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

The doctrine of recoupment is similar to setoff, but there are material distinctions between them. Recoupment is a defensive tool used by a creditor to cancel a claim asserted against it by a debtor where the creditor has a mutual claim against the debtor. Recoupment may only be used to net mutual obligations incurred in connection with the same transaction. In contrast, setoff rights can be used more broadly to cancel mutual obligations arising out of wholly unrelated transactions/contracts so long as they are still between the same parties. Unlike setoff, recoupment is not subject to the automatic stay.

From the creditor's viewpoint, the ability to offset mutual debts is just. Setoff rights encourage creditors not to terminate their business relationship with a financially distressed counterparty pre-bankruptcy. Because the right of setoff opens the door to potential abuse that could lead to preferential treatment for certain creditors, section 553 imposes strict requirements for a creditor to take any offset.

In bankruptcy, first the creditor must establish a right to setoff under state law. Then, the prepetition right of setoff is preserved by section 553 only if: 1) both the creditor's claim against the debtor and its indebtedness to the debtor arose prepetition; 2) the offsetting debts are "mutual" (i.e., they run between the same parties); and 3) both the claim and the debt are valid and enforceable. These requirements are construed narrowly. For example, a creditor cannot offset a prepetition debt owed to the debtor against a postpetition obligation owed by the debtor because the prepetition debtor and postpetition debtor are not deemed to be the same entity for mutuality purposes.

In line with the narrow construction of section 553, courts have found that the "mutuality" requirement prohibits multiparty or "triangular" setoffs even where the party holding the claim against the debtor is an affiliate of the party who owes a debt to the debtor. From a commercial perspective, the creditor may consider its global (affiliated) transaction with the same debtor to be one economic relationship worthy of netting. However, as discussed below, the separateness of the affiliates destroys the availability of setoff, mandating that the creditor pay its debt to the debtor's estate even though it (or a related entity) has a claim against the debtor (or its affiliate).

Caught In a Triangle

In Orexigen, the Delaware Bankruptcy Court denied a triangular setoff involving affiliates and, in doing so, walked through a variety of reasons why the federal bankruptcy policy of fair and equitable treatment mandated denial. And the Orexigen court denied the creditor's attempt to execute a triangular setoff despite its unambiguous right to do so under its contract with the debtor. While the court recognized that setoff rights originated under state law, it followed a line of similar cases in finding that Bankruptcy Code requirements not only limit but — with respect to triangular setoffs — prohibit such rights altogether.

Let's review the facts: The Debtor, a drug manufacturer, was party to a core distribution agreement (the Distribution Agreement) with McKesson Corporation (McKesson), under which McKesson purchased and distributed the Debtor's drug to pharmacies. The Debtor was also party to a services agreement (the Services Agreement) with McKesson Patient Relationship Solutions (MPRS), a wholly owned subsidiary of McKesson, under which MPRS managed a program that allowed patients to obtain price discounts on the Debtor's drug.

The Distribution Agreement and the Services Agreement were separate transactions. Under the Distribution Agreement, however, McKesson had a right to set off the debts it owed to the Debtor against the debts owed by the Debtor to McKesson or its affiliates. Fast forward, the Debtor files for bankruptcy. The two debts at issue in the case were: 1) approximately $6.9 million that McKesson owed to the Debtor under the Distribution Agreement; and 2) approximately $9.1 million that the Debtor owed to MPRS under the Services Agreement.

The Orexigen court's analysis began with the traditional two-pronged inquiry under section 553: 1) whether the party seeking a setoff has the right to exercise a setoff under "applicable nonbankruptcy law"; and 2) whether such party meets the requirements of section 553 of the Bankruptcy Code.

The court noted that McKesson satisfied the first prong because it had a prepetition right to setoff under both the Distribution Agreement and California law. With respect to the second prong, however, the court examined the key requirements of section 553 and, applying them to the facts of the case, found that the proposed triangular setoff ran afoul of the bankruptcy policy in favor of equitable treatment of similarly-situated creditors.

Let's unpack the arguments. First, under section 553, the court recognized that a party seeking to effectuate a setoff against a debtor must be a "creditor" at the time of the offset. McKesson had based its standing as a "creditor" on the fact that it had a $6,932,816.40 prepetition claim against the Debtor pursuant to the Distribution Agreement. The Debtor opposed McKesson's right to setoff arguing that McKesson was no longer a "creditor" because it previously paid the Debtor the full amount owed under the Distribution Agreement in connection with certain postpetition stipulations (the Stipulations).

It could have been game over for McKesson when it made the payment (making this article irrelevant). Importantly, however, the Stipulations regarding McKesson's payment to the Debtor specifically provided that such payments were made subject to the express preservation of McKesson's setoff right and that the paid funds should be maintained in a segregated account pending the outcome of its motion to effectuate a setoff. In light of the Stipulations, the court found that McKesson had "no intent to extinguish" the liability it was seeking to offset and, on that basis, distinguished it from cases where the payment of indebtedness rendered a party no longer a "creditor" and thus ineligible to exercise a setoff.

Moving on to the headlining act, the court then addressed that the two debts the creditor seeks to offset must be "mutual." While the concept of mutuality is not defined in the Code, the court, citing numerous cases, reasoned that state and federal courts have coalesced around the view that debts are mutual only if "they are due to and from the same persons in the same capacity."

