Contents

  • Is Triangular Set-off Enforceable Under U.S. Laws?
  • Third Circuit Clarifies Degree of Control Necessary to Be an Insider
  • Delaware Court Allows Corporate Waste Claim Based on Executive Compensation
  • Fourth Circuit Rules on Safe Harbor Protections For Commodity Forward Contracts
  • As Bank Insolvencies Loom, Lending Groups Should Act Now to Protect Themselves
  • Bona Fide Purchasers Protected From Trustee Action
  • Knowledge of Bankruptcy Does Not Bar State Action Where Creditor Is Not Given Formal Notice
  • Fifth Circuit Upholds Bad Faith Sanctions
  • 11th Circuit: Lease Termination Fees Can Qualify as Preferential Payments " Lender May Be Liable for Allowing Disbursements in Excess of Loan Budget
  • Junior Lien Holder Bankruptcy Stays Foreclosure by Senior Lien Holder
  • Are Attorney's Fees Recoverable in State Actions For Work Done in Bankruptcy Court?

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Is Triangular Set-off Enforceable Under U.S. Laws?

By Andrea J. Pincus

The U.S. Bankruptcy Court for the District of Delaware recently issued a decision addressing triangular set-off provisions, which potentially has very far-reaching implications for the enforceability of contractual set-off rights under U.S. law.

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 nondefaulting party to apply against the amount owed as a result of an agreement termination, any amounts owing between the nondefaulting party and affiliates of the defaulting party. Such clauses generally do not appear as standard in industry-wide contracts (e.g., the ISDA Master Agreement), but commonly are added by mutual agreement of the parties, most often in contracts that are governed by U.S. laws.

On January 9, 2009, the federal bankruptcy court in Delaware, presiding over the jointly administered chapter 11 bankruptcy cases of In re SemCrude L.P., et al., 399 B.R. 388 (Bankr. D. Del. Jan. 9, 2009), held that triangular set-offs are impermissible under section 553 of the U.S. Bankruptcy Code (11 U.S.C. 101 et seq.) ("Bankruptcy Code") regardless of express contractual provisions permitting such set-offs. See In re Semcrude, L.P., et al,; 2009 Bankr. Lexis 21, Case No. 08-11525 (BLS). The court held 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 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 Jan. 20, 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.

Contract Provisions

Chevron's purchases under the three contracts were governed by three sets of terms and conditions that 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.

Bankruptcy Court's Opinion

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 nonbankruptcy 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 this 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 thus is 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" that 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 that apply to qualified financial contracts and financial participants, excepting them from certain restrictions of the automatic stay, and allowing special rights for non-debtor counterparties to swap agreements, forward agreements and other financial contracts. 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 that 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.

Although the legal classification of such physically settled forward oil and gas contracts (i.e, those forward contracts for the sale and purchase of a commodity, providing for the physical delivery of commodities themselves rather than a cash settlement reflecting the market pricing of the underlying commodities) is an issue disputed in the U.S. bankruptcy courts, Chevron may find support from the timely Feb. 11, 2009 decision of the U.S. Court of Appeals for the Fourth Circuit, in Hutson v E.I. Dupont De Nemours & Co., et al. (In re National Gas Distributors LLC, ) No. 07-2105 (Hutson). In Hutson, the Fourth Circuit reversed the ruling of the North Carolina Bankruptcy Court that found physically settled commodity contracts, as matter of law, were mere supply contracts not subject to safe harbor protections.

Instead, the Fourth Circuit determined that a physically settled "commodity forward agreement" may qualify as a "swap agreement" under the U.S. Bankruptcy Code, and fall within the so-called "safe harbor" provisions of the Bankruptcy Code, regardless of whether these over-the-counter transactions are (a) settled by physical delivery of a commodity (rather than cash), (b) assignable, or (c) traded on a financial market or exchange.

