Third Circuit Axes Triangular Setoffs in Bankruptcy

In a March 19, 2021, decision in In re Orexigen Therapeutics, Inc., the Third Circuit joined the Second, Fifth and Seventh Circuits, prohibiting triangular setoff in a bankruptcy proceeding. A triangular setoff occurs when Party A attempts to set off a debt owed by it to Party B against a debt owed by Party B to Party C. This raises practical concerns for parties that have multiple contracts with a third party, particularly if affiliates or subsidiaries are parties to some of those contracts.

Background

In July 2016, Orexigen entered into a “Services Agreement” with McKesson Patient Relationship Solutions (MPRS), a wholly owned subsidiary of McKesson Corporation, Inc. The agreement concerned a loyalty rebate program, under which MPRS advanced funds to pharmacies to finance discounts and then billed Orexigen for reimbursement, creating an account payable by Orexigen to MPRS. Separately, Orexigen and McKesson were parties to a “Distribution Agreement,” under which, McKesson purchased drugs manufactured by Orexigen and distributed them to pharmacies. This created an account payable by McKesson to Orexigen. The Distribution Agreement included a setoff provision that allowed “[McKesson] and its affiliates … to set-off, recoup and apply any amount 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.”

When Orexigen filed for bankruptcy in March 2018, it owed MPRS approximately $9.1 million under the Services Agreement and McKesson owed Orexigen approximately $6.9 million under the Distribution Agreement. McKesson argued for the right to set off its debt against the amount Orexigen owed to MPRS. If permitted, the setoff would have reduced McKesson’s obligations to Orexigen to $0 and Orexigen’s obligations to MPRS to $2.2 million, for which MPRS could have sought payment as an unsecured claim in the bankruptcy.

Based on the expected recovery of only 2% on unsecured claims in the bankruptcy, MPRS/McKesson was effectively seeking to surrender $138,000 in distributions in the bankruptcy case — the difference between MPRS’s expected recovery of $182,000 on a $9.1 million unsecured claim and a setoff-adjusted recovery of $44,000 on a $2.2 million unsecured claim — in exchange for eliminating a $6.9 million debt owed by McKesson to Orexigen. Orexigen objected to the setoff.

Third Circuit’s Discussion

Section 553 of the U.S. Bankruptcy Code states that “[e]xcept as otherwise provided …, 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.” Orexigen argued that even if McKesson had a state-law right to setoff under state law and the terms of the Distribution Agreement, it could not affect that setoff right in bankruptcy. It argued that the obligation from McKesson to Orexigen and the obligation from Orexigen to MPRS lacked the strict bilateral mutuality necessary to apply the setoff under the Bankruptcy Code. The bankruptcy court, and the district court on appeal, agreed.

In affirming the decisions of the lower courts, the Third Circuit, relying significantly on the Delaware Bankruptcy Court’s opinion in In re SemCrude, rejected the interpretation of Section 553 that any setoff right enforceable under state law is enforceable in bankruptcy. Instead, the circuit court held that the word “mutual” in Section 553 imposes a strict limitation. Recognizing that a triangular setoff arrangement does not, by definition, involve mutual debts — there being no reciprocal obligations between the debtor and another singular party — the Third Circuit agreed and adopted the SemCrude court’s “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.”

The Third Circuit additionally held that parties cannot contract around the Section 553 limitation. In dismissing McKesson’s argument that the Distribution Agreement transformed the nonmutual debts between McKesson, MPRS and Orexigen into mutual debts, the court stated that “mutuality cannot be supplied by a multi-party agreement” — even where, as the case was, the parties seeking to exercise the contractual setoff are affiliated entities. Underlying the holding was the recognition that setoff, in effect, permits a party to receive a preference; essentially enabling the party to recover in full on the proportionate amount of the claim that is extinguished. Highlighting that one of the “primary goals” of the Bankruptcy Code is to ensure that similarly situated creditors are treated equally, the court found that Congress was deliberate in restricting setoffs in bankruptcy to bilateral obligations. Accordingly, Third Circuit determined that “the policies of the [Bankruptcy] Code disfavor a contractual exception to mutuality.”

Takeaways

With the Third Circuit joining the growing number of courts that have prohibited triangular setoff in bankruptcy and prohibiting clever contracting to avoid the effect of Section 553, clients should consider the alternative arrangements. For instance, where practicable, agreements should be structured to have the same entities generating the accounts payable and the accounts receivable rather than having affiliates or subsidiaries engaged in separate agreements. Inter-company accounting can then be used to deal with any subsidiary/affiliate obligations. Alternatively, a client could protect itself by taking a security interest in the counterparty’s accounts receivable if there is a triangular relationship.