Third Circuit Adopts Delaware Bankruptcy Judge Shannon’s Position Regarding “Triangular Setoffs”

Third Circuit Adopts Delaware Bankruptcy Judge Shannon’s Position Regarding “Triangular Setoffs”

On March 19, 2021, the Third Circuit, in In Re: Orexigen TherapeuticsInc., No. 20-1136, 2021 WL 1046485 (3d Cir. March 19, 2021) issued a unanimous and precedential opinion adopting the analysis set forth by Bankruptcy Judge Shannon in In Re: SemCrude L.P., 399 B.R. 388 (Bankr. D.Del. 2009) wherein the Court disallowed what is known as “triangular setoffs,” opining that they lack “mutuality” as required by Bankruptcy Code Section 553(a), and therefore are unenforceable. Here, although an issue of first impression in the Third Circuit, this ruling follows most of the other courts that have decided this issue, including three other Circuit Courts.

In this case, the Debtor owed a subsidiary (“Subsidiary”) of one of its creditors $9.1 million. That same creditor (“Creditor”) had owed the Debtor approximately $7 million. The issue to be decided was whether the creditor who had a right under non-bankruptcy law to set-off these amounts, had a right of setoff in the bankruptcy proceeding. This concept is generally known as a “triangular setoff.” Put another way, if the Bankruptcy Court allowed this right of setoff, the Creditor would owe nothing to the Debtor and the Debtor would owe the Subsidiary $2 million.

The Bankruptcy Court found that setoff was improper, opining that Bankruptcy Code Section 553(a)’s requirement of mutuality is immutable.  The District Court affirmed and the ruling was appealed to the Third Circuit. The Third Circuit, adopting the “sound analysis” presented by the Bankruptcy Court, found that the language of the statute imposed a distinct limitation on any exercise of setoff rights to a debtor’s claim against the creditor and that creditor’s claim against the Debtor. It was articulated that Congress intended for “mutuality” to mean only the debts between the same two parties. The concept of “mutuality” does not include anything except for a bilateral arrangement and that the triangular setoffs are not mutual, and that there can be no contractual exception to the mutuality requirement. The Third Circuit stated that allowing anything beyond this scope would fly in the face of a fundamental principle underlying the Bankruptcy Code which, inter alia, tries to maximize all returns to the creditors themselves. They stated that mutuality is literally tied to the identity of a particular creditor that owes an offsetting debt, declaring that this right is personal and that there is no way around the language of Section 553.

Interestingly though, in dicta, the Third Circuit did hint that there are measures which could be adopted by a number of market participants which could include the use of “joint and several” arrangements in tri-party structures.

To discuss this topic or any other issues relating to creditors rights and bankruptcy, please contact Leslie Beth Baskin, Esquire at 215-241-8926 or lbaskin@sgrvlaw.com.

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