Don't Set Me Off: No Triangular Setoff Among Affiliated Entities and a Debtor Counterparty

The Bankruptcy Code provides debtors with the opportunity for a fresh start in the face of mounting financial obligations. The Code also provides for fair and equitable treatment of creditors. These policies date back decades. In today's global economy, companies often have multiple business lines operating through separate entities. Outside of bankruptcy, these affiliated operations sometimes transact in a holistic — albeit legally distinct — debtor-creditor relationship with their counterparty. But, as this article discusses, the legal separateness of affiliates can hinder economic protections that a creditor might have otherwise when its counterparty files for bankruptcy.

Creditors and debtors often have monetary obligations that run both ways. Under state law, the creditor can protect itself by netting out these obligations. Section 553 of the Bankruptcy Code recognizes this right of setoff. It is a straightforward analysis when the counterparties are only two — one creditor and one debtor. However, courts have grappled with the application of section 553 when applied to multiparty transactions, especially those involving affiliated entities. The ability to effect a "triangular offset" can run afoul of the "fair and equitable treatment" policy and, as recently addressed by the Delaware Bankruptcy Court in In re Orexigen Therapeutics, Inc., No. 18-10518, 2018 WL 6841350 (Bankr. D. Del. Nov. 13, 2018), has been held impermissible.

Setting the Stage for Setoff

Setoff permits a creditor to cancel a prepetition debt that it owes to a debtor to the extent of any prepetition claim such creditor has against the debtor. While the cancellation of mutual debts may seem a mere administrative action outside of bankruptcy, the right to setoff is valuable in bankruptcy where a creditor is likely to receive less than a full recovery on its claim. Absent setoff, the debtor collects 100% of the amount the creditor owes to it, while the creditor only collects its pro rata share of the value available for distribution to its class (which could be much less than 100%). Section 553, however, allows the creditor to receive full recovery on the portion of its claim that is subject to setoff.