No Setoff Here: Third Circuit Resolves Triangular Setoff Debate Once and for All

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Introduction

In a recent decision, In re Orexigen Therapeutics, Inc., No. 20-1136, 2021 U.S. App. LEXIS 8075 (3d Cir. Mar. 19, 2021), the Third Circuit held that triangular setoff arrangements are unenforceable under section 553 of the Bankruptcy Code. A triangular setoff arrangement arises when one party to a contract attempts to not only set off debts owed to another (debtor), but also debts owed by nonparty affiliates of such counterparty. For instance, if A and B are parties to a contract, under a triangular setoff arrangement A may be able to reduce its outstanding liabilities owed to B by setting off–or canceling–amounts owed to A by C, who is an affiliate of B but not a party to the contract between A and B. Once a party to a contract files for bankruptcy protection, section 553 of the Bankruptcy Code governs and places, among others, a “mutuality” requirement on the parties to a contract, which in turn limits nonbankruptcy setoff rights, even in instances where parties expressly contract for such protections.

Executive Summary

I. The Players

In 2016, pharmaceutical company and producer of weight management drug “Contrave”, Orexigen Therapeutics, Inc. (“Orexigen”) entered into a pharmaceutical distribution agreement (the “Distribution Agreement”) with McKesson Corporation, Inc. (“McKesson”) to sell and distribute Contrave to pharmacies. The Distribution Agreement included a provision that permitted McKesson to reduce the amounts it owed to Orexigen by any amount that Orexigen owed to McKesson, or any of McKesson’s affiliates (the “Setoff Provision”).

After entering into the Distribution Agreement, Orexigen entered into a separate agreement with one of McKesson’s affiliates, McKesson Patient Relationship Solutions (“MPRS”, and together with Orexigen and McKesson, the “Parties”) whereby MPRS assisted Orexigen with a consumer discount program by advancing payment to pharmacies to which Orexigen was obligated to reimburse MPRS (the “Services Agreement”, and together with the Distribution Agreement, the “Prepetition Agreements”).

II. Bankruptcy & District Courts

On March 12, 2018 (the “Petition Date”), Orexigen filed for chapter 11 relief in the Bankruptcy Court for the District of Delaware. As of the Petition Date, McKesson owed Orexigen approximately $6.9 million under the Distribution Agreement and Orexigen owed MPRS approximately $9.1 million under the Services Agreement. If the Parties had exercised their prepetition setoff rights pursuant to the Setoff Provision, Orexigen would have owed MPRS approximately $2.2 million and McKesson would have owed Orexigen nothing. The resulting situation before the Bankruptcy Court was quite the contrary.

Shortly after the Petition Date, Orexigen filed a motion to sell substantially all of its assets (the “Sale”), to which McKesson objected. McKesson and MPRS then asked the Bankruptcy Court to decide their rights to the segregated funds under the Setoff Provision and section 553. The Bankruptcy Court rejected McKesson’s argument to set off the amounts owed between the Parties (i.e., McKesson’s $6.9 million owed to Orexigen against the $9.1 million owed by Orexigen to MPRS, resulting in no payment by McKesson) stating the relationship “does not supply the strict mutuality required in bankruptcy.” The Bankruptcy Court held that under the Bankruptcy Code, contracts cannot turn nonmutual debts into debts subject to setoff as if they had been mutual. The Bankruptcy Court relied on its own precedent in In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009) in reaching its decision.

In connection with the Sale, Orexigen rejected the Prepetition Agreements and Orexigen’s plan for liquidation was confirmed. McKesson then appealed the Bankruptcy Court’s decision as it related to mutuality to the District Court, which affirmed.

III. Third Circuit

Further on appeal, in affirming the decisions of the District and Bankruptcy Courts, the Third Circuit first discussed the effect of the term “mutual” explicitly provided for in section 553 and held that the Bankruptcy Code–opposed to state law–governs the meaning of mutuality and that section 553 “imposes a distinct limitation strictly construed to prohibit enforcement of a setoff agreement involving three or more parties and indirect debt obligations.”

Having found that the analysis in SemCrude was sound, the Third Circuit determined that mutuality is a distinct and limiting requirement of section 553, and reinforced 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.” In reaching its decision, the Court noted that the Second, Third, Fifth, and Seventh Circuits have indicated that triangular setoff arrangements are definitionally not mutual. The Court quoted In re Lehman Bros. Inc., 458 B.R. 134, 141 (Bankr. S.D.N.Y. 2011) that “[p]arties may freely contract for triangular setoff rights, but not in derogation of [the] mandates of the Bankruptcy Code.” The Third Circuit then rejected all argument that the contractual Setoff Provision in the Distribution Agreement turned the debts between Orexigen, McKesson, and MPRS from a triangular arrangement into a mutual debt. Such reasoning effectively excludes triangular setoff arrangements and in particular, the Setoff Provision.

Takeaways & Practical Implications

This is another example of a circuit court providing that you cannot contract around the mutuality requirement provided for in section 553 to offset other parties’ claims. As suggested by the Third Circuit, if a party wants to set off its liability in a subsequent bankruptcy using debts owed to a third party affiliate, it should consider:

  1. Making itself the party to the agreement instead of one of its affiliates; or
  2. Having the affiliate take a security interest in the counterparties’ accounts receivables as to obtain a priority right equal to the amount potentially set off.

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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