy Code (11 U.S.C. 101 et seq.) (“Bankruptcy Code”) regardless of express contractual provisions permitting such set-offs. See In re Semcrude, L.P., et al,; 2009 Bankr. Lexis 21, Case No. 08-11525 (BLS). The court held that (a) triangular set-off provisions cannot satisfy the “mutuality” requirement of the Bankruptcy Code; and (b) there is no contract exception to the express and limited set-off language of the Bankruptcy Code.  

The court denied the motion of Chevron Products Company (“Chevron”) to apply express contractual rights of set-off against three affiliated debtors in connection with three separate agreements for the sale and purchase of crude oil, regular unleaded gasoline, and/or butane, isobutane and propane, respectively. Chevron moved for reconsideration Jan. 20, arguing that the three contracts are forwards and swap agreements, fall within the Bankruptcy Code’s “safe harbor” provisions for financial contracts, and as such, should fall into an exception to the court’s narrow interpretation of the Bankruptcy Code’s set-off provisions. Contract Provisions  

Chevron’s purchases under the three contracts were governed by three sets of terms and conditions that were cross-referenced in each of the contracts with the three subject debtors, SemCrude LP, SemFuel LP, and SemStream LP. Each contract provided that:

in the event either party fails to make a timely payment ... or ... a timely delivery of product or crude oil … the other party may offset any deliveries or payments under this or any other agreement between the parties and their affiliates.

When the SemCrude bankruptcy case commenced, Chevron owed payment to SemCrude, but was owed substantially more from the other two debtors, both affiliates of SemCrude. Because the commencement of the cases under Chapter 11 of the Bankruptcy Code resulted in an automatic stay enjoining ordinary contract parties from acting against the debtors, including enforcing set-off rights, Chevron sought leave of the court to undertake the contractual triangular set-off among the affiliated debtors.

Bankruptcy Court’s Opinion

The court took a strict approach to interpreting the set-off provisions of the Bankruptcy Code, and found that express contractual set-off provisions like those in the Chevron contracts (which allow a single creditor to set off obligations with several different—but affiliated—debtor entities) were unenforceable in bankruptcy as a matter of law. The court noted that the Bankruptcy Code preserves for a creditor’s benefit set-off rights it may have under nonbankruptcy law, but imposes additional conditions that must be met to effect set-off against a debtor in bankruptcy. These additional conditions include that the obligations must be “mutual” pre-petition debts, and thus must be due to and from the same persons or entities in the same capacities.

The court acknowledged that U.S. common law appears to establish a contractual exception to the mutuality requirement when contracts expressly provide for cross-affiliate set-off and netting. The court, however, dismissed this argument as at best merely theoretical in nature, finding support neither in the plain reading of the controlling Bankruptcy Code section, nor in the reported cases (none of which in fact allowed contractual triangular set-off). In short, the court held that an agreement to set off funds as among multiple affiliates cannot satisfy the Bankruptcy Code’s mutuality requirement because such agreement does not create the required indebtedness from one party to another, and thus is unenforceable in a bankruptcy case.

Motion for Reconsideration

Chevron countered with a motion to reconsider the opinion, arguing that the subject contracts are “forward contracts” and “swap agreements” that fall under the so-called “safe harbor provisions” of the Bankruptcy Code, and that as a result, exceptions to the general rules for set-off should apply and lead to a contrary outcome. The “safe harbors” are a set of statutory provisions under the Bankruptcy Code that apply to qualified financial contracts and financial participants, excepting them from certain restrictions of the automatic stay, and allowing special rights for non-debtor counterparties to swap agreements, forward agreements and other financial contracts. Such rights include, among other things, the right upon a bankruptcy filing to terminate, liquidate and accelerate their swap agreements; apply master netting agreements and contractual set-off rights; and to foreclose on pledged collateral.

Importantly, the safe harbor provisions that permit termination, netting and set-off as applied to pre-petition commodities or forward contracts and swap agreements state that such contractual rights “shall not be stayed, avoided or otherwise limited by operation of any provision of this title or by any order of a court … in any proceeding under this title.”

By seeking to recast the three pre-petition supply contracts as forwards and swap agreements, and itself as a forward contract merchant and swap participant, Chevron argues that its right as a non-debtor counterparty to such contracts to terminate, net and apply set-off to the three contracts is expressly excepted from the automatic stay, and that complete deference to the contractual set-off provision is required by the court for forwards and swap agreements.

