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Contract Rejection Damages May Not Be Eligible for Setoff After All Says Delta Court

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Bankruptcy practitioners agree that a creditor can set off rejection damages caused by a debtor's rejection of an executory contract against any pre-petition debt the creditor owed the debtor. This is because §§365(g) and 502(g) of the Bankruptcy Code provide that ordinarily, the rejection of an executory contract constitutes a breach of that contract immediately before the date of filing. Thus, upon rejection a creditor has a pre-petition claim for damages. Until recently, it seemed clear that this pre-petition claim for damages could be set off against a pre-petition debt without running afoul of the section that preserves setoff rights, §553(a). But practitioners will have to rethink their position in light of In re Delta Airlines Inc.1

In Delta, the U.S. Bankruptcy Court for the Southern District of New York—contrary to the two leading bankruptcy treatises and several decisions of other courts—held that as a matter of law, rejection damages cannot be set off against a pre-petition debt. As surprising as the holding may be, more disconcerting is the court's reasoning. Debtors across the country are sure to cite Delta to challenge not only rejection damage setoffs (and §502(h) preference damages), but setoffs that had never before been challenged, such as setoffs for contingent and unmatured claims. Business people who were confident that all was not lost because they could satisfy their pre-petition payables by setoff against rejection damages must now reassess their position in light of Delta. Because the decision was not appealed, it looms large, and bankruptcy practitioners must assess whether the court's reasoning is likely to be persuasive.

Delta: Rejection Damages, as a Matter of Law, Cannot Be Set Off

In Delta, the Greater Orlando Aviation Authority (GOAA) sought to set off its damages caused by Delta's §365(a) rejection of its airport lease and use agreement against amounts GOAA owed the debtor, Delta. The court denied GOAA's motion for setoff because it "conclude[d]" that "as a matter of law, rejection damages under §§365(g) and 502(g) may not be set off against a pre-petition claim or debt."2

The court's analysis rests on what it "emphasized" are two supposedly "fundamental points" necessary to understanding the effect of §553(a). First, the court noted that only mutual debts owing between the debtor and a creditor that arose before commencement of the case may be set off. This first "fundamental point" appears to be little more than a restatement of the statute. It is the court's second "fundamental point," a somewhat suspect proposition, that drives the court's decision regarding rejection damages:

[T]he setoff right to which the statute applies is exclusively a right under nonbankruptcy or state law. Section 553(a) does not create a federal right of setoff, nor does it enhance, diminish or otherwise modify any state law right of setoff.3

The court cites no authority for this proposition, but attempts to buttress it by adding that

this is made explicit in §553(a) when it states "this title does not affect any right of a creditor to offset" mutual debts owing between creditor and debtor pre-petition. What the statute makes explicit, the case law uniformly holds.4

For support, the court relies on a string cite of more than 20 cases. But the majority of these cases simply hold that §553(a) "preserves" or does not diminish existing setoff rights, not that Title 11 cannot have any "effect" whatsoever on a state law right of setoff.

The court states that its "fundamental points" "result in one statutory imperative: if no right of setoff under state law existed before commencement of the case, none exists under §553(a)."5 The court reasons that the plain meaning of §553(a) demands as much. Therefore, the court concludes that §§365(g) and 502(g) cannot be read into §553(a) to allow a creditor to set off rejection damages, thereby "affect[ing]," i.e., enhancing, the creditor's setoff rights. For purposes of §553(a) then, the court held that GOAA's

rejection damage claim is not "a claim...against the debtor that arose before the commencement of the case" as a matter of state law. The rejection claim did not "arise" pre-petition in any sense of the word. It did not exist pre-petition either as an actual claim or as a contingent claim, any more than the possibility of some future breach-of-contract claim can be said to "arise" or exist before the actual breach. Thus, as a matter of temporal fact and as a matter of state law, there was no claim of GOAA against Delta that "arose" pre-petition to be offset against Delta's putative or supposed pre-petition claim against GOAA based on the credits. Since the cases uniformly recognize that the Code does not create a right of setoff, and that the only right of setoff preserved under §553(a) is a right that existed under nonbankruptcy state law before the bankruptcy filing, GOAA's claimed setoff must fail.6

