In re SemCrude LP Reigning in Triangular Setoff and Preserving by benbenzhou


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In re SemCrude LP: Reigning in Triangular Setoff
and Preserving Creditor Equality
Written By:                                                                                                                   were “affiliates” as the term was used in
Pamela Foohey                                                                               About the Author                  the agreements.
U.S. Bankruptcy Court; Wilmington, Del.                                                                                           As of the petition date, Chevron
                                                                                  Pamela Foohey is law clerk to Hon.                                                                                                owed about $1.4 million to SemCrude,
                                                                                  Peter J. Walsh of the U.S. Bankruptcy

       etoff finds its historical roots in the                                                                                and Chevron was owed about $10.2
                                                                                  Court for the District of Delaware and
       Roman doctrine of compensation:                                                                                        million from SemFuel and about $3.3
                                                                                  also is a post-graduate research fellow
       the cancelling of cross debts. 1                                                                                       million from SemStream. In August
                                                                                  at Harvard Law School.
When employed by solvent parties,                                                                                             2008, Chevron filed a motion to obtain
setoff is efficient and logical: Setoff                                                                                       release from the automatic stay so it
                                                                                 68873, the court was presented with a        could effectuate a setoff of the amount
disposes of “the absurdity of making                                             series of these contracts and, in holding
A pay B when B owes A.”2 But when                                                                                             it owed to SemCrude against the amount
                                                                                 that a prepetition contract providing        owed to it by SemFuel and SemStream.
setoff is used by a creditor against                                             for triangular setoff does not fulfill
an insolvent debtor in bankruptcy,                                                                                            The debtors, the unsecured creditors’
                                                                                 §553’s mutuality requirement and that        committee, and numerous other
the priority scheme embodied in the                                              there is no “contractual exception” to
Bankruptcy Code is disturbed if that                                                                                          creditors filed objections to Chevron’s
                                                                                 the mutuality requirement, definitively      motion, arguing that the Bankruptcy
creditor is afforded a greater payout                                            disallowed triangular setoff.
than it otherwise would have received.                                                                                        Code does not permit parties to contract
                                                                                                                              around §553’s mutuality requirement.
Section 553 permits setoff in bankruptcy                                         Facts of In re SemCrude LP                   In response, Chevron asserted that
under certain circumstances: A creditor                                             SemGroup LP and certain of its
invoking setoff must be entitled to a right                                                                                   a valid, prepetition contract fulfills
                                                                                 subsidiaries filed for chapter 11 in July    §553’s mutuality requirement and/or
of setoff under applicable nonbankruptcy
law, and the debts being offset must be
mutual, prepetition debts.3 Recognizing
that in the context of bankruptcy, setoff                                          Feature
effectively creates a preference, courts
have long defined mutuality such                                                 2008. Before the bankruptcy filing,
that setoff is available only when the                                                                                        constitutes a permissible contracting
                                                                                 Chevron Products Company (Chevron),          around the requirement.
applicable debts “are due to and from                                            a division of Chevron USA Inc., entered
the same person in the same capacity.”4                                          into contracts for the purchase and/or       The Decision
    Following this logic, courts also                                            sale of various energy products with             The court’s ultimate decision that
have held that triangular setoff is                                              three subsidiaries of SemCrude LP            Chevron was not permitted to effect
impermissible and that setoff among                                              (SemCrude), SemFuel LP (SemFuel)             a setoff is separated into three parts:
a company’s related subsidiaries                                                 and SemStream LP (SemStream). Each           (1) examination of existing case law
constitutes triangular setoff.5                                                  relevant contract contained identical        addressing agreements that provide for
Nevertheless, companies with related                                             netting provisions that provided that        triangular setoff, (2) analysis of whether
subsidiaries often contract around the                                           “in the event either party fails to make a   a prepetition contract providing for
statutory triangular setoff ban, hoping                                          timely payment of monies due and owing       triangular setoff fulfills §553’s mutuality
courts will uphold their contracts. In In                                        to the other party, or in the event either   requirement and (3) analysis of whether
re SemCrude LP, Case No. 08-11525                                                party fails to make timely delivery of       there is a “contractual exception” to
(BLS), 2009 Bankr. LEXIS 21 (Bankr.                                              product or crude oil due and owing the       §553’s mutuality requirement.
