The U.S. Court of Appeals for the Third Circuit recently became the first circuit court to address the question of whether a corporate parent can set off an obligation that it owes to a bankrupt company against a claim owed by such company to the parent’s subsidiary. A couple of years ago, in the chapter 11 case of Orexigen Therapeutics in the District of Delaware, former Bankruptcy Judge Kevin Gross denied a motion to allow such a “triangular” setoff. Last month, the Third Circuit affirmed, handing down a clear opinion that should largely put to rest an issue that has vexed debtors and creditors in numerous chapter 11 cases. (Kelley Drye & Warren LLP represents the indenture trustee for the holders of certain secured notes in Orexigen Therapeutics, but took no part in the matters 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 inequity 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. The right of setoff thereby creates a significant exception to a fundamental policy underlying the Bankruptcy Code, which is that similarly-situated creditors should receive similar treatment.

The facts in Orexigen Therapeutics are straightforward.  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. The terms of the distribution agreement stated that obligations owed by Parent to Orexigen could be set off against debts owed by Orexigen to any affiliate of Parent.

A sale of substantially all of Orexigen’s assets fell significantly short of the amounts owed to Orexigen’s secured creditors, leaving unsecured creditors with claims worth no more than a few cents on the dollar at best.  Knowing that Subsidiary’s claim would otherwise be virtually worthless, Parent sought permission to exercise its right under the distribution agreement to effectuate a triangular setoff and apply the amounts owed by Parent to Orexigen against the amounts owed by Orexigen to Subsidiary.

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”. Aware that courts have construed the mutuality requirement to mean that the debts to be set off against each other be due to and from the same persons or entities in the same capacity, Parent argued that the key factor instead was whether Parent would have had a cognizable right of setoff outside of bankruptcy. Seeking to minimize the importance of the “mutuality” requirement, Parent emphasized 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.

The Third Circuit disagreed. The “mutuality” requirement set forth in section 553, it held, is a limiting term, and it dismissed Parent’s contention that parties could contractually work around “mutuality”. In reaching this determination, the Third Circuit panel adopted the reasoning of Judge Brendan Shannon in In re SemCrude,L.P., an earlier Delaware Bankruptcy Court opinion on which Judge Gross had relied. In rejecting a similar effort to enforce a contractual triangular setoff right, Judge Shannon had determined that the mutuality requirement of Section 553 compelled the disallowance of such setoffs, because the debts were owed to and from different corporate entities. Judge Kent Jordan, writing for the unanimous Third Circuit panel, stated, “[We] agree with and adopt the SemCrude court’s well-reasoned conclusion that Congress intended for mutuality to mean only debts owing between two parties . . . [and that] Congress did not intend to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.”

The Orexigen decision is the first ruling by a U.S. Court of Appeals on triangular setoffs. Given the ubiquity of dealings among related corporate entities, and the minimal recoveries usually obtained by unsecured creditors in chapter 11 cases, it can be expected that there will be further attempts to effectuate triangular setoffs in bankruptcy cases outside of the Third Circuit. However, despite the creative arguments that counsel for such creditors are likely to develop and assert, it can reasonably be expected that the Third Circuit’s reasoning will be followed in most cases, and that triangular setoffs in bankruptcy are effectively a dead letter.