According to the court, Congress could have drafted §553(a) to permit, or not permit, setoff of rejection damages, and Congress did not do so. This omission did not lead the court to conclude that the statute was ambiguous. Instead, the court concluded that, if the "does not affect" language of §553(a) means anything, it

must mean that §§365(g) and 502(g) of "this title" do not affect whatever right or lack of right a creditor had pre-petition to offset against a debtor, so that if a creditor had no offset rights pre-petition, the Bankruptcy Code does not create a right to offset.7

Delta Fails to Distinguish between State Law and Code

The result in Delta, one could argue, is a product of the court's failure to distinguish between the state law8 setoff rights incorporated in §553(a) and the bankruptcy law framework within which those rights are recognized. Whereas the court presumed that §§365(g) and 502(g) affect the substantive right of setoff, most courts clearly distinguish between substantive state setoff law and the applicable bankruptcy law that establishes itself when a claim arises. Although state law determines the substance of a claim,9 "it is well settled that federal law governs when a claim arises."10 Since §§365(g) and 502(g) only establish when a claim arises, these sections arguably do not affect a creditor's nonbankruptcy setoff rights.

If the court's failure to recognize this distinction is ignored, its reasoning appears somewhat persuasive. Congress could have said that the Code does not "prejudice" a setoff right, but it chose to use the much broader word "affect."11 Thus, it would perhaps follow that §§365(g) and 502(g) could not be used to enlarge the right of setoff, as such would be to affect the right of setoff.

But if the Delta court's reading of §553(a) is correct, it would extend even further. Ordinarily, under state law, "[u]nmatured or contingent claims cannot be used as a setoff or counterclaim."12 But under the Code, pursuant to the expansive definition of a claim found in §101, unmatured and contingent claims are eligible for setoff.13 Not so under the holding of Delta, because the expansive definition of claim, found in the same title as §553(a), would "affect" a creditor's right of setoff and thus would be inapplicable. Therefore, it appears that in addition to denying the setoff of rejection damages, Delta precludes setoffs that are now routinely allowed.

The Delta court did recognize that its decision is contrary to several court decisions and the two leading bankruptcy treatises.14 Those cases hold that rejection damages can be set off under §553(a) because they arise pre-petition as provided in §§365(g) and 502(g). The Delta court dismissed those cases, however, by simply asserting that none considered the plain language of §553(a) and the plain language, according to the court, "precludes the application of §§365(g) and 502(g) 'of this title' to the right of offset existing under nonbankruptcy state law which is preserved in §553(a)."15 As for the treatises, the court argues, in part, that their positions are not well supported, and the court simply relies on its assertions to counter the treatises' reasoning.

Delta Fails to Recognize that §553(a) Is Ambiguous

The Delta court's argument that §553(a) unambiguously mandates its result is unconvincing, especially considering that the court's reasoning is inconsistent with that of numerous other courts. Furthermore, although the Delta court attempted to address the conflicts it created, it failed to consider additional implications of its decision. For example, several of the terms used in §553(a) are defined in Title 11. To consult any such definition certainly "affects" §553(a), and thus the court's literal application of §553(a) apparently requires that the definitions not be consulted. It is difficult to believe that the "unambiguous" mandate of §553(a) is that it be applied in a vacuum where only state law rights are considered. The court does not consider such implications, but only steadfastly asserts that the "plain and ordinary meaning rule," as the court applies it, requires its result.

