Triangular Setoff Loses (Again) Under § 553 of the Bankruptcy Code

Setoff is a valuable state law remedy for trade creditors with a claim against, and an obligation owing to, an insolvent customer. The right of setoff allows a creditor to “net” or cancel mutual debts to avoid having to pay its debt to a debtor in full while standing in line to recover its claim against the debtor. “Triangular setoff” is a contractual right of setoff that permits one party to net and set off contractual claims of its affiliated entities against another party.

Section 553(a) of the Bankruptcy Code preserves a creditor’s right to offset the mutual debts of the creditor and debtor. Bankruptcy courts find that debts are “mutual” for purposes of section 553(a) “only when they are due to and from the same persons in the same capacity.” (emphasis added).[1] As a result, courts are refusing to allow parties to exercise “triangular setoff” rights under § 553 due to the absence of mutuality.

Most recently, on Nov. 13, 2018, Judge Gross of the U.S. Bankruptcy Court for the District of Delaware ruled that a triangular setoff does not satisfy the Bankruptcy Code’s mutuality requirement. The Court found that even though a contractual right allowing the creditor and its parent corporation to effect a prepetition triangular setoff was enforceable under state law, the arrangement did not comport with the strict mutuality required under the Bankruptcy Code.

§ 553 of the Bankruptcy Code

Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case.”[2] Setoff under § 553 is limited in three ways: (1) the right of setoff must first exist under “applicable nonbankruptcy law” (e.g. state law);[3] (2) a creditor can only offset mutual, pre-petition debts — that is, a creditor cannot use setoff to recover a pre-petition debt out of post-petition payments owed to the debtor;[4] and (3) a creditor’s right to setoff is automatically stayed (i.e., suspended) when a debtor files for bankruptcy protection.[5]

“Mutuality is the lynchpin of setoff under section 553(a).”[6] While there is no statutory definition of “mutuality” or a “mutual debt” under the Bankruptcy Code, the authorities make it clear that mutuality requires that “each party must own his claim in his own right severally, with the right to collect in his own name against the debtor in his own right and severally.”[7] Mutuality is strictly construed against the party seeking setoff, and the party seeking setoff has the burden of proof on the mutuality requirement.[8]

There Is No Contractual Exception to Mutuality

In Orexigen, McKesson Corp. (McKesson) owed the debtor almost $7 million pursuant to the parties’ distribution agreement, and the debtor owed McKesson Specialty Arizona Inc. (MPRS) — a subsidiary of McKesson — approximately $9.1 million under a separate services agreement between the debtor and MPRS. The distribution agreement between McKesson and the debtor permitted McKesson and its affiliates to “setoff, recoup and apply” any amounts owed to the debtor against all amounts owed by the debtor to McKesson or its affiliates.[9]

Post-petition, McKesson paid the debt it owed to the debtor in its entirety. Subsequently, McKesson sought to claw back its payment through a triangular setoff. McKesson argued that because the debtor owed its subsidiary in excess of the amount owed by McKesson, § 553(a) enables McKesson to set off the subsidiary’s claim against McKesson’s payment.

The bankruptcy court disagreed. It concluded that McKesson did not have a mutual debt under § 553 because the debtor owed debt to McKesson’s subsidiary, which was a separate and distinct legal entity.[10] Judge Gross agreed with the analysis from SemCrude finding that mutuality “cannot be supplied by a multi-party agreement contemplating a triangular setoff” and rejecting the contention that parties can contract around the mutuality requirement of § 553.[11] In doing so, the Delaware court emphasized the fact that no court has “actually permitted a triangular setoff or addressed the merits of this purported exception as it relates to section 553(a).”[12] The court found no indication in the language of the Bankruptcy Code to provide for a contractual exception to mutuality, and therefore concluded that under the plain language of § 553(a), it is clear that there is no such exception.[13]

Conclusion

Orexigen marks a clear trend against the availability of triangular setoffs in bankruptcy. Absent further developments in the appellate courts, or subsequent decisions by bankruptcy courts, cross-affiliate setoff without mutuality appears to be impermissible in Delaware.[14] As a result, parties seeking multiparty setoff should reexamine their agreements and reassess their counterparty bankruptcy risk.