SemCrude, Setoff, and the Collapsing Triangle: What Contract Parties Should Know

SemCrude, Setoff, and the Collapsing Triangle: What Contract Parties Should Know NORMAN S. ROSENBAUM, ALEXANDRA STEINBERG BARRAGE, AND JORDAN A. WISHNEW Recently, the U.S. Bankruptcy Court for the District of Delaware held that a valid, prepetition contract cannot vitiate the strict mutuality requirement found in Section 553(a) of the Bankruptcy Code. The authors explain the court s decision and conclude that, after this ruling, contract parties should not rely on a negotiated cross-affiliate setoff the triangle is no longer as sturdy as it may have once seemed. On January 9, 2009, the Honorable Brendan L. Shannon of the U.S. Bankruptcy Court for the District of Delaware held in SemCrude 1 that a valid, prepetition contract cannot vitiate the strict mutuality requirement found in Section 553(a) of the Bankruptcy Code. In light of SemCrude, enterprises, such as energy trading and marketing companies, who rely on contractually based cross-affiliate or triangular setoff provisions as a means of setting off amounts owed among various entities should re-examine their agreements and reassess their counterparty bankruptcy risk. As SemCrude illustrates, 2 parties should also understand all of the legal remedies including the potential applicability of the safe harbor provisions that may be available to them under the Bankruptcy Code. 341

Pratt s Journal of Bankruptcy Law SETOFF AND TRIANGULAR SETOFF DEFINED A setoff in bankruptcy, as defined by Section 553(a) of the Bankruptcy Code, involves the offset of mutual, valid, and enforceable prepetition debts between the same parties in the same capacities i.e., a prepetition debt owing by a creditor ( Party A ) to a debtor ( Party B ) against a prepetition claim of Party A against Party B. 3 The requisite elements of a Section 553 setoff are as follows: The creditor holds a claim against the debtor that arose before the commencement of the case; The creditor owes a debt to the debtor that also arose before the commencement of the case; The claim and debt are mutual; and The claim and debt are each valid and enforceable. 4 Setoff, in effect, elevates an unsecured claim to secured status, to the extent that the debtor has a mutual, prepetition claim against the creditor. 5 Section 553 does not define mutual. The most common use of mutual includes the requirement that the prepetition claim and debt be owed among the same parties and that the parties be acting in the same capacity. 6 By comparison, a triangular setoff typically involves the setoff of a debt owing from Party A to Party B against a debt of Party B owing to an affili- Norman Rosenbaum is a partner in the Bankruptcy and Restructuring Group of Morrison & Foerster LLP in its New York office. Mr. Rosenbaum has extensive experience representing creditors as well as public and private debtors in transactional, litigation, and advisory work relating to Chapter 11 cases, and non-bankruptcy workouts. Alexandra Steinberg Barrage is counsel in the firm s office in Washington, D.C. Her practice focuses on bankruptcy and distressed debt trading. Jordan Wishnew is a senior associate in the firm s New York City office. His practice focuses on representing creditors, creditors committees and other parties in interest in bankruptcy cases and workouts. The authors can be contacted at nrosenbaum@mofo.com, abarrage@mofo.com, and jwishnew@mofo.com, respectively. 342

