10/04/2011 – Memorandum Decision Enforcing the Automatic Stay filed in the Lehman Brothers Inc. Securities Investor Protection Act proceedings before U.S. Bankruptcy Judge James M. Peck in the United States Bankruptcy Court for the Southern District of New York.

Southern District of New York Bankruptcy Judge James M. Peck grants the motion of James W. Giddens, as Trustee (the “SIPA Trustee”) of Lehman Brothers Inc. (“LBI”) and orders UBS AG (“UBS”) to turn over $23 million of “excess collateral” under a terminated swap agreement.  Judge Peck rejects UBS argument that a setoff right created by contract, either renders inapplicable or satisfies the mutuality requirement specified in 11 U.S.C. § 553(a). Judge Peck holds that “a contractual right of setoff that permits netting by multiple affiliated members of the same corporate family outside of bankruptcy may no longer be enforced after commencement of a [bankruptcy case].”  ).

The UBS Affiliates – Lehman Brothers Triangular Setoff

LBI had deposited collateral with UBS to secure LBIs performance under a swap agreement.  USB terminated the swap agreement prior to commencement of the SIPA proceedings.  After reconciling all claims between USB and LBI, USB held approximately $23 million in unapplied collateral (the “Remaining Collateral”).  With respect to this Remaining Collateral, UBS asserted setoff rights for amounts allegedly due from LBI to two UBS affiliates, UBS Securities and UBS Financial Services .  These setoff rights were asserted pursuant to a provision in the swap agreement that allowed for the set off of debts owed by UBS or any UBS affiliate against debts owed by LBI or any LBI affiliate.

Judge Peck observed that, outside of the Bankruptcy Code, this type of setoff provision was “valid and enforceable” under New York law and that Section 553 of the Bankruptcy Code preserves rights of setoff arising under applicable non-bankruptcy law, including setoff rights created by contract.  He went on to note, however, that Section 553 has express limitations on the scope of setoff rights permitted under the Bankruptcy Code:

To be eligible for setoff under section 553, “(1) the amount owed by the debtor must be a prepetition debt; (2) the debtor’s claim against the creditor must also be prepetition; and (3) the debtor’s claim against the creditor and the debt owed the creditor must be mutual.” [In re Lehman Brothers Holdings Inc., 433 B.R. 101, 107 (Bankr. S.D.N.Y. 2010) (“Swedbank”)] (citations omitted). In Swedbank, this Court addressed the mutuality requirement under section 553(a) as it applies to a creditor attempting to offset post-petition funds deposited in a bank account against pre-petition indebtedness arising under a swap agreement. There the Court specifically referred to “the axiomatic principle of bankruptcy law, codified in section 553, requiring mutuality in order to exercise a right of setoff.” Swedbank, 433 B.R. at 109. While the mutuality question now before the Court involves the identity of the parties to the proposed setoff rather than the characterization of the funds as pre-petition or post-petition, the principle of mutuality is no less axiomatic here than it was in Swedbank.

What Creates the Setoff Right Creates the Mutuality?

UBS maintained that since Section 553 looked to non-bankruptcy law to create the setoff right, the elements of Section 553 not defined in the Bankruptcy Code – e.g. mutuality – were defined by non-bankruptcy law.  More specifically, UBS argued that the triangular setoff provisions in the swap agreement established a “mutual debt owing by such creditor to the debtor” under Section 553(a).  Judge Peck did not agree, concluding:

According to UBS, the debts between LBI and UBS Securities should be viewed as mutual because of the express provision allowing UBS to offset amounts owed to its affiliate, notwithstanding the fact that this affiliate is not a named party to the Agreement. The theory is that the contract supplies the required mutuality by collecting all affiliates under the same corporate umbrella and treating them as if they were a single counterparty. This attempt to override the independent status of UBS Securities disregards a consistent pattern of authority prescribing that, even where a setoff right exists under applicable state law, the Bankruptcy Code imposes its own strict requirements – namely, that the debtor owes a pre-petition debt to the creditor, the creditor has a pre-petition claim against the debtor, and the debt and claim are mutual. See, e.g., Shugrue v. Fischer (In re Ionosphere Clubs, Inc.), 164 B.R. 839, 841 (S.D.N.Y. 1994) (citing Braniff Airways, Inc. v. Exxon Co., USA, 814 F.2d 1030, 1034 (5th Cir. 1987); Swedbank, 433 B.R. at 107; see also, supra at 7 (setting forth eligibility requirements for setoff under section 553). The argument advanced by UBS fails because the allegedly mutual debts flunk the test that they must be “in the same right and between the same parties, standing in the same capacity.” Lines, 743 F. Supp. at 183.


