That darn Lehman Brothers bankruptcy sure is raising some interesting insolvency issues for derivatives market participants (and their lawyers of course). It’s interesting (at least for us insolvency nerds) to think about how some of those issues might play out under Canadian insolvency laws. Here are some thoughts on one of the recent cases with my Canadian spin.

The mutuality issue as it relates to netting under an ISDA Master Agreement that most often concerns market participants is whether netting protections apply to a netting agreement that seeks to include transactions with a counterparty’s affiliates within the netting calculation. That is the paradigm tri-party or non-mutual netting situation. The recent Lehman decision precluding set-off by Swedbank AG against amounts owed to it by Lehman Brothers Holding Inc. (LBHI) isn’t about non-mutual affiliate set-off. The parties had taken care of that particular mutuality issue by having LBHI guarantee its affiliates obligations under ISDA Master Agreements. (This would also be the practice in Canada to ensure that the obligations would be within the netting safe-harbours.)

This recent Lehman’s case was actually dealing with the effectiveness in bankruptcy of the more general set-off clause included in many ISDA Master Agreements that permits set-off of a net termination amount against a claim owing to or by the counterparty under another agreement. In this case the net termination amount was owed by LBHI and the claim sought to be set-off was one in favour of LBHI, but it arose post-bankruptcy.

This month (May, 2010) in the U.S. proceedings with respect to LBHI, the Bankruptcy Court for the Southern District of New York held that the netting safe-harbours in the U.S. Bankruptcy Code for swap agreements still had to satisfy the statutory requirements for enforceability of set-off generally and those requirements included mutuality. Swedbank, in reliance on the general set-off clause in one of the Master Agreements it had entered into with LBHI, froze LBHI’s deposit account with the bank and was intending to set-off the amounts on deposit against the net termination amount owing under the ISDA Master. The problem was that most of the money in the account had been deposited by the trustee after commencement of the bankruptcy proceedings.

The court first considered the general Bankruptcy Code protection for set-off (section 553(a)). That provision expressly requires that the amount owed by the creditor to the bankrupt debtor must be a prepetition debt and that the debts to be set-off must be mutual. With respect to the amounts deposited to the account post petition, the debt of Swedbank to LBHI was neither mutual (since after bankruptcy the party owed the debt is the trustee not the company) or pre-petition. The court holds that mutuality was lacking because of the fact that the funds were deposited post-petition. The court treated the requirement that it be a prepetition obligation as part and parcel of the “mutuality” requirement of the section (perhaps because a post-petition obligation is by definition not mutual).

But Swedbank argued that the netting safe-harbours in sections 560 and 561 of the Bankruptcy Code applied to their set-off right, that those provisions did not require mutuality and that they rendered the general set-off provision inapplicable. Justice Peck, who anyone who has been following these Lehman cases will know, does not like to mince words, called Swedbank’s interpretation “self-interested”, “without precedent” and “unsupported by a fair reading of the textual language”. (Aren’t most litigants self-interested? I thought that was the point of the advocacy system of justice– but that’s an aside.)

The court held, however, that mutuality requirement in section 553 still applied to the safe-harbours. The wording of the safe-harbours in the U.S. Bankruptcy Code exempts from any stay a swap participant’s right to exercise “any” contractual rights to offset or net out any termination values or payment amounts arising under or in connection with termination, liquidation or acceleration. Protecting “any” contractual set-off right did not mean that the set-off right didn’t have to meet the fundamental requirements for set-off of the Bankruptcy Code, namely mutuality and not being a post-petition obligation. Consequently, Swedbank was not permitted to freeze the deposit account or set off against the net termination amount.

While the case was not about affiliate netting, presumably the court’s reasoning would apply to affiliate netting if the Master Agreement allowed for it and there were no guarantees to rely on to create the required mutuality.

Would the same analysis apply in a Canadian insolvency case? A Canadian bankruptcy case might come to the same result, but would be decided for different reasons. The main difference is there is no safe-harbour provision under the Bankruptcy and Insolvency Act (BIA) that applies to a bankruptcy proceeding. It’s not considered to be needed because netting and set-off more generally are not stayed. The general set-off provision in the BIA is similar in concept to section 553 of the U.S. Bankruptcy Code, but the wording is quite different. Whether the BIA set-off protection goes so far as to protect non-mutual contractual set-off is an open question. Something isn’t “set-off” just because you describe it as set-off, and perhaps it is a fundamental characteristic of set-off that the obligations be mutual ones. On the other hand, Canadian bankruptcy law does recognize equitable set-off and mutuality is not a requirement for equitable set-off (at least at the time of the set-off - it probably is necessary that there have been mutuality at some point in time). A contract could create a fundamental relationship between non-mutual claims that would qualify it for equitable set-off, but presumably a general set-off clause would not have the effect of creating that fundamental relationship for every obligation between the parties. However, even if non-mutual set-off is not protected by the general set-off protection it is a principle of bankruptcy law that the trustee has no higher rights under an agreement than the bankrupt - if the bankrupt is subject to a contract that says it can set-off the obligations owed by or to a third party, then that just may be enforceable. There is some support for non-mutual contract set-off in the case law.

But is any of that to the specific situation addressed in the Lehman case? The wording of the typical ISDA set-off provision would only seem to allow set-off of a net termination amount against an amount owing to the counterparty (or perhaps its affiliates if so drafted). So if the amount is owed, not to the counterparty, but to its trustee because it is a post-petition amount, it would not seem that the clause would apply. (Canadian law also recognizes that there is a change of mutuality upon a bankruptcy.) On that basis I think the result in a Canadian bankruptcy proceeding would likely be the same, but for different reasons.

In other Canadian insolvency proceedings where the safe-harbours do apply, there is often not a change of mutuality upon commencement of the proceeding (e.g CCAA, BIA proposal). Therefore, the precise issue about the set-off of post-petition deposit amounts would not necessarily arise. In the context of restructuring proceedings, I believe trustees and monitors are careful not to deposit money to bank accounts that are subject to set-off without dealing with the issue in some way before doing so.

In any event, the wording of the safe-harbours for eligible financial contracts may be intended to apply only to the set-off or netting of amounts owing with respect to the protected types of transactions, not the set-off of amounts owing under other agreements that are not themselves eligible financial contracts.

Further, the Canadian safe-harbours apply to the netting or setting off of obligations “between the insolvent person and the other parties to the eligible financial contract”. The mutuality requirement is built right into the safe-harbour itself, so there is no need to import the requirements of the general set-off provision (assuming it even does require mutuality) to the Canadian safe-harbours. In Canada, the eligible financial contract safe-harbours stand alone.