Although the legal classification of such physically settled forward oil and gas contracts (i.e, those forward contracts for the sale and purchase of a commodity, providing for the physical delivery of commodities themselves rather than a cash settlement reflecting the market pricing of the underlying commodities) is an issue disputed in the U.S. bankruptcy courts, Chevron may find support from the timely Feb. 11, 2009 decision of the U.S. Court of Appeals for the Fourth Circuit, in Hutson v E.I. Dupont De Nemours & Co., et al. (In re National Gas Distributors LLC, ) No. 07-2105 (Hutson). In Hutson, the Fourth Circuit reversed the ruling of the North Carolina Bankruptcy Court that found physically settled commodity contracts, as matter of law, were mere supply contracts not subject to safe harbor protections.

Instead, the Fourth Circuit determined that a physically settled “commodity forward agreement” may qualify as a “swap agreement” under the U.S. Bankruptcy Code, and fall within the so-called “safe harbor” provisions of the Bankruptcy Code, regardless of whether these over-the-counter transactions are (a) settled by physical delivery of a commodity (rather than cash), (b) assignable, or (c) traded on a financial market or exchange.

In reaching its decision, the Fourth Circuit first rejected the bankruptcy court’s assumption that a “swap agreement,” which is defined to include a “commodity forward agreement,” must be “regularly the subject of trading in financial markets.” The Fourth Circuit based its rejection on the twin principles that:  

(1) Every “forward contract” is a “forward agreement,” since the term “agreement” is broader than and encompasses the term “contract.”  

(2) The legislative history, case law, and market practices relating to forward contracts permit such contracts to be directly negotiated and do not require that such contracts be traded in a financial market to be part of an overall hedging program.  

Second, on the basis of legislative history, case law, and common definitions of a forward agreement, the Fourth Circuit rejected the bankruptcy court’s assumption that a “commodity forward agreement” must be cash-settled.

The Fourth Circuit’s decision is binding on courts within its circuit, and likely to materially influence other courts considering similar issues. Whether its influence will be felt in Delaware and to Chevron’s benefit remains to be seen. Chevron’s motion for reconsideration was scheduled at press time to be argued March 12.  

Weighing the Risks

The SemCrude opinion, issued by a trial-level court, is not controlling law outside of Delaware and remains subject to reconsideration and appeal. That said, the opinions of the federal bankruptcy court in Delaware—one of the busiest and most prolific U.S. bankruptcy courts—are instructive and often relied upon by state courts nationwide. Further, while the issue of the applicability of the safe harbor provisions to physically settled forward contracts is unlikely to be resolved in connection with SemCrude, it continues to percolate among the U.S. bankruptcy courts, and has been squarely addressed by the Fourth Circuit Court of Appeals.

In the interim, parties should be aware that a substantial risk exists that triangular set-off provisions will be held to be ineffective in U.S. bankruptcy cases. Care therefore should be taken when drafting contractual provisions that the requirements of mutuality and pre-existence of the obligations to be set-off are satisfied. That may be addressed, for instance, by having all the parties concerned execute a multilateral netting agreement that expressly provides for both. The SemCrude opinion as it stands, however, does not address whether any such

enhanced contractual set-off ultimately could be relied upon in a U.S. insolvency. The most prudent approach—especially in contracts providing for a physical delivery—therefore is not to rely on set-off across affiliates as a way to reduce exposure to a counterparty’s insolvency. Alternatively, parties should seek independent credit evaluations of each counterparty on an individualized basis, and consider contracting for collateral and obtaining guarantees.

Case update: On March 20, the bankruptcy court entered a decision denying the motion to reconsider based on Chevron’s failure to raise the safe harbor provisions in its initial moving papers. The court found that Chevron failed to satisfy the standard for reconsideration under Bankruptcy Rule 59(e)(i.e., reconsideration of a decision based on (a) an intervening change in controlling law; (b) new or previously unavailable evidence, or (c )to correct a manifest error on the part of the court). See Memorandum Order Denying Chevron Products Company’s Motion for Reconsideration of This Court’s Opinion dated January 9, 2009 Regarding Contractual Netting (Bankr. D. Del. March 20, 2009).

The court did not address the substantive issue of set-off under the safe harbor provisions, noting that Chevron did not raise the safe harbor issue as an alternative ground for relief when it moved to lift the stay to apply cross-affiliate set-off, and instead merely cited to Section 553 of the Bankruptcy Code. Raising the safe harbor grounds in the motion for reconsideration was procedurally too late to be recognized. Chevron has filed a notice of appeal and we will follow for developments.