Setoff Agreement

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                                                                                                                       Bruce Nathan, Esq.

                              Triangular Setoff: A Viable
                              Remedy or a Thing of the Past?

                           A        trade creditor that sells goods or provides ser-
                                    vices on credit terms to a financially distressed
                              customer risks an uncollectable unsecured claim in the                     id
                                                                                                               NACM’s 113th
                                                                                                                                   Bruce will be speaking
                                                                                                                                   on these topics:
                                                                                                                                   17041. Practical Bankruptcy

                              event of the customer’s bankruptcy filing. However, the

                                                                                                 ndo, Flo
                                                                                                       Credit Congress                    Knowledge for Survival
                              creditor could enhance its recovery prospects when the                       & Expo                         in Today’s Troubled

                              creditor and customer do business and have mutual                                                           Economic Climate
                              claims against each other that are subject to setoff.
                                                                                                                                   17057. Hot and Emerging
                                                                                                                                          Legal Issues
                              Setoff rights serve as valuable security for payment of a
                              trade claim. For instance, suppose a trade creditor sold                                             17068. Creditors’ Rights Forum
                              goods to a financially distressed customer and is owed
                              $100,000. At the same time, the customer sold goods to
                              the creditor and is also owed $100,000. The customer
                              then files for bankruptcy. The creditor can exercise its       L.P., the United States Bankruptcy Court in Delaware
                              setoff rights, subject to obtaining relief from the auto-      rejected the applicability of triangular setoff, despite the
                              matic stay, by applying its claim against the customer on      existence of a pre-petition agreement among the credi-
                              a dollar-for-dollar basis in reduction of the creditor’s       tor, debtor and debtor’s affiliates that permitted the
                              obligation to the customer. That enables the creditor to       creditor to set off its claims against two debtor affiliates
                              obtain a full recovery of its claim against the customer.      in reduction of the creditor’s obligation to a third debt-
                                                                                             or affiliate. And, in In Garden Ridge Corporation, the
                              Now let us take this hypothetical one step further. Sup-       United States District Court in Delaware also rejected a
                              pose the creditor had sold $100,000 of goods to a finan-       creditor’s invocation of triangular setoff rights, despite
                              cially distressed customer and purchased $100,000 of           the prior substantive consolidation of the affiliated
                              goods from that customer’s affiliate. This is known as         debtors’ bankruptcy estates.
                              triangular setoff. Does the creditor have the same setoff
                              rights to apply its claim against the customer in reduc-       So what can we make of these developments?
                              tion of the creditor’s obligations to the customer’s affili-
                              ate? The problem with the creditor’s enforcing its trian-      A Quick Synopsis of Setoff Rights
                              gular setoff rights is that one of the prerequisites for       Setoff is an equitable state law remedy that allows enti-
                                                                                             ties owing money to each other to cancel out or apply
                                                                                             their mutual debts against each other. The debts could
     Two recent decisions have thrown cold                                                   arise under either the same or different contracts. This
                                                                                             avoids the absurd and unfair result of making A pay B
     water on a creditor’s ability to exercise                                               when B owes A. It would be unfair to force a trade cred-
     triangular setoff rights.                                                               itor to pay the full amount of its indebtedness to an
                                                                                             insolvent debtor while receiving payment of only a frac-
                                                                                             tion of its offsetting claim against the debtor.
                              setoff, a mutuality of obligations between the parties to
                              the setoff, is lacking between the creditor and debtor’s       Section 553 of the Bankruptcy Code does not create set-
                              affiliate. But could the creditor create mutual obliga-        off rights, but instead preserves state law setoff rights,
                              tions with the debtor’s affiliate by the creditor, debtor      subject to certain limitations. A creditor seeking to assert
                              and its affiliate entering into a setoff agreement that        setoff rights against a debtor in bankruptcy must satisfy
                              permits a netting of obligations among the companies?          the following requirements: (a) the creditor must hold a
                              Or does the substantive consolidation of the bankrupt-         pre-petition claim against the debtor; (b) the creditor
                              cy cases of the debtor affiliates create mutuality?            must owe indebtedness to the debtor that arose pre-peti-
                                                                                             tion; (c) the creditor’s claim against and indebtedness to
                              Well, in some bad news for trade creditors, two recent         the debtor must be mutual; (d) the creditor’s claim
                              decisions have thrown cold water on a creditor’s ability       against and indebtedness to the debtor must each be
                              to exercise triangular setoff rights. In In re SemCrude,       valid and enforceable; and (e) the creditor must obtain

