Alert Memo NEW YORK MAY 7, 2010 Lehman Bankruptcy Court Declines To Hold That The Safe Harbor Provisions Of Sections 560 And 561 Of The Bankruptcy Code Permit An Exception To Mutuality In Setoff On May 5, 2010, the U.S. Bankruptcy Court for the Southern District of New York declined in the bankruptcy proceeding of Lehman Brothers Holdings Inc. ( LBHI ) to find that the safe harbor provisions of Sections 560 and 561 of the Bankruptcy Code permit an exception to mutuality in setoff. Specifically, the Court ruled that [a] contractual right to setoff under derivative contracts does not change well established law that conditions such a right on the existence of mutual obligations. As a result, the Court found that the attempt by Swedbank S.A. ( Swedbank ) to set off 82.7 million Swedish Krona (approximately $11.7 million USD) deposited in LBHI s account at Swedbank (the Swedbank Account ) post-petition against Swedbank s approximately $32 million in claims against LBHI was a violation of the automatic stay. The Court ordered Swedbank to release its administrative freeze on the Swedbank Account and return to LBHI all funds held therein deposited after the LBHI bankruptcy filing date. Yesterday, the Court denied Swedbank s motion to stay the Court s order pending an appeal and directed Swedbank to pay LBHI all post-petition deposit amounts by the close of business today. Also yesterday, Swedbank filed a notice appealing the Court s decision to the United States District Court for the Southern District of New York. Background Prior to LBHI s bankruptcy filing on September 15, 2008, Swedbank was party to four ISDA Master Agreements with various Lehman affiliates pursuant to which LBHI was guarantor. LBHI was also a primary obligor under an ISDA Master Agreement between it and Swedbank, which contained a broad contractual right of setoff. LBHI s bankruptcy filing triggered bankruptcy-related events of default under these ISDA Master Agreements which resulted in termination payments of $13.9 million purportedly becoming due and owing to Swedbank. Swedbank also allegedly had a claim of approximately $18 million against LBHI arising under a senior promissory note it held. Cleary Gottlieb Steen & Hamilton LLP, 2010. All rights reserved. This memorandum was prepared as a service to clients and other friends of Cleary Gottlieb to report on recent developments that may be of interest to them. The information in it is therefore general, and should not be considered or relied on as legal advice.
The balance in the Swedbank Account was SEK 2,140,897.40 on September 15, 2008. Shortly thereafter, Swedbank placed an administrative freeze on the Swedbank Account, blocking LBHI from withdrawing funds, but still allowing additional monies to be deposited and/or wired into the account, resulting in the accumulation of SEK 82,765,466.45 of additional funds. Swedbank subsequently informed LBHI that it intended to exercise its contractual right of setoff by offsetting, against Swedbank s obligations as bank with respect to the amounts on deposit in the Swedbank Account, LBHI s obligations under the ISDA Master Agreements and the note. LBHI then brought a motion for an order enforcing the automatic stay against, and compelling payment of post-petition funds by, Swedbank. The Decision The Court held that Swedbank s setoff did not satisfy the mutuality requirement for setoff in Section 553 of the Bankruptcy Code because Swedbank s claims against LBHI arose pre-petition, while the deposit obligations to LBHI that it sought to set off arose postpetition. In relevant part, Section 553 provides that: Except as otherwise provided in this section and in sections 362 and 363 of this title, this title 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 Court emphasized that, for purposes of mutuality analysis, a post-petition debtor is considered to be different from the pre-petition entity because it is not standing in the same capacity. Swedbank acknowledged at the hearing on the motion that its attempted setoff failed the mutuality test. Swedbank argued, however, that the safe harbor provisions of Sections 560 and 561 of the Bankruptcy Code render the mutuality requirement in Section 553 inapplicable in this context. Section 560 provides, in relevant part, that a creditor that is a swap participant is entitled to: [E]xercise any contractual right... to offset... any termination values or payment amounts arising under or in connection with the termination, liquidation, or acceleration of one or more swap agreements and that the exercise of such right(s) shall not be stayed, avoided, or otherwise limited by operation of any provision of title or by any order of a court or administrative agency in any proceeding under this title. Section 561 provides, in relevant part, that: 2
The exercise of any contractual right to cause the termination, liquidation, or acceleration of or to offset or net termination values, payment amounts, or other transfer obligations arising under or in connection with one or more... swap agreements shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by any order of a court or administrative agency in any proceeding under this title. Accordingly, Swedbank argued that its contractual right of setoff contained in the ISDA Master Agreements was not constrained by the mutuality requirement in Section 553. The Court was not persuaded by these arguments. It held that [b]y their plain terms, these safe harbor provisions do not alter the axiomatic principle of bankruptcy law... requiring mutuality in order to exercise a right of setoff. These safe harbor provisions simply do not directly address the requirement of mutuality under section 553(a)... [and] [g]iven the silence of the safe harbor provisions with respect to the mutuality requirement of section 553(a), the Court declines to read an exception into the statute. The Court supported its finding by pointing to the fact that Congress enacted sections 560 and 561 well after section 553 had become established as the statutory basis for permitting setoff in bankruptcy and with full knowledge of that section s mutuality requirement and therefore reasoned that [i]f Congress had intended to eliminate the mutuality requirement of section 553(a), it would have done so directly and with clarity. In concluding, the Court noted that [s]ections 560 and 561 preserve contractual rights of setoff for mutual pre-petition obligations - essentially assuring the nondebtor swap counterparty that... [a] bankruptcy will not frustrate pre-petition commercial expectations relating to setoff and netting, but do not improve the position of a nondebtor counterparty beyond its pre-petition commercial expectations. Accordingly, the Court concluded that a finding allowing Swedbank to exercise such a non-mutual setoff would result in a windfall to Swedbank to the detriment of other creditors. The Court dismissed Swedbank s argument that mutuality should not be read into Sections 560 and 561 since those sections provide that the contractual right of a party to offset or net out is not to be stayed, avoided, or otherwise limited by operation of any provision of this title. The Court also viewed as technical, rather than significant, the deletion of the word mutual from related automatic stay safe harbor provisions in Sections 362(b)(6), (17) and (27) in the 2006 amendments to the Bankruptcy Code. Implications While this case addressed only the setoff of pre-petition against post-petition claims, it has broader implications. The Court found that, notwithstanding the absence of an explicit requirement of mutuality for setoff in the safe harbor provisions of Sections 560 and 561, mutuality is an essential and well understood aspect of bankruptcy practice. If affirmed 3
on appeal, the Court s decision will likely reduce, at least in the Southern District of New York, the likelihood of success for arguments that Sections 560 and 561 can be used in other setoff circumstances where mutuality is not present. * * * If you have any questions about this case or the Lehman bankruptcy more generally, please contact any of your regular bankruptcy, restructuring or structured finance contacts, or any of our partners and counsel listed under Bankruptcy and Restructuring or Derivatives in the Practices section of our website at http://www.clearygottlieb.com. CLEARY GOTTLIEB STEEN & HAMILTON LLP 4
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