2020 is on pace to set a record as the busiest year for bankruptcy filings since the Great Recession.  In this episode on Kelley Drye Legal Download podcast, Bankruptcy and Restructuring Partner Bob LeHane and Special Counsel Jennifer Raviele discuss the current state of retail and restaurant bankruptcy cases, the impact of the global pandemic, and what to expect in the future.

Listeners can tune into their episode of Kelley Drye Legal Download podcast here and get future episodes on their preferred platform – Apple Podcasts, Google Play or Spotify.

The impact of COVID-19 is being felt at all levels of the economy and will work its way through bankruptcy courts for years to come.  In these early days, many creditors who are themselves suffering are providing assistance to troubled companies.  Suppliers and commercial landlords are agreeing to various forms of relief, including modified credit terms and rent relief to allow customers to bridge this period of unprecedented disruption.  While these corporate good Samaritans are providing immediate aid they may be subjecting themselves to the risk of future losses.

Consider the supplier extending terms now to a customer who inevitably files for bankruptcy.  As creditors to troubled businesses know, payments received from a debtor within 90 days of bankruptcy are subject to potential avoidance as a preference.  One of the primary preference defenses is the “ordinary course” defense, which insulates payments received in the ordinary course of business with the debtor.  The defense can be weakened if the payments at issue are made later than historic averages or eliminated if the payments are made by special arrangement.  As a result, under current law, the supplier who works with its customer and modifies payment terms to help them confront the economic fallout of COVID-19 may suffer increased future exposure because one of the most common statutory preference defenses is harder to prove.  

The risk to landlords is similar as courts have held that (i) an agreement to forbear from eviction does not insulate back rent payments from avoidance, and (ii) deferred rent payments are avoidable because payments made pursuant to unique agreements are not in the ordinary course of business.

Lenders that agree to loan amendments and forbearances to address COVID-19 will face similar concerns.  What of the lender that agrees to amend a financing agreement, extending maturity or offering interest-only terms during the crisis, and takes a lien on additional collateral as protection against the increased risk?  If the borrower ultimately files for bankruptcy, the lien on new collateral may be subject to preference attack.  

Absent fraud or other misconduct, should such creditors be penalized for working to find solutions during times of crisis?  Congress could make clear that, absent fraud or misconduct, creditor concessions granted during the COVID-19 crisis are presumptively immune from avoidance under the Bankruptcy Code.  This would protect parties that proactively step in to help, and might encourage others to do the same.  

The economic fallout from the COVID-19 pandemic will leave in its wake a significant increase in commercial chapter 11 filings. Many of these cases will feature extensive litigation involving breach of contract claims, business interruption insurance disputes, and common law causes of action based on novel interpretations of long-standing legal doctrines such as force majeure. These issues could be particularly problematic to resolve because of questions stemming from recent Supreme Court decisions regarding the constitutional authority of United States bankruptcy courts to make final rulings on these types of disputes. Fortunately, however, a recent decision by the U.S. Court of Appeals for the Third Circuit in the case of Millennium Lab Holdings suggests a different approach for addressing these constitutional concerns. The Third Circuit’s approach anticipates where the Supreme Court’s jurisprudence appears to be heading, and should provide useful guidance to bankruptcy courts during what is going to be a challenging period for both judges and practitioners.

Uncertainties regarding the authority of bankruptcy courts to issue final orders in certain types of cases have existed for decades, but were mostly quiescent until the Court’s opinion nine years ago in Stern v. Marshall.  In that case, which arose out of the endless litigation between Anna Nicole Smith and the son of her late husband, the Supreme Court stunned the commercial legal community by reopening what many had believed were long-settled constitutional questions regarding the United States bankruptcy courts.  Since then, practitioners and lower courts have struggled to deal with the ramifications of that decision.

The problems created by Stern, in a nutshell, are as follows:

Congress has the express power under Article I, Section 8 to pass uniform laws on bankruptcy. It used that power to create the modern bankruptcy court system pursuant to Article I of the Constitution rather than under Article III, the source of the federal government’s judicial power.

