Before filing its own bankruptcy petition, Delphi Automotive Systems LLC became entangled in the bankruptcy of one of its suppliers and customers, U.S. Aeroteam Inc. (USAT). The entanglement was indicative of many of the relationships in the U.S. automobile industry—suppliers supply each other as well as the end users. Creditors are debtors and debtors are creditors, all in an industry where the end user is squeezing tighter and tighter. Because of the relationship between creditor and debtor, state law rights of setoff and recoupment may end up trumping the rights of lenders that believe their blanket liens are airtight. If trade creditors exercise rights of setoff or recoupment under state law either before or during a bankruptcy case, the lender may find that the collateral securing its loan has less value. This was the lesson learned by Provident Bank in U.S. Aeroteam Inc. v. Delphi Automotive Systems LLC (In re U.S. Aeroteam Inc.), 327 B.R. 852 (Bankr. S.D. Ohio 2005).

Facts of U.S. Aeroteam Inc.

In 2003, USAT sought protection from its creditors by filing a chapter 11 petition in the U.S. Bankruptcy Court for the Southern District of Ohio. At the time USAT filed its bankruptcy petition, Provident Bank held a security interest in substantially all of USAT's assets, including its accounts receivable. USAT owed Provident Bank approximately $2.045 million at the time of the bankruptcy petition. In manufacturing its parts, USAT used parts manufactured by Delphi and Texas Foundries. Delphi also bought parts from USAT. The core relationship, however, was the purchase by Delphi of parts from USAT. Each purchase order used by Delphi to purchase parts from USAT contained "general terms and conditions" governing the terms of shipping, billing quality, termination and other aspects of the parties' contractual obligations. Specifically, the general terms and conditions stated:

With respect to any monetary obligations of seller [USAT] or seller's affiliates to buyer [Delphi] or buyer's affiliates, buyer may (1) set off such obligations against any sums owing to seller or seller's affiliates and/or (2) recoup such obligations from any amounts paid to seller or seller's affiliates by buyer or buyer's affiliates.

After USAT began having trouble meeting its contractual obligations to Delphi, Delphi stopped payment on its accounts payable to USAT.

USAT filed a voluntary bankruptcy petition on Dec. 24, 2003. Following the USAT bankruptcy filing, Dephi owed USAT $819,857 and USAT owed Delphi $755,120. In addition, Delphi had paid another supplier to USAT, Texas Foundries, $187,436 and had taken an assignment of the Texas Foundries' claim against USAT. Shortly after the USAT petition, Delphi filed a motion to modify the automatic stay to allow it to set off or recoup amounts Delphi owed USAT against amounts USAT owed Delphi. USAT and Provident Bank both objected to the motion, raising separate defenses. Thus, the court was required to scrutinize the intersection of Article 9 of the Uniform Commercial Code (UCC) with state law rights of recoupment and setoff and with §553 of the Bankruptcy Code.

Delphi's Right of Setoff Against USAT's Claims Against Delphi

Setoff is a state law right that is preserved in bankruptcy under 11 U.S.C. §553. Setoff allows entities who owe money to each other to cancel out or apply their mutual debts against each other, thereby avoiding the "absurdity of making A pay B when B owes A."¹

To exercise a right of setoff in bankruptcy, a creditor must begin by demonstrating valid setoff rights under the applicable state law. The obligations involved must be mutual. Although the Code does not define mutual debt, courts require that the obligations in question be in the same rights and be between the same parties standing in the same capacity. Delphi's claim against USAT was derived from two USAT obligations. The first was a debt owed directly by USAT to Delphi for component parts purchased from Delphi. The second part of the claim was the result of USAT's purchase of rotors from Texas Foundries, an entity unrelated to Delphi.

Based on the mutuality of the obligations and the contract terms, the court found that Delphi established a right to setoff under state law with respect to $567,683 that USAT owed to Delphi for rotors.

