Introduction

The Bankruptcy Code allows for the setoff of “mutual debts” in a bankruptcy proceeding under 11 U.S.C. 553(a).  Section 553 makes no reference to non-mutual debts, which courts interpret to mean that non-mutual debts are not subject to setoff under the Bankruptcy Code.  Recently, in the SemCrude bankruptcy, the Honorable Brendan L. Shannon issued a decision finding that a multi-party agreement that contemplates a triangular setoff lacks the mutuality required for setoff under section 553.  This post provides a general look at setoffs under section 553, plus looks at the Court’s analysis of triangular setoffs in SemCrude. (Read the decision in SemCrude here).

The Bankruptcy Code and Setoff

Setoff allows entities that owe each other money to apply their mutual debts against one another.  The Bankruptcy Code does not create a right of setoff, but instead preserves a creditor’s right to setoff under non-bankruptcy law.  Section 553(a) of the Bankruptcy Code provides, in pertinent part,  that the Code “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.”

The Setoff Claim in the SemCrude Bankruptcy

SemCrude commenced its bankruptcy action on July 22, 2008.  At the time it filed for bankruptcy, one of SemCrude’s debtor entities, SemFuel, owed Chevron over $10.2 million and another debtor-entity, SemStream, owed Chevron $3.3 million.  Chevron, on the other hand, owed SemCrude $1.4 million.  Under the parties’ prepetition contracts, in the event one party failed to pay the other, the other party could “offset any deliveries or payments due under this or any other agreement between the parties and their affiliates.”

One month after SemCrude filed for bankruptcy,  Chevron filed a motion with the Bankruptcy Court seeking to lift the automatic stay and allow Chevron to apply its setoff.  Many parties, including the Debtors and the creditors’ committee, objected to Chevron’s motion, arguing that the triangular setoff sought by Chevron did not satisfy the Code’s requirement that debts be mutual in order to be setoff.  Chevron, on the other hand, argued that the terms of its contracts allowed it to setoff the debt it owed to SemCrude against the debt owed to Chevron by SemFuel and SemStream.

Triangular Setoff Not Permitted Under the Bankruptcy Court

The Court rejected Chevron’s motion to lift the stay, finding that section 553 prohibits triangular setoff, as a matter of law, due to lack of mutuality.  Citing to the “overwhelming majority of courts to the consider the issue,”  the Court found that debts are mutual only if the debts are due to and from the same parties in the same capacity.  Even though the parties may have agreed to the setoff, such an agreement did not give rise to a debt that is due and owing to another party.  SemCrude did not owe Chevron under the contract.  Instead, Chevron’s claims were against SemStream and SemFuel.  The parties agreement did not provide Chevron with a right to collect against SemCrude, but instead only a right to setoff.  Lacking a right to collect against SemCrude, Chevron lacked the mutuality required under section 553 of the Code.

In reaching its decision, the Court looked to the language under section 553.  The section preserves only the “right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement [of the bankruptcy case] against a claim of such creditor against the debtor that arose before the commencement of the case.”  The Court emphasized the Code’s use of the phrase “such creditor” as indicating exactly who must owe whom a debt to effect a setoff.

Chevron’s setoff claim failed because Chevron sought to setoff the debt it owed to SemCrude against the amounts owed to it by two other debtors:  SemFuel and/or SemStream.  SemCrude owed nothing to Chevron, therefore the Court could not convert a non-mutual debt into a mutual one.

No “Exception” to the Mutuality Requirement

The Court also rejected Chevron’s argument that the mutuality requirement was subject to a contractual exception.  Relying on the plain meaning of the statute, the Court found that nothing within section 553 permits a contractual exception to the mutuality requirement.  Aside from the clear meaning of the statute, the Court’s finding is also supported by the policy behind the Bankruptcy Code – to insure similarly situated creditors are treated fairly.

Conclusion

The decision in SemCrude is one of a string of decisions that finds that triangular setoffs lack the required mutuality under section 553.  Chevron lacked mutuality due to the contract’s failure to provide a “right to collect” against SemCrude.  It remains to be seen whether triangular setoff agreements may be drafted in a way that provide the mutuality needed to satisfy the requirements of the Bankruptcy Code.