The End of Triangular Setoffs

3rd Circuit Rules against Triangular Setoffs in Bankruptcy Cases

The 3rd Circuit Court of Appeals has ruled in the appeal of the McKesson Corporation to a Delaware Bankruptcy Court’s decision in In Re: Orexigen Therapeutics, Inc. (Bankr. D. Del. Nov. 13 2018) that so-called triangular setoffs will not satisfy the mutuality requirement of 11 U.S.C. § 553.

Its decision confirms that the requirement of Section 553 that a setoff be mutual is to be strictly construed.

While the 6th Circuit has not specifically ruled on the same question, it can be presumed that this decision will bear upon similar discussions in this and other jurisdictions.

The 3rd Circuit did suggest other ways to achieve a similar result that may be enforceable such as joint and several liability or taking a security interest in the affiliate’s receivables.

What Is a Setoff?

A setoff is a reduction in a debt owed by Party A to Party B because of a separate debt owed by Party B to A, arising from different transactions.

It is a mutual obligation, in other words.

The right to a setoff is rooted in state law.

Although bankruptcy is a Federal legal process, governed by the U.S. Bankruptcy Code (11 U.S.C.), it does not address all legal questions.

In a bankruptcy proceeding, whether or not a party’s right to a setoff exists, will be determined by the law of the state in which the bankruptcy case is filed.

When a setoff is allowed in a bankruptcy proceeding, it allows a creditor to deduct what is owed by the debtor from a claim it has against the debtor.

The establishment of this setoff right to a bankruptcy creditor’s benefit my allow that creditor to retain collateral property or funds owned by the debtor that would otherwise be required to be returned to the debtor or seized and liquidated for the benefit of all of the debtor’s creditors, in priority order.

It can allow a creditor that may otherwise be low priority unsecured creditor in a Chapter 7, Chapter 13, or Chapter 11 bankruptcy proceeding to benefit ahead of secured or other priority creditors.

What Is a Triangular Setoff?

The “triangular setoff” alleged by the McKesson Corporation to exist in the case on point, here, was a relationship created by a contract between the Chapter 11 debtor in 3rd Circuit matter, Orexigen, and McKesson.

The two companies formulated a contract for a pharmaceutical distribution deal that contained a provision allowing McKesson, distribution of the product, to reduce what it owed to Orexigen, the manufacturer of the product, by any amount owed by Orexigen to McKesson or any McKesson subsidiary.

Such a subsidiary—McKesson Patient Relationship Solutions (“MPRS”)—did eventually come to hold a $9 million debt owed by Orexigen. At the same time, McKesson owed Orexigen $7 million.

When Orexigen filed for Chapter 11 bankruptcy, McKesson moved to set off the amount it owed to Orexigen by the amount owed by Orexigen to MPRS, relying on the above-described contractual provision.

If allowed, it would have reduced McKesson’s debt to zero and MPRS’s claim to $2 million.

In other words, this triangular setoff involved a setoff of a debt owed to Company B by Company A because of a debt owed by Company A to Company C.

The Bankruptcy Court denied McKesson’s request, and the 3rd Circuit affirmed that denial.

Why?

11 U.S.C. § 553: Mutuality Required

Section 553 of the Bankruptcy Code states that the Bankruptcy Code does not affect the right of any creditor to offset “… a mutual debt owing by such creditor to the debtor that arose before the commencement of [the bankruptcy case.]”

In this 3rd Circuit case, McKesson argued that Section 553 was merely an acknowledgement or statutory preservation of any state law right to setoff and, essentially, that the actual wording of Section 553 should not be taken literally.

The Bankruptcy Court and the 3rd Circuit disagreed and held that Section 553 means exactly what it says.

The court stated that the requirement that a debt be mutual is limiting and not merely reinforcing a non-bankruptcy entitlement under state law.

It held that the requirement of mutuality is indeed a distinct limitation under Federal law that defines what is and what is not a setoff for purposes of a bankruptcy proceeding.

While the right to a setoff must exist under state law to be enforced in a bankruptcy proceeding, Section 553 of the Bankruptcy Code defines the extent of that right.

Based on this section’s explicit requirement that the debt obligation be mutual, the 3rd Circuit disagreed with McKesson’s claim of a “triangular” right to setoff between it, the debtor, and MPRS.

While the court found that the parties were in contractual privity with one another, this did not mean that MPRS was party to a mutual obligation.

Relying on strong precedent, the court noted that McKesson’s argument would render Section 533 redundant as regards state law, a breach of one of the primary rules of statutory interpretation (that a statute not be read to construe its explicit language meaningless).

The court was not persuaded by McKesson’s argument, which was, in essence, that Congress could have simply written Section 533 to be even more explicit than it already is if it had wanted mutuality to be a limiting requirement.

Conclusion: Triangular Setoffs and Bankruptcy Proceedings

The bottom line is that, pursuant to the 3rd Circuit’s decision in this case, companies and individuals should not presume that they can contract their way into a triangular right of setoff in hypothetical future bankruptcy proceedings.

The court pointed out in its decisions here that, if McKesson had wanted a right of setoff, it could have contracted to provide to Orexigen the service that MPRS eventually did.

The court also suggested other ways that McKesson could have effectively achieved a similar result by either providing for joint and several liability or having MPRS take a security interest in in the receivable owed by McKesson to Orexigen. 

When contracting for services among affiliates with a third party, market participants should consider these arrangements closely and how best to protect themselves in the event of the third party bankruptcy.