Mutuality – Irrefutable Requirement for Setoff Under Section 553

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Another decision has been issued that reinforces that section 553 does not allow setoff without mutuality, or “triangular setoff.” On November 13, 2018, Judge Gross of the United States Bankruptcy Court for the District of Delaware denied a motion in In re Orexigen Therapeutics, Inc. to affect a triangular setoff under section 553 of the Bankruptcy Code due to the lack of mutuality.[1] The Court found that even though a contractual right allowing McKesson Corporation and its subsidiary corporation to affect a prepetition triangular setoff was enforceable under state law, the arrangement did not comport with the strict mutuality required under the Bankruptcy Code.

Section 553

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.” The setoff provision of the Bankruptcy Code does not create right of setoff; it preserves for creditor’s benefit any setoff right that it may have under applicable non-bankruptcy law and imposes additional restrictions that must be met in order for the creditor to impose a setoff against a debtor in bankruptcy.[2] Specifically, the Bankruptcy Code requires that the debts and credits must both have arisen before bankruptcy and that there would be “mutuality” between the debiting and crediting parties.[3] While the Bankruptcy Code does not define “mutuality,”[4] courts interpreting this provision find debts to be mutual only where the debts exist between the “same parties” in the “same capacity.”[5] Mutuality is strictly construed against the party seeking setoff.

Analysis

Here, McKesson sought to effectuate a triangular setoff by offsetting it’s almost $7 million debt to the Debtor against the Debtor’s approximately $9 million debt to McKesson’s subsidiary. McKesson argued that because the Debtor owed its subsidiary in excess of the amount owed to McKesson, section 553(a) enables McKesson to set off the subsidiary’s claim against McKesson’s payment.

The Court’s review of the relevant case law and underlying policies behind section 553 made it clear that “[m]utuality is the lynchpin of setoff under section 553(a).”[6] McKesson did not have a mutual debt under section 553(a) because the debt was owed to its subsidiary – a separate and distinct legal entity. Judge Gross found that McKesson ran into “fatal contrary bankruptcy precedent” that found triangular setoffs to be impermissible under section 553(a) without mutuality.[7] Without such mutuality between McKesson and the Debtor, the Court could not allow the setoff.

Judge Gross further explained that “section 553(a) aligns with the fundamental bankruptcy policy of ensuring similarly-situated creditors receive an equal distribution from the debtor’s estate.” The Court refused to read a contractual exception to the strict mutuality requirement of section 553 because that would create the situation where creditors could receive a greater distribution than other equal-footed creditors and thus dilute the bankruptcy estate to the detriment of all creditors.[8]

McKesson also tried to argue that the subsidiary was a third-party beneficiary under the contract between McKesson and the Debtor, and that the contractual third-party beneficiary doctrine provides the required mutuality.[9] The Court found this argument to be another attempt by McKesson to validate a contractual exception to mutuality. The Court found this “unavailing” because “if there w[as] a contractual third-party beneficiary status exception, parties would merely add language intending that a third-party be a third-party beneficiary of a contract allowing for triangular setoff.” The Court refused to provide an avenue for deliberate circumvention of the Bankruptcy Code.

Takeaways

The decision is another upset for the accessibility of triangular setoffs in bankruptcy. Setoff under section 553 of the Bankruptcy Code requires real mutuality; the Court’s decision makes it abundantly clear that mutuality requires the “same parties” in the “same capacity.” This case supports the trend that parent companies cannot simply argue triangular setoff to mix and match the debits and credits arising from discrete contracts held by the individual entities within its organizational structure.

 

[1] No. 18-10518 (KG), 2018 Bankr. LEXIS 3579, at *1 (Bankr. D. Del. Nov. 13, 2018).

[2] In re SemCrude, L.P., 399 B.R. 388, 393 (Bankr. D. Del. 2009), aff’d, 428 B.R. 590 (D. Del. 2010).

[3] The Court also discussed how section 553(a) requires the party seeking setoff to be a “creditor.” In re Orexigen Therapeutics, Inc., 2018 Bankr. LEXIS 3579, at *9. The Court found that McKesson was a creditor only because the parties treated McKesson as a creditor in its’ stipulations; the Court noted that it would not have otherwise deemed McKesson as a creditor because McKesson had paid off its debt to the Debtor, extinguishing its claim. Id.

[4] 5 Collier on Bankr. ¶ 553.03 (16th 2018).

[5] See In re SemCrude, 399 B.R. at 393 (“[T]he authorities are also clear that debts are considered ‘mutual’ only when ‘they are due to and from the same persons in the same capacity.’” (quoting Westinghouse Credit Corp. v. D’Urso, 278 F.3d. 138, 149 (2d Cir. 2002)).

[6] Id. at *24.

[7] In re Orexigen Therapeutics, Inc., 2018 Bankr. LEXIS 3579, at *9 (citing In re SemCrude, L.P., 399 B.R. 388, 393 (Bankr. D. Del. 2009) and In re Lehman Bros. Inc., 458 B.R. 134, 139 (Bankr. S.D.N.Y. 2011)).

[8] Id.

[9] A third-party beneficiary to a contract is a party who directly or incidentally benefits from a contract between two other parties.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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