First Impressions: Third Circuit Scuttles Triangular Setoff in Bankruptcy

The ability of a creditor to exercise its contractual, common law or statutory rights under non-bankruptcy law to set off amounts owed to a debtor in bankruptcy against the debtor's obligations to the creditor gives offsetting creditors an important advantage. Unlike many other creditors, creditors with setoff rights can receive preferential treatment in the form of full payment on their claims up to the amount of the setoff. However, a limitation on the exercise of setoff rights in bankruptcy is the Bankruptcy Code's requirement that the debts involved must be "mutual," a concept that is not well understood and sometimes disputed in the courts. The U.S. Court of Appeals for the Third Circuit recently addressed the meaning of mutuality in this context as a matter of first impression. In In re Orexigen Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021), the Third Circuit affirmed lower court rulings that a "triangular setoff" does not satisfy the Bankruptcy Code's mutuality requirement. 

Setoff in Bankruptcy

Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code "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." Section 553 does not create setoff rights—it merely preserves certain setoff rights that otherwise would exist under contract or applicable nonbankruptcy law. See Collier on Bankruptcy ("Collier") ¶ 553.04 (16th ed. 2021) (citing Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995)). As noted by the U.S. Supreme Court in Studley v. Boylston Nat. Bank, 229 U.S. 523, 528 (1913), setoff avoids the "absurdity of making A pay B when B owes A."

With certain exceptions for setoffs under "safe harbored" financial contracts, a creditor is precluded by the automatic stay from exercising its setoff rights without bankruptcy court approval. See 11 U.S.C. §§ 362(a)(7), (b)(6), (b)(7), (b)(17), (b)(27), and (o). However, if it applies, the automatic stay merely suspends the exercise of such a setoff pending an orderly examination of the respective rights of the debtor and the creditor by the court, which will generally permit the setoff if the requirements under applicable law are met, except under circumstances where it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008).

A creditor stayed from exercising a valid setoff right must be granted "adequate protection" (see 11 U.S.C. § 361) against any diminution in the value of its interest caused by the debtor's use of the creditor's property. Ealy, 392 B.R. at 414.

Setoff is expressly prohibited by section 553 if: (i) the creditor's claim against the debtor is disallowed; (ii) the creditor acquires its claim from an entity other than the debtor either after the bankruptcy filing date or after 90 days before the petition date while the debtor was insolvent (with certain exceptions); or (iii) the debt owed to the debtor was incurred by the creditor after 90 days before the petition date, while the debtor was insolvent, and for the purpose of asserting a right of setoff (with certain exceptions). See 11 U.S.C. § 553(a)(1)-(3).

Thus, for a creditor to be able to exercise a setoff right in bankruptcy, section 553 requires on its face that: (i) the creditor has a right of setoff under applicable non-bankruptcy law; (ii) the debt and the claim are "mutual"; (iii) both the debt and the claim arose prepetition; and (iv) the setoff does not fall within one of the three prohibited categories specified in the provision. Although some courts have permitted the setoff of mutual postpetition debts (see, e.g., Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016)), the remedy is available in bankruptcy only "when the opposing obligations arise on the same side of the … bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015).

Creditors typically rely on the remedy of setoff if the mutual debts arise from separate transactions, although the issue is murky. See Collier at ¶ 553.10. By contrast, if mutual debts arise from the same transaction, the creditor may have a right of "recoupment," which has been defined as "a deduction from a money claim through a process whereby cross demands arising out of the same transaction are allowed to compensate one another and the balance only to be recovered." Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 146 (2d Cir. 2002); accord Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1399 (9th Cir. 1996); In re Matamoros, 605 B.R. 600, 610 (Bankr. S.D.N.Y. 2019) ("recoupment is in the nature of a defense and arises only out of cross demands that stem from the same transaction"). Unlike setoff, recoupment is not subject to the automatic stay (see In re Ditech Holding Corp., 606 B.R. 544, 600 (Bankr. S.D.N.Y. 2019)), and may involve both pre- and postpetition obligations. See Sims v. U.S. Dep't of Health and Human Services (In re TLC Hosps., Inc.), 224 F.3d 1008, 1011 (9th Cir. 2000) (citing Collier at ¶ 553.10).

