The US Bankruptcy Court for the District of Delaware, in a decision in the SemCrude, L.P. (SemCrude) bankruptcy case that was announced on 9 January 2009, held that the Bankruptcy Code prohibits a triangular set-off of debts in bankruptcy in the absence of mutuality.

Set-off is a right that arises under state law or under contract that allows entities that are mutually indebted to each other to apply their mutual debts against each other, thereby avoiding "the absurdity of making A pay B when B owes A" (Citizens Bank of Maryland v. Strumpf, 516 US 16, 18 (1995)).

Triangular set-off arises where A, B and C agree that A may set off amounts owed by A to B against amounts owed to A by C.

Preservation of set-off rights in a bankruptcy case is advantageous to creditors because "every setoff by its very nature is a preference" (In re NWFX, Inc., 864 F.2d 593, 595 (8th Cir. 1989)), and exercising set-off rights often permits creditors to realise a greater recovery than otherwise similarly situated creditors.

The Bankruptcy Code itself does not create a right of set-off. Section 553 of the Bankruptcy Code merely recognises and preserves set-off rights that arise under applicable non-bankruptcy law, to the extent that such set-off rights meet the conditions set out in that section. Because the effect of recognising set-offs in a bankruptcy case is contrary to the Bankruptcy Code's policy of equality of distribution, courts have tended to strictly apply the conditions to valid set-off in section 553. The main issue to be decided by the bankruptcy court in the SemCrude case was whether section 553's requirement of mutuality rendered the contractual triangular set-off arrangement between the parties unenforceable in bankruptcy.

The facts of the case were as follows:

The bankruptcy court denied Chevron's motion, holding that, for a set-off to be enforceable in bankruptcy, the debts to be off-set must be mutual, pre-petition debts. Chevron had argued that an enforceable, pre-petition agreement between a debtor, a creditor and one or more third parties (like the one between it and the three SemGroup affiliates) either satisfies section 553's mutuality requirement or is a recognised exception to the mutuality requirement.

Chevron cited a number of cases in support of its position. Although the bankruptcy court agreed that "at first blush," these cases seemed to support Chevron's argument, on closer analysis, it found that none of the cases Chevron cited actually enforced an agreement that allowed for a triangular set-off. Instead these decisions simply recognised such an exception in the course of denying the requested set-off or finding mutuality independent of the agreement.

The bankruptcy court therefore found that there was a complete absence of controlling or persuasive decisions on the question, and so set about examining two distinct questions.

The first was whether mutuality could be supplied by a multi-party agreement contemplating a triangular set-off. In answering this question, the bankruptcy court construed the definition of "mutuality" strictly. Although "mutuality" is not defined in the Bankruptcy Code, the bankruptcy court held that there is clear authority that debts are "mutual" only when "they are due to and from the same persons in the same capacity." The triangular set-off arrangement did not give rise to a debt owed by SemFuel and SemStream to Chevron. The set-off merely provided that SemCrude would see one of its own receivables reduced or eliminated. Likewise, the triangular set-off arrangement did not purport to give Chevron a right to collect from SemFuel and SemStream. This was not the type of arrangement that could be viewed as giving rise to debts due to and from the same persons in the same capacity. Thus, the bankruptcy court held that non-mutual debts cannot be transformed into mutual debts under section 553 by a multi-party agreement allowing for set-off of non-mutual debts between the parties to the agreement.

The bankruptcy court next examined the question of whether there was a contractual exception to the mutuality requirement. Focusing on the language of section 553 itself, the bankruptcy court found nothing on which to base a conclusion that there is a contractual exception to the mutuality requirement. The "great weight" of authority for the holding that there is no reason to extend the right of set-off beyond that provided for in the Bankruptcy Code also influenced the bankruptcy court's decision. The bankruptcy court further noted that its holding was consistent with the primary goal of the Bankruptcy Code, to ensure that similarly situated creditors enjoy an equality of distribution from a debtor unless there is a compelling reason to depart from this principle. The bankruptcy court thus held that parties could not contract around the mutuality requirement in section 553 by private agreement.

The SemCrude decision, if followed by other courts, could have implications for companies that attempt to manage their counterparty risk exposure to a corporate group through contractual provisions that allow that company to offset amounts it owes to one member of the group against amounts owed to it from that member's affiliates.

Although this was not addressed by the bankruptcy court, we do not believe that this decision would apply to safe harboured contracts. In fact, Chevron filed a motion for reconsideration on 20 January 2009, in which it argues that its contracts with the SemGroup debtors are "forward contracts" or "swap agreements" within the meaning of sections 556 and 560 of the Bankruptcy Code, respectively.

Chevron argues that section 561(a) of the Bankruptcy Code takes safe harboured contracts out of the scope of section 553, by providing that such contracts will not be stayed, avoided or otherwise limited by the operation of any provision in the Bankruptcy Code, a position that is supported by a leading authority on the Bankruptcy Code.

The hearing date on this motion is set for 12 March 2009.