Triangular Setoff: When It Comes to Securities Contracts, It Still Takes Two—and Only Two—to Tango

Contributed by Eric Kasenetz
Affiliates that require cross-affiliate setoff provisions in their contracts should take note of the recent decision in Sass v. Barclays Bank PLC (In re American Home Mortgage, Holdings, Inc.), No. 11-51851 (CSS) (Bankr. D. Del. Nov. 8, 2013).  Judge Sontchi of the United States Bankruptcy Court for the District of Delaware held that a “triangular” setoff fails the mutuality requirement of section 553 of the Bankruptcy Code.  Even the so-called “safe harbor” provisions (sections 559-561 of the Bankruptcy Code) applicable to securities contracts do not trump the mutuality requirement.
The Securities Contracts and Triangular Setoff
American Home Mortgage Investment Corp. and Barclays Capital were parties to a repurchase agreement, pursuant to which AHMI sold securities to Barclays Capital, and AHMI was obligated to later repurchase the securities at the stated repurchase price.  In August 2007, Barclays Capital terminated the agreement upon AHMI’s default, retained possession of the securities, and asserted a deficiency claim against AHMI for the remainder of the repurchase price.
Separately, AHMI and Barclays Bank—an affiliate of Barclays Capital—had entered into several interest rate swap transactions that were governed by an ISDA Master Agreement and other related transactional documents.  In August 2007, upon AHMI’s default under the swap documents, Barclays Bank terminated the transactions.  As of the termination date, Barclays Bank held collateral posted by AHMI that was worth more than the amount AHMI owed Barclays Bank under the swaps.
One of the governing swap documents contained a broad setoff provision that, according to the Barclays entities, authorized Barclays to perform “cross-obligation setoffs” and “cross-affiliate setoffs.”  Barclays alleged that the setoff provision permitted the “triangular setoff” of Barclays Bank’s obligations to AHMI under the swap agreement against amounts AHMI allegedly owed Barclays Capital under the repurchase agreement.
Following the commencement of AHMI’s chapter 11 case, Barclays invoked the triangular setoff provision and applied the surplus in collateral under the swap agreement—i.e., the excess collateral payable by Barclays Bank to AHMI—against the amounts allegedly owed by AHMI to Barclays Capital under the repurchase agreement.  The Plan Trustee for AHMI challenged the triangular setoff as impermissible under the Bankruptcy Code.  Barclays filed a motion to dismiss, arguing that the safe harbor provisions permitted triangular setoff and provided an exception to the mutuality requirement of section 553 of the Bankruptcy Code.
The Court’s Analysis: No Exception to Mutuality
Section 553 of the Bankruptcy Code requires “mutuality” between the debtor’s claim against the creditor and the debt owed the creditor.  For guidance on the definition of mutuality, Judge Sontchi turned to In re SemCrude, L.P.  The SemCrude court analyzed triangular setoff and held that “mutuality cannot be supplied by a multi-party agreement,” as section 553 speaks of a mutual debt “owing between a particular creditor and a particular debtor.”  Debts are mutual only if they are due to and from the same persons in the same capacities, and “each corporation is a separate entity from its sister corporations absent a piercing of the corporate veil.”  Adopting the reasoning in SemCrude, Judge Sontchi agreed that parties cannot contract around the mutuality requirement for the exercise of the right to setoff in bankruptcy.
The American Home Mortgage court then analyzed whether the safe harbor provisions exempt swap and repurchase agreements from the mutuality requirements.  Section 561 of the Bankruptcy Code provides, in pertinent part, that “[t]he exercise of any contractual right . . . to offset or net termination values, payment amounts, or other transfer obligations arising under or in connection with one or more . . . (5) swap agreements . . . shall not be stayed, avoided, or otherwise limited by operation of any provision of this title . . . .”
Judge Sontchi reviewed two decisions from the United States Bankruptcy Court for the Southern District of New York in the cases of In re Lehman Brothers Holdings Inc., 433 B.R. 101 (Bankr. S.D.N.Y. 2010) (“Lehman I”) and In re Lehman Brothers Inc., 458 B.R. 134 (Bankr. S.D.N.Y. 2010) (“Lehman II”).  In both cases, Judge Peck addressed the interplay between section 553 and the safe harbor provisions.  In Lehman I, the court found that the safe harbor provisions do not nullify the mutuality requirement of section 553(a) because such provisions “simply do not directly address the requirement of mutuality under section 553(a).”  Instead, the safe harbor provisions permit the exercise of the contractual right of setoff notwithstanding any provision of the Bankruptcy Code that could operate to stay, avoid or limit that right.  That right, however, must exist in the first place—where mutuality fails, such a right does not exist.  On appeal, the District Court for the Southern District of New York, expounding on the legislative history of the safe harbor provisions, affirmed.
In Lehman II, the court, addressing facts similar to those before Judge Sontchi, did not find any “contract exception” to the mutuality requirement, even within the safe harbor exceptions to the automatic stay.  “Because there is no mutuality,” the court stated, “[the creditor] has no right of offset, and nothing in section 561 of the Bankruptcy Code can be read to preserve or protect a right that does not otherwise exist.”
Judge Sontchi agreed and denied Barclays’ motion to dismiss, holding that the safe harbor exceptions to the automatic stay cannot be interpreted as implicitly removing the mutuality requirement for setoff.  Those provisions do not preserve or protect a setoff right “that does not exist.”  The court also concluded that the equitable distribution policies of the Bankruptcy Code support the mutuality requirement because otherwise, a handful of creditor-affiliates could contract around the Bankruptcy Code’s priority scheme.
American Home Mortgage joins several other courts in holding that a triangular setoff lacks the requisite mutuality under section 553 of the Bankruptcy Code.   Barclays moved for leave to appeal, so be sure to check back here for any developments.  In the meantime, the decision provides a warning to affiliates conducting business with a common counterparty:  even if the contracts—including securities contracts—explicitly provide for cross-affiliate setoffs, a court might render such triangular setoffs unenforceable in bankruptcy.  As they say, the feeling (or debts) must be mutual.
Weil represents Lehman Brothers Holdings Inc. in its chapter 11 case and litigated the triangular setoff issue in Lehman I.  Weil also represented the debtors in SemCrude and litigated the triangular setoff issue addressed in that decision.