Joining three other circuits, the Third Circuit disallowed triangular setoffs, saying they lack “mutuality” as required by Section 553(a).

Embracing the “sound” analysis by Bankruptcy Judge Brendan L. Shannon in In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), the appeals court adopted his “well-reasoned conclusion” regarding mutuality.

The creditor owed the chapter 11 debtor some $7 million. The agreement between the two allowed the creditor to offset anything the debtor owed to any of the creditor’s subsidiaries.

The debtor owed $9 million to one of the creditor’s subsidiaries.

The creditor asserted a right of setoff under Section 553(a). Were it allowed, the creditor would have owed nothing to the debtor, and the subsidiary would have had a claim for $2 million. Were the setoff disallowed, the creditor would be obliged to pay the debtor $7 million while the subsidiary would have a $9 million claim.

Bankruptcy Judge Kevin Gross of Delaware disallowed the setoff, saying there was no mutuality required by Section 553(a). Judge Gross relied heavily on SemCrude. After 14 years as a bankruptcy judge, Judge Gross stepped down from the bench one year ago to join a firm in Wilmington.

The district court affirmed Judge Gross, prompting the creditor to appeal.

In an opinion on March 19 by Circuit Judge Kent A. Jordan, the Third Circuit affirmed.

The outcome was governed by Section 553(a), which provides that the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor . . . against a claim of such creditor against the debtor . . . .”

Like the bankruptcy court, the appeals court assumed that the triangular setoff was valid and enforceable under state law. In large part, the creditor argued that Section 553(a) permits any setoff that is allowed by state law. In other words, the creditor believed that Section 553(a) imposed no independent mutuality limitation beyond whatever the requirement would be under state law.

The Third Circuit had not written on the meaning of “mutual.” In addition, Judge Jordan said that the Third Circuit had not decided whether a contract “can create an exception to the requirement of direct mutuality.”

Citing SemCrude, Judge Jordan found a “compelling body of precedent” that “treats mutuality in § 553 as a limiting term, not a redundancy.”

Saying the analysis by Judge Shannon in SemCrude was “sound,” Judge Jordan said that Judge Gross and the district court “rightly treated mutuality as a distinct statutory requirement under § 553.” He therefore held “that contracts cannot turn nonmutual debts into debts subject to setoff under the Code, as if they had been mutual.”

If state law subsumed whatever mutuality requirements there might be, Judge Jordan said that “mutual” in Section 553(a) would be “redundant.” He continued:

We again agree with and adopt the SemCrude court’s well-reasoned conclusion that Congress intended for mutuality to mean only debts owing between two parties, specifically those owing from a creditor directly to the debtor and, in turn, owing from the debtor directly to that creditor. Congress did not intend to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.

Judge Jordan joined the Second, Fifth and Seventh Circuits by holding “that triangular setoffs — in which party A owes party B who next owes party C who then owes party A — are definitionally not mutual.” He said that SemCrude “persuasively rejected the attempt to escape triangularity by redefining what constitutes a ‘claim’ under § 553,” citing SemCrude, id., 399 B.R. at 397.

Judge Jordan buttressed his interpretation of the statute with policy arguments. For instance, he said that disallowing triangular setoffs “promotes predictability in credit transactions.”

The creditor had alternatives to accomplish the desired result. Judge Jordan said that the creditor could have perfected a security interest in the subsidiary’s account receivable from the debtor.

The opinion is McKesson Corp. v. Orexigen Therapeutics Inc. (In re Orexigen Therapeutics Inc.), 20-1136 (3d Cir. March 19, 2021).