The Court: "Where do you get a right under 364 for that purpose?"

This question was posed to counsel seeking to have a debtor in possession (DIP) loan1 prime a setoff right, a situation which – if not monitored and timely objected to – may result in a bank (or other entity with a setoff right) effectively losing its setoff right. Setoff is a matter of state law and varies according to state law, but the doctrine’s purpose is to avoid "the absurdity of making A pay B when B owes A."2 In perhaps the most familiar setoff scenario, a debtor in bankruptcy may be both a borrower and a depositor at the same bank, with the bank holding, at times significant, deposits that it may wish to setoff against what the debtor owes on its loan.

Based solely on the language of the Bankruptcy Code, it would appear that the Code preserves the bank’s right to setoff as it would exist under nonbankruptcy law.3 However, in practice, DIP financing orders may contain language specifically priming setoff rights.4 In other instances – likely occurring more often and of more concern to banks with a common depositor/borrower – the proposed DIP order contains broad language priming "all interests." Courts entering orders containing such language may be doing so either without an intention to alter setoff rights, or these courts may be doing so pursuant to a broader interpretation of the term "lien" in 11 U.S.C. § 364 and/or pursuant to the general equitable powers of 11 U.S.C. § 105. This "may" be the case because, notably, there is a dearth of authority explicitly holding that a DIP order may prime setoff rights, although examples of DIP orders with such explicit language exist.5

Practitioners seeking to prime setoff rights may be advancing the following argument in favor of doing so: if the deposited funds are a significant or primary asset of the debtor, and the bank’s right to setoff is not primed, the DIP lender will not receive the secured position that it may typically expect and desire.6 While many DIP loans end up being approved with the consent of secured lenders, a bank seeking to oppose such a proposed DIP order should consider asserting that a DIP loan proponent lacks legal authority to prime setoff rights, and that there can be no meaningful adequate protection for its interest in the deposited funds if its setoff right is primed.

If timely and proper opposition is raised with the Court, DIP orders seeking to prime setoff rights (whether using specific or catch-all language) may face this article’s introductory question, which was originally posed by New Jersey Bankruptcy Judge Morris Stern, along with skepticism as to the authority to prime setoff rights, which Judge Stern expressed as follows:

The Court: If Title 11 can’t affect any right of a creditor to setoff but for 362 and 363, I think you have no argument at all. And to the extent that you’ve advanced this argument in many courts, I think you’ve made a mistake and the courts, if they’ve granted it, have made a mistake. There’s no impact of setoff rights by virtue of the Bankruptcy Code if 553 is complied with except with respect to the automatic stay, and certain aspects of 363, which are totally irrelevant here.7

To unpack Judge Stern's comments, the section of the Bankruptcy Code specifically addressing DIP financing, 11 U.S.C. § 364(d), provides that a DIP loan may prime liens but says nothing of priming setoff rights. Likewise, the section of the Bankruptcy Code, specifically addressing setoff, 11 U.S.C. § 553, provides that the Bankruptcy Code does not affect any right of a creditor to offset a mutual prepetition debt owing by the creditor to the debtor against a prepetition claim of the creditor against the debtor, except as provided in § 362 (providing that the automatic stay applies to setoff rights) and § 363 (providing, inter alia, for use by a debtor of property of the estate and for sale of such property free and clear of interests of others in the property in certain circumstances).8 The setoff provisions of § 553 make no mention of the DIP financing provisions of § 364. Thus, Judge Stern’s question: where is the authority to prime setoff rights?

