While the Bermuda Triangle is a mystery that may never be solved, the Third Circuit Court of Appeals recently settled the intriguing question of whether contractual provisions allowing for "triangular setoff" are enforceable in bankruptcy. The Third Circuit concluded such contractual provisions are unenforceable in In re Orexigen Therapeutics, Inc.1, due to the "strict bilateral mutuality" requirement of Section 553 of the Bankruptcy Code. Bilateral mutuality simply means that the debts must be owed between the same two legal entities. The Third Circuit did not, however, settle the mystery of the missing ships and aircraft in the Bermuda Triangle.

But what is triangular setoff? Why does it matter to your business? And what can be done to protect your business interests before a contract counterparty files bankruptcy? You will have to read on to find out.

What is triangular setoff?

A traditional bilateral setoff occurs when A owes B a debt, and B owes A a debt. These two mutual debts can be setoff against each other. In a bankruptcy context, a creditor's ability to setoff mutual, pre-petition debts is powerful because a creditor can recover against its claim by the entire amount of the debt it owes to the debtor. By contrast, if a creditor cannot exercise the right of setoff, it will have to pay the debt it owes to the debtor and it may only receive pennies on the dollar for the debt owed to it.

Triangular setoff is when A owes B a debt, and C owes A a debt (where B and C are affiliates). In a triangular setoff scenario, A sets off the debt it owes to B against the debt that C owes to A. Outside of bankruptcy, triangular setoff is permitted only if authorized by contract and state common law. However, after the Third Circuit's ruling, it is clear that triangular setoff, even where parties have contracted to authorize it, will not be permitted in bankruptcy (at least in that circuit), and there is a likelihood that other circuits may follow suit.

The Orexigen Bankruptcy & Triangular Setoff

Orexigen Therapeutics, Inc. (the "Debtor"), a pharmaceutical drug manufacturer, entered into a distribution agreement with McKesson Corporation (the "Distributor") in June 20162. The distribution agreement between [the Debtor] and the Distributor included a provision (hereafter, the "Setoff Provision") that allowed "each of [the Distributor] and its affiliates...to set-off, recoup and apply any amounts owed by it to [the Debtor's] affiliates against any [and] all amounts owed by the Debtor or its affiliates to any of [the Distributor] or its affiliates."3 In short, the Setoff Provision provided broad setoff rights between the Debtor and its affiliates, and the Distributor and its affiliates.

The Debtor also entered into a services agreement with McKesson Patient Relationship Solutions (the "Affiliate"), one of the Distributor's subsidiaries, in July 2016.4 The services agreement between the Debtor and the Affiliate did not reference, incorporate, or integrate the distribution agreement between the Debtor and the Distributor.5

Nearly two years after entering into the distribution agreement with the Distributor and the services agreement with the Affiliate, the Debtor filed for Chapter 11 bankruptcy in the District of Delaware.6 At the time of the filing, (i) the Debtor owed the Affiliate approximately $9.1 million, and (ii) the Distributor owed the Debtor approximately $6.9 million.7 The Distributor and the Affiliate filed a motion in the Bankruptcy Court to setoff the amounts the Distributor owed to the Debtor against the amounts that the Debtor owed to the Affiliate.8 The net result would be the Debtor owing the Affiliate $2.2 million.

The Bankruptcy Court disagreed with the Distributor's position. Section 553(a) of the Bankruptcy Code generally preserves the "right of a creditor to offset a mutual debt owing by such creditor to a debtor that arose before" the bankruptcy was filed. The Bankruptcy Court explained that the relief seeking triangular setoff of pre-petition debts did not meet Section 553(a)'s mutuality requirement.9 The Bankruptcy Court held that contracts could not alter Section 553(a)'s requirement that the pre-petition debts be between the same two parties and stemming from the same right.10 On appeal, the District Court affirmed the Bankruptcy Court's decision.11

In affirming the lower courts' decisions, the Third Circuit agreed that a contract could not create an exception to Section 553(a)'s requirement of direct mutuality.12 Instead, the Third Circuit held that Section 553(a)'s mutuality requirement is "a distinct and limiting requirement of federal bankruptcy law."13 In examining the effect of that limitation, the court explained that Congress did not intend to allow a contractual workaround to mutuality where a straightforward, bilateral relationship was meant.14 Accordingly, where contracts create a right to setoff debts owed by a creditor or its affiliates against obligations owed by a debtor or its affiliates, the contractual relationship will not be transformed from a triangular set of requirements into a bilateral mutuality.

