Template:Bankruptcy set-off capsule

As we have said elsewhere, bankruptcy is a strange time. The usual cast-iron certainties that accopmpany dealings amongst merchants in the financial markets give way to a spooky, primordial dreamtime, where nothing is sure. All are beset by phantoms, nightmares and the dark pantomime of the supernatural.

Lawyers do not like this, but it keeps them in employment, so do not shed too many tears.

Normally, as JC’s article about set-off describes, peace-time set-off is a sensible, self-help remedy where parties can take matters into their own hands, apply a quid against a quo of equal value, and no part of the jurisprudence of fairness will be upset. I owe you, you owe me, to save forking over equal sums, we call it quits. My claim for £100 from you is the same my liability for £100 to you, so we put the two together and they vanish in a puff of legal and mathematical logic. Simple.

Bankruptcy changes all this. When, as a going concern, you face a bankrupt, your claim for £100 is not worth £100. It may be worth nothing. You must take your place in the queue of creditors and find out. And if, at the same time, you have a liability to that very same bankrupt for the very same £100 it is still worth £100. The bankrupt can make you pay the whole lot. This seems unfair, but this is the game of cosmic chicken we play by extending credit.

So, you see, an enforceable set-off is a highly attractive proposition — for you. For the bankrupt’s administrator, on the other hand, at least as far as the bankrupt’s other creditors are concerned, avoiding that set off is a highly attractive proposition.

This is the palaver that close-out netting and the vaunted Single Agreement concept addresses. The trick it tries to pull is to work like an enforceable set-off, without actually being a set-off, precisely because in bankruptcy, set-offs are notoriously unreliable.

We have seen wishful game-playing in insolvency scenarios. This is unlikely to work, but the fact that it has occurred to people to try it will give you a glimpse into the venal minds that operate in the capital markets.

A large Texan Energy conglomerate has gone titten hoch, leaving behind it, in that smoking crater, a portfolio of energy swaps it bought from you — Debtor A — which, against all the odds, are heavily in the money to the bankrupt. You owe, let’s say, a couple of hundred million. Reports in the market suggest that a number of your competitors — Creditors B, C and D — are in the opposite position — they are all owed a lot of money and the bankrupt, being a blackened stump in the middle of said crater, is not going to be able to pay them. Their combined claims against the bankrupt add up to roughly $200m. Indications are that these contracts will pay 10 cents on the dollar. If your counterparties are lucky they’ll get $20m between them, and that will take 5 years and God knows how much time, resources and legal fees.

There is a trade to be done here: Debtor A buys the claims of Creditors B, C and D for $25 million dollars. The Creditors all avoid five years of the swamp, and get out for more money than they were expecting. This is a great outcome. Debtor A acquires $200m of notional claims against Bankrupt E for 12.5 cents on the dollar, and then sets off that £200m claim against the $200m it already owes Bankrupt E under the portfolio of energy swaps. Creditor A has paid $25m to avoid a certain £200m loss.

Now, let’s be clear: while bankruptcy laws differ wildly this would not work in a jurisdiction with sophisticated bankruptcy regime: though the bankrupt is not involved — so it would not be directly voidable, bankruptcy administrators tend to have wide discretionary powers, and courts generally will take a dim view of actions that usurp the function of the administrator, as this clearly would do. Whether it might hold up if engineered before a bankruptcy, however, is another question. It would make a great play.