The answer: nowhere explicitly in § 364, at least inasmuch as a court finds that a setoff right, while treated as a secured claim by at least one other section (§ 506) of the Bankruptcy Code, is not a lien.9 The Third Circuit U.S. Court of Appeals has held as much where, in the context of a § 363 sale, it distinguished a lien from a setoff right:

The terms "lien" and "setoff" have also been distinguished within the purview of § 363(f). In Marley v. United States, 180 Ct. Cl. 898, 381 F.2d 738, 743 (Ct. Cl. 1967), the Court of Claims noted that the terms "setoff" and "lien" "connote independent concepts, governed by distinct legal principles." The court turned to the definitions of these terms to illustrate its point. “Setoff,” the court stated, referred to “situations where both plaintiff and defendant have independent causes of action maintainable against each other in separate actions which can be mutually deducted whenever either one brings a suit against the other.” In contrast, the court noted that a "lien" has been defined as "a charge or encumbrance upon property to secure the payment or performance of a debt, duty, or other obligation. It is distinct from the obligation which it secures."

It is clear from the definitions of "lien" and "setoff" that the term "setoff" does not refer to the same type of interest as a "lien." A lien is distinct from the obligation it secures while the same is not true of a right of setoff or recoupment. They have no value separate and apart from a debtor’s or purchaser’s claim.

Folger Adam Security, Inc. v. DeMatteis/MacGregor JV, 209 F.3d 252, 259-260 (3d Cir. 2000) (internal citations omitted).

Folger is consistent with the text of 11 U.S.C. § 506, which uses both the term "lien" and the term "setoff" in defining a secured claim, thus distinguishing between these two concepts:

[a]n allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditors’ interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be...

11 U.S.C. § 506(a)(1) (emphasis added). Thus, the text of §§ 364, 506 and 553, as well as the language of Folger, provide support for the view that setoff rights cannot be primed under § 364.

Putting aside the arguments and authority for or against priming setoff rights, orders priming setoff rights, once entered by a bankruptcy court, may be very difficult for a bank with a common borrower/depositor to challenge after the fact. The bottom line for such banks is to beware of such proposed orders, particularly those containing generic language priming all interests, and object as necessary or appropriate to ensure that their setoff rights are preserved.

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1A debtor in possession (DIP) loan provides financing for Chapter 11 debtors while in bankruptcy and frequently includes provisions priming existing liens (i.e., providing the DIP lender with the most senior priority, notwithstanding liens that may have been recorded earlier in time by other parties).
2Studley v. Boylston Nat. Bank of Boston, 229 U.S. 523, 528 (U.S. 1913) (discussing setoff of mutual prepetition debts and the rationale behind the doctrine). While the Bankruptcy Code requires, but does not define, "mutuality,"state law often provides that setoff exists if the parties and their capacities are the same, even if the transactions are different. See, e.g., In re Patterson, 967 F.2d 505, 510 (11th Cir. 1992) (applying Alabama law).
3See 11 U.S.C. § 553(a); see also, e.g., In re Patterson, 967 F.2d at 509 (setoff right, as it exists under state law, is preserved by 11 U.S.C. § 553).
4See, e.g., In re deCODE genetics, Inc., No. 09-14063, 2009 Bankr. LEXIS 5013, at *13-14
(Bankr. D. Del. Dec. 11, 2009) (“Except as set forth herein, the DIP Lender’s Liens under this Final Order and the DIP Loan Agreement shall continue to be at all times first and senior in priority to all other liens, encumbrances or security interests of every kind and shall not be subordinate or pari passu with any other lien, encumbrance or security interest or right of setoff, including liens in respect of the Prepetition Note Obligations, and no [sic] Hen, encumbrance or security interest shall be permitted which shall be senior to or pari passu with the DIP Lender's Lien granted hereunder or under the DIP Loan Agreement.") (emphasis added).
5See supra text accompanying note 4.
6For instance, the DIP lender might ask for a bank account control agreement in the alternative.
7See In re St. Mary’s Hospital, No. 09-bk-015619 (Bankr. D. N.J. Mar. 31, 2009), ECF No. 140 at 67:3-11.
8The Bankruptcy Code also limits the ability to setoff disallowed claims, certain claims transferred by an entity other than the debtor, and certain claims incurred by the creditor for the purpose of obtaining a right of setoff against the debtor. See 11 U.S.C. 553(a)(1)-(3).
9A "lien" is defined by 11 U.S.C. § 101(37) as "a charge against or interest in property to secure payment of a debt or performance of an obligation."