UBS also asserts that because it was free to contract with LBI for triangular setoff rights under New York law and because the parties intended for these rights to be valid and enforceable, even in bankruptcy, the Court should honor the agreement and allow the triangular setoff. Br. Opp’n at 23. This argument is neutralized by the plain language of section 553. See Duncan v. Walker, 533 U.S. 167, 172 (2001) (noting that a court’s “task is to construe what Congress has enacted”); 11 U.S.C. § 553; see also, Connecticut Nat’l Bank v. Germain, 503 U.S. 249, 253-54 (1992) (citations omitted) (explaining that “courts must presume that a legislature says in a statute what it means and means in a statute what it says there”); Devine v. United States, 202 F.3d 547, 551 (2d Cir. 2000) (citing Germain) (additional citations omitted). Section 553 expressly preserves the “right of a creditor to offset a mutual debt owing by such creditor to the debtor … against a claim of such creditor against the debtor.” 11 U.S.C. § 553(a) (emphasis added). The clarity of this language is conclusive – mutuality quite literally is tied to the identity of a particular creditor that owes an offsetting debt. The right is personal, and there simply is no ability to get around this language. Parties may freely contract for triangular setoff rights, but not in derogation of these mandates of the Bankruptcy Code.

Contrary Authority – A Game of  “Whisper down the Lane”

Judge Peck refused to join a chain of “nearly a dozen cases” that he concluded sprung from a misreading 1964 Seventh Circuit decision, Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.), 327 F.2d 401 (7th Cir. 1964). In support of his position, Judge Peck referenced findings and analysis in In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), aff’d, 428 B.R. 590 (D. Del. 2010).

An examination of the decisions that are thought to imply that the courts would have enforced a triangular setoff right if there had been such an agreement lends support to the finding in SemCrude that the so-called contract exception cited in these cases actually was created by a game of “whisper down the lane” from decision to decision. For example, the court deciding Va. Block Co. v. Bushong (In re Va. Block Co.), 16 B.R. 560 (Bankr. W.D. Va. 1981), cited Berger Steel in its statement that the contract exception exists, but found it to be inapplicable. Va. Block, 16 B.R. at 562. See also, In re Balducci Oil Co., 33 B.R. 847, 853 (Bankr. D. Colo. 1983) (citing, inter alia, Berger Steel and Va. Block for the existence of the exception, but relying on an unrelated Ninth Circuit case for the proposition that a parent corporation may not pierce the veil of its subsidiary for purposes of establishing mutuality); In re Fasano/Harriss Pie Co., 43 B.R. 864, 870-71 (Bankr. W.D. Mich. 1984) (recognizing Va. Block and Balducci Oil as carving out a contract exception, but finding that no such agreement existed in the case at bar); In re Lang Mach. Corp., 1988 Bankr. LEXIS 1667, at *13 (Bankr. W.D. Pa. 1988) (citing, inter alia, Va. Block for existence of contract exception, but finding that no evidence of alleged oral agreement was ever introduced); Wooten v. Vicksburg Refining, Inc. (In re Hill Petroleum Co.), 95 B.R. 404, 412-13 (Bankr. W.D. La. 1988) (citing, inter alia, Va. Block as recognizing “the narrow exception to the rule against three party ‘triangular’ setoffs … where there is a formal agreement by the debtor that two entities may aggregate debts owed to and from the debtor,” but finding no such agreement existed).


Conceivably, the courts in these cases might have mistakenly enforced a triangular setoff right simply on the basis of string citations if presented with an enforceable agreement for triangular setoff, but that does not establish a legitimate basis for a contractual exception to the requirement of mutuality. These cases assume the existence of a contract exception but fail to engage in any analysis demonstrating that the exception actually fits within the statutory scheme. The careful analysis in SemCrude is persuasive. There simply is no contract exception to section 553(a), because the statute itself does not allow for one.