F or a trade creditor with a customer that has fjled Let Bruce - PDF document

n A T i o n A l A S S o c i A T i o n o F c R e d i T M A n A G e M e n T M A R C H 2 0 1 2 The PublicATion FoR cRediT & FinAnce PRoFeSSionAlS $7.00 Bruce Nathan, Esq. and Scott Cargill, Esq. Got Setoff Rights? Think Again Contractual Provision Allowing Triangular Setoff is Unenforceable in Bankruptcy S E L E C T E D T O P I C F or a trade creditor with a customer that has fjled Let Bruce inform and for bankruptcy protection, one of the key goals is entertain you in: to minimize the creditor’s exposure and maximize its recovery from the debtor’s bankruptcy estate. Ofuen, 20029. Risk Mitigation When Dealing with Troubled Companies Before, the creditor’s claim against the debtor is based on credit During and After Bankruptcy decisions made in the weeks and months prior to the bankruptcy fjling. Tie creditor’s recovery will be deter- 20040 & 20050. Ignorance is Not Bliss: mined by the debtor’s assets available for distribution, Challenging Non-Bankruptcy Legal the total amount of claims against the debtor, and the Issues Facing Credit Professionals other claims that have priority in right of payment over 20070. Bankruptcy 2012: What’s the creditor’s claim in the hierarchy of the federal bank- Hot, What’s Not! ruptcy distribution scheme. A signifjcant state law right to help a trade creditor reduce its exposure on its claim against a fjnancially dis- ABC may have outstanding indebtedness to XYZ for tressed customer is the creditor’s ability to “setofg” or electronic components that ABC purchased from XYZ “net out” the creditor’s claim owed by the debtor against on credit. ABC also has a difgerent line of business that the creditor’s obligations to the debtor. Setofg rights designs and manufactures computer chips used in elec- tronics, and sells these computer chips to XYZ to pro- The question of whether XYZ can setoff the duce XYZ’s electronic components. Accordingly, at any time, XYZ may owe money to ABC on account of XYZ’s $700 it owes to ABC against the $1,000 purchases of ABC’s computer chips. that ABC owes to XYZ will have signifjcant A creditor’s setofg rights simply mean that if ABC owes implications on XYZ’s prospects for recovery XYZ $1,000 and XYZ also owes ABC $700, then XYZ can net out, or setofg, the amounts owed so that ABC in ABC’s bankruptcy case. only need pay XYZ the net amount of $300 owed. XYZ’s setofg rights are easily understandable and effjcient— ofuen exist where the trade creditor and the debtor each they eliminate ABC having to pay XYZ $1,000 and then operate difgerent lines of business and sell goods or pro- requiring XYZ to immediately pay $700 back to ABC. vide services to each other. For example, ABC Compa- ny may have a line of business that manufactures tele- Tiis otherwise straightforward principle becomes phones and buys electronic components for the extremely important when viewed in the context of telephones from XYZ Company. At any given moment, a bankruptcy fjling. Let’s assume that ABC fjles for 1 B U S I N E S S C R E D I T M A R C H 2 0 1 2

bankruptcy and is only able to pay its unsecured creditors, transactions discussed below, a creditor attempting to exer- including XYZ, 10% of the face amount of their claims. Not- cise its setofg rights against a debtor must fjrst seek and obtain withstanding the bankruptcy fjling, XYZ is still indebted to bankruptcy court approval. Tie bankruptcy court decides ABC for the $700. Tie question of whether XYZ can setofg the whether to permit the exercise of setofg rights. Setofg will ordi- $700 it owes to ABC against the $1,000 that ABC owes to narily be permitted, unless it is prohibited or limited by Sec- XYZ will have signifjcant implications on XYZ’s prospects for tion 553 of the Bankruptcy Code. recovery in ABC’s bankruptcy case. However, the Lehman Brothers court, If XYZ can exercise its setofg rights, it will not have to write a following other court decisions, cast $700 check to ABC. Instead, the $700 will be credited, or set- ofg, against the $1,000 that ABC owes XYZ. Afuer application doubt on the enforceability in of the setofg, XYZ will be lefu with a net claim of $300 against ABC that will be paid at 10 cents on the dollar, so XYZ will bankruptcy of “cross affjliate” netting receive $30 at the conclusion of ABC’s bankruptcy case. provisions, or other setoff agreements to By comparison, XYZ sufgers additional losses if it cannot allow triangular setoff, because they do