However, the Supreme Court has long held that “separation of powers” concerns require that Article I courts be limited to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (e.g., cases involving claims of citizens against the government).  Claims of citizens against one another under state law, such as for breach of contract or common torts, are “private rights” that must be heard by an Article III judge.

Prior to Stern, it was generally believed that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power” under Article I, constituted a type of “public right” that could be heard and decided by an Article I bankruptcy judge.

The Court, however, never handed down a clear ruling as to where the line between “public rights” and “private rights” should be drawn in bankruptcy proceedings, even though “the restructuring of debtor-creditor relations” often necessitates the resolution of “private rights” disputes. Moreover, the Court, both in Stern and in recent non-bankruptcy cases, has significantly narrowed the “public rights” doctrine.

This has created confusion and given rise to substantial litigation in bankruptcy cases over the constitutional authority of bankruptcy judges to issue final orders on numerous issues which could implicate “private rights.”

In Millennium, the Third Circuit affirmed lower court opinions that turned aside a constitutional challenge to the authority of a bankruptcy court to confirm a plan of reorganization. The plan included the non-consensual release by third parties of certain claims against various non-debtor entities. The debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests.  The plan embodied a compromise, whereby the equity holders were to pay $325 million in exchange for a release of all claims against them held either by the debtor’s estate or directly by third parties.

Certain of the debtor’s lenders had commenced separate litigation against the equity holders, and objected to the releases in the plan that would preclude their claims. The lenders contended that under Stern the releases were tantamount to resolving a “private rights” dispute between two non-debtor parties, and that the bankruptcy court therefore lacked constitutional authority to enter a final order resolving it.

The Third Circuit rejected the lenders’ arguments. However, the decision avoids the thicket of the Supreme Court’s “public rights” jurisprudence, and strongly implies that such jurisprudence no longer provides support for bankruptcy courts’ constitutional authority to issue final orders which are dispositive of parties’ “private rights.” The Third Circuit reviews the Court’s recent decisions in this area and suggests that the Court is heading towards an alternative approach:

Judge Kent A. Jordan, writing for the court, steps away from the “public rights” doctrine and towards a straight-forward alternative – an express recognition that specialized bankruptcy courts under Article I should be viewed as an additional category of historical exception to the judicial power of Article III.

This would place the constitutional authority of bankruptcy courts to make dispositive rulings in cases involving “private rights” on far firmer ground than it currently rests under the “public rights” doctrine. Judge Jordan cites a passage that appears to endorse the “historical exception” rationale from a recent separate opinion by Chief Justice Roberts, who authored Stern:

“When the Framers gathered to draft the Constitution, English statutes had long empowered nonjudicial bankruptcy ‘commissioners’ to collect a debtor’s property, resolve claims by creditors, order the distribution of assets in the estate, and ultimately discharge the debts. This historical practice, combined with Congress’s constitutional authority to enact bankruptcy laws, confirms that Congress may assign to non-Article III courts adjudications involving ‘the restructuring of debtor-creditor relations, which is at the core of the federal bankruptcy power.’”

This approach has also been suggested in a separate opinion by Justice Thomas, who was part of the Court’s majority in Stern:

“Congress . . . has assigned the adjudication of certain bankruptcy disputes to non-Article III actors since as early as 1800. . . Bankruptcy courts clearly do not qualify as territorial courts or courts-martial, but they are not an easy fit in the “public rights” category, either. . . We have nevertheless implicitly recognized that the claims allowance process may proceed in a bankruptcy court, as can any matter that would necessarily be resolved by that process, even one that affects core private rights. . . . For this reason, bankruptcy courts . . . more likely enjoy a unique, textually based exception, much like territorial courts and courts-martial do. . .  That is, Article I’s Bankruptcy Clause serves to carve cases and controversies traditionally subject to resolution by bankruptcy commissioners out of Article III, giving Congress the discretion, within those historical boundaries, to provide for their resolution outside of Article III courts.”

