The Third Circuit Holds that Triangular Set Off Debts are Non-Mutual under the Code

The Third Circuit Holds that Triangular Set Off Debts are Non-Mutual under the Code

The Court of Appeals for the Third Circuit, on March 19, 2021, affirmed the decision of the lower court, thereby rejecting the “triangular setoff” agreements as a proper basis for the application of setoff rights given under Section 553 of the Bankruptcy Code.[1] In re Orexigen Therapeutics, Inc. 2021 WL 1046485 (3^rd Cir. 2021)

In the stated case, Orexigen Therapeutics, Inc. entered into a distribution agreement with McKesson Corporation, Inc. under which McKesson was to distribute Orexigen’s weight-loss drug. The distribution agreement provided a setoff provision, vide which Mckesson and its affiliates were allowed to set off, recoup and apply any amount owed by it to Orexigen and its affiliates against any and all amount owed by Orexigen or its affiliates to McKesson or its affiliates. Later, one of the McKesson’s subsidiaries, namely, McKesson Patient Relationship Solutions (MPRS) executed a service agreement with Orexigen, vide which MPRS would provide funds to pharmacies selling the Orexigen manufactured weight loss drug, and Orexigen would later reimburse the payment (funds). A notable point was that the distribution agreement and the services agreement did not acknowledge or refer one another, and McKesson and MPRS were different legal entities.

In March 2018, voluntary Chapter 11 bankruptcy proceedings were initiated against Orexigen, in the District of Delaware. As on the date of the filing of the petition, Orexigen owed MPRS around $9.1 million under the Service Agreement, while McKesson owed Orexigen around $6.9 million under the distribution agreement. Both the entities, McKesson and MPRS contended that they had triangular set off rights under both the agreements, and were enforceable under the applicable state law. McKesson claimed that it created substantial mutuality under Section 533(a) of the Bankruptcy Code, in order to allow it to equate its outstanding petition date indebtedness to Orexigen against Orexigen’s petition date indebtedness to MPRS.  

The Third Circuit adjudged on the issue of “mutuality” stated under Section 533(a)[2] of the Code by finding dispositive the statutory text which stated that “this title does not affect any right of a creditor to offset a mutual debt”. The Court found that the text effectively limits exercise of set off right to a debtor’s claim against a creditor and a creditor’s claim against the debtor. Further, intention of Congress was to give “mutuality” a limited meaning of debts owning between two parties, especially those owing from a creditor directly to the debtor and debts owing from the debtor directly to that creditor. However, the stated section does not include within the concept of mutuality anything except a simple bilateral relationship. Thus, the Court refuted the contention that the triangular set offs were mutual.  The Court also stated that if the triangular set off agreements is allowed into the provision under Section 533(a), it would weaken the fundamental purpose of the Code, which is to limit the priority claims and aims to maximize creditor payouts. It further noted that excluding non-mutual debts from the state provision would ensure predictability in credit transactions.

The judgment delivered by the Court is an exceptional one as it has provided much need clarity and held that a triangular set off would not be considered mutual under Section 533(a). Further, it also highlights the importance for the creditor to gain knowledge of their customers and understand the significance of corporate distinctiveness and its impact on the set off rights.

[1] 11 U.S. Code § 553

[2] 11 U.S. Code § 553 (a)