Triangular set-off
Asituation wherein a derivative counterparty seeks to set-off obligations it is owed under one ISDA Master Agreement by one bankrupt counterparty against liabilities it has under another ISDA Master Agreement to another derivatives counterparty in the same group.
Triangular set-off
traɪˈæŋɡjələ ˈsɛtˈɒf (n.)
A forlorn attempt to rob Peter to pay his brother Paul. Does not work, without quite a lot of ugly machinery.
If this sounds like a hopeful try-on, well that’s because it is. But it was an untested try-on, before the courts, until September 2008. Despite ignoring basic precepts of commerce and contract law, it still passed, in polite legal eagley circles, as rather a grand idea. It seems to have made its way into many a Part 5.
But then it was tested, in the generational shitstorm that followed the Lehman failure. The test did not go well. Now three-way set-off might work, amongst cooperative parties, in ordinary, non-bankrupt times, but only because they are cooperating and no-one is testing it, not because it is legally effective.
But set-off is a drastic remedy; you do not invoke it in ordinary times while parties are cooperating. In unordinary times, when august institutions are spontaneously imploding to your left and right, triangular set-off won’t work. That, alas, is the one time you would ever want it to.
Cross-affiliate set-off cannot be enforced in bankruptcy. It does not work at common law. It requires mutuality of counterparties that Q.E.D. is not there between three legal entities. You can’t create “trilateral mutuality” just by saying it under a couple of bilateral contracts.
No, “safe harbor” provisions for derivatives in the Bankruptcy Code don’t help: they don’t let you exercise a contractual set-off right where there is no mutuality between parties any more than the common law does.
There are now a multitude of client notes advising, definitively:
Thanks to a ruling of this or that circuit of the district court of Southern New York, it is now confirmed that triangular set-off is ineffective in bankruptcy —
When really they should say:
duh — of course triangular set-off doesn't work. It is a contradiction in terms. What kind of weed were you smoking when you thought it might?
This all became a hot topic when the aforesaid Lehman Brothers — a banking conglomerate in the habit of having far more trading entities than served any plausible purpose other than sharp accounting and tax optimisation — collapsed. Counterparties found they were in the hole to, for example, Lehman Brothers International Europe, while they were owed big style by Lehman Brothers Holdings Inc.
Smug legal eagles reached for their triangular set-off clauses, embedded in Part 5 of their ISDA Schedules, and went to set these respective obligations off against each other. And found — it didn’t work so well after all.
It is the wrong end of the airbag - steering-wheel continuum of risk management, as the premium section will endeavour to explain.
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