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BUSINESS RESTRUCTURING REVIEW FIRST IMPRESSIONS: THIRD CIRCUIT SCUTTLES TRIANGULAR SETOFF in THIS ISSUE in BANKRUPTCY 1 First Impressions: Third Charles M

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BUSINESS RESTRUCTURING REVIEW FIRST IMPRESSIONS: THIRD CIRCUIT SCUTTLES TRIANGULAR SETOFF in THIS ISSUE in BANKRUPTCY 1 First Impressions: Third Charles M VOL. 20 • NO. 3 MAY – JUNE 2021 BUSINESS RESTRUCTURING REVIEW FIRST IMPRESSIONS: THIRD CIRCUIT SCUTTLES TRIANGULAR SETOFF IN THIS ISSUE IN BANKRUPTCY 1 First Impressions: Third Charles M. Oellermann ■ Mark G. Douglas Circuit Scuttles Triangular Setoff in Bankruptcy The ability of a creditor to exercise its contractual, common law or statutory rights under 4 Should Equitable non-bankruptcy law to set off amounts owed to a debtor in bankruptcy against the debt- Mootness Bar Appeals or’s obligations to the creditor gives offsetting creditors an important advantage. Unlike Only of Chapter 11 Plan many other creditors, creditors with setoff rights can receive preferential treatment in the Confirmation Orders? form of full payment on their claims up to the amount of the setoff. However, a limitation on the exercise of setoff rights in bankruptcy is the Bankruptcy Code’s requirement that 7 Debate Intensifies on the debts involved must be “mutual,” a concept that is not well understood and sometimes Substantial Contribution disputed in the courts. The U.S. Court of Appeals for the Third Circuit recently addressed Claims in Chapter 7 Cases the meaning of mutuality in this context as a matter of first impression. In In re Orexigen 10 Bankruptcy Court Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021), the Third Circuit affirmed lower court rulings Recharacterizes Purported that a “triangular setoff” does not satisfy the Bankruptcy Code’s mutuality requirement. Loan as Equity 14 In Brief: “Failing” Delaware SETOFF IN BANKRUPTCY Corporation Can Transfer Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Assets to Creditors in Lieu Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by of Foreclosure Without such creditor to the debtor that arose before the commencement of the case under this Shareholder Consent title against a claim of such creditor against the debtor that arose before the commence- 15 U.S. Supreme Court ment of the case.” Section 553 does not create setoff rights—it merely preserves certain Declines Review of setoff rights that otherwise would exist under contract or applicable nonbankruptcy law. Landmark Tribune Safe See COLLIER ON BANKRUPTCY (“COLLIER”) ¶ 553.04 (16th ed. 2021) (citing Citizens Bank of Harbor Ruling Maryland v. Strumpf, 516 U.S. 16 (1995)). As noted by the U.S. Supreme Court in Studley v. Boylston Nat. Bank, 229 U.S. 523, 528 (1913), setoff avoids the “absurdity of making A pay B 16 Newsworthy when B owes A.” With certain exceptions for setoffs under “safe harbored” financial contracts, a creditor is precluded by the automatic stay from exercising its setoff rights without bankruptcy court approval. See 11 U.S.C. §§ 362(a)(7), (b)(6), (b)(7), (b)(17), (b)(27), and (o). However, if it applies, the automatic stay merely suspends the exercise of such a setoff pending an orderly examination of the respective rights of the debtor and the creditor by the court, which will generally permit the setoff if the requirements under applicable law are met, except under circumstances where it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008). A creditor stayed from exercising a valid setoff right must be money claim through a process whereby cross demands aris- granted “adequate protection” (see 11 U.S.C. § 361) against any ing out of the same transaction are allowed to compensate one diminution in the value of its interest caused by the debtor’s use another and the balance only to be recovered.” Westinghouse of the creditor’s property. Ealy, 392 B.R. at 414. Credit Corp. v. D’Urso, 278 F.3d 138, 146 (2d Cir. 2002); accord Newbery Corp. v. Fireman’s Fund Ins. Co., 95 F.3d 1392, 1399 (9th Setoff is expressly prohibited by section 553 if: (i) the creditor’s Cir. 1996); In re Matamoros, 605 B.R. 600, 610 (Bankr. S.D.N.Y. 2019) claim against the debtor is disallowed; (ii) the creditor acquires (“recoupment is in the nature of a defense and arises only out its claim from an entity other than the debtor either after the of cross demands that stem from the same transaction”). Unlike bankruptcy filing date or after 90 days before the petition date setoff, recoupment is not subject to the automatic stay (see In re while the debtor was insolvent (with certain exceptions); or Ditech Holding Corp., 606 B.R. 544, 600 (Bankr. S.D.N.Y. 2019)), and (iii) the debt owed to the debtor was incurred by the creditor after may involve both pre- and postpetition obligations. See