But if one accepts that the impact of the term "affect" is ambiguous, it is a basic principle of statutory interpretation that other relevant sections, and the Code as a whole, ought to be considered. Sections 365(g) and 502(g) unambiguously command that the rejection of an executory contract constitutes a pre-petition claim for breach of that contract. Until Delta, there was virtually no authority holding that rejection damages could not be set off as pre-petition damages under §553(a). In light of the contrary case law and alternative readings of the statutes at issue, the court's reasoning does not measure up to the task of causing the dramatic setoff sea change its holding dictates.

Most courts hold that §553(a) merely preserves state law setoff rights, and those rights are exercised within the artificial setting of a bankruptcy case. If a court cannot consult any section of Title 11 because it may "affect" a state law setoff, then Delta requires that many setoffs that are now routinely allowed must be denied.

For example, assume Party A owes Party B $100 under contract one, and Party B owes Party A $50 under contract two. If Party B sues Party A in state court for the $100, state law allows Party A to set off the $50 owed to him or her by Party B. Thus, state law recognizes a right to setoff in this scenario.

Of course, the debt must be due and owing at the time of the proposed setoff. When a lawsuit is initiated in state court, state law determines whether the debt is due and owing. If, instead, Party B filed for bankruptcy protection, state law would still determine the substance of Party A's claim—for example, whether a breach of contract had occurred. But in bankruptcy, it is federal bankruptcy law that determines when Party A's claim arose, not state law. As suggested above, this distinction is important to implementing the policies of the Code. Congress intended to adopt a broad definition of claim, and thus, for example, "a party may have a bankruptcy claim and not possess a cause of action on that claim."16

Bankruptcy courts have developed at least four approaches to determine when a claim arises.17 These approaches are creations of the bankruptcy courts and independent of the underlying substantive law. Thus, because of the Code's broad definition of a claim, it is possible that Party A may not have a right of setoff in a state court lawsuit, but might nevertheless have had a right to setoff if Party B had instead filed for bankruptcy on that same day.18

Scores of cases hold that the Code's broad definition of "claim" applies when determining a party's §553(a) setoff rights. As discussed above, Delta did not address that its holding seemingly invalidates these cases. If it is proper to use the Title 11 definitions, it is not a great leap to suggest that §§365(g) and 502(g) ought to be consulted as well. At the very least, the use of these definitions illustrates the ambiguity regarding the impact of the word "affect" in §553(a). Given this ambiguity, the Delta court's "plain language" interpretation of §553(a), and its anomalous result, is highly questionable.

Section 553(a) Is Subject to Multiple "Plain Meaning" Interpretations

The Delta court could have adopted an alternative "plain meaning" interpretation of §553(a) that does not conflict with the holdings of other courts, the reasoning of the leading bankruptcy treatises, and the expectations of practitioners and their clients. Section 553(a) provides that "this title does not affect any right...." Well, as a threshold matter, when speaking of executory contracts, no setoff right exists immediately before the commencement of a bankruptcy case. So even if one agrees with the Delta court that §553(a) cannot affect a preexisting right, §553(a) does not preclude the application of other Title 11 sections; there is no right to be affected.

Once an executory contract is rejected, after commencement of the case, §§365(g) and 502(g) mandate that the rejection gives rise to a pre-petition claim for breach of contract. Only then does the right arise. As a result, the creditor has a pre-petition claim that gives rise to a right to set off that claim against a pre-petition debt. Now that the right has come into existence post-petition, it is preserved by §553(a).

This is a plausible interpretation of §553(a), which, when contrasted with the Delta court's interpretation, establishes that §553(a) is ambiguous. Once it is established that §553(a) is ambiguous, a court cannot simply choose one literal interpretation over another, but must consider external factors such as congressional intent and the purposes of §553(a) and the Code as a whole.