The Supreme Court has attempted for many years to force bankruptcy courts to fit within the permissible parameters for courts created under Article I – territorial courts, military tribunals, and courts created to hear cases involving public rights – but that effort appears to have run its course and has led to uncertainty and confusion. Judge Jordan’s opinion indicates that the Third Circuit believes that the Supreme Court is in the process of abandoning its efforts to apply “public rights” jurisprudence to the specialized system of bankruptcy courts created by Congress, and is on course instead to recognize such courts as a fourth category of exception to Article III courts.

Millennium is now binding precedent in the Third Circuit. It will likely be interpreted broadly by the judges in the District of Delaware, one of the most influential bankruptcy districts in the country, and be viewed as persuasive authority by judges elsewhere. With a plethora of “private rights” litigation in bankruptcy cases on the immediate horizon, the reasoning of Millennium, if ultimately adopted by the Supreme Court, will place bankruptcy courts’ ability to make final rulings in such matters on firmer constitutional footing, and end much of the uncertainty and needless litigation over bankruptcy judges’ authority.

 

Last week, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, implementing broad relief for individuals and businesses affected by COVID-19.  One of the sections of the CARES Act receiving less attention is a temporary amendment to the Bankruptcy Code to provide streamlined reorganization procedures for businesses with debt of less than $7.5 million. 

In February 2020, President Trump signed into law the Small Business Reorganization Act (SBRA) designed to decrease the cost and complexity of reorganization for small businesses with debt of less than $2,725,625.  The SBRA allows these smaller businesses to confirm a plan without the need for a disclosure statement and owners to retain their business without providing new value under the plan.  In an SBRA bankruptcy, an unsecured creditors’ committee will generally not be formed, and each case will have a trustee who can assist the debtor in negotiating a plan and administering plan payments. 

For the next year, the CARES Act expands eligibility for the SBRA by increasing the debt limit under the SBRA from $2,725,625 to $7.5 million.  This increase temporarily opens the door to streamlined chapter 11 tools to assist larger businesses than originally contemplated facing unprecedented challenges during this time.  

We expect additional changes to the Bankruptcy Code will be enacted to address the economic fallout from COVID-19.  At Kelley Drye, we have a team of legal advisors across practices and geographies collaborating to help clients navigate this uncertain environment.  We invite you to access the Kelley Drye COVID-19 Resource Center for information and webinars on these rapidly evolving circumstances.

As the nation hunkers down to combat the novel coronavirus (COVID-19), bankruptcy courts throughout the country have moved quickly to implement procedures to preserve access to the courts while limiting in-person interaction during the crisis.  Each court’s specific COVID-19 procedures are different, but they largely prohibit in-person hearings, recognize the need for flexibility and adjournments for non-emergent matters whenever possible, and encourage the creative use of technology to allow as many matters to go forward as scheduled, including evidentiary hearings.  A schedule summarizing COVID-19 procedures adopted in various jurisdictions can be accessed HERE.  We expect regular amendments as the crisis unfolds and the economic fallout increases the volume of cases requiring bankruptcy court intervention.

Please do not hesitate to reach out to the Kelley Drye bankruptcy team with any questions or for any assistance during this time.  For additional up-to-date information about the potential legal and business implications of the evolving coronavirus pandemic and the latest advisories and legal updates on COVID-19 we invite you to visit Kelley Drye’s COVID-19 Resource Center website.

Social distancing.  Elbow bumps.  Flatten the curve.  These are the new phrases and behaviors we have learned to avoid exposure to the novel coronavirus (COVID-19).  This epic struggle forces us to reexamine and reevaluate our daily habits, lifestyles and customs as we work collectively to minimize the harm to our families, friends and neighbors throughout the United States.  While some of the lifestyle changes and limitations will be temporary, the human and economic effects of COVID-19 will be profound and, as always, the disruption undoubtedly will lead to increased innovation and societal change.