In reaching its decision, the Fourth Circuit first rejected the bankruptcy court's assumption that a "swap agreement," which is defined to include a "commodity forward agreement," must be "regularly the subject of trading in financial markets." The Fourth Circuit based its rejection on the twin principles that:

  1. Every "forward contract" is a "forward agreement," since the term "agreement" is broader than and encompasses the term "contract."
  2. The legislative history, case law, and market practices relating to forward contracts permit such contracts to be directly negotiated and do not require that such contracts be traded in a financial market to be part of an overall hedging program.

Second, on the basis of legislative history, case law, and common definitions of a forward agreement, the Fourth Circuit rejected the bankruptcy court's assumption that a "commodity forward agreement" must be cash-settled.

The Fourth Circuit's decision is binding on courts within its circuit, and likely to materially influence other courts considering similar issues. Whether its influence will be felt in Delaware and to Chevron's benefit remains to be seen. Chevron's motion for reconsideration was scheduled at press time to be argued March 12.

Weighing the Risks

The SemCrude opinion, issued by a trial-level court, is not controlling law outside of Delaware and remains subject to reconsideration and appeal. That said, the opinions of the federal bankruptcy court in Delaware—one of the busiest and most prolific U.S. bankruptcy courts—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 continues to percolate among the U.S. bankruptcy courts, and has been squarely addressed by the Fourth Circuit Court of Appeals.

The CRAB Alert will continue to monitor these issues and report on further developments.

In the interim, parties should be aware that a substantial risk exists that triangular set-off provisions will be held to be ineffective in U.S. bankruptcy cases. Care therefore should 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 ultimately could be relied upon in a U.S. insolvency.

The most prudent approach—especially in contracts providing for a physical delivery—therefore is 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.

Case update: On March 20, the bankruptcy court entered a decision denying the motion to reconsider based on Chevron's failure to raise the safe harbor provisions in its initial moving papers. The court found that Chevron failed to satisfy the standard for reconsideration under Bankruptcy Rule 59(e)(i.e., reconsideration of a decision based on (a) an intervening change in controlling law; (b) new or previously unavailable evidence, or (c )to correct a manifest error on the part of the court). See Memorandum Order Denying Chevron Products Company's Motion for Reconsideration of This Court's Opinion dated January 9, 2009 Regarding Contractual Netting (Bankr. D. Del. March 20, 2009).

The court did not address the substantive issue of set-off under the safe harbor provisions, noting that Chevron did not raise the safe harbor issue as an alternative ground for relief when it moved to lift the stay to apply cross-affiliate set-off, and instead merely cited to Section 553 of the Bankruptcy Code. Raising the safe harbor grounds in the motion for reconsideration was procedurally too late to be recognized. Chevron has filed a notice of appeal and we will follow for developments.

Editor's note: Andrea's bankruptcy practice includes all aspects of chapter 11 cases, as well as out-of-court workouts involving private and publicly held companies. In addition, she represents hedge funds, banks and other financial institutions in connection with investing or trading strategies, structured debt, and derivative transactions based on ISDA documentation, with a focus on credit default swaps and valuation disputes. Andrea also advises commodities traders in commodities contract disputes, cross-border issues, counterparty insolvency, and derivatives disputes under ISDA and similar documentation.


Third Circuit Clarifies Degree of Control Necessary to Be an Insider

By Ann E. Pille

A recent opinion from the U.S. Court of Appeals for the Third Circuit confirms that "actual control" over a debtor is not necessary to qualify as a nonstatutory "insider" for the purpose of extending the period for preference recovery under Section 547 of the Bankruptcy Code. See Schubert v. Lucent Technologies, Inc. (In re Winstar Communications, Inc.), 554 F.3d 382 (3rd Cir. 2009).

In Schubert, the chapter 7 trustee sought to recover more than $188 million from Lucent Technologies, Inc. that was transferred prior to the 90-day statutory period applicable to non-insiders under the Bankruptcy Code. The transfer did take place within the one-year statutory period applicable to insiders of the debtor. See 11 U.S.C. § 547(b)(4)(B).

