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 non-defaulting party to apply against the amount owing as a result of the termination of the agreement any amounts owing between the non-defaulting party and affiliates of the defaulting party. Such clauses do generally not appear as standard in industry wide contracts (e.g. the ISDA Master Agreement), but are commonly added by mutual agreement of the parties, most often in contracts that are governed by U.S. laws.
On January 9, 2009, the United States Bankruptcy Court for the District of Delaware, presiding over the In Re SemCrude Chapter 11 bankruptcy case, held that triangular set-offs are impermissible under section 553 of the U.S. Bankruptcy Code (“Bankruptcy Code”) regardless of express contractual provisions permitting such set-off. This decision holds 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 decision has potentially very far-reaching implications for the enforceability of contractual set-off rights under U.S. law.
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 on January 20, 2009, 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. The key issues are summarized below.
Chevron’s purchases under the three contracts were governed by three sets of terms and conditions which 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.
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 non-bankruptcy 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 such 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 is thus 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” which 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 which apply to qualified financial contracts and financial participants, excepting them from certain restrictions of the automatic stay and allowing non-debtor counterparties to swap agreements, forward agreements and other financial contracts special rights. 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 which 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. The motion for reconsideration faces a difficult challenge, however, as the legal classification of such physically settled forward oil and gas contracts is an issue hotly disputed in the U.S. bankruptcy courts and is currently pending before a higher court, the 4th Circuit Court of Appeals, in the Hutson v. Smithfield Packing (In re Natural Gas Distributors LLC) case.
The SemCrude Court’s opinion, coming out of a trial level court, is not controlling law outside of Delaware and remains subject to reconsideration and appeal. That said, the opinions of that Court – one of the busiest and most prolific Bankruptcy Courts in the U.S. – 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 is percolating among the U.S. bankruptcy and appellate courts and is currently pending before the Court of Appeals for the 4th Circuit. We continue to monitor the litigations and will report on the developments.
In the interim, be cautioned that a substantial risk exists that triangular set-off provisions will be held ineffective in U.S. bankruptcy cases. Care should therefore 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 could be ultimately relied upon in a U.S. insolvency. The most prudent approach – especially in contracts providing for a physical delivery – is therefore 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.