Earlier this year, the United States Bankruptcy Court for the District of Delaware ruled that a nondebtor cannot effect a “triangular” setoff of the amounts owed between it and three affiliated debtors, even if the parties had entered into pre-petition contracts that expressly contemplated multiparty setoff.1 In reaching its decision, the Court relied principally on the plain language of section 553(a) of the United States Bankruptcy Code, which limits setoff to “mutual” obligations — i.e., direct obligations between a single obligor and obligee. The immediate consequence of this ruling was that Chevron USA, Inc. (“Chevron”) could not setoff its pre-petition obligation to debtor SemCrude L.P. (“SemCrude”) against amounts owed to Chevron by affiliated debtors SemFuel, L.P. (“SemFuel”) and SemStream, L.P. (“SemStream”).

The Court’s decision resulted from its analysis of standardized fuel supply contracts, as opposed to derivatives contracts that enjoy the protection of a Bankruptcy Code safe harbor.2 The safe harbor provisions of the Bankruptcy Code suggest that, where triangular setoff or another form of multiparty setoff is being effected under a protected financial contract, the mutuality requirement of section 553(a) is inapplicable.

Seeking a “second bite at the apple,” Chevron filed a motion for reconsideration of the Court’s decision in order to argue that, in fact, its agreements with the debtor were safe harbored swaps, forwards, commodities agreements and/or master netting agreements to which the mutuality requirement of section 553(a) did not apply.3 The Court denied the motion to reconsider on procedural grounds because there was no intervening change in controlling law or new factual development to justify reconsideration, and never reached Chevron’s substantive safe harbor argument.4 Given the current economic climate, however, the issue of whether triangular setoff is permitted under the financial contract safe harbors is likely to resurface in the near future.

Background

In July 2008, energy industry services company SemGroup, L.P. and certain of its direct and indirect subsidiaries filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. At the time of the filing, Chevron had contracts for the sale or purchase of various fuels with three affiliated debtors: SemCrude, SemFuel and SemStream. These contracts were governed by various standardized agreements, some of which provided:

[I]n 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.5

As of the petition date, Chevron owed a balance of $1.4 million to SemCrude, while SemFuel owed Chevron $10.2 million and SemStream owed Chevron $3.3 million.6 Chevron claimed that, pursuant to the terms of the contracts, the amount it owed to SemCrude could be setoff against the amounts owed to it by SemFuel and SemStream, and it sought relief from the automatic stay of section 362(a) of the Bankruptcy Code to do so. The debtors, the creditor’s committee, and a number of other creditors objected, citing the requirement of section 553 of the Bankruptcy Code that debts must be “mutual” in order to be setoff.7 Chevron responded that either its pre-petition contracts with the debtors — which it stated on the record were not safe harbored8 — satisfied the mutuality requirement, or the Bankruptcy Code allowed parties to contract around the mutuality requirement by providing for setoff across affiliates.

Mutuality Cannot Be Created Through a Private Agreement

In examining whether an agreement that contemplates triangular setoff can create mutuality under section 553, the Court scrutinized the meaning of the term “mutual debt,” as section 553 only applies to the setoff of “mutual debts.” Finding that the nature of mutuality under section 553 was well-settled, the Court stated: “The authorities are . . . clear that debts are considered ‘mutual’ only when they are due to and from the same persons in the same capacity.” 9 It continued, “[p]ut another way, mutuality requires that ‘each party must own his claim in his own right severally, with the right to collect in his own name against the debtor in his own right and severally.’”10 In light of this definition, the Court concluded that “mutuality cannot be supplied by a multi-party agreement contemplating a triangular setoff.”11

Court Refuses to Recognize an Exception to the “Mutual Debt” Requirement

Less well-settled was whether an exception exists to the mutuality requirement that would allow for triangular setoffs under pre-petition contracts. Nearly a dozen cases decided over the last 30 years suggested that a contract providing for non-mutual setoff could be enforced. However, the Court’s scrutiny of these cases led it to determine that “not one of these cases has actually upheld or enforced an agreement that allows for a triangular setoff; each and every one of these decisions have simply recognized such an exception in the course of denying the requested setoff or finding mutuality independent of the agreement. Moreover, these decisions cite only to other cases that recognize this purported exception in dicta, or, in some of the more recent cases, to a short reference in Collier on Bankruptcy, which also relies on this same handful of decisions for authority.”12