In support of her claims, the trustee asserted that Lucent was a nonstatutory insider of the debtor as a result of its pre-petition "strategic partnership" with the debtor, pursuant to which Lucent agreed to help finance and construct the debtor's global broadband telecommunications network.

In response, Lucent argued the strategic partnership was an arm's-length transaction, and because Lucent did not exercise "actual control" over the debtor, it could not qualify as an insider under the Bankruptcy Code.

Affirming the bankruptcy court's decision in favor of the trustee, the Third Circuit determined that the arrangement between Lucent and the debtor was not an arm's-length transaction. In support of this holding, the Third Circuit affirmed the bankruptcy court's findings that Lucent:

  1. Controlled many of the debtor's decisions relating to the build-out of the debtor's telecommunications network;
  2. Forced the debtor to purchase Lucent's goods well before equipment was needed and, in many instances, even though the equipment was not needed at all; and
  3. Treated the debtor as a captive buyer for Lucent's goods.

Winstar, 554 F.3d at 397.

The Third Circuit affirmed the bankruptcy court's finding that "what began as a 'strategic partnership' to benefit both parties quickly degenerated into a relationship in which the much larger company, Lucent, bullied and threatened the smaller Winstar into taking actions that were designed to benefit the larger at the expense of the smaller." 554 F.3d at 392-93, quoting 348 B.R. 234, 251 (Bankr. D. Del. 2005). Consequently, the Third Circuit determined that the relationship was not an arm's-length transaction.

Further, the Third Circuit rejected Lucent's assertion that it could not be a nonstatutory insider under Section 101 of the Bankruptcy Code because it did not exercise actual control over the debtor's operations in the same way that a director or officer might. In considering this point, the Third Circuit reviewed the definition of "insider" under the Bankruptcy Code.

The court noted that Section 101(31) of the Bankruptcy Code defines the term "insider" and enunciates several categories of insiders, known as "statutory insiders" because they are expressly included in the language of the statute. See 11 U.S.C. § 101(31).

Still, it is well-settled that Section 101(31) also includes certain parties not expressly defined by the language of the statute, known as nonstatutory insiders.

Nonstatutory Insiders

In Winstar, the Third Circuit held that actual control (or its close equivalent) is necessary to qualify as a statutory insider under Section 101(31). Winstar, 554 F.3d at 396. In contrast, a demonstration of actual control is not necessary to qualify as a nonstatutory insider. A party can qualify as a non-statutory insider if "there is a close relationship between debtor and creditor and [there is] anything other than closeness to suggest that any transactions were not conducted at arm's length." Id.

The characteristics of the relationship between the debtor and Lucent were indicative of a transaction that was not at arm's length, the Third Circuit concluded.

The court further differentiated the relationship between Lucent and the debtor from relationships in which a creditor simply exerts financial pressure over a debtor. The Third Circuit noted that "it is well established that the exercise of financial control incident to the creditor-debtor relationship does not make the creditor an insider." In the instant case, however, the facts were not limited to Lucent compelling payment of debts or other financial concessions related to its agreements with the debtor.

Instead, the Third Circuit found, among other things, that Lucent had the ability to coerce Winstar to make unnecessary purchases and used Winstar as a mere instrumentality to inflate Lucent's own revenues. As such, Lucent exercised sufficient control to qualify as a nonstatutory insider, and the Third Circuit affirmed the Bankruptcy Court's ruling that the longer statutory period applicable under Section 547(b)(4)(B) applied.

Further, given Lucent's treatment of Winstar, which the Bankruptcy Court determined was "egregious," the Trustee also prevailed on her breach of contract and equitable subordination claims against Lucent.

This case illustrates that companies entering into a strategic partnership should make sure the partnership is negotiated at arm's length. The failure to do so could subject an otherwise unaffiliated party to a substantially longer statutory period for preference liability, as well as other longer statutory terms applicable to insiders under the Bankruptcy Code.


