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In a recent decision, the Court of Appeals for the Third Circuit closed the door on triangular setoffs, ruling that the mutuality requirement under Section 553 of the Bankruptcy Code must be strictly construed and requires that the debt and claim sought to be setoff must be between the same two parties. In re: Orexigen Therapeutics, Inc., No. 20-1136 (3d. Cir. 2021).
Orexigen Therapeutics, Inc. (“Orexigen”) produced a weight management drug called Contrave. Orexigen entered a Distribution Agreement for Contrave with McKesson Corporation, Inc. (“McKesson”), a drug distributor. The Distribution Agreement contained a “Setoff Provision” that permitted “each of [McKesson] and its affiliates … to set-off, recoup and apply any amounts owed by it to [Orexigen’s] affiliates against any [and] all amounts owed by [Orexigen] or its affiliates to any of [McKesson] or its affiliates.”
Shortly thereafter, one of McKesson’s subsidiaries, McKesson Patient Relationship Solutions (“MPRS”), entered into a separate Services Agreement with Orexigen. Under the Services Agreement, MPRS was to manage a customer loyalty program for Orexigen whereby patients would receive price discounts from pharmacies. MPRS would advance funds to pharmacies selling Contrave for which Orexigen would reimburse MPRS. Neither the Distribution Agreement nor the Services Agreement referenced, incorporated, or integrated one another, and the parties agreed that McKesson and MPRS were distinct legal entities.
When Orexigen filed for Chapter 11, it owed MPRS $9.1 million under the Services Agreement, and McKesson owed Orexigen $6.9 million under the Distribution Agreement. McKesson and MPRS asked the Bankruptcy Court to decide their rights under the Setoff Provision and Section 553 of the Bankruptcy Code. McKesson requested to setoff its debt by the amount Orexigen owed MPRS, which would have reduced MPRS’s claim to approximately $2 million and McKesson’s debt to zero.
The Bankruptcy Court rejected McKesson’s argument for a setoff, holding that the relationship between McKesson and MPRS did not supply the requisite mutuality required under Section 553 of the Bankruptcy Code, and the District Court affirmed.
The Third Circuit noted that determining the meaning of the term “mutual” in Section 553, as well as whether there exists a contractual exception to the required mutuality, were matters of first impression for the Court.
Following a well-established body of case law, the Court held that the mutuality requirement is not a redundancy that simply incorporates state laws’ setoff requirements; rather it is a distinct limitation of the state law right to exercise setoff. After determining that mutuality is a distinct and limiting requirement of federal bankruptcy law, the Court held that it prohibits triangular setoffs and that parties may not contract around the prohibition. Agreeing with the Delaware bankruptcy court decision in SemCrude and the S.D.N.Y. bankruptcy court decision in Lehman Bros., the Court held that the setoff right is personal and that there is no way to get around the mutuality limitation by contracting around it.
The Third Circuit observed that if McKesson wanted the mutuality contemplated by Section 553, it should have taken on the customer loyalty support itself instead of having its subsidiary MPRS handle it for Orexigen. Alternatively, MPRS could have sought a perfected security interest in the amounts owed by McKesson to Orexigen, thus obtaining priory to these amounts over Orexigen’s other creditors.
The Third Circuit’s decision is the first Circuit level opinion holding in no uncertain terms that setoff in bankruptcy requires bilateral obligations, and contractually created triangular setoffs are unenforceable. While Third Circuit opinions are non-precedential outside of the circuit, they have enormous weight in bankruptcy cases outside the circuit and are binding precedent on the Delaware bankruptcy court, one of the premier bankruptcy courts in the nation.
Thus, contracting parties should take careful note of the Court’s observation as to the proper way to accomplish the economic result of a triangular setoff without running afoul of its unenforceability.