D. Del. Jan. 9, 2009) and 2009 WL                                                other party, the other party may offset          As noted by the court, there is
1	 Stephen	L.	Sepinuck,	“The	Problems	With	Setoff:	A	Proposed	Legislative	       any deliveries or payments due under         case law that appears to recognize
   Solution,”	30	Wm. & Mary L. Rev.,	51,	51-52	(1988).
                                                                                 this or any other Agreement between          an exception to §553’s mutuality
2	 Studley v. Boylston Nat’l Bank, 229	U.S.	523,	528	(1913).
3	 See, e.g., In re Tarbuck, 318	B.R.	78,	81	(Bankr.	W.D.	Pa.	2004).             the parties and their affiliates.” Both      requirement based on an agreement
4	 In re Sentinel Prods. Corp., 192	B.R.	41,	45	(N.D.N.Y.	1996).	
5	 See, e.g., In re Garden Ridge Corp.,	 338	 B.R.	 627,	 633-34	 (Bankr.	 D.	   Chevron and the debtors acknowledged         among related entities such that
   Del.	2006)	(defining	“triangular	setoff”	as	“where	A	attempts	to	offset	      that SemCrude, SemFuel and SemStream         triangular setoff is permissible, but that
   an	obligation	owed	by	B	against	B’s	debt	to	C”).                                                                           case law is very weak. In re SemCrude

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LP, 2009 Bankr. LEXIS 21, at *12. For                                              divided into two mutually exclusive                                                  conforms with the intentions of the
example, the U.S. Bankruptcy Court                                                 questions: Whether private agreements                                                Code’s drafters.12
for the District of Delaware observed                                              can bestow mutuality on nonmutual                                                        The legislative history of §553,
in 2005 that “an express agreement                                                 debts and, if not, whether there is an                                               legislative documents produced in
between related entities may create                                                exception to the mutuality requirement.                                              accordance with earlier, unenacted
mutuality for setoff purposes,”6 citing,                                           As to whether nonmutual debts can                                                    versions of the bankruptcy reform act
among others, a 1988 decision of the                                               be transformed into mutual debts,                                                    of the 1970s and the 1898 Conference
U.S. Bankruptcy Court for the Western                                              prior case law is abundantly clear that                                              Report issued with the passage of the
District of Louisiana that stated,                                                 “mutuality” as used in §553 is to be                                                 Bankruptcy Act do not contain any
“[t]he narrow exception to the rule                                                construed narrowly and against the                                                   indication that Congress intended to
against three party, ‘triangular’ setoffs,                                         party requesting setoff. In re Bennett                                               allow parties to contract for mutuality
occurs where there is a formal agreement                                           Funding Group Inc., 212 B.R. 206, 212                                                or triangular setoff. 13 Other courts
by the debtor that two entities may                                                (2d Cir. BAP 1997). Following this case                                              examining the legislative history
aggregate debts owed to and from the                                               law as required, the court easily and                                                of §553 have noted that in enacting
debtor,”7 which in turn cited 5 Collier on                                         appropriately concluded that “mutuality                                              §553, “Congress recognized [that]
Bankruptcy §553.03[3][b][ii] (15th ed.                                             cannot be supplied by a multi-party                                                  setoffs work against both the goal of
rev. 2008), which cites that same 1988                                             agreement contemplating a triangular                                                 orderly reorganization and the fairness
decision and two other decisions for the                                           setoff.” 9 In arriving at this holding,                                              principle because they preserve
proposition that “[a] narrow exception                                             the court used Chevron’s contract with                                               serendipitous advantages accruing to
exists with respect to certain setoffs that                                        SemCrude to explain why mutuality was                                                creditors who happen to hold mutual
are contractually based.” However, all                                             lacking: Although Chevron may have                                                   obligations, thus disfavoring equally-
the cases that Collier and other relevant                                          had privity of contract with SemCrude,                                               deserving creditors and interrupting
cases cite lead back to a 1964 decision                                            it did not have a “right to collect”                                                 the debtor’s cash flow.” 14 Likewise,
from the Seventh Circuit that discussed                                            against SemCrude because SemCrude                                                    the legislative history of §553
contracting for triangular setoff, but                                             did not owe Chevron anything, which                                                  indicates that Congress considered
only referenced cases decided upon                                                 was necessary to supply Chevron with                                                 “whether setoff should be permitted
state law or the common law of equity                                              a debt “due to” it that would create                                                 or the right dispensed with in order