The court explained that its decision was consistent with policies underlying the Bankruptcy Code: "one of the primary goals—if not the primary goal—of the Code is to ensure that similarly-situated creditors are treated fairly and enjoy an equality of distribution from a debtor absent a compelling reason to depart from this principle."15 The court reasoned that "[t]riangular setoffs undermine that goal."16 If allowed in this case, the Affiliate would have in effect received a 100% distribution on $6.9 million of its $9.1 million claim as well as a pro-rata distribution on its remaining $2.2 million claim, and the Debtor would have received nothing from the Distributor from which to make distributions to creditors. In short, the Affiliate's recovery would be vastly greater than that of similarly situated unsecured creditors. By contrast, if triangular setoff was not allowed, (i) the Debtor will receive $6.9 million from the Distributor, (ii) the Affiliate will have a claim against the Debtor for $9.1 million, and (iii) any distribution that the Affiliate receives will be pro rata and identical to any distribution received by another similarly situated creditor. By strictly enforcing Section 553(a)'s mutuality requirement, the Third Circuit reasoned that the goal of equal treatment of creditors would be best served.

Why does triangular setoff matter to your business?

To the extent your business is comprised of affiliated legal entities that each enter into contracts with the same counterparty (or its affiliates), avoiding triangular setoffs will be crucial to maximize your recovery in the event of a counterparty's bankruptcy case. As described in Orexigen, even broad contractual provisions authorizing triangular setoff will not be enforced and your business may be in the unpleasant position of having one affiliate pay the entirety of a debt it owes to a debtor while another affiliate receives just pennies on the dollar on the debt owed to it. Thus, it's best to be prepared for the possibility of a counterparty filing for bankruptcy and take steps now to maximize your business's recovery.

What can be done to protect your business from falling victim to the Bermuda "triangular setoff"?

While the ability to contract for triangular setoff within the Third Circuit appears to have vanished without a trace, there are still ways that your business can emerge from the Bermuda "triangular setoff" unscathed. Indeed, the Orexigen court suggested a few options. First, the Distributor could have taken steps to have the Affiliate be granted a perfected security interest in the Debtor's account receivable due from the Distributor to secure the debt owed to the Affiliate. Second, the court suggested that the Distributor and Affiliate be made jointly and severally liable to the Debtor. Another option, which was not raised by the court, is to have one of your businesses' entities enter into most material contracts with a counterparty where there may be a bankruptcy risk, but expressly authorize your contracting entity to delegate its duties to an affiliate. Although these steps may be cumbersome, thinking through these issues at the point of contracting—particularly when there may be substantial debts owed between the parties—may be the difference between a nominal and a substantial recovery in a future bankruptcy case.

Footnotes

1 990 F.3d 748 (3d Cir. 2021)

2 Id. at 751.

3 Id.

4 Id.

5 Id.

6 Id.

7 Id.

8 Id.

9 In re Orexigen Therapeutics, Inc., 596 B.R. 9, 12 (Bankr. D. Del. 2018).

10 Id. at 18.

11In re Orexigen Therapeutics, Inc., No. BR 18-10518-KG, 2020 WL 42824 (D. Del. Jan. 3, 2020).

12 In re Orexigen Therapeutics, Inc., 990 F.3d at 753-54.

13 Id. at 754.

14 Id.

15 Id. at 755. (Internal citation and quotation omitted).

16 Id.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.