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Navigating Triangular Setoff Through Safe Harbors

By Jeff J. Friedman and John J. Ramirez

Section 553(a) of the Bankruptcy Code preserves a creditor's prepetition right to setoff. Courts have strictly construed Section 553(a) to limit the preservation of setoff rights to claims and debts that arose prior to the commencement of the debtor's bankruptcy case. Courts have also strictly construed the mutuality requirement in Section 553(a) to require that debts be due to and from the same two parties in the same legal capacities. This construction has been routinely held to prevent what has been labeled as “triangular setoff” with respect to a debtor in bankruptcy.

Virtually all definitions of setoff provide for the netting of debts or claims and counterclaims between the same two parties acting in the same legal capacities. What is typically meant by the term “triangular setoff” is a contractual agreement where the debtor has agreed that a debt owed to the debtor by party A, can be applied to satisfy a debt owed by the debtor to party B. As one court observed, “outside of the bankruptcy context, ' [such a triangular setoff provision] without a question is [] valid and enforceable ' .” In re Lehman Brothers Inc., 458 B.R. 134, 139 (Bankr. S.D.N.Y. 2011) ( Lehman/UBS ).

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