receivership, and that did not address the                                         mutuality as required by the detailed                                                to prevent the creditor asserting
more restrictive setoff provisions of the                                          language of §553.                                                                    the right to setoff from obtaining
Bankruptcy Act.8                                                                       As to whether there is an exception                                              a greater percentage of [her or]
    The court was correct to discard                                               to the mutuality requirement, the court                                              his claim than unsecured creditors
the seemingly relevant case law as                                                 relied wholly on tenants of statutory                                                generally,” but that Congress retained
unpersuasive: each case’s reference to                                             interpretation to find that there is no                                              setoff in order to encourage banks
a narrow exception to triangular setoff                                            “contractual exception” to §553’s                                                    to help debtors through bankruptcy
was essentially dicta, no court found                                              mutuality requirement: “Absent a                                                     and to avoid harming merchants. 15
that a formal agreement contracting                                                clear indication from the text of the                                                Though Congress may have opted to
around triangular setoff existed, and                                              Code that such an exception exists, the                                              include setoff in the Code, it gave no
no court concretely addressed the                                                  Court deems it improper to recognize                                                 indication that such inclusion should
alleged exception; a close reading of                                              one. To do so would run counter to                                                   be interpreted as Congress’ blessing
the underlying decision which each                                                 the great weight of authority holding                                                of parties contracting around the plain
case traces reveals that the underlying                                            that there is no reason for enlarging                                                and explicit language of §553. This
decision was based on facts easily                                                 the right of setoff beyond that allowed                                              is likely because allowing parties to
distinguished from a case solidly                                                  i n t h e C o d e . ” 10 W h e n a s t a t u t e ’ s                                 do so would contravene the broader
implicating §553. Indeed, based on                                                 language is plain, a court’s function                                                policies of the Code that Congress
policy considerations, which are                                                   is to enforce that plain language. 11                                                also expounded on in the Code’s
discussed in detail below, it is unlikely                                          Section 553(a) provides that the                                                     legislative history.
that a court fully analyzing the effect of                                         Code “does not affect any right of a
the agreements purporting to contract                                              creditor to offset a mutual debt owing                                               Policy Behind the Decision
around §553’s mutuality requirement                                                by such creditor to the debtor that                                                       The U.S. Bankruptcy Court for
would arrive at the conclusion                                                     arose before the commencement of the                                                 the District of Delaware spent little
espoused by Chevron. Moreover,                                                     [bankruptcy] case...against a claim of                                               time discussing how its decision
as evident by the court’s in-depth                                                 such creditor against the debtor that                                                comported with the guiding principles
analysis, policy considerations only                                               arose before the commencement of the                                                 fundamental to the Bankruptcy Code.
serve to bolster the court’s ultimate                                              case.” 11 U.S.C. §553. It is difficult to                                            Nevertheless, the policy considerations
holding, which can be arrived at based                                             read any ambiguity into that language                                                underlying its decisions are readily
on prior case law discussing §553 and                                              and, although not discussed by the                                                   a p p a r e n t i n t h e f i n a l substantive
tenants of statutory interpretation.                                               court because the language of §553                                                   12	 See id. at	 242	 (“The	 plain	 meaning	 of	 legislation	 should	 be	 conclusive,	
    Thus, the court was faced with a                                               and the case law surrounding the                                                         except	in	the	‘rare	cases	[in	which]	the	literal	application	of	a	statute	will	
                                                                                                                                                                            produce	a	result	demonstrably	at	odds	with	the	intentions	of	its	drafters’”	
question of first impression, which it                                             mutuality requirement is so clear, a                                                     (quoting	Griffin v. Oceanic Contractors Inc.,	458	U.S.	564,	571	(1982)).