Applying this definition to the facts of the case, the court determined that mutuality was lacking between the debts at issue and, as a result, barred McKesson from taking the triangular setoff. The Court relied primarily on the Delaware District Court's decision in In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), and the bankruptcy court decision it affirmed, to support the conclusion that section 553 prohibits triangular setoffs, and unless the corporate veil is pierced, a parent's debt may not be set off against the credit of its subsidiary.

McKesson recognized that SemCrude and other cases prohibit triangular setoffs but argued that those decisions inappropriately disregarded that setoff is a creature of state law. Specifically, McKesson cited to the seminal U.S. Supreme Court case, Butner v. United States, 440 U.S. 48, 55 (1979), for the principle that courts must look only to applicable state law to determine whether mutuality exists. As an initial matter, while McKesson cited cases in support of its view that, under California law, the definition of mutuality permits triangular setoffs involving a parent and its subsidiary, the court disagreed with this interpretation and instead found that the California Supreme Court has denied the exercise of triangular setoffs. Moreover, to the extent the Seventh Circuit In re Berger Steel Co., 327 F.2d 401 (7th Cir. 1964) decision and its progeny suggest there may be a "contractual exception to mutuality," the court agreed with the conclusion Judge Shannon reached in SemCrude — that the plain language of section 553(a) is clear and no such state law exception exists.

Importantly, in balancing state law property rights and the Bankruptcy Code's polices, the court held that federal bankruptcy law supersedes any contractual or state law right to setoff held by McKesson. Congress specifically drafted section 553 to promote a federal interest — that is, "the fundamental bankruptcy policy of ensuring similarly-situated creditors receives an equal distribution from the debtor's estate." It is this important federal policy, the court opined, that section 553 and its strict mutuality requirement were intended to address, and which therefore takes precedence over state law.

Finally, the court addressed McKesson's argument that mutuality existed because MPRS was a third-party beneficiary of the Distribution Agreement. The court disagreed with McKesson's citation to two cases in support of the argument that a third-party beneficiary to a contract possessed the necessary mutuality under section 553(a). The court again rejected this argument as a matter of federal bankruptcy policy, positing that a third-party beneficiary exception to section 553 would encourage parties to circumvent the Code's mutuality requirement by conferring third-party beneficiary status on persons or entities unconnected to a contract.

Boxed In By the Triangle

Orexigen reflects bankruptcy's fundamental policy that creditors should be treated fairly and equitably. The court prohibited McKesson from using its affiliation with MPRS to affect a setoff and enhance its position relative to that of the estate's other creditors. In doing so, the court made abundantly clear that while setoff rights are created by state law, any attempt to exercise such rights in a way that contravenes federal bankruptcy policy fails.

Nonetheless, Orexigen offers some useful practice pointers. First, the court opined that a creditor's postpetition payment to a debtor, in satisfaction of its prepetition obligation to the debtor, could be fatal to that creditor's right of setoff. Had McKesson not entered into the Stipulations that made explicit its intent to preserve its right to assert a setoff, McKesson's payment of its debt to the debtor would have foreclosed any possible right to setoff. (This would have applied whether or not the setoff was triangular.).

A best practice for a creditor who elects to make a payment to the debtor's estate while a disputed setoff is outstanding is to obtain a court ordered stipulation that: 1) the creditor explicitly reserves its right to assert a setoff claim notwithstanding its payment of the debt; and 2) the funds paid to the debtor should be deposited into an escrow account or held in reserve under the order while the determination of the creditor's setoff right is pending.

A second — potential — practice pointer arising out of Orexigen relates to the structuring of contracts and payment mechanics to seek to preserve mutuality. Where distinct affiliated creditor parties are engaged in a business relationship with a single counterparty (or group of affiliated counterparties), consideration should be given to structuring the governing contract in a way that best preserves the argument that there is mutuality between the counterparties. While the Orexigen court ultimately ruled that parties may not contract around the mutuality requirement through third party beneficiary language, in Orexigen the operative contracts were still distinct and among separate affiliates. McKesson's debt and MPRS's claim (i.e., the two debts McKesson sought to offset) arose under different contracts providing for the performance of different services.

While it may not always be practical to do so for non-bankruptcy reasons, creditors seeking to preserve their right to setoff might fare better if the transactions are structured as one integrated master agreement that explicitly permits setoff of the various obligations under the single agreement. These may still not be sufficient to establish mutuality under section 553 in light of SemCrude and Orexigen. However, if the parties can institute a mechanism for consolidated payments between the creditor affiliates, on the one hand, and the debtor entities on the other — perhaps building a netting reconciliation process into the contract, they may just preserve mutuality. Nonetheless, creative structuring of contracts may not always be feasible for non-bankruptcy reasons. If that is the case, Orexigen reaffirms the prohibition on triangular setoffs, highlighting that its narrow interpretation of the mutuality requirement is necessary to maintain the well-established bankruptcy policy of fair treatment of creditors.

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Adam C. Rogoff is a partner in the Corporate Restructuring and Bankruptcy Department of Kramer Levin Naftalis & Frankel LLP and a member of this newsletter's Board of Editors. The author gratefully acknowledges the assistance of David Braun, an associate in the Department, in the preparation of this article.