In the restructuring arena, many effects are direct and foreseeable.  Workers and businesses in the travel, restaurant, retail, hospitality and gaming industries will be immediately and severely challenged as their customers choose or are forced to stay home. The Centre for Aviation reports that without a significant government bailout, several major airlines will be bankrupt by mid-May.  Government mandated shopping center and restaurant closures will exacerbate the already severe challenges facing the retail industry, and disruptions in the global supply chain create inventory pressures for retailers and manufacturers alike.  And, as employees suffer reductions in the work-force, reduced income, medical debt and stock market losses, discretionary spending will decrease.  Regardless of whether you were bullish or bearish on 2020 last week, the financial impact of COVID-19 will be real and undeniable.

Continue Reading A Season of Viral Disruption

U.S. Bankruptcy Judge Dennis Montali recently ruled in the Chapter 11 case of Pacific Gas & Electric (“PG&E”) that the Federal Energy Regulatory Commission (“FERC”) has no jurisdiction to interfere with the ability of a bankrupt power utility company to reject power purchase agreements (“PPAs”). Although this question has divided courts which have considered it, Judge Montali made clear that he would not allow FERC to limit either PG&E’s rights under the U.S. Bankruptcy Code, or his own power to oversee PG&E’s bankruptcy case. (Kelley Drye & Warren LLP represents certain creditors in the PG&E case but took no part in the issues discussed here.)

The U.S. Bankruptcy Code provides an enterprise that is seeking to reorganize under chapter 11 with a number of tools to rehabilitate its business prospects. One of the most important is the ability, under Section 365, to reject burdensome executory contracts. An executory contract is generally considered to be any contract of the debtor for which there are material obligations to be performed by both parties. In considering a debtor’s request to reject a contract, courts typically defer to the debtor’s “reasonable business judgment” as to whether rejection would be in the best interest of its creditors and its bankruptcy estate — a very low standard to meet. The rejection of such a contract frees the debtor from any ongoing obligations under the contract, and is deemed to be a breach of such contract as of immediately prior to the filing of the bankruptcy petition. The non-debtor party to the contract is afforded a claim for damages arising from the breach, which is treated in the bankruptcy case as a general unsecured claim.

In the bankruptcy cases of power utility companies such as PG&E, the question of whether the debtor can reject its PPAs has become a crucial issue. PPAs are unquestionably executory in nature. Due to the volatile nature of power pricing, such agreements can often be significantly burdensome for the debtor. It would therefore appear that PPAs can readily be rejected by utility companies in bankruptcy.

Nevertheless, there is a significant split among courts on this issue. Some courts have determined that power utility companies do not have the unfettered ability to reject PPAs, under the rationale that, because the purchase and sale of energy for distribution to consumers “is affected with a public interest,” the Federal Power Act (“FPA”) requires the approval of FERC before a PPA can be terminated in a bankruptcy proceeding.

The dispute in the PG&E case arose last January when PG&E disclosed that it intended to file for protection under Chapter 11 of the Bankruptcy Code due to its potential massive liabilities for wildfire damage claims in California. PG&E is party to numerous PPAs for electricity generated by alternative sources such as solar and wind. The price for such energy sources has dropped considerably in the last few years. Two of PG&E’s power suppliers, anticipating that PG&E could want to extricate itself from having to pay above-market rates, petitioned FERC to rule that PG&E could only reject PPAs with FERC’s consent. In response, FERC issued a decision stating that it had “concurrent jurisdiction” with the bankruptcy court “to review and address the disposition of [PPAs] sought to be rejected through bankruptcy.” PG&E, immediately after filing its Chapter 11 petition, commenced an adversary proceeding in the bankruptcy case, seeking a declaratory judgment that the bankruptcy court has exclusive jurisdiction over this question.

Judge Montali noted the “unsettled” law regarding the rejection of PPAs in bankruptcy. Some courts have looked at the “filed rate doctrine,” which is FERC’s mandate under the FPA to certify contract rates for electricity as “just and reasonable,” and have determined that FERC has authority over PPAs in bankruptcy. In the chapter 11 case of NRG Energy, for example, a district court judge in New York ruled that FERC retained its regulatory authority over the debtor’s PPAs notwithstanding the bankruptcy filing, and that the FPA required deference to FERC. A few years later, in the chapter 11 case of Calpine Corp., another New York district court judge concluded that Congress had granted FERC substantial authority over energy contracts and found no evidence that it intended for the Bankruptcy Code to supersede such authority.

