Permissibility of Triangular Setoff via Pre-Petition Agreement

The Bankruptcy Code, under § 553, expressly preserves a creditor’s pre-petition right to setoff of mutual debt with the debtor. However, courts have consistently rejected the permissibility of triangular setoff under § 553. Courts premise this prohibition of triangular setoff on section 553’s use of the term “mutual debt.” Courts have rationalized that because triangular setoff does not contemplate setoff of debts that are held between the same parties, triangular setoff lacks the mutuality of debts that § 553 requires. The permissibility of triangular setoff in bankruptcy has become uncertain, though, when a creditor asserts a right to triangular setoff pursuant to a pre-petition contract. The issue has arisen whether a pre-petition contract allows parties to bypass the mutuality required by § 553. 

Recently, in In re SemCrude LP, [1] a bankruptcy court held that the Code did not permit triangular setoff of debts between a creditor and debtors, notwithstanding a pre-petition contract among those parties that contemplated such an exchange. In holding that no contract exception existed that permitted triangular setoff in bankruptcy, the court dismissed years of case law that recognized the existence of such an exception.

Setoff and § 553
The concept of setoff in general applies when parties are mutually indebted to one another. [2] Derived from principles of equity and practical logic, setoff “allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding ‘the absurdity of making A pay B when B owes A.’” [3] Thus, setoff allows parties “to apply one debt in satisfaction of the other.” [4] The Code recognizes setoff under § 553, [5] which states that:

Except as otherwise provided in this section and in sections 362 and 363 of this title, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case. [6]

Section 553 does not create an independent right to setoff. Rather, it preserves a creditor’s pre-existing setoff rights under applicable non-bankruptcy law. [7] Furthermore, for setoff under § 553, the Code requires that the debts between creditors and debtors be mutual, and that the debts existed pre-petition. [8] 

While the Code requires mutuality of debts for setoff, it does not define mutuality. [9] Authorities have interpreted debts to be mutual only where the debts exist between the same parties. [10] Thus, “the threshold requirement of mutuality is that the relevant claim and debt exist between the ‘same parties,’ meaning simply enough that, whereas A and B may offset their mutual obligations, A may not offset an obligation that it owes B against a debt that B owes C.” [11]

Triangular setoff, by its nature, does not contemplate the mutuality requirement that debts be due to and from the same parties. [12] “In general, a triangular setoff arises if A attempts to offset an obligation owed by B against B’s debt to C.” [13] Therefore, triangular setoff involves offsetting a debt against an obligation owed to or from a third party. Because triangular setoff applies obligations related to non-parties to a transaction, courts have found that the structure of triangular setoff lacks mutuality because the offset debts are not owed between the same parties. [14]

Despite courts holding that triangular setoff lacks the mutuality required by § 553, authorities have recognized a contract exception that permits triangular setoff in bankruptcy. [15] This exception allows a creditor to assert, against its mutual obligations to a debtor, offset of the obligations of a third party, if all three parties executed a pre-petition agreement permitting triangular setoff of their debts. [16] Therefore, this contract exception permits a creditor to bypass the mutuality requirement for setoff under § 553 and to assert triangular setoff.

Judicial Recognition of a Contract Exception
In Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.), [17] the court first addressed a contract exception that permitted triangular setoff under federal bankruptcy law. [18] In this case, a parent company sold steel to the debtor, and the debtor manufactured merchandise that it sold to the parent’s wholly-owned subsidiary. [19] After the debtor filed for bankruptcy, the parent attempted to affect a triangular setoff by receiving the subsidiary’s debt owed to the debtor in consideration of the debtor’s debt owed to the parent. [20] The parent argued that the three parties had orally agreed to such a setoff to induce the parent to extend credit to the debtor. [21] This agreement, the parent argued, permitted setoff under § 68 of the Bankruptcy Act of 1898 (§ 553’s predecessor). [22] The Seventh Circuit rejected the parent’s argument and upheld the findings by the referee in bankruptcy, as affirmed by the district court, that no oral agreement existed. [23]

After affirming the referee’s findings, the Seventh Circuit examined cases that the parent provided to support its argument that parties may affect triangular setoff in bankruptcy pursuant to a pre-petition agreement. [24] None of these cases, however, were decided under the Bankruptcy Act, so that these cases did not address triangular setoff under § 68. [25] Furthermore, the Seventh Circuit only concluded that “none of these cases correspond in factual situation to the case before us.” [26] Thus, while the court considered a contract exception, it did not hold or opine on the exception’s legality under the Bankruptcy Act. 

Though the Seventh Circuit did not rule on the existence of a contract exception, courts began citing Berger Steel for the proposition that creditors could use pre-petition agreements to circumvent the mutuality requirement for setoff under bankruptcy law. [27] The result has been three decades of bankruptcy cases that have recognized a contract exception by either citing Berger Steel or citing cases that relied on Berger Steel. [28] These bankruptcy cases have followed the pattern of citing precedent for a contract exception, while finding the contract exception to be inapplicable to the facts of the cases. [29] Thus, while a chain of authorities has developed that recognizes the existence of a contract exception, none of these cases has actually applied a contract exception in its holding.    