14   Business Credit April 2009
bankruptcy court approval for relief from the automatic stay         its product lines were limited to propane and other natural
to permit the creditor’s exercise of setoff rights.1                 gas products. Other affiliates engaged in similar transactions
                                                                     with different energy products and/or in different markets.
A triangular setoff takes place when A offsets an obligation to
B against the indebtedness of B’s affiliate’s, C, to A. The issue
with triangular setoff is whether it satisfies Section 553’s mutu-                 The issue with triangular setoff is
ality requirement. SemCrude addressed whether a creditor can
create mutuality by entering into a setoff agreement with the                      whether it satisfies Section 553’s
debtor and its affiliate. Garden Ridge addressed whether mutu-
ality can arise as a result of the substantive consolidation of
                                                                                             mutuality requirement.
affiliated debtors’ bankruptcy estates. The courts held that
mutuality did not arise in either circumstance.                      Chevron Products Company, a division of Chevron USA, Inc.
                                                                     (“Chevron”) entered into contracts with SemCrude, SemFuel
In Re SemCrude, L.P.                                                 and SemStream for the sale and purchase of crude oil, regular
SemGroup, L.P. and certain of its direct and indirect subsid-        unleaded gasoline and/or butane, isobutene and propane
iaries, including SemCrude, L.P., SemFuel, L.P. and Sem-             respectively. Chevron’s contracts with each of these compa-
Stream, L.P., provided goods and services to the energy indus-       nies included terms and conditions with the following identi-
try. Each company engaged in a separate line of business with        cal netting provisions:
its own distinct products and functions. For instance, Sem-
Crude gathered, transported, stored, branded, marketed and           “ the event either party fails to make a timely payment of
distributed crude oil in the United States to refineries and         monies due and owing to the other party, or in the event
other resellers in various types of sale and exchange transac-       either party fails to make timely delivery of product or crude
tions. SemFuel’s business focused on the transportation and          oil due and owing to the other party, the other party may off-
distribution of refined petroleum products like gasoline and         set any deliveries or payments due under this or any other
kerosene. SemStream was engaged in a similar business, but           Agreement between the parties and their affiliates.”

                                                                                                                      Business Credit April 2009   15
                The terms and conditions defined “affiliate” as “a corporation         The court then addressed two questions. First, can debts
                controlling, controlled by or under common control with                among different parties be considered mutual where the par-
                either party.” There was no dispute that SemCrude, SemFuel             ties’ contract permitted a setoff of all claims among the par-
                and SemStream were affiliates of each other.                           ties? Assuming a negative answer to the prior question, the
                                                                                       court then considered whether there is a contractual excep-
                Chevron and SemCrude, SemFuel and SemStream entered                    tion to Section 553’s debt mutuality requirement.
                into several transactions governed by these contracts. On July
                22, 2008 (the “Petition Date”), SemGroup and certain of their          A Setoff Agreement Concerning Non-Mutual
                subsidiaries, including SemCrude, SemFuel and SemStream,               Debts Does Not Create Mutuality
                filed Chapter 11 petitions with the United States Bankruptcy           The court first found no mutuality of obligations where the
                Court for the District of Delaware. On the Petition Date,              parties had entered into a multi-party agreement that allowed
                Chevron owed a balance of approximately $1.4 million to                for setoff of their non-mutual debts. In SemCrude, Chevron
                SemCrude but was owed approximately $10.2 million by                   had no claim against, or right to payment from, SemCrude,
                SemFuel and $3.3 million by SemStream.                                 despite the provisions in Chevron’s contracts with SemCrude,
                                                                                       SemFuel and SemStream that allowed Chevron to offset its
                                                                                       indebtedness to Chevron against Chevron’s claims against
     The court ruled that Section 553                                                  affiliates, SemFuel and SemStream. At most, Chevron had the
     prohibits triangular setoff because of the                                        right to pay less to SemCrude than Chevron would have oth-
                                                                                       erwise had to pay to the extent Chevron exercised its triangu-
     absence of mutual pre-petition debts                                              lar setoff rights through its claims against SemFuel and Sem-
                                                                                       Stream. The court concluded that this right did not create the
     between the parties to the setoff.                                                debt mutuality for setoff required by Section 553.

