Canada: Additional Set-Off Rights Against Cash Collateral Accounts - Better Be Clear

Bank of America N.A. v. Lehman Brothers Holdings Inc. and Lehman Brothers Special Financing Inc. 439 B.R. 811 (2010) (U.S. Bankr. Ct., S.D.N.Y.)

I do love the food for thought these Lehman Brothers bankruptcy cases provide. While they often turn (as this one does) on specific provisions of U.S. bankruptcy or state law, they do remind us of the importance of stating very clearly what is or is not permitted, especially when it comes to set-off. Although the case considers the Bankruptcy Code netting safe-harbour and security interests in cash collateral accounts, it is in essence a case about the availability of common law set-off in the context of cash collateral arrangements.

As you may know by now, BOA was found by Judge Peck to have breached the bankruptcy stay by setting-off an amount LBHI owed to it as guarantor of terminated swap contracts entered into between BOA and LBSFI against cash collateral credited to an LBHI account at BOA. The main question was whether BOA was entitled to exercise that right of set-off under state law against this particular account. In Canada we do not have any stay on the exercise of set-off rights in a bankruptcy proceeding, so the issue relating to the stay would not arise here. However, the main issue of whether a right of set-off was available might.

The cash collateral had been provided pursuant to a negotiated security agreement under which it was clear that the security interest secured only certain overdraft facilities LBHI had with BOA. LBHI's guarantee liability was not an obligation secured by this cash collateral. Consequently, the court found that the statutory safe-harbour did not apply, i.e. the protection from the stay for exercising contractual rights under any security agreement forming part of or related to a swap agreement. (While the language in the Canadian safe-harbours is quite different, we'd see the same result here if we were dealing with an insolvency proceeding that involved a stay on collateral enforcement, such as the CCAA. Under the CCAA, the right to set-off the value of financial collateral requires that the collateral have been provided for the eligible financial contract.)

The more interesting legal issue in the case related to whether BOA could rely on a common law right of set-off. The security agreement pursuant to which the cash collateral had been provided that BOA retained the right to exercise any remedy provided by applicable law and stated that the rights, powers and remedies given to BOA by the agreement were in addition to all rights, powers and remedies given by virtue of any statute or rule of law. BOA argued that this meant it retained its state law rights of set-off.

The court disagreed. To give these boilerplate provisions an interpretation that would permit BOA to set-off any other obligation against the cash collateral was inconsistent with the purpose of the agreement, which was to secure the specific obligation relating to intra-day overdrafts.

Granted it is difficult to draw a distinction between a cash collateral set-off arrangement and a set-off agreement or right that does not involve a security interest. However, there are differences. With cash collateral arrangements (as was the case with LBHI) the collateral provider had certain obligations with respect to the cash collateral as it relates to the secured indebtedness. It has to maintain a certain amount on the deposit as a condition of maintaining the overdraft, and it has to give notice if it wants to withdraw the funds or may not be permitted to withdraw the funds. These types of contractual requirements and restraints which apply to the funds on deposit and relate specifically to the indebtedness provide assurance that the set-off opportunity will ultimately be available and in that vernacular sense "secure" the indebtedness. There is no such assurance that other obligations will ultimately be available for set-off since those contractual obligations do not apply to them. It's not necessarily inconsistent with the intention of the parties to allow both the specific contractual set-off with respect to the specifically secured indebtedness and the more random, see where we are when the music stops, set-off at common law or perhaps under a general set-off clause, such as the ISDA standard form set-off provision.

Much of the analysis in the case focused on whether the cash collateral account was a special or a general account. Under N.Y. law rights of set-off cannot be asserted against a special account. The court found it was a special account and precluded the set-off on that basis. Canadian common law does not draw a distinction between special and general accounts, at least not expressly. A fund, such as a trust fund, may be created for a certain purpose and only accessible for that purpose, so I won't say that this type of analysis would never apply. However, it's more likely that it would be argued as an implied waiver of the set-off right in Canada and that may have been harder to argue given the preservation of rights in the agreement.

In any event, the lesson of the case is that your boilerplate may not be as helpful as you think. With cash collateral arrangements, if the definition of secured indebtedness is narrow, you may want to be clearer about what rights of set-off are retained. The inclusion of the standard form of set-off clause in the 2002 ISDA Master (and in many earlier versions) would have added an interesting dynamic to this case.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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