In a recent decision in “a matter of first impression,” the U.S. Court of Appeals for the Third Circuit squarely rejected the view that “triangular setoffs” fall within the protective circle of § 553 of the Bankruptcy Code. In so ruling, the court, in its decision in In re Orexigen Therapeutics Inc.,[1] adopted the view that “strict bilateral mutuality” is required for § 553 to apply and that parties “cannot transform a triangular set of obligations into bilateral mutuality” with contractual provisions.
Statutory Context
Section 553 states:
Except as otherwise provided in this section and in sections 362 and 363 of this title, this title 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]
As noted by one court, the right to exercise setoff rights “allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A.”[3]
The obligations owing between A and B in the example above is an illustration of bilateral mutuality; i.e., A owes B, and B owes A. As discussed below, the issue before the Third Circuit in Orexigen was whether a creditor can set off an obligation it owes to a debtor against an obligation the debtor owes not to the creditor, but to the creditor’s affiliate; i.e., A owes B, and B owes C.
Background in Orexigen
In 2016, Orexigen Therapeutics Inc. entered into a distribution agreement with McKesson Corporation Inc. under which Orexigen sold a weight-management drug to McKesson, which in turn provided the drug to pharmacies. Orexigen also entered into a services agreement with one of McKesson’s subsidiaries, McKesson Patient Relationship Solutions (MPRS), pursuant to which MPRS managed a customer-loyalty program for Orexigen. The distribution agreement and the services agreement did not reference, incorporate or integrate one another; however, a broad setoff provision in the distribution agreement permitted “each of McKesson and its affiliates ... to set-off, recoup and apply any amounts owed by it to [Orexigen’s] affiliates against any [and] all amounts owed by [Orexigen] or its affiliates to any of [McKesson] or its affiliates.”
On March 12, 2018, Orexigen filed a petition for relief under chapter 11 of the Bankruptcy Code with the U.S. Bankruptcy Court for the District of Delaware. At the time of the filing, Orexigen owed MPRS approximately $9.1 million under the services agreement, and McKesson owed Orexigen approximately $6.9 million under the distribution agreement. Relying on the setoff provision and § 553 of the Bankruptcy Code, McKesson sought to set off its obligation to Orexigen against Orexigen’s obligation to MPRS, which would have resulted in Orexigen owing $2.2 million to MPRS and McKesson owing nothing to Orexigen.
The bankruptcy court rejected McKesson’s argument “because, while the Setoff Provision constituted an enforceable contractual right allowing a parent and its subsidiary corporation to effect a prepetition triangular setoff under state law, that relationship does not supply the strict mutuality required in bankruptcy.” Relying on its prior decision in SemCrude, the bankruptcy court further held “that contracts cannot turn nonmutual debts into debts subject to setoff under the Code, as if they had been mutual.” On appeal, the U.S. District Court for the District of Delaware affirmed the bankruptcy court’s decision.
The Decision
Relying heavily on the reasoning in SemCrude, the Third Circuit affirmed the bankruptcy court’s decision, finding that the lower court had “rightly treated mutuality as a distinct statutory requirement under § 553.”
In reaching its conclusion, the court rejected McKesson’s argument that the term “mutual,” as it appears in § 553, is nothing more than a “definitional scope provision that identifies the state-law right that is thereby preserved unaffected in bankruptcy.” Rather, the court adopted the view that mutuality in § 553 is “a limiting term, not a redundancy,” and thus that § 553 only applies if the obligations at issue are mutual.
Having determined that mutuality is a distinct and limiting requirement for exercising setoff rights under § 553, the court, again relying on SemCrude, concluded 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, owning from the debtor directly to that creditor,” and that “Congress did not intend to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.” The court thus rejected McKesson’s argument that the setoff provision in the distribution agreement “turns the debt between Orexigen and MPRS and between McKesson and Orexigen from a triangular debt arrangement into a mutual debt.” Relying again on SemCrude, the court stated:
[C]ontractual arrangements cannot transform a triangular set of obligations into bilateral mutuality. The mutuality requirement set a limit, and the effect of mutuality’s narrow construction is 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.... Moreover, the policies of the Code disfavor a contractual exception to mutuality. In particular, one of the primary goals — if not the primary goal — of the Code is to ensure that similarly situated creditors are treated fairly and enjoy an equality of distribution from a debtor absent a compelling reason to depart from this principle. Triangular setoffs undermine that goal.
The court further noted that allowing contractual setoff agreements to “shoehorn multiparty debts into § 553 would disincentivize public disclosure of prioritized claims, weakening a fundamental purpose of the Code.” The court observed that McKesson could have obtained its desired outcome if, for example, it had negotiated for MPRS to have a perfected security interest in Orexigen’s accounts receivables due from McKesson, stating that “by perfecting a security interest, MPRS may have obtained a priority right to the same amount McKesson now seeks via setoff, which would have had the added benefit of placing Orexigen’s other creditors on advance notice of that priority claim.”
Takeaways
As the court notes, its ruling in Orexigen aligns with decisions by other courts finding that triangular setoffs, while potentially enforceable under state law, do not provide the strict mutuality required under § 553 and, therefore, are unenforceable in bankruptcy — even if the parties contracted for such protection. Parties, therefore, cannot rely solely on a contractual right to a triangular setoff to exercise such setoff rights in bankruptcy. Instead, as the court recognized, there may be other ways to structure a deal to provide for protections similar to those offered by a triangular setoff and that may be enforceable in bankruptcy, such as joint and several liability arrangements and perfected security interests in receivables.