Setoff is a doctrine based as much on practical considerations as on equitable ones. As numerous courts have observed, setoff "is grounded on the absurdity of making A pay B when B owes A."1 The Bankruptcy Code does not create any rights of setoff, however, but merely preserves such rights to the extent that they exist under applicable nonbankruptcy law and additionally either satisfy the various conditions set forth in Section 553 of the Bankruptcy Code or are protected by the so-called "safe harbor" provisions of the Bankruptcy Code.2 Generally speaking, Section 553 protects a creditor's setoff rights where four requirements are satisfied: (i) the creditor holds a claim against the debtor that arose prepetition; (ii) the creditor owes a debt to the debtor that also arose prepetition; (iii) such claim and debt are "mutual"; and (iv) such claim and debt are valid and enforceable.3 Confusion surrounds the mutuality requirement of Section 553 (i.e., whether the offsetting claim and debt must be owed between the same parties acting in the same capacity), and some courts have suggested that Section 553 preserves so-called "triangular setoffs" in bankruptcy.

In In re SemCrude, L.P., et al.,4 however, the Bankruptcy Court for the District of Delaware (the "Court") ruled that Section 553 does indeed preclude triangular setoff.5 Prior to the bankruptcy filing, SemGroup, L.P. and its various affiliates (collectively, the "Debtors") had been providers of goods and services in the energy sector. Chevron Products Company ("Chevron") was a party to certain contracts (the "Sem Contracts") to sell and purchase gas and oil products with three of the Debtors: SemCrude, L.P. ("SemCrude"), SemFuel, L.P. ("SemFuel"), and SemStream, L.P. ("SemStream"). Certain agreements governing the parties' business relationships (including the Sem Contracts) provided, "in the event either party fails to make a timely payment of monies due and owing to the other party, or in the event either party fails to make timely delivery of product or crude oil due and owing to the other party, the other party may offset any deliveries or payments due under this or any other Agreement between the parties and their affiliates."6 Neither Chevron nor the Debtors disputed that SemCrude, SemFuel and SemStream each qualified as an affiliate of the others. At the time of the bankruptcy filing on July 22, 2008 (the "Petition Date"), Chevron owed SemCrude approximately $1.4 million, SemFuel owed Chevron $10.2 million, and SemStream owed Chevron approximately $3.3 million.

Nearly a month after the Petition Date, on August 21, 2008, Chevron filed a motion for relief from the automatic stay so that it could set off the amounts owed between it and the Debtors. Chevron's primary argument was that an enforceable, prepetition agreement between a debtor, a creditor and one or more third parties (like the one between it and the three Debtors) either satisfies Section 553's mutuality requirement or allows the parties to contract around it. The Debtors and a number of other parties, including the Official Committee of Unsecured Creditors, objected to Chevron's motion, asserting that triangular setoff was impermissible under Section 553, even in the face of a valid prepetition agreement.

As an initial matter, the Court recognized that, in a number of cases decided over the past thirty years, several courts had observed that an exception to Section 553's mutuality requirement did exist. The Court further noted, however, that a more careful reading of these cases demonstrated that none of them actually enforced an agreement providing for triangular setoff; instead, the courts that had issued those decisions merely acknowledged that an exception existed before going on either to deny the setoff request or to uphold mutuality on grounds apart from the tripartite agreement. The Court asserted that the same "logical inconsistencies" found in those opinions could be seen in Chevron's setoff request. On the one hand, Chevron claimed that "multi-party mutuality" had been produced between it and the three Debtors as a result of the setoff language that governed the Sem Contracts; on the other hand, Chevron argued that contractually created triangular setoffs constituted a valid exception to Section 553's mutuality requirement. In the Court's view, it was impossible to reconcile these two positions. If two debts are mutual, then the requirement of mutuality would be satisfied without any recourse to an exception. If, however, a setoff is only enforceable as an exception, then the mutuality requirement must never have been satisfied in the first place.

Having established the legal framework for its discussion, the Court turned to the task of answering two specific questions. First, it considered whether debts among different parties could be deemed mutual in the face of an agreement that expressly contemplated triangular setoff. The Court adopted the narrow interpretation of "mutuality" that has been adopted by a majority of courts, finding that debts between parties are mutual only if the debts are "due to and from the same persons in the same capacity." From this perspective, triangular setoff language cannot supply mutuality. The triangular setoff arrangement espoused by Chevron did not create a debt that was owed to Chevron by SemCrude. SemCrude did not have to pay anything to Chevron and, upon exercise of the setoff, Chevron would simply see the receivable owed by Chevron either reduced in size or eliminated altogether. Similarly, the tripartite agreement between the parties did not give Chevron the right to collect anything from SemCrude. Because it would thus be impossible for mutual debts to exist between those two parties, the mutuality required by Section 553 was clearly absent.

The Court found additional support for its conclusions in the language of Section 553. It noted that, in drafting Section 553(a), Congress had been deliberately precise in stating exactly who must owe a debt to whom in order to realize a permissible setoff. Here, Chevron was seeking to set off a debt it owed to SemCrude against debts owed to Chevron by two other Debtors – not a debt owed to it by SemCrude. Accordingly, the Court ruled that an agreement between a debtor, a creditor and one or more third parties did not have the ability to transform non-mutual debts between those parties into mutual obligations as contemplated by Section 553.

Next, the Court analyzed whether a contractual exception to the mutuality requirement existed. Guided by the cardinal canon of statutory construction (i.e., in the absence of ambiguity, a court's function is to enforce a statute by its plain language), the Court found nothing in the text of Section 553 to justify recognition of an exception. Moreover, the Court noted that its ruling was consistent with one of the Bankruptcy Code's primary purposes: to ensure the fair and equal treatment of similarly situated creditors. If parties are allowed to contract around Section 553's mutuality requirement, a creditor could obtain payment from a debtor at the expense of other creditors, giving such creditor an unfair advantage.

The SemCrude decision makes clear that triangular setoff is a thing of the past, at least in the context of contracts not subject to the protections afforded by the Bankruptcy Code's safe harbor provisions. (Safe harbor contracts should remain outside of the scope of Section 553(a), although no court has issued a decision on this particular question to date.) In the future, parties that have relied on tripartite agreements of the kind at issue in the SemCrude case may consider protecting themselves by including language that mandates the netting of payments owed between them rather than simply allowing them to effect setoffs or, if feasible, by structuring their agreements as safe harbor contracts.