United States: Bankruptcy Code "Safe Harbor" Provisions Do Not Protect Contractual Right To Triangular Setoff

CASE SNAPSHOT

Prior to filing for bankruptcy, a debtor entered into a repurchase agreement with an investment bank and a swap agreement with an affiliate of the investment bank. Following commencement of the debtor's bankruptcy case, the investment bank and its affiliate effectuated a triangular setoff whereby the banks offset monies owed to the debtor under the swap agreement against funds owed to the investment bank under the repurchase agreement. The United States Bankruptcy Court for the District of Delaware (the "Court") determined that the banks' contractual right to a triangular setoff was not protected by the safe harbor provisions of sections 559-561 of the Bankruptcy Code and, consequently, the exercise of such right constituted a violation of the automatic stay.

FACTUAL AND PROCEDURAL BACKGROUND

In February 2006, an investment bank (the "Investment Bank") entered into a Master Repurchase Agreement (the "Repurchase Agreement") with a retail mortgage lender ("Debtor"). In March 2006, Debtor entered into a series of interest rate cap transactions governed by the ISDA Master Agreement (the "Swap Agreement") with an affiliate (the "Affiliated Bank") of the Investment Bank. The Swap Agreement contained a broad setoff provision that purported to authorize the Affiliated Bank to perform cross-obligation and cross-affiliate setoffs, including a "triangular setoff" of the Affiliated Bank's obligations to Debtor under the Swap Agreement against amounts that Debtor owes to the Investment Bank under the Repurchase Agreement.

On August 2-3, 2007, the Investment Bank and the Affiliated Bank (together, "Defendants") declared events of default and exercised their termination rights under the Repurchase Agreement and the Swap Agreement. The Affiliated Bank notified Debtor of its intent to setoff any amounts payable by the Affiliated Bank to Debtor under the Swap Agreement against Debtor's unsatisfied obligations to the Investment Bank under the Repurchase Agreement. On August 6, 2007, Debtor and its affiliates filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. Thereafter, Defendants effectuated a triangular setoff by applying the excess collateral under the Swap Agreement to amounts owed by Debtor to the Investment Bank under the Repurchase Agreement.

In April 2011, Debtor filed a complaint against Defendants requesting a declaratory judgment as to whether the triangular setoff effectuated by Defendants constituted a violation of the automatic stay. Defendants filed a motion to dismiss, arguing that the Bankruptcy Code and the Swap Agreement permit triangular setoffs under these circumstances.

COURT ANALYSIS

The issue before the Court was whether an agreement to permit triangular setoffs is enforceable under the safe harbor provisions in sections 559-561 of the Bankruptcy Code. The Court held that a contractual right of setoff that permits netting by multiple affiliates of the contract-counterparty outside of bankruptcy may not be enforced after the commencement of the debtor's bankruptcy case. The safe harbor provisions provide no exception.

Section 553 of the Bankruptcy Code imposes restrictions on a creditor's right of setoff against a debtor in bankruptcy. Among other things, the debtor's claim against the creditor and the debt owed the creditor must be mutual. Debts are considered "mutual" only when they are due to and from the same persons in the same capacity. Because of the mutuality requirement, courts routinely hold that triangular setoffs are impermissible in bankruptcy.

Defendants acknowledged the mutuality requirement, but argued that the safe harbor provisions of sections 559-561 of the Bankruptcy Code exempt triangular setoffs in swap and repurchase agreements from its application. The Court disagreed. Relying upon two recent decisions from the United States Bankruptcy Court for the Southern District of New York, the Court determined that the safe harbor provisions could not be interpreted as implicitly doing away with the mutuality requirement. The safe harbor provisions permit the exercise of a contractual right to offset any termination values or payment amounts arising under certain financial contracts. However, as a result of section 553 and the mutuality requirement, the right to a triangular offset does not exist after commencement of a bankruptcy case. Nothing in the safe harbors can be read to protect a right that does not exist.

PRACTICAL CONSIDERATIONS

The safe harbor exceptions to the automatic stay embodied in sections 559-561 of the Bankruptcy Code cannot be interpreted as providing an implicit exception to the mutuality requirement for setoffs exercised after commencement of the debtor's bankruptcy case. As a result, non-debtor counterparties to swap and repurchase agreements must move for relief from the automatic stay before exercising control over property of the estate by retaining funds in exercise of their alleged triangular setoff rights.

The case may be found here.

Good day. Good stay. TSR

This article is presented for informational purposes only and is not intended to constitute legal advice.