                                                                                       The court went as far as to question, but not decide, whether
                Chevron moved for relief from the automatic stay in the
                                                                                       triangular setoff would have been appropriate if SemCrude
                Bankruptcy Court to permit Chevron to exercise triangular
                                                                                       had guaranteed the payment of SemFuel’s or SemStream’s
                setoff by offsetting the amounts it owed SemCrude against the
                                                                                       indebtedness to Chevron. The court noted the division of
                amounts SemFuel and SemStream owed Chevron. Chevron
                                                                                       authority concerning whether an unpaid guaranty can create
                argued that its contracts with SemCrude, SemFuel and Sem-
                                                                                       the mutuality necessary for setoff under Section 553. This
                Stream authorized Chevron’s exercise of triangular setoff
                                                                                       issue was left for another day because SemCrude had not
                rights by allowing a netting of Chevron’s claim against Sem-
                                                                                       guaranteed payment of the obligations of SemFuel and Sem-
                Crude against Chevron’s indebtedness to SemCrude’s affili-
                                                                                       Stream to Chevron.
                ates, SemFuel and SemStream. SemCrude, SemFuel, Sem-
                Stream and other parties objected to the triangular setoff
                                                                                       The court also noted that Section 553 does not authorize tri-
                sought by Chevron. They argued that Chevron’s attempted
                triangular setoff violated Bankruptcy Code Section 553’s debt          angular setoff. Section 553 recognizes a creditor’s right to off-
                mutuality requirement because of an absence of mutual obli-            set a mutual pre-petition debt owing by the creditor to the
                gations between Chevron and SemCrude.                                  debtor against such creditor’s pre-petition claim against that
                                                                                       same debtor. Chevron sought something different, which Sec-
                The Bankruptcy Court rejected Chevron’s exercise of triangu-           tion 553 does not permit: triangular setoff of its pre-petition
                lar setoff rights, denying Chevron’s lift stay motion. The court       indebtedness to SemCrude in reduction of Chevron’s claims
                ruled that Section 553 prohibits triangular setoff because of          against SemFuel and SemStream. Chevron had no right to
                the absence of mutual pre-petition debts between the parties           payment from and, therefore, no claim against SemCrude. As
                to the setoff, Chevron and SemCrude. Mutual debts are due              a result, there was no mutuality of debts between Chevron
                to and from the same persons acting in the same capacity.              and SemCrude to justify setoff in these circumstances.
                That would ordinarily preclude a creditor from offsetting a
                debt it owes to one debtor against the sums owed to it by an           No Contractual Exception to the Mutual
                affiliated debtor.                                                     Debts Requirement of Section 553
                                                                                       The court also ruled that there is no contractual exception to
                The court rejected Chevron’s argument that a valid pre-peti-           Section 553’s mutual debt requirement for setoff. First, the
                tion multi-party setoff agreement, allowing triangular setoff          court noted that Section 553 contains no such exception. Any
                through a netting of the parties’ claims, either satisfies, or is an   contractual exception to the mutual debt requirement for set-
                exception to, the mutuality requirement for setoff. The court          off would also be contrary to the Bankruptcy Code’s goal of
                distinguished numerous prior court decisions cited by Chev-            equitable distribution of estate assets. That would grant the
                ron in support of its triangular setoff rights because none of         creditor exercising triangular setoff rights favorable treatment
                them upheld or enforced an agreement that allowed triangu-             at the expense of, by reducing the distribution to, the debtor’s
                lar setoff.                                                            other creditors.