In particular, the cases supporting contractual non-mutual setoff generally rely on the decision of the Seventh Circuit Court of Appeals in Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.).13 Berger Steel was decided under the Bankruptcy Act of 1898 (the predecessor statute to the Bankruptcy Code), and was the first case to raise the possibility that an exception to the Bankruptcy Act’s mutuality requirement might exist for a contract allowing triangular setoff.14 In Berger Steel, a party attempted to effect a triangular setoff based upon an oral agreement between it and two other parties that allegedly created sufficient mutuality of amounts owing and owed to make a valid triangular setoff. The Berger Steel court found that no such agreement existed, but noted that certain cases allowed a triangular setoff to be taken pursuant to a valid contract. However, each of these cases was decided under state law or the common law of equitable receivership, not under the restrictive language of the Bankruptcy Act or Bankruptcy Code. Thus, the SemCrude court concluded that Berger Steel did not stand for the proposition that nonmutual setoff provisions in a contract can be enforced against a debtor in bankruptcy.15

Finding no actual precedent for enforcing non-mutual setoff, the Court focused on the plain language of section 553(a) of the Bankruptcy Code. Section 553(a), in the Court’s view, clearly and unambiguously requires mutuality.16 Furthermore, the Court found that non-mutual setoff would be contrary “to the principle of equitable distribution that lies at the heart of the Code” because “one creditor or a handful of creditors could unfairly obtain payment from a debtor at the expense of the debtor’s other creditors, thereby upsetting the priority scheme of the Code and reducing the amount available for distribution to all creditors.”17

Conclusions and Recommendations

The SemCrude decision eliminates the possibility of triangular setoff or other non-mutual setoff, at least where the contracts at issue are not safe harbored. Although, in this case, the nondebtor was trying to setoff obligations between it and multiple debtors, under the Court’s reasoning, the result would likely have been the same if the nondebtor was trying to use obligations between itself and its affiliates and a single debtor. Even though a policy argument could be made that non-mutual setoff involving multiple debtors is more problematic, because it mixes the assets and liabilities of different bankruptcy estates, the Court’s analysis— in particular its reliance on the plain language of section 553(a)—suggests that the direction of the triangle does not matter.

In denying Chevron’s motion to reconsider, the Court noted the absence of grounds for relief under the Federal Rules of Bankruptcy Procedure upon which Chevron relied—Rules 52(b), 59(e) and 60(b). Chevron failed to demonstrate: (1) that there had been an intervening change in controlling law (which could not consist of a Fourth Circuit decision decided after the date of Chevron’s motion for reconsideration), (2) the availability of new evidence, or (3) any need to correct clear error or prevent manifest injustice. The Court was compelled to deny Chevron’s motion because, in its view, Chevron had merely changed its legal theory to one that it had failed to raise at the outset of the proceedings.18 Particularly in light of several objections that sought clarification of the Court’s earlier decision, however, the Court was careful to emphasize that its decision in SemCrude did not address safe harbored contracts.19

The 2005 and 2006 amendments to the Bankruptcy Code’s safe harbor provisions, especially those that eliminated certain mutuality language from the safe harbor portions of section 362(b) of the Bankruptcy Code, suggest that, in the case of safe harbored contracts, section 553(a) does not apply and that the safe harbored contracts can be enforced as written, including giving effect to non-mutual setoff provisions in those contracts. With the Court’s denial of Chevron’s motion to reconsider on procedural grounds, this question has still not been decided by any court.

As an alternative to relying exclusively on triangular setoff rights, parties implementing master netting agreements may choose to rely instead on liens and pledges establishing cross-collateralization. If security interests are properly created and perfected, the nondebtor does not need to rely on setoff, and the mutuality issue need not come into play.