In its recent opinion arising out of the Orexigen Therapeutics Inc. bankruptcy case, the US Court of Appeals for the Third Circuit affirmed that while a creditor retains its direct setoff rights against a debtor under Section 553 of the Bankruptcy Code when both it and the debtor owe debts to one another, so called “triangular” setoffs – setoffs relating to affiliated third party debts – are not similarly protected, even if provided for contractually.1 In so holding, the Third Circuit became the first US circuit court of appeals to reach the issue and affirmed a substantial body of law on the topic developed by numerous lower courts.
Section 553 of the Bankruptcy Code provides that a debtor’s bankruptcy filing “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.” In accordance with this provision it is clear that if a creditor and a debtor in bankruptcy owe debts to one another which arose prior to the bankruptcy and would be subject to a right of offset under applicable law, the creditor’s setoff rights are preserved, notwithstanding the bankruptcy. One question under the statute, however, is what the drafters meant when they required those debts to be “mutual” in order to qualify for Section 553’s protections.
With respect to the Orexigen case, the underlying dispute at issue arose out of two contracts—a distribution agreement between the Debtor and McKesson Corporation, Inc. (“McKesson”) and a consumer discount program services agreement between the Debtor and McKesson’s affiliate McKesson Patient Relationship Solutions (“MPRS”). The distribution agreement included a setoff provision that permitted McKesson “and its affiliates” to set off amounts they owed to Orexigen and Orexigen’s affiliates against any amounts that Orexigen and Orexigen’s affiliates owed to them. At the time of Orexigen’s bankruptcy filing, McKesson owed Orexigen approximately $6.9 million under the distribution agreement, while Orexigen owed McKesson’s affiliate MPRS approximately $9.1 million under the services agreement. Based on the setoff clauses in the contracts, McKesson argued that these debts were “mutual” for Section 553 purposes and therefore argued that it owed nothing to Orexigen and Orexigen owed approximately $2.2 million to it.
In addressing McKesson’s arguments, the Third Circuit first rejected McKesson’s argument that the word “mutual” in Section 553 did not add anything substantive to the statute and was instead merely descriptive of setoff rights that the parties already had under non-bankruptcy law (i.e., if the parties had setoff rights under applicable state law or contract that ended the inquiry; there was to be no separate, analysis of whether the parties’ debts were “mutual”). Instead, the Third Circuit emphasized that Section 553’s mutuality requirement was “consistently viewed as a distinct limitation on the ability to assert a setoff.” Otherwise, the word “mutual” would be redundant – the statute could simply have provided that a debtor’s bankruptcy filing “does not affect any right of a creditor to offset a … debt owing by such creditor to the debtor…” and left out the descriptive “mutual debt.” The Third Circuit concluded that Congress, by including that word, intended to add “a distinct and limiting requirement of federal bankruptcy law” to Section 553.
The Third Circuit next addressed whether a contract—such as the distribution agreement at issue in Orexigen could “transform a triangular set of obligations” not otherwise eligible for Section 553 protections in bankruptcy “into bilateral mutuality” that would satisfy Section 553’s plain language. Citing approvingly to the reasoning of the Delaware Bankruptcy Court in its 2009 In re Semcrude decision,2 the Third Circuit held that a contract could not artificially create mutuality. The mutuality requirement in Section 553 sets a limit, requiring each party to claim only “in his own right.” This right, the Third Circuit noted, “is personal” and there is “simply no ability to get around this language.” While Parties “may freely contract for triangular setoff rights,” they may not do so “in derogation of [the] mandates of the Bankruptcy Code.”
After its textual analysis, the Third Circuit also addressed the parties’ triangular setoff arguments on policy grounds. As a general matter, the court noted, one of the primary goals of bankruptcy is to ensure that similarly situated creditors are treated similarly. In Section 553, Congress provided a limited exception, allowing one type of creditor to recover more than other similarly situated creditors based on setoff rights under applicable non-bankruptcy law. But, in providing that such debts had to be “mutual” in order to qualify for this exception, Congress intended that the statute be “strictly construed against the party seeking setoff.” The court concluded that if McKesson wanted mutuality for the debts in question, there were ways it could have achieved that, such as by taking on the customer loyalty program itself that it instead delegated to its affiliate, or by negotiating to have a security interest granted to its affiliate in the very account that McKesson owed to Orexigen. What it could not do, however, was “shoehorn multiparty debts” into Section 553 and claim mutuality since doing so would weaken “a fundamental purpose of the Code.”
As the first circuit-level opinion on the permissibility of triangular setoffs under Section 553, and a reinforcement of a substantial line of lower court decisions on the topic, the Third Circuit’s opinion in Orexigen will likely prove useful to debtors opposing triangular setoffs in bankruptcy. Going forward, creditors may want to consider other options to strengthen offset rights across affiliates, including potentially by seeking a security interest in the applicable accounts in the manner suggested by the Third Circuit.
1 In re Orexigen Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021).
1 399 B.R. 388, 296 (Bankr. D. Del. 2009).