16   Business Credit April 2009
In Garden Ridge Corporation                                        the severance and relocation expenses that Ferguson had
Garden Ridge Corporation, and affiliated companies, (collec-       claimed against GRP and Ferguson’s obligations to GRLP
tively “Garden Ridge”) was a home decor retailer with 35           under the Note. Specifically, the court held that mutuality did
stores in 13 states throughout the South, Midwest and Atlan-       not arise as a result of the substantive consolidation of the
tic regions of the United States. Garden Ridge Management,         GRM and GRLP bankruptcy estates.
Inc. (“GRM”), one of the Garden Ridge entities, was a man-
agement services company that employed all of the staff and
management utilized in Garden Ridge’s stores. Garden Ridge,
L.P. (“GRLP”), another Garden Ridge company, operated all
                                                                            Any contractual exception to the
the Garden Ridge stores and paid a fee to GRM for the use of               mutual debt requirement for setoff
GRM’s employees in the stores.
                                                                                would also be contrary to the
Daniel Ferguson was a Senior Vice President of Supply Chain
for GRM. Ferguson had entered into an employment agree-
                                                                          Bankruptcy Code’s goal of equitable
ment with GRM on January 28, 2001. Ferguson was entitled                         distribution of estate assets.
to payment of (1) one year’s base salary of $250,000 as sever-
ance in the event of his termination without cause and (2)
certain relocation costs in conjunction with Ferguson’s move       Ferguson appealed the Bankruptcy Court’s order. Ferguson
to Houston. Ferguson’s paychecks and W-2 forms listed GRM          argued for triangular setoff because the substantive consoli-
as Ferguson’s employer.                                            dation of the GRP and GRLP bankruptcy estates created the
                                                                   necessary mutuality of obligations. Ferguson also contended
On January 31, 2003, Ferguson executed a promissory note, in       that he had satisfied the mutuality requirement because all of
the principal amount of $250,000, in favor of GRLP (the            the Garden Ridge entities, including GRP and GRLP, should
“Note”) as a result of a delay in the sale of Ferguson’s home in   have been treated as a single entity for purposes of setoff.
Michigan. The Note became due and payable upon the earlier
of (a) 30 days after the closing of the sale of Ferguson’s Mich-   The United States District Court in Delaware upheld the
igan home; (b) the date of Ferguson’s termination of employ-       Bankruptcy Court’s rejection of Ferguson’s exercise of trian-
ment with GRM and (c) December 31, 2003.                           gular setoff. First, the District Court concluded that there was

Ferguson’s employment with GRM was terminated on Sep-
tember 12, 2003. Following his termination, Ferguson com-
menced a lawsuit in the Texas state court against both GRM
and GRLP for recovery of severance pay of $250,000 (one
year’s base salary) and $60,000 in unpaid relocation costs.

On February 2, 2004, Garden Ridge, including GRP and
GRLP, filed Chapter 11 petitions with the United States Bank-
                                                                     Mechanic’s Lien & Bond workshop
ruptcy Court in Delaware. On March 29, 2005, Garden Ridge
filed a Chapter 11 plan of reorganization. The plan provided
for a substantive consolidation of all of the Garden Ridge
bankruptcy estates, including the GRP and GRLP estates.
                                                                     Liens & Bonds: Building the
Substantive consolidation resulted in pooling all of the assets
of all of the Garden Ridge entities (including GRP and GRLP)
                                                                     Optimal Credit Department
and allowed all of the creditors of the Garden Ridge entities
(including the creditors of GRP and GRLP) to share in the
pooled assets according to the priority status of their claims.
However, the plan preserved the separate legal and corporate
structures and all of the defenses of the Garden Ridge entities
(including GRP and GRLP) that existed prior to the Chapter
11 filing date. The Bankruptcy Court approved the plan in an
order dated April 28, 2005.