Judge Montali, however, dismissed the argument that FERC’s authority with respect to energy contract prices provided it with jurisdiction over the rejection of such contracts in a chapter 11 case. His starting point in the jurisdictional analysis was Section 1334(a) of the U.S. Judicial Code, which provides federal district courts (and by extension bankruptcy courts) with “exclusive” jurisdiction over all bankruptcy cases.

He observed that “[n]othing in the FPA or the Bankruptcy Code grants FERC concurrent jurisdiction with this court over Section 365 motions to reject executory contracts covering federal power matters. The issue here is Section 365 and not any of the permutations and applications of the filed rate doctrine.” He held that the matter before him did not arise under the FPA and he was not reviewing any decision by FERC regarding energy prices; instead he was considering only whether PG&E, a debtor in a Chapter 11 case, could exercise a statutory right to reject, i.e., effectively breach, a contract. He therefore determined that “[t]he rejection of an executory contract is solely within the power of the bankruptcy court, a core matter exclusively this court’s responsibility.”

Judge Montali agreed with the reasoning of the Fifth Circuit, the only circuit Court of Appeals that has considered the issue. In the case of Mirant Corp., the Fifth Circuit found no conflict between the FPA and Bankruptcy Code. The court determined that FERC’s authority under the FPA deals only with energy prices, and that a bankruptcy court’s decision to permit rejection of a PPA therefore does not interfere with such authority. Judge Montali also cited a recent decision in the FirstEnergy chapter 11 case in Ohio, which followed the Fifth Circuit in ruling that there is no inherent conflict between FERC’s jurisdiction under the FPA and the authority of a bankruptcy court to permit the rejection of a PPA under the Bankruptcy Code.

Judge Montali viewed FERC’s assertion of “concurrent jurisdiction” over PPAs as an improper encroachment by an executive branch agency on the authority of United States bankruptcy courts. He concluded, “Section 365(a) and 28 U.S.C. § 1334, taken together, clearly lead to the inescapable conclusion that only the bankruptcy court can decide whether a motion to reject should be granted or denied, and under what standards.”

The ruling is heading to the Ninth Circuit following Judge Montali’s certification for a direct appeal. With the Sixth Circuit also now considering the FirstEnergy decision on appeal, it appears likely that this issue will be before the Supreme Court in the near future.

If it sounds too good to be true, it probably is. But does that age-old maxim apply to a bankrupt customer offering to pay you 100% of your unsecured claim through a “prepackaged” bankruptcy or under a critical vendor program? The answer can be complicated. Partner Eric Wilson and senior associate Maeghan McLoughlin were featured in the Credit Research Foundation’s CFR News with their article which explores what it means to be “unimpaired” and paid in full in prepackaged bankruptcies and under critical vendor programs and outlines some of the potential pitfalls that can be faced by unsecured creditors under these scenarios.

You can read the full article by clicking here.

 

The Supreme Court this week resolved a long-standing open issue regarding the treatment of trademark license rights in bankruptcy proceedings. The Court ruled in favor of Mission Products, a licensee under a trademark license agreement that had been rejected in the chapter 11 case of Tempnology, the debtor-licensor, determining that the rejection constituted a breach of the agreement but did not rescind it.  The decision means that a holder of rights under a trademark license will retain such rights even if its underlying license agreement is rejected in bankruptcy.

Tempnology was a sportsware manufacturing company. Prior to filing for chapter 11, it had entered into a distribution agreement with Mission Products, and granted Mission Products a license to use its trademarks.

