On November 8, 2013, the US Bankruptcy Court for the District of Delaware, in Sass v. Barclays Bank PLC (In re American Home Mortgage, Holdings, Inc.), ruled that the mutuality requirement of section 553 of the Bankruptcy Code prohibits a creditor from using excess collateral it holds to set off a debt owed by the debtor to an affiliate of the creditor against its own obligations to the debtor. Although section 561 of the Bankruptcy Code protects a party's contractual right to setoff in connection with a swap agreement, section 553 requires mutuality for this setoff right to exist in the first place.

On February 8, 2006, American Home Mortgage Investment Corp. (AHM) entered into a master repurchase agreement (repo) with Barclays Capital, Inc. (Barclays Capital). Typical of a standard repo agreement, the repo required AHM to transfer to Barclays Capital certain securities in exchange for funds and Barclays agreed to transfer back identical securities for a different sum at a future date. Barclays Capital subsequently asserted a breach of the repo agreement and accelerated the demand for repurchase to August 3, 2007. AHM did not have the requisite funds on that date, so Barclays Capital retained the securities (as is customary under a repo agreement in such circumstances) and asserted a deficiency claim against AHM for the difference between the value of the repurchase price as set out in the repo agreement and the value of the retained securities, an amount which the parties dispute. For more information on repo agreements, see Practice Note, Repos: Overview (US).

In March of 2006, AHM undertook an unrelated securitization transaction that was underwritten by Barclays Bank PLC (Barclays Bank), an affiliate of Barclays Capital. The securitized assets had an average interest rate cap of 10% while the notes issued in the securitization (AHM Notes) required payment of an uncapped floating interest rate. AHM agreed to provide liquidity support to the AHM Notes and therefore was required to cover any deficiency between interest earned from the securitized assets and the interest required to be paid on the AHM Notes, which could occur if interest rates rose significantly. If AHM was required to provide this support, the credit rating of the Notes would have been downgraded. To maintain the Notes' AAA credit rating, AHM entered into a series of interest rate cap swaps with Barclays Bank that would provide funds to cover a deficiency if interest rates rose (the interest rate swaps). The interest rate swaps were governed by an ISDA Master Agreement (ISDA Master), which:

On August 2, 2007 Barclays Bank sent a letter to AHM terminating the interest rate swaps due to an alleged default by AHM. At the time the swaps were terminated, Barclays Bank owed AHM the excess margin collateral AHM had posted to Barclays Bank to cover exposures to it under the interest rate swaps. However, rather than return these amounts, Barclays Bank notified AHM that it intended to offset AHM's posted collateral against amounts that AHM owed Barclays Capital under the (unrelated) repo as per the cross-affiliate setoff provision in the ISDA Master.

On August 6, 2007, AHM filed for Chapter 11 bankruptcy protection and the Delaware Bankruptcy Court allowed AHM to continue to operate as a debtor-in-possession. In April 2011, AHM brought this adversary proceeding against Barclays asserting that, among other things, so-called "triangular setoff" is not allowed under the Bankruptcy Code because section 553 of the Bankruptcy Code requires mutuality of obligations for a party's contractual setoff right to be enforceable under the Bankruptcy Code. For more information on setoff, see Practice Note, Creditors' Setoff Rights in Bankruptcy.

The Bankruptcy Court noted that the case turned on whether the Bankruptcy Code allows for triangular setoff when a party has entered into a swap agreement and a repurchase agreement with two separate but affiliated counterparties. The Court began by examining section 553 of the Bankruptcy Code to determine whether a setoff requires mutuality, and held, as other courts have done, that section 553:

Examining case law, the Bankruptcy Court agreed with other courts that have examined the matter and held that mutuality only exists when debts are due to and from the same persons in the same capacity and that each party must own his claim in his own right severally, with the right to collect in his own name against the debtor in his own right and severally (see Legal Update, SemCrude Decision Could Spell the End to Triangular Set-off Agreements).

The Bankruptcy Court then turned to the interaction of section 553 and the safe harbor of section 561 of the Bankruptcy Code. Section 561 provides that the exercise of any contractual right to offset transfer obligations made in connection with a swap agreement cannot be stayed, avoided or limited by any Bankruptcy Code provision or court or agency order. The Bankruptcy Court examined two cases that addressed the applicability of section 553 when a party invokes sections 561, which held that:

Agreeing with these prior decisions, the Bankruptcy Court held that section 553 requires mutuality to preserve a contractual right of setoff in bankruptcy. While section 561 permits the exercise of a contractual right of setoff in bankruptcy notwithstanding any other provision that would inhibit this right, without mutuality, this right does not exist in the first place.

The Bankruptcy Court found additional support for its findings within the public policy underlying the Bankruptcy Code. The primary goal of the Bankruptcy Code, the Court reasoned, is to ensure that similarly situated creditors are treated fairly and enjoy equitable distributions. This goal would be frustrated if a group of affiliates were allowed to contract for setoff rights without a mutuality requirement by allowing that group to obtain payment from the debtor at the expense of the other creditors of the debtor. As a result of these findings, the Court held that triangular setoff is impermissible under the Bankruptcy Code.

This case joins previous decisions from the US Bankruptcy Courts for the Southern District of New York and the District of Delaware that have held that section 553 requires mutuality for a setoff right to exist. These courts have held that, without mutuality, no contractual setoff right exists in bankruptcy, despite previously bargained-for triangular setoff provisions. Affiliate lenders should be aware that, while contractual triangular setoff rights may be valid and enforceable outside of bankruptcy, once a counterparty or borrower files a bankruptcy petition, non-mutual contractual setoff rights against that party may become invalid. If a creditor chooses to exercise a non-mutual setoff right against a debtor in bankruptcy, it may be in violation of the automatic stay.