USAT's Debt to Delphi as Assignee of the Texas Foundries' Claim

Delphi also argued that the claim assigned to it by Texas Foundries should also be the basis for a setoff or recoupment of the amount owed by Delphi to USAT. USAT argued that because the claim was not originally owed by Delphi to USAT, the required element of mutuality was missing. The court explained that debts are "mutual" when they are owing between two parties in the same right and same capacity."² The essence of mutuality is that at the time of setoff each party owns its claim independently. Thus, if A attempts to offset an obligation owed to B against B's debt to C, mutuality would not exist and a setoff would not be proper.

There are instances, however, where mutuality exists because one party has taken over the obligations of another. If A pays the obligation owed by B to C and C owes A, there is now mutuality of obligations between A and C through the doctrine of equitable subrogation. Mutuality can also be gained through assignment, which is what Delphi relied upon in establishing mutuality and a right of setoff for the USAT debt owed to Texas Foundries against that owed by Delphi to USAT.

Courts have generally allowed mutuality to be established through assignment, so long as the party attempting setoff complies with the requirements of §553. Section 553 is drafted in such a way that it prevents "trafficking" of claims in order to establish setoff advantages—the elevation of an unsecured claim into a claim that can be immediately paid through the "setoff." To prevent this, the setoff right cannot be established after the 90 days before the petition date and while the debtor is insolvent. Thus, if the claim was acquired prior to the 90 days, it can be the basis of the "setoff."

Delphi argued that it acquired the Texas Foundries' claim by assignment prior to the 90-day pre-petition period. The court agreed that the assignment established that Delphi became the true owner of the Texas Foundries' claim and that this was sufficient to establish the right to setoff. During the 90 days prior to the petition date, however, Delphi's accounts payable to USAT built up and increased its setoff rights. USAT claimed that Delphi was not entitled to set these off against what USAT owed Delphi because USAT was insolvent during the 90-day period. Delphi did not dispute the buildup of payables during the 90 days prior to the petition date, but denied that USAT was insolvent. Delphi argued that USAT owned a claim that, if added to USAT's assets, would create a positive asset value.³ Based on this argument, the court determined that a trial on this issue was appropriate.

Priority of Setoff Rights vs. Security Interests in Accounts Receivable

Provident Bank and USAT objected to the setoff by Delphi. To secure the loan made by Provident to USAT, USAT granted a security interest in substantially all of its assets, including its accounts receivable. USAT and Provident asserted that the security interest gave Provident a superior right in the receivables, and the superior right prevented Delphi from exercising its setoff rights. USAT and Provident argued that Article 9 of the UCC governed priority disputes between setoff rights that conflict with an Article 9 security interest. Specifically, USAT argued that under UCC §9-322, a perfected security interest in accounts receivable prevailed over an unperfected setoff right in the same collateral.

A split of authority exists as to the applicability of Article 9 to setoff rights. This bankruptcy court decision provides a good summary of the holdings of various courts. The line of cases supporting USAT's argument that the right of setoff is an unperfected security interest, and therefore setoff rights are subordinate to perfected security interests under UCC §9-322 and its "first to file" rule is the minority position. The holdings of these cases have largely been dismissed, as setoff rights are simply not security interests and are not treated as such under Article 9 of the UCC.⁴ Thus, reliance on UCC §9-322 is unfounded because the section is designed to determine priority between competing security interests.

The court held, however, that Article 9 is designed to apply to rights of recoupment or setoff against deposit accounts under UCC §§9-340 and 9-404 with respect to defenses or claims of an account debtor. Section 9-404 is titled "Rights Acquired by Assignee; Claims and Defenses against Assignee." The section states:

Assignee's rights subject to terms, claims and defenses: exceptions. Unless an account debtor has made an enforceable agreement not to assert defenses or claims, and subject to subsections (b) through (e), the rights of an assignee are subject to:
(1) all terms of the agreement between the account debtor and assignor and any defense or claim in recoupment arising from the transaction that gave rise to the contract; and
(2) any other defense or claim of the account debtor against the assignor which accrues before the account debtor receives a notification of the assignment authenticated by the assignor or the assignee.