Delaware Court Allows Corporate Waste Claim Based on Executive Compensation

By Herbert F. Kozlov & Jonathan P. Moyer

The Delaware Court of Chancery recently held that large executive compensation packages paid by corporations that lose money may not survive corporate waste analysis. See In Re Citigroup Inc. Shareholder Derivative Litigation, Civil Action No. 3338-CC (Del. Ch. Feb. 24, 2009).

The decision, issued in a consolidated stockholders' derivative action brought against current and former directors and officers of Citigroup,1 did provide some solace for corporate executives amid the current economic downturn. The court refused to hold directors and officers personally liable for breach of fiduciary duty based on taking business risks that resulted in substantial losses for the corporation.

Waste Claims

The Citigroup plaintiffs' claims centered on the directors' alleged breaches of the fiduciary duty of care and waste of corporate assets.2 Specifically, plaintiffs alleged that Citigroup's directors breached their duty of care by failing to adequately oversee, manage and disclose the company's exposure to massive losses the company ultimately suffered in the subprime mortgage market.3

The plaintiffs' corporate-waste claims sought to recoup from the directors a $68 million severance and benefit package paid to Citigroup's former CEO upon his retirement; $2.7 billion spent to acquire subprime loans; funds paid through a share repurchase program at allegedly inflated prices; and investments in failing special investment vehicles.4

It is a "cardinal precept" of Delaware law that directors, rather than shareholders, manage the corporation.5 Therefore, under Court of Chancery Rule 23.1, stockholder plaintiffs alleging derivative claims must either: (1) plead that they made a pre-suit demand on the corporation's board to take remedial action and that the board wrongfully refused to bring suit on behalf of the corporation; or (2) plead facts showing that such a demand on the board would have been futile.6

Since the plaintiffs in Citigroup did not make a pre-suit demand on the company's board, the defendants moved to dismiss the complaint on the grounds that the plaintiffs failed to meet the more stringent pleading requirements under Rule 23.1, and plead with particularity facts showing demand futility.7

Excessive Compensation Claim

The plaintiffs' waste claims based on the former CEO's multimillion-dollar retirement package survived the defendants' motion to dismiss.

For their waste claims to survive dismissal, under Rule 23.1 the plaintiffs had to plead facts establishing a reasonable doubt that the approval of the challenged transactions was a valid exercise of business judgment.8

The court found that plaintiffs had complied with Rule 23.1. In so doing, the court noted that directors of Delaware corporations generally have "the authority and broad discretion to make executive compensation decisions."9 The court cautioned, however, "the discretion of directors in setting executive compensation is not unlimited."10 Instead, Delaware case law makes clear that "there is an outer limit" to a board's discretion to set executive compensation that is reached when "executive compensation is so disproportionately large as to be unconscionable and constitute waste."11

Ultimately, the court concluded that plaintiffs' allegations that the multimilliondollar retirement package was paid to a retiring CEO who was "allegedly responsible, in part, for billions of dollars of losses at Citigroup"12 raised a reasonable question as to whether it was "so one sided" that it met the test for corporate waste.13

'Duty to Monitor'

The rest of the plaintiffs' fiduciary duty and waste claims were dismissed under Rule 23.1.

In particular, the court held that "[u]ltimately, the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be personally liable if the company experiences losses."14

The plaintiffs' main fiduciary-duty claim was based on a subset of the duty of care—the "duty to monitor" first enunciated in the Caremark case.15 The Delaware "duty to monitor" standard first was enunciated by the Court of Chancery in the 1996 opinion In re Caremark Int'l Inc. Derivative Litig. Claims based on an alleged breach of the so-called "duty of oversight" are "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."16

