Mid Atlantic: In re Orexigen Therapeutics, Inc., 990 F.3d 748 (2021), United States Court of Appeals for the Third Circuit
Overview:
In a matter of first impression, the United States Court of Appeals for the Third Circuit held that triangular setoffs are not permissible in a bankruptcy proceeding due to section 553 of the Bankruptcy Code’s mutuality requirement. A triangular setoff occurs when a creditor attempts to set off an obligation it owes to a debtor against an obligation the debtor owes to the creditor’s affiliate. The Third Circuit affirmed the order of the District Court for the District of Delaware that affirmed the Bankruptcy Court’s ruling which rejected a creditor’s attempt to enforce its setoff rights on the basis that the obligations to be set off were not “mutual” under section 553 and that contractual arrangements cannot “transform” a triangular debt into a mutual debt.
The prior decision at the Bankruptcy Court level was reported in the Spring 2019 edition of ACIC Private Notes.
Full Summary:
In June 2016, Orexigen Therapeutics, Inc., a biopharmaceutical company that manufactured Contrave, a drug that treats obesity (“Orexigen”), entered into a distribution agreement with McKesson Corporation (“McKesson”) under which McKesson would purchase and distribute Contrave to certain pharmacies in the U.S. The distribution agreement, which was governed by California law, provided 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.
In July 2016, Orexigen entered into a services agreement with a wholly-owned subsidiary of McKesson, McKesson Patient Relationship Solutions (“MPRS”), under which MPRS was to manage a program of Orexigen under which patients could receive price discounts on Contrave from retail pharmacies. Under the services agreement, MPRS was to advance funds to pharmacies selling Contrave, with reimbursement arriving later from Orexigen.
When Orexigen filed a voluntary petition under chapter 11 of the Bankruptcy Code in March 2018, it owed MPRS approximately $9.1 million under the services agreement, and McKesson owed Orexigen approximately $6.9 million under the distribution agreement.
McKesson asserted that it had setoff rights under the Setoff Provision and section 553 of the Bankruptcy Code, and through a setoff, it owed nothing to Orexigen while Oreixgen owed MPRS $2.2 million. The Bankruptcy Court rejected McKesson’s argument for a setoff because, while the Setoff Provision was an enforceable contractual right allowing a parent and its subsidiary to effect a prepetition triangular setoff under state law, that relationship did not provide the strict mutuality requirement under section 553. The Bankruptcy Court held that contracts cannot turn nonmutual debts into debts subject to setoff under the Bankruptcy Code. McKesson appealed the Bankruptcy Court’s mutuality decision, which the District Court for the District of Delaware affirmed.
On appeal, the United States Court of Appeals for the Third Circuit affirmed the lower courts’ rulings noting that this was a matter of first impression and that while other circuit courts have opined on the distinct limitation of section 553, they had not ruled on whether a contact can create an exception to the mutuality requirement.
The Court first held that the term “mutual” in section 553 imposes a distinct limitation. Section 553 provides that “[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 that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case . . . .” McKesson argued that section 553’s mutuality requirement was defined by state law and that section 553 imposed no independent mutuality limitation. McKesson pointed out that section 553 includes three enumerated federal exceptions to the right to enforce a setoff and that Congress would have included an enumerated exception bearing on mutuality if it had intended mutuality to serve as a limitation under federal law. The Court disagreed providing that McKesson’s reading of the statute would render the term “mutual” redundant. The Court further noted that section 553’s timing requirement that the debtor’s claim against the creditor and the creditor’s claim against the debtor arise pre-petition “is consistently viewed as a distinct limitation on the ability to assert a setoff right, and there is no persuasive reason to treat the requirement of mutuality any differently.”
The Court then held that mutuality under section 553 excludes triangular setoffs, including the Setoff Provision in the distribution agreement. The Court cited the SemCrude court’s ruling that Congress intended for mutuality to mean only debts owing between two parties, specifically those owing from a creditor directly to the debtor and, in turn, owing from the debtor directly to that creditor. The Court dismissed McKesson’s argument that the distribution agreement transformed the parties’ triangular debt arrangement into a mutual debt on the basis that “mutuality cannot be supplied by a multi-party agreement contemplating a triangular setoff.” The Court also found that a triangular setoff is at odds with a fundamental policy of bankruptcy because it permits a creditor to obtain full satisfaction of a claim by extinguishing an equal amount of the creditor’s obligation to the debtor, in other words, in effect, the creditor receives a preference. Furthermore, the Court noted that one of the primary goals of the Bankruptcy Code is to ensure that similarly situated creditors are treated equally and that triangular setoffs would undermine that goal.
The Court also noted alternative ways to achieve the same economic results as the parties’ triangular setoff arrangement. For example, (1) McKesson could have taken on the obligations under the services agreement instead of having MPRS handle for Orexigen or (2) McKesson could have arranged to provide MPRS with a perfected security interest in Orexigen’s account receivable due from McKesson. The Court observed that McKesson’s desired outcome under the contractual setoff arrangement could shoehorn multiparty debts into section 553 and create disincentives for public disclosure of priority claims, which would weaken the fundamental goals of the Bankruptcy Code.
By: Margaret G. Parker-Yavuz (Akin Gump LLP) and Chanwon (Pio) Yoon (Akin Gump LLP)