                                                                                                                                                                        13	 See	H.R.	Rep.	No.	95-595	(1st	Sess.	1977);	Report of the Commission
6	 In re Garden Ridge Corp., 338	B.R.	at	634	(emphasis	added).
                                                                                   literal application of the language                                                      on the Bankruptcy Laws of the United States,	 H.R.	 Doc.	 No.	 137	 (1st	
7	 In re Hill Petroleum Co., 95	B.R.	404,	411	(Bankr.	W.D.	La.	1988).              9	 In re SemCrude LP, 2009	Bankr.	LEXIS	21,	at	*21.                                      Sess.	1973);	S.	Doc.	No.	55-294	(2d	Sess.	1898)	(Conf.	Rep.).
8	 In re Berger Steel Co., 327	 F.2d	 401	 (7th	 Cir.	 1964).	 For	 a	 complete	   10	 Id.	 at	 *28	 (quoting	 In re NWFX Inc.,	 864	 F.2d	 593,	 595-96	 (8th	 Cir.	   14	 Public Serv. Co. of New Hampshire v. New Hampshire Elec. Coop., 884	
   listing	of	the	relevant	cases,	see In re SemCrude LP,	2009	Bankr.	LEXIS	            1989))	(internal	quotations	omitted).                                                F.2d	11,	13	(1st	Cir.	1989).
   21,	at	*13-15.                                                                  11	 U.S. v. Ron Pair Enters. Inc., 489	U.S.	235,	241	(1989).                         15	 See H.R.	Rep.	No.	95-595,	at	184	(1st	Sess.	1977).

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paragraph of its decision: “[T]he                                               to contract around preference liability                                                 the bankruptcy process. Other courts
Court’s holding also is consistent                                              or the automatic stay 18 because these                                                  presented with parties attempting
with...the broader policies of the Code.                                        arrangements could result in disastrous                                                 to contract around §553’s mutuality
One of the primary to ensure                                         consequences for the debtor’s estate                                                    requirement would be wise to follow
that similarly-situated creditors are                                           and the debtor’s creditors: A single                                                    its holding. n
treated fairly and enjoy an equality                                            creditor contracting around these                                                       Reprinted with permission from the ABI
of distribution from a debtor absent a                                          protections could wipe out the debtor’s                                                 Journal, Vol. XXVIII, No. 2, March 2009.
compelling reason to depart from this                                           estate, leaving little or nothing for the
principle.” 16 Whenever one creditor                                            debtor’s other creditors. This is the                                                   The American Bankruptcy Institute is a
is afforded priority in payment over                                            policy that the court recognized and                                                    multi-disciplinary, nonpartisan organization
other creditors, those other creditors’                                         promoted by holding that there is no                                                    devoted to bankruptcy issues. ABI has
recovery from the insolvent debtor is                                           “contractual exception” to §553’s                                                       more than 12,500 members, representing
diminished. That is what setoff does:                                           mutuality requirement.                                                                  all facets of the insolvency field. For more
It prefers one creditor over other                                                                                                                                      information, visit ABI World at www.