Mutuality and Triangular Setoffs

The Bankruptcy Code does not define the term "mutual debt." Debts are generally considered mutual when they are due to and from the same persons or entities in the same capacity, but there is some confusion among the courts on this point. See generally Collier at ¶ 553.03[3][a] (citing cases).

For example, an exception to this strict mutuality requirement may exist in cases involving "triangular setoff," the provenance of which is commonly traced (rightly or wrongly) to a 1964 ruling construing section 68(a) of the former Bankruptcy Act of 1898 by the Seventh Circuit Court of Appeals in Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.), 327 F.2d 401 (7th Cir. 1964). In such a situation, A might have a business relationship with B and C, where B and C are related parties. Triangular setoff occurs when A owes B, and A attempts to set off that amount against amounts C owes to A. The validity of triangular setoff in the bankruptcy context, as distinguished from under state contract or common law, is subject to debate.

In In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), aff'd, 428 B.R. 590 (D. Del. 2010), Bankruptcy Judge Brendan L. Shannon of the Delaware bankruptcy court ruled that triangular setoff is not permitted in bankruptcy due to the absence of mutuality. According to the court, "mutuality cannot be supplied by a multi-party agreement contemplating a triangular setoff." The court rejected the contention that parties can contract around section 553's mutuality requirement. It also rejected Berger Steel as authority for the proposition that non-mutual setoff provisions in a contract can be enforced against a debtor.

In In re Lehman Bros. Inc., 458 B.R. 134 (Bankr. S.D.N.Y. 2011), a New York bankruptcy court similarly ruled that triangular setoff does not satisfy the Bankruptcy Code's mutuality requirement and that the Bankruptcy Code's safe-harbor provisions for financial contracts (see 11 U.S.C. §§ 555-56, 559-62) do not eliminate that requirement in connection with setoffs under such contracts.

Consistent with the rulings in SemCrude and Lehman, a Delaware bankruptcy court held in In re American Home Mortgage Holdings, Inc., 501 B.R. 44 (Bankr. D. Del. 2013), that: (i) parties cannot contract around section 553's mutuality requirement; (ii) the Bankruptcy Code's safe harbor provisions for financial contracts "cannot be interpreted as implicitly removing the mutuality requirement for setoff"; and (iii) without moving for relief from the stay, the nondebtor counterparty to a swap or repurchase agreement cannot exercise control over estate property by retaining funds via exercising alleged triangular-setoff rights.

Other courts have also concluded that triangular setoff does not involve the mutuality required for setoff in bankruptcy. See, e.g., Ciber Global, LLC v. SAP Am., Inc., 2021 WL 1141661, *8 (E.D. Pa. Mar. 25, 2021); In re Celebrity Contractors, Inc., 524 B.R. 95, 110 (Bankr. E.D. La. 2014); In re Arcapita Bank B.S.C., 2014 WL 2109931, *3 (Bankr. S.D.N.Y. May 20, 2014). 

Until recently, however, this issue had not been ruled upon at the court of appeals level. The Third Circuit considered this question in Orexigen.

Orexigen

In 2016, pharmaceutical company Orexigen Therapeutics, Inc. ("OTI") entered into a distribution agreement with McKesson Corporation ("McKesson") under which McKesson agreed to distribute weight management drugs manufactured by OTI to pharmacies. The distribution agreement included a "setoff provision" that allowed "each of [McKesson] and its affiliates … to set-off, recoup and apply any amounts owed by it to [OTI's] affiliates against any [and] all amounts owed by [OTI] or its affiliates to any of [McKesson] or its affiliates."

Later in 2016, OTI entered into a separate services agreement with McKesson subsidiary McKesson Patient Relationship Solutions ("MPRS") under which MPRS managed a customer loyalty program for OTI whereby patients would receive price discounts from pharmacies. MPRS advanced funds to pharmacies selling OTI's drugs, and OTI reimbursed MPRS for the advances. The distribution agreement and the services agreement did not reference, incorporate, or integrate one another.

OTI filed for chapter 11 protection on March 12, 2018, in the District of Delaware. At that time, OTI owed MPRS approximately $9.1 million under the services agreement, and McKesson owed OTI approximately $6.9 million under the distribution agreement. Had there been a setoff under the distribution agreement prior to the petition date, OTI would have owed MPRS approximately $2.2 million, and McKesson would have owed OTI nothing.