Sims v. 90 days before the petition date, while the debtor was insolvent, U.S. Dep’t of Health and Human Services (In re TLC Hosps., Inc.), and for the purpose of asserting a right of setoff (with certain 224 F.3d 1008, 1011 (9th Cir. 2000) (citing COLLIER at ¶ 553.10). exceptions). See 11 U.S.C. § 553(a)(1)-(3). MUTUALITY AND TRIANGULAR SETOFFS Thus, for a creditor to be able to exercise a setoff right in bank- ruptcy, section 553 requires on its face that: (i) the creditor has a The Bankruptcy Code does not define the term “mutual debt.” right of setoff under applicable non-bankruptcy law; (ii) the debt Debts are generally considered mutual when they are due to and and the claim are “mutual”; (iii) both the debt and the claim arose from the same persons or entities in the same capacity, but there prepetition; and (iv) the setoff does not fall within one of the three is some confusion among the courts on this point. See generally prohibited categories specified in the provision. Although some COLLIER at ¶ 553.03[3][a] (citing cases). courts have permitted the setoff of mutual postpetition debts (see, e.g., Official Comm. of Unsecured Creditors of Quantum For example, an exception to this strict mutuality requirement Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 may exist in cases involving “triangular setoff,” the provenance B.R. 729 (Bankr. D. Del. 2016)), the remedy is available in bank- of which is commonly traced (rightly or wrongly) to a 1964 ruling ruptcy only “when the opposing obligations arise on the same construing section 68(a) of the former Bankruptcy Act of 1898 by side of the … bankruptcy petition date.” Pa. State Employees’ Ret. the Seventh Circuit Court of Appeals in Inland Steel Co. v. Berger Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Steel Co. (In re Berger Steel Co.), 327 F.2d 401 (7th Cir. 1964). In Pa. 2015). such a situation, A might have a business relationship with B and C, where B and C are related parties. Triangular setoff occurs Creditors typically rely on the remedy of setoff if the mutual when A owes B, and A attempts to set off that amount against debts arise from separate transactions, although the issue is amounts C owes to A. The validity of triangular setoff in the murky. See COLLIER at ¶ 553.10. By contrast, if mutual debts bankruptcy context, as distinguished from under state contract or arise from the same transaction, the creditor may have a right common law, is subject to debate. of “recoupment,” which has been defined as “a deduction from a 2 In In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), selling OTI’s drugs, and OTI reimbursed MPRS for the advances. aff’d, 428 B.R. 590 (D. Del. 2010), Bankruptcy Judge Brendan L. The distribution agreement and the services agreement did not Shannon of the Delaware bankruptcy court ruled that triangu- reference, incorporate, or integrate one another. lar setoff is not permitted in bankruptcy due to the absence of mutuality. According to the court, “mutuality cannot be supplied OTI filed for chapter 11 protection on March 12, 2018, in the by a multi-party agreement contemplating a triangular setoff.” District of Delaware. At that time, OTI owed MPRS approximately The court rejected the contention that parties can contract $9.1 million under the services agreement, and McKesson owed around section 553’s mutuality requirement. It also rejected OTI approximately $6.9 million under the distribution agreement. Berger Steel as authority for the proposition that non-mutual Had there been a setoff under the distribution agreement prior setoff provisions in a contract can be enforced against a debtor. to the petition date, OTI would have owed MPRS approximately $2.2 million, and McKesson would have owed OTI nothing. In In re Lehman Bros. Inc., 458 B.R. 134 (Bankr. S.D.N.Y. 2011), a New York bankruptcy court similarly ruled that triangular setoff In OTI’s bankruptcy, McKesson argued that it should be permitted does not satisfy the Bankruptcy Code’s mutuality requirement to exercise the setoff but later agreed to pay the $6.9 million it and that the Bankruptcy Code’s safe-harbor provisions for finan- owed to OTI, which amount was segregated pending resolution cial contracts (see 11 U.S.C. §§ 555-56, 559-62) do not eliminate of the dispute by the bankruptcy court. Bankruptcy Judge Kevin that requirement in connection with setoffs under such contracts. Gross denied McKesson’s request to exercise the setoff. He con- cluded that, although the setoff provision created an enforceable Consistent with the rulings in SemCrude and Lehman, a Delaware contractual right to effect a prepetition triangular setoff under bankruptcy court held in In re American Home Mortgage state law, that relationship “does not supply the strict mutuality Holdings, Inc., 501 B.R.
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