SemCrude, Setoff, and the Collapsing Triangle ate of Party A, rather than directly to Party A. 7 In the energy trading marketplace, triangular setoff is used to manage risk among multiple affiliates trading under the same ultimate parent. Triangular setoff is considered to be a much more efficient means of managing credit exposure and maximizing the efficiency of collateral than limiting setoff to the obligations of the parties under each contract. 8 The need for triangular setoff is even more acute when affiliates share the same guarantor of their obligations. 9 SUMMARY OF JUDGE SHANNON S DECISION Despite the appeal and convenience of triangular setoff, the SemCrude decision should cause contract parties to re-evaluate the risk that triangular setoffs will not be enforceable against a debtor-in-possession. In SemCrude, the court denied the motion of Chevron Products Company ( Chevron ) for relief from the automatic stay in order to set off the balances owed by Sem- Fuel, L.P. ( SemFuel ) and SemStream, L.P. ( SemStream ) to Chevron against the sum Chevron owed to SemCrude, L.P. ( SemCrude ). Specifically, Chevron owed SemCrude approximately $1.4 million for the sale and purchase of crude oil, SemFuel owed Chevron approximately $10.2 million for the delivery and purchase of gasoline, and SemStream owed Chevron approximately $3.3 million for the delivery and purchase of butane. 10 Each of the agreements among Chevron and the SemCrude parties contained identical netting provisions that provided in pertinent part: [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. 11 SemCrude and at least seven other parties filed objections to Chevron s motion. The primary focus of these objections was that the triangular setoff sought by Chevron was impermissible because the Bankruptcy Code does not permit parties to contract around the mutuality require- 343

Pratt s Journal of Bankruptcy Law ment set forth in Section 553 of the Bankruptcy Code. Chevron relied on a common law exception to the mutuality requirement, which recognized that parties could create mutuality through a contractual arrangement; 12 but upon a closer examination of the precedent cited by Chevron, Judge Shannon stated that in the court s view none of the cited cases actually upheld or enforced an agreement that allows for a triangular setoff; each and every one of the decisions have simply recognized such an exception in the course of denying the requested setoff or finding mutuality independent of the agreement. 13 In the absence of what the court viewed as controlling or persuasive authority concerning the validity of triangular setoffs, Judge Shannon addressed two related questions: (1) may debts owing among different parties be considered mutual when there are contractual netting provisions governing the parties business relationship; and (2) if not, is there a contractual exception to Section 553 s mutuality requirement? 14 Parties Cannot Contract Around Mutuality The court held that non-mutual debts cannot be transformed into a mutual debt under Section 553 simply because a multi-party agreement allows for setoff of non-mutual debts between the parties to the agreement. 15 For debts to be mutual, the debts must be due to and from the same persons in the same capacity. 16 Therefore, Chevron did not have mutuality with SemCrude because even though Chevron owed SemCrude money, SemCrude did not have a debt due and owing to Chevron. The court made an important distinction between a guaranty obligation, which creates a debt between guarantor and creditor, and a setoff agreement, which does not create indebtedness between parties and only provides that a party s receivable may be reduced or eliminated. While there was a debt due from Chevron to SemCrude, as well as debts due from SemStream and SemFuel to Chevron, there was no reciprocal debt owing from SemCrude to Chevron. Even if Chevron had privity of contract with each of the debtors, it lacked the mutuality with SemCrude required by Section 553. As a result, Chevron could not enforce the contractual netting provisions to set off the monies it owed to SemCrude against 344

SemCrude, Setoff, and the Collapsing Triangle the monies owed to it by SemFuel and SemStream because its proposed setoff fell outside the express terms of Section 553. There is No Contractual Exception to Mutuality Based on a strict interpretation of Section 553 and for public policy reasons, the court also held that there was no contract exception to the mutuality requirement of Section 553. The court found no indication in the language of the Bankruptcy Code to provide for such an exception. 17 Since Section 553 of the Bankruptcy Code is unambiguous, an expansive reading enlarging a party s setoff right was inappropriate. The court also noted: One of the primary goals if not the primary goal of the [Bankruptcy] Code is to ensure that similarly situated creditors are treated fairly and enjoy an equality of distribution from a debtor absent a compelling reason to depart from this principle. By allowing parties to contract around the mutuality requirement of section 553, 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. 18 THE LIMITS OF SEMCRUDE AND THE UNPAID GUARANTEE SCENARIO The court did not specifically address the issue of whether an unpaid guarantee could create mutuality for purposes of Section 553. 19 As the court emphasized, unlike a guarantee of debt, where the guarantor is liable for making a payment on the debt it has guaranteed payment of, an agreement to setoff funds does not create indebtedness from one party to another. 20 That an unpaid guarantee would give rise to indebtedness (whereas a triangular setoff mechanism would not) may suggest that a prepetition guarantee structure could achieve the same result as a triangular setoff 345