Section 365(a) of the Bankruptcy Code allows a debtor to assume executory contracts (i.e., contracts for which material obligations remain unperformed on both sides) which are favorable, and to reject executory contracts which are burdensome or detrimental, in order to maximize the value of its bankruptcy estate for the benefit of its creditors.  Section 365(g) states that the rejection of a contract “constitutes a breach of such contract,” and provides the non-debtor counterparty with a claim against the bankruptcy estate for damages arising from such breach.  Following the commencement of its bankruptcy case, Tempnology chose to reject the distribution agreement, which meant that Tempnology no longer had to perform any its obligations.  A dispute arose, however, over Mission Products’ ongoing right to use Tempnology’s trademarks following the rejection.

Tempnology based its arguments primarily on Section 365(n), a provision added to the Bankruptcy Code by Congress in order to negate the effects of Lubrizol Enterprises v. Richmond Metal Finishers, a judicial decision regarding patent rights.  In Lubrizol, the Fourth Circuit Court of Appeals ruled that a debtor’s rejection of a patent license agreement terminated the licensee’s rights to use the patent.  In response, Congress specified in Section 365(n) that a licensee under a contract granting the right to use “intellectual property” could elect to retain its rights under such contract and continue to use such rights for the duration of the contract.  The definition of “intellectual property” inserted into the Bankruptcy Code did not, however, include trademarks.  Tempnology contended that the failure of Congress to include trademarks within the scope of intellectual property protected by Section 365(n) created a negative inference, and that trademark rights cannot be retained by a licensee under a rejected trademark license agreement.

The Court rejected Tempnology’s arguments. The Court emphasized that rejection of a contract in bankruptcy under Section 365 operates as a breach of the contract and not as a rescission, and that the non-debtor counterparty’s rights do not “vaporize.”  Moreover, the Court found no negative inference from the failure of Congress to include trademarks in Section 365(n).

The key to the Court’s decision is its determination that contract rejection does not permit rights granted under a trademark license agreement to be rescinded. The Court makes clear that the language in Section 365(g) that rejection “constitutes a breach” is intended to allow the debtor to cease performing under a burdensome contract, but does not allow the debtor to rescind the rights previously conveyed under such contract.  The Court observed that outside of bankruptcy, the breach of a trademark license agreement would not permit the licensor to terminate the licensee’s rights.  Allowing trademark license rights to be terminated in bankruptcy, through contract rejection, would therefore violate a basic rule of bankruptcy law by giving debtor-licensors greater rights in bankruptcy than they could possess outside of it.  The Court also noted that allowing contract rejection to terminate a licensee’s rights would effectively allow a debtor to avoid a conveyance of property (i.e., the license rights) while circumventing the Bankruptcy Code’s detailed and narrow provisions for unwinding pre-bankruptcy transfers.

The Court similarly found no merit in Tempnology’s arguments regarding Section 365(n). Tempnology contended that the specific protections to retain rights provided under Section 365(n) to holders of patent and other intellectual property licensees meant that no such protection exists for trademark licensees.  The Court held, however, that accepting Tempnology’s logic would require a reading of Section 365(g) that would be “essentially opposite” to its language that rejection “constitutes a breach.”  Moreover, it ignored that Section 365(n) was an amendment to the Bankruptcy Code designed to undo a specific judicial decision (Lubrizol), and that its legislative history expressly stated that no inferences should be drawn from its failure to include trademarks within its scope.

Many of the Supreme Court’s recent bankruptcy law rulings have not been models of clarity.  The Mission Products decision is a welcome departure from that trend.

Few issues in bankruptcy create as much contention as disputes regarding the right of setoff. This was recently highlighted by a decision in the chapter 11 case of Orexigen Therapeutics in the District of Delaware.  Judge Kevin Gross denied a motion to allow a “triangular” setoff, whereby a corporate parent sought to have an obligation that it owed to the debtor applied against a claim owed by the debtor to the parent’s subsidiary. (Kelley Drye & Warren LLP represents the indenture trustee for the holders of certain secured notes in Orexigen Therapeutics, but took no part in the dispute discussed here).

