The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), analyzing a recent decision of interest:
The United States Court of Appeals for the Third Circuit recently ruled that a triangular arrangement which allowed for set off of money the debtor owed to a company’s affiliate against what the parent company owed to the debtor was not allowed under section 553 because the necessary mutuality was not present, despite the fact that such arrangement was enforceable as a set off under state law. In re Orexigen, 2021 WL 1046485 (3rd Cir. March 19, 2021).
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McKesson Corporation, Inc. (McKesson) and Orexigen Therapeutics, Inc. (the debtor) entered into a contract for McKesson to distribute the debtor’s pharmaceutical products. The contract provided that any amount the debtor owed to any McKesson subsidiary could reduce amounts McKesson owed the debtor. McKesson’s subsidiary McKesson Patient Relationship Solutions (MPRS) entered into an agreement to help the debtor with a consumer discount program by advancing cash to pharmacies which the debtor was obligated to reimburse.
The debtor filed a chapter 11 petition in 2018 at a time when it owed MPRS about $9 million and McKesson owed the debtor about $7 million. McKesson asserted in the bankruptcy court that it had a right under state law (California in this instance) to set off the sums the debtor owed to MPRS against what it owed the debtor. The result would be that it owed nothing to the debtor, whereas the debtor owed MPRS about $2 million.
The Delaware Bankruptcy Court, relying on its earlier decision in In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), disallowed the setoff because the debts were not mutual as required by the Bankruptcy Code. McKesson appealed the bankruptcy court mutuality decision to the district court, which affirmed, then to the Third Circuit, which likewise affirmed.
The Third Circuit began with the words of section 553: “[e]xcept as otherwise provided…, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor…against a claim of such creditor against the debtor[.]” (emphasis added by the Circuit court). It noted that its task was to understand what Congress meant in using the term “mutual” in that Code section, recognizing that it was an issue of first impression in the circuit. The case cited by the bankruptcy court, SemCrude, had been cited with favor by bankruptcy courts around the country and its reasoning adopted by sister circuits, all of which had interpreted mutuality to be strictly bilateral. The Third Circuit found that reasoning sound, which resulted in disallowance of setoff in a triangular arrangement such as the one between the debtor, McKesson, and MPRS.
McKesson argued that because section 553 essentially blessed the concept of setoff if allowed under applicable state law and its contractual arrangement was enforceable under California law, then the bankruptcy court was bound to accept those rights. It argued that the term “mutual” was nothing more than a “definitional scope provision that identifies the state-law right that is thereby preserved unaffected in bankruptcy.” The Third Circuit rejected that argument, agreeing with a “compelling body of precedent” that treated mutuality in section 553 as a limiting term, not a redundancy, which McKesson’s argument would make it be.
Once it determined that mutuality was a distinct and limiting requirement of federal bankruptcy law, the Third Circuit adopted the SemCrude well-reasoned conclusion that Congress intended for mutuality to mean only debts owing between two parties – from debtor to creditor and from creditor to debtor – which would make the third party affiliate provision in McKesson’s contract not mutual. Denominating such arrangement a “triangular setoff”, the Circuit held a triangular setoff lacked mutuality as required by the Code.
The Third Circuit remarked that McKesson was not without other options to achieve the outcome it desired. First, it could have undertaken the customer loyalty program under its own guise. Second, it could have followed the requirements of the Uniform Commercial Code and secured the obligations owed to MPRS on any money owed by itself to the debtor. In either circumstance, third parties would have been on sufficient notice of what essentially created a priority claim.
This outcome is not surprising, given that many bankruptcy courts have followed the reasoning of SemCrude for the past dozen years and those circuits which have weighed in have also rejected the concept of triangular mutuality. The case is a good lesson about just how far underlying state law, which controls so much of what happens in a federal bankruptcy proceeding, can affect the outcome of a legal argument when the Bankruptcy Code itself provides limiting factors. Section 553 on its face seems to say that setoff rights between the parties before a bankruptcy was filed will remain viable in a bankruptcy proceeding. However, Congress added the key word “mutual” to the statute, requiring what has been interpreted as bilateral mutuality only before the state court rights would prevail. Therefore, the specific language of the Code, if limiting as it is here, can override state law provisions.
The Third Circuit itself gives us our practice pointers. If a company desires the benefits of mutuality to be present if a bankruptcy should be filed in the future, it should take the contract in its own name from the beginning, avoiding the troublesome triangulation. If that is not feasible within its business plan, then have the affiliate follow the UCC provisions and perfect a security interest in any moneys owed by the company to the potential debtor.
These materials were authored by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., ret.), a member of the ad hoc group, with editorial assistance from Monique D. Jewett-Brewster, a shareholder with Hopkins & Carley, ALC, a member of the ad hoc group and past Chair of the CLA Business Law Section. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.