EDITOR’S NOTE: In this article from the American Bankruptcy Institute’s Unsecured Trade Creditors Committee Newsletter, Tim Brink discusses the Third Circuit’s decision holding that “triangular” setoffs are not permissible in bankruptcy and rejecting the argument that parties can contract around the requirement of strict bilateral neutrality.
In its recent decision in In re Orexigen Therapeutics Inc.,1 the Third Circuit Court of Appeals held that triangular setoffs are not permissible in bankruptcy because they do not satisfy the mutuality requirement of § 553 of the Bankruptcy Code. In doing so, the court categorically rejected the argument that parties can contract around the requirement of strict bilateral mutuality.
McKesson Corp. and Orexigen Therapeutics entered into an agreement under which McKesson would distribute a drug manufactured by Orexigen, which included a provision that McKesson could set off amounts owed to Orexigen against amounts owed by Orexigen to McKesson or any McKesson subsidiary. Later, a McKesson subsidiary, McKesson Patient Relationship Solutions (MPRS), entered into a customer loyalty program agreement with Orexigen under which MPRS would advance funds to pharmacies for price discounts that Orexigen would later reimburse.
At the time of Orexigen’s bankruptcy filing, McKesson owed Orexigen $6.9 million under the drug-distribution agreement, and Orexigen owed MPRS $9.1 million under the customer loyal program agreement. McKesson asked the bankruptcy court to enforce its setoff rights, which would have resulted Orexigen owing $2.2 million to MPRS and McKesson owing nothing to Orexigen. The bankruptcy court denied McKesson’s request, stating that while the setoff provision was enforceable under state law, it did not supply the “the strict mutuality required in bankruptcy.”2 Relying on its earlier SemCrude3 decision, the bankruptcy court held that contracts cannot turn non-mutual debts into debts subject to setoff under the Bankruptcy Code as if they had been mutual.4 McKesson appealed to the district court, which affirmed, and then to the Third Circuit.
The Third Circuit’s Decision
While noting that the meaning of the term “mutuality” in § 553 of the Bankruptcy Code was a matter of first impression, the Third Circuit wasted little time in affirming the lower courts’ decisions, concluding that “the analysis set forth in SemCrude is sound and the Bankruptcy Court and District Court here rightly treated mutuality as a distinct statutory requirement under § 553.”5
The Third Circuit began by considering whether mutuality is defined by state law, with § 553 imposing no independent mutuality limitation, as urged by McKesson, or whether the term “mutual” as used in § 553 imposes a distinct limitation on the ability to assert a setoff right in bankruptcy, as Orexigen argued. Relying heavily on SemCrude and “a compelling body of precedent, including from this Court, [that] treats mutuality in § 553 as a limiting term, not a redundancy,” the Third Circuit determined that “mutuality is a distinct and limiting requirement of federal bankruptcy law.”6
Having decided this threshold question, the Third Circuit then considered the effect of this limitation on triangular setoffs. Again relying on SemCrude, the Third Circuit 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, owing from the debtor directly to that creditor,”7 and rejected McKesson’s argument that its contractual arrangements with Orexigen transformed a triangular debt arrangement into a mutual debt. It likewise rejected McKesson’s alternative argument that the setoff provision in the drug-distribution agreement between McKesson and Orexigen gave rise to a direct claim by McKesson against Orexigen as “a recasting of its failed effort to defeat the purpose and meaning of § 553.”8
The Third Circuit took pains to explain that McKesson could have achieved mutuality for the debts owing to and from Orexigen if it had “taken on the customer loyalty [program agreement] that it instead had its subsidiary MPRS handle for Orexigen”; alternatively, it could have “obtained a priority right to the same amount [it] now seeks via setoff” by arranging for “MPRS to have a perfected security interest in Orexigen’s account receivable due from McKesson.” According to the Third Circuit, this latter approach “would have had the added benefit of placing Orexigen’s other creditors on advance notice of [MPRS’s] priority claim,” whereas “McKesson’s desired outcome, wherein contractual setoff agreements can shoehorn multiparty debts into§ 553, would disincentivize public disclosure of prioritized claims, weakening a fundamental purpose of the Code.”9
In joining the Second, Fifth and Seventh Circuits in holding that triangular setoffs are by definition not mutual, the Third Circuit appears to have left little room for argument that multi- party debts may be set off under § 553. In the meantime, organizations that do business with counterparties using multiple entities should consider streamlining their contractual arrangements to a single entity in order to preserve their setoff rights in the event of counterparty bankruptcy, or employing the accounts receivable security interest or similar pledge arrangement to achieve the same result.
Reprinted with the permission of the American Bankruptcy Institute’s Unsecured Trade Creditors Committee Newsletter. Copyright © 2022. All rights reserved.
1 990 F.3d 748 (3d Cir. 2021).
2 In re Orexigen Therapeutics Inc., 596 B.R. 9, 12 (Bankr. D. Del. 2018).
3 In re SemCrude L.P., 399 B.R. 388 (Bankr. D. Del. 2009).
4 Orexigen Therapeutics Inc., 596 B.R. at 18.
5 Orexigen Therapeutics Inc., 990 F.3d at 752-53.
6 Id. at 753-54.
7 Id. at 754.
8 Id. at 757.
9 Id. at 756.