CLIENT ALERT: Two’s Company, Three’s a Crowd: Third Circuit Rejects Triangular Setoff

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Bennett Murphy and Razmig Izakelian of Quinn Emanuel Urquhart & Sullivan, LLP; Christopher M. Samis and L. Katherine Good of Potter Anderson & Corroon LLP

On March 19, 2021, Quinn Emanuel and Potter Anderson achieved a significant victory before the Third Circuit and further clarified the law surrounding the troublesome issue of triangular setoff. Specifically, the Third Circuit, in In re Orexigen Therapeutics, Inc., No. 20-1136, 2021 WL 1046485 (3d Cir. Mar. 19, 2021), rejected triangular setoff and held that a creditor cannot contract around the “mutuality” requirement of § 553 of the Bankruptcy Code. Section 553 states, in relevant part, that the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt” that creditor owes to the debtor against a debt the debtor owes to that creditor. A triangular setoff typically arises where parties A, B and C agree that A may offset amounts owed by A to B against amounts owed to A by C.

Orexigen entered two separate agreements with McKesson Corporation, Inc. (“McKesson”) and its affiliate McKesson Patient Relationship Solutions (“MPRS”) in connection with Orexigen’s weight loss drug. Id. at *1. The agreement with McKesson (the “Distribution Agreement”) permitted McKesson to distribute the drug, and it granted McKesson the right to offset any debt owed to Orexigen or its affiliates against any debt Orexigen owed to McKesson or any of its affiliates—the prototypical triangular setoff. Id. The second agreement between Orexigen and MPRS contemplated that MPRS would run a discount program for the drug. Id.

When Orexigen filed for bankruptcy, McKesson owed Orexigen approximately $7 million under the Distribution Agreement, and Orexigen owed MPRS approximately $9 million under the second agreement. Id. at *2. McKesson sought to offset its $7 million debt to Orexigen against the $9 million debt Orexigen owed to MPRS, as permitted by the Distribution Agreement. Id. The Bankruptcy Court for the District of Delaware rejected McKesson’s requested offset, which would have eliminated McKesson’s debt and left MPRS with a claim against Orexigen’s estate for about $2 million. Id. McKesson appealed to the District Court, which affirmed. McKesson then appealed to the Third Circuit. Id.

On appeal, McKesson argued that the word “mutual” in § 553 does not create an additional burden for creditors seeking setoff in bankruptcy. Id. at *3. Rather, if the creditor could pursue setoff under state law, then § 553 allows the creditor to pursue setoff in bankruptcy. Id. Orexigen argued that the word “mutual” in § 553 is a modifier that imposes a distinct limitation prohibiting enforcement of triangular setoff agreements in bankruptcy. Id.

The Third Circuit agreed with Orexigen. Id. at *4. It held that the word “mutual” in § 553 refers to debts owed directly between the same two parties. Id. Additionally, contractual provisions intended to turn a triangular debt arrangement into a mutual debt between two parties will not be enforced under § 553. Id. The Court noted that allowing a triangular setoff would undermine a primary goal of the Bankruptcy Code, to ensure that similarly situated creditors receive an equal distribution from the debtor. Id. at *5.

The Third Circuit posed two alternatives that McKesson could have pursued if it wanted to have the necessary mutuality between the two debts in this case. Id. at *6. First, McKesson could have simply taken on the second agreement itself, rather than delegating it to MPRS. Id.  Second, MPRS could have required a security interest in Orexigen’s accounts receivables due from McKesson as part of the deal between MPRS and Orexigen. Id. In this scenario, MPRS’s claim for $9 million would have been secured up to the $7 million that McKesson owed Orexigen. MPRS would have been able to recover the $7 million in full as a secured claim, achieving essentially the same result for McKesson as setoff.

Perhaps the simplest solution for companies looking to preserve their setoff rights in bankruptcy is found in footnote 14 of the decision. A parent company seeking to preserve setoff rights in bankruptcy should join as a party with its subsidiary to any subsequent agreements, with the subsequent agreement creating a joint and several obligation to the debtor from both the parent company and its subsidiary. Id. at *5 n.14. In this scenario, the first contract would be between A (the debtor) and B. The second contract would be between A (the debtor) on one side and both B and C on the other side. If B is jointly and severally liable for C’s debts to A, C could seek to offset any debt it owed to A under the second contract against any debt A owed to B under the first contract without running afoul of the mutuality requirement. Of course, it may not be commercially feasible for an affiliate to agree to be liable for the debts of another affiliate under all circumstances.

Following Orexigen, triangular setoff provisions in contracts will not be enforceable in bankruptcy within the Third Circuit. Instead, if loss of setoff rights in bankruptcy is a concern, creditors should take steps to become a party to both the contract creating the debt and the contract creating the obligation to ensure the necessary “mutuality” exists.

Should you have any questions regarding the opinion or the discussion above, please do not hesitate to contact any of the below attorneys on the Quinn Emanuel or Potter Anderson litigation teams.

Bennett Murphy, Esq. - bennettmurphy@quinnemanuel.com
Razmig Izakelian, Esq. - razmigizakelian@quinnemanuel.com
Christopher M. Samis, Esq. - csamis@potteranderson.com
L. Katherine Good, Esq. - kgood@potteranderson.com

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