exercise setofg rights, which demonstrates their importance to XYZ. XYZ will have to pay ABC the $700 owed on account not satisfy the mutuality requirement of the computer chips it purchased from ABC. While XYZ for setoff found in the Bankruptcy Code. will still have its claim against ABC for the full $1,000, XYZ will receive only $100 on account of its claim against ABC because ABC’s unsecured creditors will receive only 10% of Triangular Setoff their claims. As part of many business structures, it is highly unlikely that a Now let us take this hypothetical one step further. Suppose company would operate difgerent lines of business within a XYZ had sold goods to ABC, but purchased goods from single entity. For a variety of reasons, including risk mitiga- ABC’s affjliate. Does XYZ have the same setofg rights to apply tion, taxation, fjnance and regulatory requirements, business- its claim against ABC in reduction of XYZ’s obligations to es normally operate through a host of related subsidiaries and ABC’s affjliate? Tiis is known as triangular setofg. Tie prob- affjliates. Tie coordinated operations of a group of affjliates lem with XYZ enforcing its triangular setofg rights is that one may provide economic benefjts to a business enterprise; how- of the prerequisites for setofg, a mutuality of obligations ever, it creates signifjcant legal issues with respect to a credi- between the parties to the setofg, is lacking between XYZ and tor’s ability to exercise setofg rights. As noted above, one of the ABC’s affjliate because the claim XYZ is seeking to setofg prerequisites for setofg is that the debtor’s claim against the against its obligation to ABC’s affjliate is against ABC. Tie creditor and the debt owed to the creditor must be mutual . If United States Bankruptcy Court for the Southern District of ABC and XYZ operate, like many businesses do, through a New York, overseeing the liquidation of Lehman Brothers Inc. group of affjliated entities, it is unlikely that the ABC affjliate (LBI), rejected a creditor’s exercise of triangular setofg rights, that bought electronic components from an XYZ affjliate is despite a provision in the contract between the parties that the exact same legal entity that also sold computer chips to permitted triangular setofg, because of the absence of mutual- that XYZ affjliate. Similarly, the XYZ affjliate that owes money ity of obligations. to an ABC affjliate for the computer chips is probably not the same entity that is owed money by an ABC affjliate for the Requirements for exercising Setoff Rights electronic components. Tie Bankruptcy Code does not provide an independent setofg right, but instead preserves substantive rights of setofg that Tiere is a long history in corporate law of respecting the sepa- already exist under applicable federal or state law. A creditor rate legal existence of each corporate entity, absent extraordi- is granted setofg rights because it would clearly be unfair to nary circumstances, and against using the assets of one entity force the creditor to pay the full amount of its indebtedness to to pay the liabilities of an affjliate. Tius, if the ABC entity that a fjnancially distressed debtor when the creditor faces the real owes a debt to an XYZ entity is not the same exact legal entity risk of a delayed payment of only a fraction of its ofgsetting that is owed money by the same XYZ affjliate, then the debts claim against the debtor. are not mutual and the requirements for exercising setofg rights have not been satisfjed. However, the Bankruptcy Code subjects a creditor’s setofg rights to several requirements. Generally, the prerequisites for Parties to contracts involving multiple affjliates are concerned setofg are: (i) the debtor’s indebtedness to the creditor must about losing their setofg rights upon a bankruptcy fjling have been incurred prior to the bankruptcy fjling; (ii) the because a court may rule that there is a lack of mutuality of the debtor’s claim against the creditor must also have been debts owed. To address this concern, triangular setofg provi- incurred prior to the bankruptcy fjling; and (iii) the debtor’s sions are routinely drafued into many commercial contracts. claim against the creditor and the debt owed to the creditor In essence, these provisions provide that, for purposes of must be mutual. Aside from certain specialized “safe harbor” setofg rights, all affjliated entities of one party to the contract 2 B U S I N E S S C R E D I T M A R C H 2 0 1 2