5 October 2011
The Bankruptcy Court for the Southern District of New York has held that a cross-affiliate netting provision in an ISDA swap agreement is unenforceable in bankruptcy. In the SIPA proceedings of Lehman Brothers Inc. (LBI), UBS AG (UBS) sought to offset UBS’s obligation to return excess collateral to LBI against claims purportedly owed by LBI to UBS subsidiaries, UBS Securities and UBS Financial Services. While the Bankruptcy Court acknowledged that the cross-affiliate netting provision was valid and enforceable outside of bankruptcy, it followed the decision in In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), aff’d, 428 B.R. 590 (D. Del. 2010), to conclude that the mutuality requirement of Section 553 of the Bankruptcy Code precluded enforcement of the provision in bankruptcy.
UBS had entered into foreign exchange swaps with LBI in transactions under a 1992 ISDA Master Agreement. The parties posted collateral to secure their respective obligations. UBS terminated the transactions under the swap agreements on September 16, 2008, shortly before the commencement of LBI’s SIPA proceedings. At the time of the early termination, UBS was holding approximately $170 million in collateral.
The LBI Trustee did not dispute UBS’s valuation notice and, after setoff, UBS still held $76 million, which the documents required it to return to LBI. However, UBS relied on Section 5(a) of the Schedule to the ISDA to assert a right to setoff amounts due from LBI to two of its subsidiaries, UBS Securities and UBS Financial Services. UBS contended that the amount of those claims exceeded the $76 million and retained the full amount. By agreement of the parties, the amount in controversy had been reduced to $23 million by the time of the Bankruptcy Court’s decision.
Section 5(a) of the Schedule to the ISDA provided for a common form of cross-affiliate netting:
… upon the designation of any Early Termination Date, in addition to and not in limitation of any other right or remedy … under applicable law the Non-defaulting Party or Non-affected Party (in either case, “X”) may without prior notice to any person set off any sum or obligation (whether or not arising under this Agreement …) owed by the Defaulting Party or Affected Party (in either case, “Y”) to X or any Affiliate of X against any sum or obligation (whether or not arising under this Agreement …) owed by X or any Affiliate of X to Y …
The Bankruptcy Court accepted UBS’s argument that this provision was valid as a matter of New York contract law. In bankruptcy, however, Section 553 of the Bankruptcy Code requires that the offsetting obligations be held in the same right, and between the same parties, standing in the same capacity. Thus, the Bankruptcy Court concluded that cross-affiliate netting was not authorized under the Bankruptcy Code because it failed to meet this mutuality requirement.
UBS argued that Section 553 only applied the mutuality requirement to common law rights of setoff, not contractual rights of setoff. The Bankruptcy Court rejected this argument as having no basis in the text of the statute, which makes no such distinction. The Bankruptcy Court also rejected UBS’s argument that the contractual provision created mutuality between all affiliates under the corporate umbrella of UBS as contrary to a “consistent pattern of authority,” which imposes strict requirements of mutuality.
UBS also argued that the swap agreements were protected contracts under Section 561 of the Bankruptcy Code, which preserves the exercise of any contractual right to offset in connection with a swap agreement. The Bankruptcy Court rejected this reasoning as it had in a previous decision in In re Lehman Brothers Holdings Inc., 433 B.R. 101 (Bankr. S.D.N.Y. 2010) (the “Swedbank decision”). According to the Bankruptcy Court, the safe harbor provision permits setoff, but does not eliminate the mutuality requirement. In addition, the Bankruptcy Court reasoned that Section 561 preserves rights of setoff, but that without mutuality, no such right exists.
Thus, absent further developments on appeal or in subsequent case law, cross-affiliate setoff appears to be unavailable in both the Southern District of New York and Delaware, the two most significant bankruptcy jurisdictions in the United States.
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