Pratt s Journal of Bankruptcy Law without impairing the requirements of Section 553. If, for example, SemCrude had guaranteed the debts of SemFuel or SemStream, there may have been mutuality (and therefore, no need for any purported exception to apply) as between Chevron and SemCrude for purposes of Section 553. But because SemGroup was the only guarantor, and SemGroup was not owed a debt by Chevron, the court did not reach a decision on the unpaid guarantee/mutuality issue. SemCrude may, therefore, leave the door open to an argument that mutuality exists between a debtor/guarantor and its nondebtor counterparty to the extent that such parties agreed in a prepetition contract that the debtor/guarantor could aggregate debts owed to and from other debtors for setoff purposes. 21 Although this guarantee structure may appear to be an attractive way to circumvent the mutuality requirement, a court could equally deem it a variation of the same contract around mutuality theme and continue to uphold the strict requirements under Section 553. SAFE HARBOR APPLICABILITY? Chevron filed a motion for reconsideration of the bankruptcy court s decision (the Reconsideration Motion ). In the Reconsideration Motion, Chevron argued that the agreements at issue were safe harbor contracts not subject to the mutuality requirements of Section 553. According to Chevron, the agreements were either forward contracts or swap agreements, and that, in either case, mutuality is no longer relevant. 22 Generally, the safe harbor provisions of the Bankruptcy Code are designed to permit a non-debtor party to terminate and close out a variety of derivative contracts, including repurchase agreements (or repos ), swaps, security contracts, commodity contracts, and forward contracts, notwithstanding the automatic stay 23 or Section 553 of the Bankruptcy Code. 24 The amendments to the Bankruptcy Code implemented by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the 2005 Amendments ) strengthened and clarified several of the safe harbor provisions. In particular, the 2005 Amendments added Section 561 which specifically preserved the contractual right to terminate, liquidate, accelerate, or offset under a master netting agreement involving a vari- 346

SemCrude, Setoff, and the Collapsing Triangle ety of derivative contracts. 25 Through Section 561 and related provisions, Congress expanded cross-product netting by allowing participants to net all qualified financial contracts under a single master agreement without violating the automatic stay. Nevertheless, the safe harbor protections do not appear to apply to cross-affiliate nettings specifically, thereby casting some doubt on whether triangular setoff will ultimately be preserved in the safe harbor context. In denying the Reconsideration Motion, the court did not address the merits of Chevron s safe harbor argument, relying instead on procedural grounds. The court held, among other things, that prior to the Reconsideration Motion, Chevron had at no point alleged that the safe harbor provisions applied, and that the applicable Bankruptcy Rules did not permit the court to address a new legal theory that could have been raised in the first instance. 26 Thus, the question remains: Could Chevron have circumvented the mutuality requirement imposed by the bankruptcy court by relying on the safe harbor provisions? SEMCRUDE S IMPACT Regardless of whether the safe harbor provisions ultimately apply, SemCrude will be hailed by some as the first definitive case after decades of jurisprudence on triangular setoff, mutuality, and its purported exceptions. As noted in Judge Shannon s opinion, the court believed that each and every prior decision simply recognized a mutuality exception in the course of denying the requested setoff or finding mutuality independent of the agreement. None actually permitted a triangular setoff or, until SemCrude, addressed the merits of this purported exception in a written opinion. 27 Equally as important, the court s rejection of a contractual exception to the mutual debt requirement and plain language interpretation of Section 553 represents a firm adherence to the strict and literal application of the Bankruptcy Code. It pays homage to the weight of authority cautioning against enlarging the right to setoff beyond that allowed in the Code. 28 And in holding that no exception to the mutual debt requirement in Section 553 can be created by a private agreement, the court underscored 347