In OTI's bankruptcy, McKesson argued that it should be permitted to exercise the setoff but later agreed to pay the $6.9 million it owed to OTI, which amount was segregated pending resolution of the dispute by the bankruptcy court. Bankruptcy Judge Kevin Gross denied McKesson's request to exercise the setoff. He concluded that, although the setoff provision created an enforceable contractual right to effect a prepetition triangular setoff under state law, that relationship "does not supply the strict mutuality required in bankruptcy."

Relying on SemCrude and Lehman, Judge Gross reasoned that contracts cannot transform non-mutual debts into debts satisfying the mutuality requirement of section 553. He rejected McKesson's argument that mutuality merely "identifies the state-law right that is thereby preserved unaffected in bankruptcy." Judge Gross also rejected the argument that MPRS's alleged status as a third-party beneficiary of the distribution agreement created mutuality, characterizing those arguments as attempts to "contract around section 553(a)'s mutuality requirement."

The district court affirmed on appeal, and McKesson appealed to the Third Circuit.

The Third Circuit's Ruling

A three-judge panel of the Third Circuit also affirmed. Writing for the court, Circuit Judge Kent A. Jordan initially noted that "[t]he meaning of mutuality in [section 553] is a matter of first impression for us" and that, although "our sister circuits have opined on the importance of mutuality as a distinct limitation of § 553, they have not ruled on whether a contract can create an exception to the requirement of direct mutuality."

Citing SemCrude and Lehman with approval, Judge Jordan rejected McKesson's contention that both the general right to enforce a setoff and the required mutuality are defined by state law, and that section 553 imposes "no independent mutuality limitation." Specifically, McKesson argued that, because section 553 includes three enumerated federal exceptions to the right to enforce a setoff in sections 553(a)(1)-(3) (as described above), lawmakers would have included an enumerated exception addressing mutuality if they "had intended that concept to serve as a limitation under federal law rather than a term simply descriptive of state law." According to Judge Jordan, "McKesson's reading of the provision would render the term 'mutual' redundant, as the phrase 'any right … to offset' provides adequate definitional scope to § 553." Moreover, he explained, the text in section 553(a) immediately following the "mutuality" requirement—which limits setoff to prepetition debts—has consistently been "viewed as a distinct limitation on the ability to assert a setoff right, and there is no persuasive reason to treat the requirement of mutuality any differently."

Having determined that mutuality is a "distinct and limiting requirement of federal bankruptcy law," the Third Circuit panel determined that triangular setoffs do not satisfy the requirement. Judge Jordan noted that setoff is inconsistent with the fundamental bankruptcy policy of equality of distribution among similarly situated creditors. For this reason, he explained, lawmakers' intent to exclude contractual modifications purporting to establish mutuality for setoff purposes beyond simple, bilateral relationships is "not surprising." According to Judge Jordan, the reasoning on this point articulated in SemCrude, Lehman and other decisions rejecting triangular setoffs (including the lower courts in this case) was persuasive. In addition to serving the goal of the Bankruptcy Code to ensure that similarly situated creditors are treated fairly and enjoy equality of distribution absent compelling circumstances, he wrote, "a rule that excludes nonmutual debts from the setoff privilege of § 553 promotes predictability in credit transactions."

Finally, the Third Circuit panel rejected McKesson's argument that it actually asserted a direct claim against OTI under the setoff provision of the distribution agreement, noting that this position, which was also considered and rejected by the SemCrude court, "is nothing but a recasting of [McKesson's] failed effort to defeat the purpose and meaning of § 553" based on a flawed interpretation of the definition of "claim."

Outlook

With Orexigen, a federal court of appeals has now apparently for the first time unequivocally concluded that, even though "triangular setoff" may be enforceable under state law, it is not permitted in bankruptcy. This means that cross-affiliate setoff without mutuality continues to be impermissible at least in the two most popular business bankruptcy jurisdictions in the United States―the Southern District of New York and the District of Delaware—and likely most other jurisdictions. However, the Third Circuit indicated in dicta that alternative structures to contractual triangular setoff provisions, such as cross-collateralization, joint and several liability, or perfected security interests in receivables owed by or to affiliates, might be enforceable in bankruptcy.

A version of this article was published in Lexis Practical Guidance. It has been reprinted here with permission.