Lehman Bankruptcy Court Rules That Safe Harbors for Derivatives Do Not Override Mutuality Requirement for Setoff

June 21, 2010


Recently the bankruptcy court overseeing the Lehman Brothers chapter 11 cases held that a bank cannot apply post-petition deposits by a bankruptcy debtor to the debtor’s prepetition obligations under a derivatives contract. The court found that the U.S. Bankruptcy Code does not recognize the right to set off or apply deposits made after the commencement of the bankruptcy case against debts that arose prior to the commencement of the case, even under safe-harbored agreements like swap agreements, and that withholding a debtor’s deposits violates the automatic stay on creditor actions in bankruptcy.[1] In so doing, the court clarified that 2005 amendments to the Bankruptcy Code that expanded safe harbors for swap and master netting agreements to include setoff rights do not override the fundamental requirement that the claims to be set off must be “mutual.”

The Dispute

Lehman Brothers Holding Inc. (“LBHI”) was both a guarantor and counterparty to Swedbank AB on various ISDA Master Agreements (“Agreements”). Under these Agreements, a bankruptcy of LBHI as counterparty and credit support provider triggered an early termination of the Agreements, and caused certain termination payments to be due by LBHI to Swedbank. One of the Agreements also contained a provision that granted Swedbank a right to set off obligations in connection with such early termination. Swedbank alleged that, as a result of LBHI’s bankruptcy filing, LBHI owed about $13.9 million under the Agreements.

LBHI also maintained a general deposit account at Swedbank (the “Account”). Following LBHI’s bankruptcy filing, Swedbank placed an administrative freeze on the Account, which blocked LBHI from withdrawing funds, but allowed funds to continue to be deposited or wired into the Account. As a result of transfers made after the commencement of the bankruptcy case, the Account balance increased from SEK 2,140,897 to SEK 84,906,363, equivalent to about $11.7 million.

The Bankruptcy Code preserves contractual rights of setoff but normally requires the debts owed by the debtor and the creditor be “mutual.” Courts interpret mutuality to exist when “the debts and credits are in the same right and are between the same parties, standing in the same capacity.” Because a Bankruptcy Code debtor does not stand in the same capacity as a non-debtor, to be mutual, both debts must arise either before or after the commencement of the bankruptcy case. Swedbank conceded that a prepetition claim arising under a swap agreement and a postpetition deposit are not mutual under the Bankruptcy Code, but argued that the new language in the safe harbor provisions concerning swap agreements and master netting agreements permitted the set-off of non-mutual obligations across contracts. LBHI disagreed.  

The Court’s Decision

The court noted that the language of the safe harbor provisions, as reformed, does not address or alter the requirement that debts to be set off be “mutual,” including the requirement that both debts be either pre- or postpetititon (i.e., both debts must arise before the filing of the petition that commences a bankruptcy case, or both must arrive after the filling of such petition). Indeed, the court found that the Bankruptcy Code does not recognize contractual rights to set off nonmutual obligations. Therefore, Swedbank had no right in bankruptcy to set off its obligation to return funds deposited postpetition against debts of the debtor that arose under prepetition swap agreements.

The court further noted that the safe harbor provisions were intended to protect the prepetition commercial expectations of swaps counterparties with respect to setoff of mutual prepetition obligations, but not to improve the position of a non-debtor counterparty beyond such expectations.

Finally, the court found that Swedbank’s refusal to deliver the funds in the Account violated the automatic stay and ordered it to deliver the Account funds.

Swedbank is appealing the decision.

Case Implications

Parties to safe harbored financial contracts under the Bankruptcy Code should note the limited nature of the protections provided by these safe harbors. Where the act is not expressly protected, a court may hesitate to grant protection. 

[1] The case is In re Lehman Brothers Holdings Inc., 08-13555, U.S. Bankruptcy Court, Southern District of New York (Manhattan).