SemCrude LP Rejects a Contract Exception
In In re SemCrude LP, the U.S. Bankruptcy Court for the District of Delaware expressly held that the Code does not permit triangular setoff of debts, notwithstanding pre-petition contracts among parties that contemplate such an exchange. [30] The creditor, Chevron Products Company, had entered into separate petroleum-related contracts with three affiliated debtors: SemCrude LP, SemFuel LP and SemStream LP [31] Each contract contained netting provisions that expressly allowed the parties to offset debts related to the contract or to any other contract between the parties and their affiliates. [32] At the time of the debtors’ bankruptcy filings, Chevron owed a debt to SemCrude LP and was owed a debt from SemFuel LP and SemStream LP. [33] Chevron argued that the terms of the pre-petition contracts permitted triangular setoff of the debts, because those terms either permissibly contracted around the mutuality requirement via a contract exception or created the required mutuality for setoff under § 553. [34] The court, however, held that no contract exception existed that would permit the setoff and that the contract arrangement did not satisfy § 553’s mutuality requirement. [35]

The SemCrude court reached its holding in three analytical stages In the first stage, the court addressed whether case law supported the existence of a contract exception and noted that bankruptcy cases have recognized an exception to the mutuality requirement, when in pre-petition agreements parties have contracted for triangular setoff. [36] The court then traced the chain of authorities recognizing the existence of a contract exception back to Berger Steel. [37] The court observed that the Berger Steel court cited cases that were decided under state law or common law of receivership (i.e., not under the Bankruptcy Act of 1898 or the Code), and that Berger Steel itself did not rule on the issue of a contract exception. [38] The SemCrude court noted, however, that subsequent courts read the Berger Steel opinion as recognizing a contract exception to the “strict” mutuality requirement under bankruptcy law. [39] The court in SemCrude further observed that none of the subsequent courts actually permitted triangular setoff via a contract exception, nor did any of those courts address the merits of an exception. [40] Therefore, the court concluded that no “controlling or persuasive published case law” existed on the issue of a contract exception. [41]

In the second stage of analysis, the court addressed whether a pre-petition contract may create mutuality between parties that lack mutual debt. The court began its analysis by examining the meaning of the term “mutual debt” in § 553. [43] The court accepted bankruptcy courts’ interpretations that debts are mutual only when the debts are due to and from the same parties.
After examining the meaning of mutuality, the court concluded that multi-party agreements permitting triangular setoff rights could not supply mutuality. [44] The court distinguished a right to collect a debt from a right to triangular setoff of a debt. [45] When a party seeks to enforce a contractual right to triangular setoff of a debt that it has no contractual right to collect, the debt cannot be mutual because there is a lack of indebtedness to that party enforcing the triangular setoff. [46] The court concluded that while agreements contemplating triangular setoff may place parties like Chevron and the relevant debtors in privity of contract, such agreements lack the mutuality required under § 553 to effect a setoff. [47]

In the third stage of analysis, the court addressed whether the language of § 553 permits a contract exception to its mutuality requirement. [48] The court succinctly examined the language of § 553(a) and held that its plain language does not permit a contract exception. [49] The court stated that “absent a clear indication from the text of the Code that an exception exists,” it would be “improper” for the court to acknowledge one, [50] and noted that a “great weight of authority” opposed the enlarging of setoff rights beyond what the Code allows. [51] The court concluded that its holding was consistent with the Code’s goals of fair treatment of similarly-situated creditors and equitable distribution from a debtor. [52]

Potential Impact of In re SemCrude LP
Not only did the SemCrude holding contradict three decades of bankruptcy opinions regarding the existence of a contract exception, it also expressly rejected the authority of those opinions. Similar to the SemCrude court, courts that recognized a contract exception determined that triangular setoffs lacked the mutuality required by § 553. [53] However, the SemCrude court distinguished itself by not assuming the validity of a contract exception. Rather, it expressly analyzed the issue of a contract exception and ruled against the merits of a purported rule of bankruptcy law.

While the SemCrude holding diverges significantly from how courts previously treated the issue, the case’s impact depends on whether its case law discussion persuades other courts. Because a district court decided SemCrude, the holding, of course, is not controlling. Therefore, courts addressing a contract exception for triangular setoff under § 553 will need to balance the persuasiveness of years of case law against the persuasiveness of the court’s analysis and rationale in SemCrude. At the very least, after SemCrude, parties should be wary of relying on a contract exception to argue that a prepetition agreement allowing triangular setoff should apply in bankruptcy.

Conclusion
Before SemCrude, a strand of authorities recognized a contract exception to the mutuality requirement for setoff under the Code, suggesting that creditors could affect triangular setoffs. However, after SemCrude expressly addressed and discarded these authorities, the permissibility of triangular setoff under the Code has become uncertain.