Prediction: Courts Will Not Likely Follow Delta

Delta was not appealed, and thus bankruptcy practitioners cannot sit idle and hope that it will be overruled. Debtors will argue that bankruptcy courts across the country should adopt the Delta reasoning and deny rejection damage setoffs and other setoffs that were formerly unquestioned. As has been illustrated, however, the Delta court's reasoning is unconvincing. So long as the Delta court's allegedly unambiguous interpretation of §553(a) is rejected, a subsequent court is unlikely to reach the same conclusion. If a court considers the appropriate factors to guide its interpretation, including congressional intent and the purposes of §553(a) and the Code as a whole, a good argument can be made that rejection damages do arise pre-petition and can be set off against a pre-petition debt. But for now, bankruptcy practitioners must prepare themselves and their clients for the possibility that an array of setoffs may no longer be available.



1 341 B.R. 439 (Bankr. S.D.N.Y. 2006).

2 Id. at 441. The court also "concluded" that the "credits" GOAA owed Delta were neither a debt nor claim that existed or arose pre-petition. Id. Under the parties' contract, GOAA owed Delta credits for excess fees Delta had paid for the use of GOAA's airport facilities. According to the contract, the credits were to be offset against use fees when the fees became due in the next fiscal year. The court's decision that the credits were not a pre-petition debt was sufficient to deny the motion for setoff, and thus the court did not need to address the rejection-damages issue. But even then, the fact that the court's rejection-damages analysis was unnecessary makes little difference if other courts find its reasoning persuasive.

3 Id. at 443 (emphasis added).

4 Id. (emphasis added).

5 Id. at 445.

6 Id. at 447.

7 Id. (emphasis added).

8 Section 503(a) incorporates nonbankruptcy law setoff rights, which include those that arise under state law. The following analysis applies equally to the broader category of nonbankruptcy law setoffs. For simplicity, this article refers to state law setoff rights.

9 Bailey v. Big Sky Motors (In re Ogden), 314 F.3d 1190, 1200 (10th Cir. 2002).

10 In re Parks, 281 B.R. 899, 902 (Bankr. E.D. Mich. 2002).

11 But the word "affect" itself is arguably ambiguous. See, e.g., McComas v. Board of Educ., 197 W.Va. 188, 205 (W.Va. 1996) (declining to adopt literal interpretation of "affected" school); Patelle v. Planning Bd. of Woburn, 20 Mass. App. Ct. 279, 282 (Mass. App. Ct. 1985) (rejecting literal definition of "affect"); Baird v. St. Louis Hospital Ass'n., 116 Mo. 419, 427 (Mo. 1893) ("it is enough to say that it (the word "affect") is often used in the sense of acting injuriously upon persons and things, and in this sense we are all of the opinion it was used in this proviso"); but see NLRB v. Suburban Lumber Co., 121 F.2d 829, 832 (3d Cir. 1941) (usage of the word "affect" in statutes is of recent origin and has the widest conceivable scope).

12 20 Am. Jur. 2d Counterclaim, Recoupment and Setoff §22 (1995).

13 United States v. Gerth, 991 F.2d 1428, 1433 (8th Cir. 1993) ("for setoff purposes, a debt arises when all transactions necessary for liability occur, regardless of whether the claim was contingent, unliquidated or unmatured when the petition was filed").

14 See 3 Norton Bankr. L. & Prac. 2d §63.4 (2006); Collier on Bankruptcy |553.03[1][i][i] 15th ed. (rev. 2004).

15 Delta, 341 B.R. at 449.

16 In re Remington Rand Corp., 836 F.2d 825, 832 (3d Cir. 1988).

17 See 5 Collier on Bankruptcy |553.03[1][b] 15th ed. (rev. 2004) (providing the accrual test, conduct test, relationship test, and fair contemplation or foreseeability test).

18 Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1398 (9th Cir. 1996) (holding that contingent and unliquidated claims can be set off); Roberds Inc. v. Lumbermen's Mut. Cas. Co. (In re Roberds Inc.), 285 B.R. 651, 657 (Bankr. S.D. Ohio 2002) ("for purposes of establishing when a claim (11 U.S.C. §101(5)) accrues under the Bankruptcy Code, the court is not limited to state law definitions of when a cause of action accrues...").

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Friday, September 1, 2006

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