Triangular Setoff Barred (Again) in Delaware

The bankruptcy courts in New York and Delaware agree: For lack of “mutuality,” a so-called triangular setoff is not permissible under Section 553(a).

A parent company had a contract where the debtor owed the parent about $9 million on the filing date. A subsidiary of the parent had a separate contract where the subsidiary owed the debtor about $6 million on the filing date.

Giving rise to a triangular setoff, the contracts contained a provision allowing the parent to set off any debt the debtor might owe to the subsidiary against anything the parent might owe to the debtor. The contract was governed by California law.

Because the contractual, triangular right of setoff was enforceable under California law, the parent filed a motion asking Bankruptcy Judge Kevin Gross of Delaware to enforce the triangular setoff under Section 553(a). The section provides that nothing in the Bankruptcy Code affects “any right of a creditor to offset a mutual debt owing by such creditor . . . against a claim of such creditor against the debtor . . . .” The statute also requires that the mutual debts and credits must both have arisen before bankruptcy.

As Judge Gross said in his Nov. 13 opinion, Section 553 does not create a federal right of setoff. The statute, he said, “merely recognizes such a party’s right under state law.” In substance, Judge Gross found two requirements in the statute: The party asserting the setoff must be a “creditor,” and the debts and credits must be “mutual.” Concededly, the parent was a creditor.

Citing Butner v. U.S., 440 U.S. 48 (1979), the creditor argued that the bankruptcy court must uphold a triangular right of setoff recognized under state law. According to Judge Gross, Butner held “that state law rights are respected in bankruptcy absent a contrary bankruptcy rule or policy.” Id. at 55. [Emphasis added.]

Presaging his conclusion, Judge Gross quoted Bankruptcy Judge Brendan L. Shannon of Delaware for the proposition that “mutuality is strictly construed against the party seeking setoff.” In re SemCrude LP, 399 B.R. 388, 396 (Bankr. D. Del. 2009). He also said that “federal courts have found to a fare-thee-well that debts are ‘mutual’ only when they are due to and from the same person in the same capacity,’” citing the Second Circuit.

Judge Gross said that SemCrude and a New York bankruptcy court’s decision in the liquidation of Lehman Brothers Inc. represented “fatal contrary bankruptcy precedent.” For instance, Judge Shannon had held in SemCrude that “courts have routinely held that triangular setoffs are impermissible in bankruptcy.” Id. at 393. SemCrude was upheld in district court. In re SemCrude LP, 428 B.R. 590 (D. Del. 2010).

Undeterred, the creditor contended there was no “federal interest” to override state law. Disagreeing, Judge Gross said that a “contractual exception to mutuality would be incongruent with the express provision of Section 553(a).” Alluding to the “plain language” of Section 553(a), he therefore “refus[ed] to read a contractual exception to strict mutuality allowing for triangular setoff in the face of contrary bankruptcy precedent and policy.”

Admittedly aware of contrary precedent and suggesting there will be an appeal, the creditor argued that SemCrude and other authorities like Lehman were incorrectly decided under Supreme Court authority.