On April 13, 2005, Ferguson moved for relief from the auto-
matic stay to setoff his claim in the amount of $310,000
against GRP in reduction of his indebtedness to GRLP under
the Note. The Delaware Bankruptcy Court denied Ferguson’s
lift stay motion based on an improper triangular setoff. The
Bankruptcy Court found no mutuality of obligations between
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                no mutuality of obligations. Ferguson’s claim was against            claim against another debtor affiliate. The SemCrude decision
                GRP while his obligations under the Note were owing to a             precludes a creditor’s exercise of triangular setoff rights
                separate entity, GRLP. The substantive consolidation of the          through a setoff agreement between the creditor and debtor
                Garden Ridge bankruptcy estates, including the GRM and               affiliates. The court in Garden Ridge further held that triangu-
                GRLP estates, did not retroactively create a mutuality of obli-      lar setoff was not permissible, despite the substantive consoli-
                gations to justify Ferguson’s attempted exercise of triangular       dation of the debtor affiliates’ bankruptcy estates, because
                setoff where there was no such mutuality when GRP and                that did not create mutual debts.
                GRLP had filed Chapter 11. That is particularly true where
                Garden Ridge’s confirmed plan had preserved all of GRP’s             So what steps can a creditor take to avoid these decisions and
                and GRLP’s defenses in existence prior to their Chapter 11           facilitate its triangular setoff rights? The SemCrude decision
                filing. One such pre-petition defense was the impermissibility       suggests that cross affiliate guarantees might not create mutu-
                of the triangular setoff sought by Ferguson because Ferguson         al obligations to do the job, though that issue is not settled.
                could not satisfy the debt mutuality requirement for setoff.         Well, what if SemCrude had assigned its $1.4 million claim
                                                                                     against Chevron to SemFuel or SemStream against whom
                                                                                     Chevron had far larger claims? Assuming Chevron is not sub-
     The court held that mutuality did not                                           ject to the safe harbor provisions of the Bankruptcy Code, the
                                                                                     answer depends on when the assignment takes place. If the
     arise as a result of the substantive                                            assignment occurs more than 90 days before the bankruptcy
     consolidation of the GrM and Grlp                                               filing, Chevron should be able to enforce its setoff rights. That
                                                                                     was reaffirmed by the United States Bankruptcy Court for the
     bankruptcy estates.                                                             Southern District of Ohio in In re U.S. Aeroteam Inc. However,
                                                                                     Section 553(a)(2) precludes setoff if, amont other things, the
                                                                                     assignment occurs within 90 days of bankruptcy.2
                The District Court also upheld the Bankruptcy Court’s refusal
                to treat GRP and GRLP as a single entity for setoff purposes.        Interestingly, in SemCrude, Chevron has moved for reconsid-
                The Court noted that Garden Ridge had maintained GRP and             eration of the Bankruptcy Court’s order denying triangular
                GRLP as separate entities. Ferguson also could not prove any         setoff. Chevron is arguing that the contracts at issue are “for-
                misconduct on the part of Garden Ridge that would have jus-          ward contacts” and/or “swap agreements” and are, therefore,
                tified disregarding GRM and GRLP as separately maintained            entitled to the protections of the safe harbor provisions of the
                legal entities. The court also could not find any precedent for      Bankruptcy Code, without regard to Section 553’s limitations
                disregarding separate legal entities to create the necessary         on setoff rights. The Bankruptcy Court has not decided Chev-
                mutuality of obligations for exercising triangular setoff rights.    ron’s reconsideration motion as of the date of submission of
                                                                                     this article. In any event, there may be an appeal from the
                Conclusion                                                           Bankruptcy Court’s decision.
                Clearly, trade creditors doing business with financially dis-
                tressed affiliated debtors should think twice about their ability    There’s a lot to ponder about these cases. Stay tuned for further
                to offset their indebtedness to one debtor affiliate against their   developments! ●

                                                                                       1. Under Section 362(a)(7), a debtor’s bankruptcy filing stays a
                                                                                     creditor’s exercise of setoff rights. An exception is made for non-debtor
                                                                                     parties to certain financial contracts with a debtor, such as a swap,
                                                                                     forward and repurchase agreement, protected by the safe harbor
                                                                                     provisions of the Bankruptcy Code. They are excused from the
                                                                                     automatic stay and certain other limitations on setoff.

                                                                                       2. An exception is made where the debtor is a party to certain financial
                                                                                     contracts, such as a swap, forward and repurchase agreement, that are
                                                                                     protected by the safe harbor provisions of the Bankruptcy Code and are
                                                                                     not subject to Section 553(a)(2)’s limits on assignment of claims.

                                                                                     Bruce Nathan, Esq. is a partner in the New York City office of the law
                                                                                     firm of Lowenstein Sandler PC. He is a member of NACM and is on
                                                                                     the Board of Directors of the American Bankruptcy Institute and is a
                                                                                     former co-chair of ABI’s Unsecured Trade Creditors Committee. He
                                                                                     can be reached via email at

18   Business Credit April 2009

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