Pratt s Journal of Bankruptcy Law the view that setoff is fundamentally at odds with the Bankruptcy Code s priority scheme. Recognizing any setoff exception based on the facts and arguments presented would have elevated Chevron s status as an unsecured creditor to that of a secured creditor, allowing it full recovery on its claim. This result, the court found, would remain in conflict with the basic principles of equal distribution for all similarly situated creditors. After the SemCrude dust settles, it may be that some contract parties benefit from the unpaid guarantee scenario or the Bankruptcy Code s safe harbor provisions, thereby mitigating SemCrude s impact. Of course, the safe harbor protections on any set of facts are never guaranteed. In the master netting agreement context where the same parties net multiple financial products, the safe harbor protections and the force of the 2005 Amendments may apply. But in the cross-affiliate netting context, it s not clear that they would apply. One thing remains clear after SemCrude: contract parties should not rely on a negotiated cross-affiliate setoff the triangle is no longer as sturdy as it may have once seemed. NOTES 1 In re SemCrude, L.P. et al., No. 08-11525 (BLS), 2009 WL 68873 (Bankr. D. Del. Jan. 9, 2009) (hereinafter, SemCrude ). 2 On January 20, 2009, Chevron filed a motion for reconsideration (the Reconsideration Motion ). In the Reconsideration Motion, Chevron argued that the agreements at issue were safe harbor contracts not subject to the mutuality requirements of Section 553. According to Chevron, the agreements were either forward contracts or swap agreements, and that, in either case, mutuality is no longer relevant. In an order dated March 19, 2009, the Reconsideration Motion was denied. On March 26, 2009, Chevron filed a Notice of Appeal of both the initial decision denying Chevron s motion for relief from the automatic stay as well as the March 19, 2009 order. 3 11 U.S.C. 553(a). 4 In re Steines, 285 B.R. 360, 362 (Bankr. D. N.J. 2002). 5 See 11 U.S.C. 506(a). 6 See SemCrude, 2009 WL 68873, *6 ( The overwhelming majority of courts to consider the issue have held that debts are mutual only if they are due to 348

SemCrude, Setoff, and the Collapsing Triangle and from the same persons in the same capacity. )(citations omitted). 7 See id., 553.03[3][b] at 553-28 (15th ed. rev. 2009). 8 Craig R. Enochs, Fundi A. Mwamba, and Paul E. Vrana, Early Termination and Liquidation Provisions As Risk Tools In Master Energy Agreements at 12 (2004), http://images.jw.com/com/publications/419.pdf. 9 Id. 10 SemCrude, 2009 WL 68873, *1-*2. 11 Id. at *2. 12 Id. at *4. 13 Id. (emphasis added). 14 Id. at *5. 15 Id. at *7. 16 Id. at *6 (citations omitted). 17 Id. at *8. 18 Id. 19 Id. at n. 7 ( This is not to say that setoff would necessarily be appropriate against SemCrude if it were a guarantor of SemStream or SemFuel s debt, however. ) (noting split of authority on issue)(citations omitted). 20 Id. at *6. 21 See id. at n.7 (citing In re Ingersoll, 90 B.R. 168 (Bankr. W.D.N.C. 1987) and Bloor v. Shapiro, 32 B.R. 993 (S.D.N.Y. 1983). 22 See 11 U.S.C. 553(b)(1). 23 Sections 362(b)(6) and 362(b)(7) of the Bankruptcy Code specifically provide an exception to the automatic stay for the exercise of certain contractual rights by certain non-debtor counterparties to a commodity contract, forward contract or securities contract, and repurchase agreement. See also 11 U.S.C. 559 (addressing contractual rights of repo participants and ipso facto clauses); 11 U.S.C. 555 addressing contractual rights of certain parties to a securities contract and ipso facto clauses); 11 U.S.C. 556 (addressing contractual rights of certain parties to a commodities contract or forward contract and ipso facto clauses). 24 See 11 U.S.C. 553(b)(1). 25 See Mot. for Recon. 6. 26 See SemCrude Mem. Order at 6-7 (March 19, 2009). 27 SemCrude, 2009 WL 68873, *10, *14]. 28 Id. at 22 (citations omitted) 349