creditors. In this way, it can be likened                                       SemCrude LP’s Implications                                                    
to granting the creditor a security                                                 Companies that have relied on
interest, thereby allowing that creditor                                        contracts providing for triangular setoff
to collect on claims that otherwise                                             will undoubtedly be dismayed by In re
would be subordinated. This is exactly                                          SemCrude LP. However, the decision
the concern Congress articulated when                                           was far from unpredictable: If the court
it was deciding whether to retain setoff                                        held that debtors could contract around
in bankruptcy and, if it was kept, how                                          §553’s mutuality requirement, that
to limit it. Indeed, commentators at the                                        decision would be clearly contrary to
time of the Code’s enactment noted                                              the precise text of §553 that, tellingly,
that “[t]he extent that setoff is treated                                       is written in greater detail than other
as a preference represents somewhat                                             sections of the Code, and that decision
of a compromise between the views of                                            would upset the Code’s goal of treating
those who favored treating it entirely                                          similarly-situated creditors equally.
as a preferential transfer and those                                            Moreover, before the Code’s enactment,
who favored the present law [the                                                courts were slowly curtailing setoff under
Bankruptcy Act] which generally                                                 §553’s less-restrictive counterpart in the
permits setoff.”17                                                              Bankruptcy Act; 19 combined with the
     When setoff is scrutinized in                                              enactment of a stricter setoff provision,
terms of the preference it produces                                             companies should have understood that
among creditors who dealt with a now                                            they were taking a risk in relying on
insolvent debtor, §553’s mutuality                                              contracts providing for triangular setoff.
requirement emerges as akin to                                                  Disgruntled companies may complain
preference liability, the automatic stay                                        that In re SemCrude LP prevents
and other Code-specific limitations,                                            them from taking advantage of what
rules and remedies put in place to                                              essentially is secured credit, but they
ensure that one creditor does not                                               will adapt to this development, perhaps
unfairly obtain payment ahead of other                                          demanding earlier payment, insisting
creditors. The mutuality requirement                                            on consensual security more often or
guarantees that the preference                                                  finding other ways to work with parties
afforded by setoff is circumscribed                                             they fear may be in financial distress.
to certain narrow circumstances                                                 Overall, the court appropriately placed
that Congress believed needed to                                                the needs of unsecured creditors who
be preserved. Essentially, §553’s                                               likely are unable to organize to voice
mutuality requirement is designed to                                            how a “contractual exception” to the
protect creditors. Although setoff has                                          mutuality requirement would severely
its roots in mutual obligations between                                         disadvantage them before the concerns
a debtor and a creditor, and has been                                           of companies currently contracting
carried forward into bankruptcy,                                                around §553.
recognizing that in some instances it                                               In re SemCrude LP is a well-
may disrupt creditor priority without                                           reasoned decision soundly grounded
creating an adequate counter-benefit,                                           in policy that recognizes that creditors
setoff is limited by the Code. It makes                                         should be afforded protections during
little sense to allow a debtor to simply                                        18	 The	overwhelming	majority	of	courts	refuse	to	enforce	prepetition	agreements	
contract around a mechanism designed                                                waiving	 the	 automatic	 stay	 in	 the	 event	 of	 bankruptcy.	 See, e.g., Ostano
                                                                                    Commerzanstalt v. Telewide Sys. Inc.,	790	F.2d	206,	207	(2d	Cir.	1986);	Assn’n
to protect that debtor’s creditors, just                                            of St. Croix Condo. Owners v. St. Croix Hotel Corp., 682	F.2d	446,	448	(3d	Cir.	
as it makes little sense to allow parties                                           1982).	But see In re Club Tower LP, 138	B.R.	307	(Bankr.	N.D.	Ga.	1991).	
                                                                                19	 See	note,	“Inequality	or	Equality	Among	Creditors?	The	Second	Circuit	
16	 In re SemCrude LP,	2009	Bankr.	LEXIS	21,	at	*29.                                Preserves	 the	 Right	 to	 Setoff:	 In re Applied Logic Corp.,”	 11	 Conn. L.
17	 James	 F.	 Queenan	 Jr.,	 “The	 Preference	 Provisions	 of	 the	 Pending	       Rev.	601	(1978-1979).
   Banking	Law,”	82	Com. L. J.	465,	472	(1977).

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