The doctrine of setoff allows for debts to be cancelled out, in order to avoid what has been described by courts as the absurdity of forcing a non-bankrupt party to pay its obligation to a bankrupt party in full, while only receiving back a small fraction of its claim. One of the most understandable examples is the common security deposit paid at the outset of a lease – the payment made by a tenant to a landlord creates a debt owed by the landlord to the tenant.  If the tenant were to go bankrupt and owe money to the landlord, the landlord could apply the security deposit on a dollar for dollar basis up to the amount owed.  Section 553 of the Bankruptcy Code recognizes the right of setoff in bankruptcy to the extent that it may be available to a creditor under applicable state law, but only so long as the debts to be set off are “mutual” – i.e., due to and from the same persons in the same capacity.

The facts in the Orexigen Therapeutics case were straight-forward.  Orexigen, a pharmaceutical company, filed for chapter 11 in March 2018.  Prior to its bankruptcy, Orexigen entered into a distribution agreement with a company (“Parent”), and a separate services agreement with Parent’s subsidiary (“Subsidiary”).  At the time of the bankruptcy filing, Parent owed nearly $7 million to Orexigen under the distribution agreement, and Orexigen owed approximately $9.1 million to Subsidiary.

In July 2018, the bankruptcy court approved the sale of substantially all of Orexigen’s assets. The sale proceeds fell significantly short of the amounts owed to Orexigen’s secured creditors, leaving unsecured creditors with claims worth no more than one or two cents on the dollar.  Realizing that Subsidiary’s claim would otherwise be virtually worthless, Parent filed a motion with the court, seeking permission to effect a triangular setoff and apply the amounts owed by Parent to Orexigen against the amounts owed by Orexigen to Subsidiary.

Parent was aware that it had an uphill battle. The right of setoff creates a large exception to a fundamental policy underlying the Bankruptcy Code, which is that similarly-situated creditors should receive similar treatment.  Courts therefore have strictly construed the mutuality requirement of Section 553.  In two recent large chapter 11 cases, SemCrude and Lehman Bros., bankruptcy judges in Delaware and the Southern District of New York determined that the mutuality requirement of Section 553 compelled the disallowance of comparable triangular setoffs, because the debts were owed to and from different corporate entities.

As Judge Gross noted, Parent made no effort to dodge or distinguish the contrary precedents. Parent acknowledged the SemCrude and Lehman Bros. decisions in its motion, but sought to convince Judge Gross to view the issue of triangular setoff in a different manner.

Parent framed a straight-forward argument. It contended that the distribution agreement expressly provided that Parent could set off amounts it owed to Orexigen against amounts owed to any of Parent’s affiliates or subsidiaries, and that California law, which governed the distribution agreement, permitted such triangular setoffs.  Parent then cited a leading Supreme Court bankruptcy case, Butner v. U.S., for the proposition that parties’ rights under state law are respected in bankruptcy proceedings, absent a contrary federal rule or policy.  Accordingly, Parent maintained that Judge Gross should disregard SemCrude and Lehman Bros. as incorrectly decided, and permit the triangular setoff.

Judge Gross declined the invitation. “The Court refuses to read a contractual exception to strict mutuality allowing for triangular setoff in the face of contrary bankruptcy precedent and policy.” Allowing parties to contract around mutuality, as suggested by Parent, “would be incongruent with the express provision of section 553(a).”  Judge Gross concluded that SemCrude and Lehman Bros. were fully consistent with Butner. He held that mutuality is the “lynchpin” of Section 553 and, by specifically furthering the Bankruptcy Code’s policy of equal treatment among similarly situated creditors, is precisely the type of federal interest contemplated by Butner that limits rights under state law.

With corporate debt at record high levels, recoveries for general unsecured creditors in upcoming large chapter 11 cases are likely to be minimal.  This, together with the ubiquity of dealings among related corporate entities, means that there will be further attempts to effect triangular setoffs.  The rulings in SemCrude, Lehman Bros. and Orexigen are clear and persuasive, but are not binding precedents.  Until higher courts weigh in, it can be expected that creditors will continue to develop and assert creative arguments in favor of triangular setoffs.