Delaware Business Bankruptcy Report : Delaware Business Bankruptcy Report : Morris James LLP Lawyers & Attorneys

The Bankruptcy Court began its analysis by noting that setoff is proper in bankruptcy only when a creditor (1) possesses an independent right of setoff under applicable non-bankruptcy law, and (2) meets the additional requirements and limitations set forth in 11 U.S.C. § 553. Section 553 requires that debts to be offset must be mutual, pre-petition debts. Debts are mutual when they are owed to and from the same entity and in the same capacity. Thus, the Bankruptcy Code does not allow triangular setoffs. 

Chevron asserted that an exception to this mutuality rule exists. It argued that a pre-petition contract executed by a creditor, a debtor, and one or more third parties either satisfied the mutuality requirement or allowed the parties to contract around the mutuality requirement. The Bankruptcy Court noted that at first glance it appeared that Chevron had identified an exception supported by caselaw. However, these cases directly or indirectly traced back to a single case, In re Berger Steel Co., 327 F.2d 401 (7th Cir. 1964), decided by the United States Court of Appeals for the Seventh Circuit under the former Bankruptcy Act. This case contemplated that a contractual exception to the mutuality requirement found in section 68 of the former Bankruptcy Act (section 68 of the Bankruptcy Act of 1898 contained similar, but not identical, language to section 553) might exist. The Bankruptcy Court stated that the Berger Steel court found that the parties did not have a triangular setoff agreement. After making this factual finding, the Berger Steel court distinguished its case from cases cited by the proponent by noting that the cases allowing triangular setoff were decided under applicable non-bankruptcy law rather than under the more restrictive confines of the Bankruptcy Code. Thus, the Bankruptcy Court determined that the Berger Steel decision did not address the broader question of whether a triangular setoff was permissible under the Bankruptcy Act. Subsequent caselaw to the Berger Steel decision recognized there might be an exception to the mutuality requirement; however, none found that such exception actually applied.

The Bankruptcy Court addressed two issues raised by this case: (1) whether private agreements can create mutual debt and (2) whether there is an exception to the mutual debt requirement.

Private Agreements Cannot Create Mutuality

Mutuality is strictly construed against the party seeking setoff. Further, debts are mutual when they are owed to and from the same entity and in the same capacity. Using the required narrow construction of mutuality, the Bankruptcy Court concluded that mutuality cannot be supplied by a multi-party agreement that contemplated triangular setoff. Such an agreement does not create indebtedness or right to collect from one party to another. The Bankruptcy Court stated that the language of 11 U.S.C. § 553 supports such an interpretation. Section 553 speaks not only of “mutual debt,” but of a mutual debt owing between a particular creditor and a particular debtor.

There is No Exception To the Mutuality Requirement

The Bankruptcy Court utilized the plain language of 11 U.S.C. § 553 to conclude that there is no contract exception to the mutual debt requirement under section 553. The Bankruptcy Court stated that nothing in the plain language of the statute indicates that there is a contractual exception to the mutual debt requirement and, absent such indication, it would be improper to recognize one. Further, the Bankruptcy Court noted that its holding was consistent with the purpose of section 553 and the Bankruptcy Code generally. In reaching this conclusion, the Bankruptcy Court recognized that one of the primary purposes of the Bankruptcy Code is to ensure all creditors are treated fairly and enjoy equality of distribution absent a compelling reason to depart from this principle. Allowing parties to contract around section 553’s mutuality requirement would allow some creditors to unfairly obtain payment from a debtor, thereby upsetting the priority scheme of the Bankruptcy Code. Thus, the Bankruptcy Court held that no exception to the mutual debt requirement in 11 U.S.C. § 553 could be created by private agreement.

On January 20, 2009, Chevron filed a Motion for Reconsideration of this Opinion.

The Debtors initially filed a petition for relief under chapter 11 of title 11 of the United Stated Code, §§ 101, et seq. (the “Bankruptcy Code”) in November 2005. Shortly thereafter, the case was converted to chapter 7. As of January 12, 2006, Tri-City owed the Debtors $218,328.96. Tri-City alleged that it was entitled to setoff the balance due against credits owed for returned goods. The Debtors contended that any setoffs that occurred within the preference period and post-petition were avoidable pursuant to 11 U.S.C. §§ 547, 548 or 549. Tri-City moved to dismiss the avoidance and recovery claims, which were premised on the Court finding that Tri-City possessed setoff rights under 11 U.S.C. § 553.

The Bankruptcy Court rejected the argument that if the Court granted the setoffs, the result would be to elevate Tri-City to secured status and thus, diminish the estate to the detriment of other creditors as irrelevant. The Court quoted Collier’s and stated that such a result is “precisely the purpose of a setoff.” As Collier’s states, “…setoff in bankruptcy is the equivalent of a lawful preference….Section 503(a)… treats rights arising through setoff in the same manner as rights arising from a security agreement or other relevant security devise.” 5 Collier on Bankruptcy ¶ 553.02 (15^th ed. rev. 2008). 

Further, the Court held that valid setoffs are not avoidable as preferential or fraudulent transfers because setoffs are not transfers of estate property. Again the Court referred to Collier’s which notes that avoidance actions require a “prepetition ‘transfer’ of an interest of the debtor in property….The term ‘transfer’ is defined in the Code section 101, and the definition intentionally omits ‘setoffs.’ The legislative history to section 101 explains the omission in clear terms; ‘Inclusion of ‘setoff’ is deleted’…section 553 provides that this title, i.e., title 11, does not affect setoff rights.  Thus, setoff cannot be a preference or a fraudulent transfer.” Id. at ¶ 553.09[1][a].

The Court also dismissed Debtors’ attempt to avoid post-petition transfers pursuant to 11 U.S.C. § 549. Section 549 permits avoidance of a transfer of estate property that is not authorized by the court. Thus, if the Court finds that Tri-City is entitled to setoff as preserved by 11 U.S.C. § 553, then such a finding provides the court authorization contemplated by § 549(a)(1)(2)(B). 

Finally, because valid setoffs cannot be avoided, § 550 is not applicable.