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Triangular Setoff Valued Up to $12 Million Not Authorized by the Bankruptcy Code

By GianClaudio Finizio

On November 8, 2013, Judge Christopher J. Sontchi of the United States Bankruptcy Court for the District of Delaware (the “Court”) held that a triangular setoff is not authorized under the Bankruptcy Code. In re Am. Home Mortgage, Holdings, Inc., 07-11047 (CSS), 2013 WL 5967967 (Bankr. D. Del. Nov. 8, 2013).  Plaintiff, Steve D. Saas, as Plan Trustee (“Trustee” or “Plaintiff”) of the American Home Mortgage Plan Trust filed a complaint seeking, among other things, a declaratory judgment that a triangular setoff effectuated by Barclays Bank PLC (“Barclays Bank”) and Barclays Capital Inc. (“Barclays Capital” and together with Barclays Bank, “Defendants”) was prohibited under the Bankruptcy Code.   Defendants’ filed a motion to dismiss the complaint.  The Court denied Defendants’ motion to dismiss.

The pertinent agreements related to the triangular setoff are a Repurchase Agreement and a Swap Agreement.  American Home Mortgage Investment Corp. (“AHM”) and Barclays Capital were parties to a Repurchase Agreement.  Pursuant to the terms of the Repurchase Agreement, on August 3, 2007, Barclays Capital declared a default and terminated the Repurchase Agreement due to AHM’s inability to pay the purchase price following Barclays Capital’s demand on AHM to repurchase securities held by Barclays Capital.

AHM, Barclays Bank and the AHM Investment Trust 2006-1 (the “Trust”) were parties to a series of interest rate cap transactions related to the Trust and certain floating rate notes issued by the Trust, as governed by a master agreement (the “Swap Agreement”).  Pursuant to the Swap Agreement, AHM transferred various bonds and cash to Barclays Bank as Swap Collateral.  On August 2, 2007, Barclays Bank declared a default under the Swap Agreement, designated such date as the early termination date, and notified AHM of Barclays Bank’s purported right pursuant to the Swap Agreement terms to setoff obligations of Barclays Bank owed to AHM under the Swap Agreement against obligations owed from AHM to Barclays Capital under the Repurchase Agreement.  On August 6, 2007, AHM and its affiliated debtors filed for relief under chapter 11 of the Bankruptcy Code.

Barclays Bank applied the Swap Collateral to setoff alleged damages for AHM’s default under the Swap Agreement.  Because the alleged damages did not exceed the value of the Swap Collateral, a Swap Collateral Surplus remained.1 Barclays Bank then asserted its rights to a triangular setoff pursuant to the terms of the Swap Agreement by applying the Swap Collateral Surplus (i.e. an obligation of Barclays Bank to AHM) against AHM’s unsatisfied obligations to Barclays Capital under the Repurchase Agreement.

In reaching its decision, the Court found that neither the terms of the Swap Agreement nor the safe harbor provisions of Bankruptcy Code sections 559-561 could override the obligation of mutuality to effectuate a setoff as set forth in section 553 of the Bankruptcy Code.  Citing to Judge Shannon’s decision in SemCrude, the Court highlighted the mutuality restriction expressly imposed by Bankruptcy Code section 553 and emphasized the meaning of “mutual debts” considered by a majority of courts to be debts due to and from the same persons in the same capacity.2  Having concluded that parties cannot contract around mutuality, the Court next looked to the interplay between Bankruptcy Code section 553 and safe harbor sections 559-561 to determine whether such safe harbor provisions alter section 553’s mutuality requirement.  The Court, citing to court rulings in the Lehman cases which analyzed this very issue by reviewing the plain language and the legislative history of these safe harbor provisions, concluded that the safe harbor sections do not alter the requirement of mutuality.3  The Court agreed with the analysis of the Lehman court which provided, in pertinent part, that while the safe harbor provisions permit the exercise of a contractual right of offset in connection with swap agreements, the right must exist in the first place, and in order for such right to exist there must be mutuality as required by Bankruptcy Code section 553.

Lastly, the Court found that the policy argument advanced in SemCrude supports the mutuality requirement for setoff.

One of the primary goals – if not the primary goal-of the Code is to ensure that similarly-situated creditors are treated fairly and enjoy an equality of distribution from a debtor absent a compelling reason to depart from this principle.  By allowing parties to contract around the mutuality requirement of section 553, one creditor or a handful of creditors could unfairly obtain payment from a debtor at the expense of the debtor’s other creditors, thereby upsetting the priority scheme of the Code and reducing the amount available for distribution to all creditors…Such a result is clearly contrary both to the text of the Code and to the principle of equitable distribution that lies at the heart of the Code.4

A copy of the Court’s opinion is available here.

1 While it was sufficient for purposes of rendering its decision for the Court to conclude that a Swap Collateral Surplus existed without having to determine the precise amount of the Swap Collateral Surplus, based upon the damages asserted by each side the actual amount of the Swap Collateral Surplus appears to be valued somewhere between $9 million and $12 million.
2 See In  re SemCrude, L.P., 399 B.R. 388, 393-394 (Del. Bankr. 2009), aff’d 428 B.R. 590 (D. Del 2010).
3 See In re Lehman Brothers Holdings Inc., 433 B.R. 101 (Bankr. S.D.N.Y. 2010); See also In re Lehman Brothers Inc., 458 B.R. 134 (Bankr. S.D.N.Y. 2011).
4 SemCrude, 399 B.R. at 399.

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