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.