Article 9 §9-102(a)(3) defines an "account debtor" as a person obliged on an account. In this case, Delphi is the account debtor attempting to execute its right to set off amounts owed by USAT.

Section 9-404 applies to a party granting a security interest in contractual rights to a third party, referred to as the "assignee." The assignment is made without notice or knowledge of the other party, referred to as the account debtor.⁵ Thus, in this case, to protect Delphi, the account debtor, the grant of the security interest to Provident Bank is made "subject to...all the terms of the contract" including "any defense or claim" that the account debtor has under the terms of the contract. The agreement between Delphi and USAT provided in the contract terms that Delphi had a right to set off amounts owing between the parties. Therefore, Provident Bank could only take its security interest in contract rights or receivables subject to Delphi's contractual right to setoff.

If Delphi had been given notice that Provident Bank held a security interest in receivables and contract rights, would this have altered the outcome of this case? One limit to the priority of Delphi's setoff rights would have been prior notification that Provident Bank held a security interest prior to setoff rights accruing. The court pointed out, however, that the mere filing of a UCC-1 financing statement would be insufficient to provide this notice to Delphi. Although the court does not provide insight into what would constitute sufficient notice, perhaps only actual notice to Delphi prior to entering into the contract with USAT would be adequate.

Lessons Learned

Lenders holding liens on accounts must be aware that these liens are subject to the contract rights attaching to the accounts, including setoff and recoupment rights. Although the trade creditor with outstanding receivables against the debtor holds nothing more that an unsecured claim against the borrower/debtor, if the trade creditor also has setoff or recoupment rights that may be exercised, the lender's claim to the borrower/debtor's receivable will be stripped of value. Although the setoff right is not a prior lien, or even a lien at all, the exercise of setoff or recoupment may significantly lessen the value of the receivables to the lender.

A lender finding itself in this position should look carefully at §353 of the Code to examine whether the setoff claim should be allowed and should ask the following questions:

• Was the transfer made after the commencement of the case or during the 90-day pre-petition period?
• Was the transfer made while the debtor was insolvent?
• Was the creditor withholding payment to obtain the right of setoff?

If the answer to all three questions is "yes," then the setoff rights are not proper under §553(a)(3). If, however, the answer to any one of the questions is "no," then right of setoff would not be proper.

All parties should be alert to existing intertwined debtor/creditor relationships, which are especially common in the automobile industry. Lenders in particular should carefully monitor the borrower's receivables where such relationships may exist, or require the borrower to disclose such intertwined relationships so that the lender is not caught unaware of this potential problem that will reduce the value of its collateral.

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Footnotes

¹ U.S. Aeroteam Inc. v. Delphi Automotive Systems LLC (In re U.S. Aeroteam Inc.), 327 B.R. 852, 861 (Bankr. S.D. Ohio 2005) (citing Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18, 116 S.Ct 286, 133 L.Ed.2d 258 (1995)). Return to article

² Id. at 864. Return to article

³ In a separate adversary proceeding, USAT claimed that Delphi's Saginaw Steering division breached a contract resulting in damages to USAT in the amount of $2.2 million. If USAT succeeded in this adversary proceeding, USAT would be deemed solvent during the 90-day pre-petition period. Return to article

⁴ See National City Bank Northwest v. Columbian Mutual Life Insurance Co., 282 F.3d 407 (6th Cir. 2002). Return to article

⁵ See National City Bank Northwest v. Columbian Mutual Life Ins. Co., 2000 WL 1675545, at 3 (N.D. Ohio Sept. 13, 2000) aff'd., 282 F.3d 407 (6th Cir. 2002); First National Bank of Boston v. Thomson Consumer Electronics Inc., 84 F.3d 397, 400 (11th Cir. 1996) (§9-404 is to govern third-party rights that arise when contract rights are assigned as part of a secured transaction). Return to article