Although Delaware courts recognize that fiduciaries of Delaware corporations have certain responsibilities to implement and monitor a system of oversight, Caremark limits liability for failing to do so to only those rare situations in which a "sustained or systematic failure of the board to exercise oversight" exists, as in situations of an "utter failure to attempt to assure a reasonable information and reporting system exists" or of consciously failing to monitor such a system after it is implemented.17

Even if such a situation exists, Delaware courts further have limited liability for failure to monitor to situations where directors and officers failed to implement proper systems in bad faith—i.e., the defendants knew they were not discharging their fiduciary obligations or they demonstrated a conscious disregard for such obligations.18

Subprime Mortgage Losses

Applying these standards, the Citigroup court dismissed the plaintiffs' "duty to monitor" claims on three grounds.

First, the court found that plaintiffs' allegations were insufficient to show likelihood that plaintiffs could rebut the presumption of the business judgment rule.19 The court observed that plaintiffs' allegations could be characterized simply as attempting to hold the directors liable for "business decisions that, in hindsight, turned out poorly for the Company."20

Second, the court addressed the merits of plaintiffs' "duty to monitor" claims. The plaintiffs asserted that the Citigroup board failed to adequately consider alleged "red flags" from 2006 - 2008 relating to the decline in the subprime mortgage market.21 The court, however, found that pleading the mere existence of such "red flags" and Citigroup's losses from the subprime crisis was insufficient to prove a knowing or conscious disregard by the board for its fiduciary obligations.

Plaintiffs therefore failed to plead with particularity a substantial likelihood of personal liability sufficient to excuse demand.22

Third, and most notably, the court refused to extend the "duty to monitor" standard of Caremark and its progeny to the directors' alleged failure to properly monitor and oversee business risks.23 Instead, the court held that "the mere fact that a company takes on business risk and suffers losses—even catastrophic losses—does not evidence misconduct and, without more, is not a basis for personal director liability."24

The court further distinguished the case before it from its recent decision in American Int'l Group, Inc. Consol. Derivative Litig. ("AIG").25 In AIG, the plaintiffs' derivative complaint alleged financial fraud involving managers at the highest levels of the corporation and, based on allegations that certain AIG insiders not only knew of the alleged fraud, but also were involved in much of the wrongdoing, survived a motion to dismiss.26

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Footnotes

1 In re Citigroup Inc. S'holder Derivative Litig. at 1–3, 10.

2 Id. at 1.

3 Id. at 4–9.

4 Id. at 1, 2, 9, 55.

5 In Re Citigroup Inc. Shareholder Derivative Litigation at 17–18 (citing Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)).

6 Del. Ch. Ct. Rule 23.1(a)(2008), In re Citigroup Inc. S'holder Derivative Litig. at 18 (citing Stone v. Ritter, 911 A.2d 362, 366-367 (Del. 2006)).

7 Id. at 2, 18–19, In Re Citigroup Inc. S'holder Derivative Litig. at 19 (Citing Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000). Del. Ch. Ct. Rule 23.1(a).).

8 In re Citigroup Inc. S'holder Derivative Litig. at at 54, 55.

9 Id.

10 Id.

11 Id. at 54, 55 (citing Brehm, 746 A.2d at note 56).

12 Id. at 55.

13 Id. at 55–56.

14 Id. at 58.

15 Id. at 21–49, In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

16 In re Caremark Int'l Inc. Derivative Litig., 698 A.2d at 967.

17 Id. at 970–971, In re Citigroup Inc. S'holder Derivative Litig. at 23, 29 (citing Stone, 911 A.2d at 370).

18 In re Citigroup Inc. S'holder Derivative Litig. at 23, 24.

19 Id. at 26, 29, 30, 39, 43.

20 Id.

21 Id. at 7–9, 34–35.

22 Id. at 34, 35.

23 Id. at 24, 25, 40, 41.

24 Id. at 38, 39.

25 Id. at 39, 40.

26 American Int'l Group, Inc. Consol. Derivative Litig., 2009 WL 366613 at 23, 24 (Del. Ch. 2009).

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