United States: Don't Set Me Off: No Triangular Setoff Among Affiliated Entities And A Debtor Counterparty

The Bankruptcy Code provides debtors with the opportunity for a fresh start in the face of mounting financial obligations. The Code also provides for fair and equitable treatment of creditors. These policies date back decades. In today's global economy, companies often have multiple business lines operating through separate entities. Outside of bankruptcy, these affiliated operations sometimes transact in a holistic — albeit legally distinct — debtor-creditor relationship with their counterparty. But, as this article discusses, the legal separateness of affiliates can hinder economic protections that a creditor might have otherwise when its counterparty files for bankruptcy.

Creditors and debtors often have monetary obligations that run both ways. Under state law, the creditor can protect itself by netting out these obligations. Section 553 of the Bankruptcy Code recognizes this right of setoff. It is a straightforward analysis when the counterparties are only two — one creditor and one debtor. However, courts have grappled with the application of section 553 when applied to multiparty transactions, especially those involving affiliated entities. The ability to effect a "triangular offset" can run afoul of the "fair and equitable treatment" policy and, as recently addressed by the Delaware Bankruptcy Court in In re Orexigen Therapeutics, Inc., No. 18-10518, 2018 WL 6841350 (Bankr. D. Del. Nov. 13, 2018), has been held impermissible.

Setting the Stage for Setoff

Setoff permits a creditor to cancel a prepetition debt that it owes to a debtor to the extent of any prepetition claim such creditor has against the debtor. While the cancellation of mutual debts may seem a mere administrative action outside of bankruptcy, the right to setoff is valuable in bankruptcy, where a creditor is likely to receive less than a full recovery on its claim. Absent setoff, the debtor collects 100% of the amount the creditor owes to it, while the creditor only collects its pro rata share of the value available for distribution to its class (which could be much less than 100%). Section 553, however, allows the creditor to receive full recovery on the portion of its claim that is subject to setoff.

An additional setoff benefit is that, under section 506 of the Bankruptcy Code, a creditor is treated as secured to the extent of its setoff claim. Creditors with setoff claims therefore enjoy certain secured creditor benefits, including entitlement to adequate protection. And as in rem rights, setoffs also are not subject to the bar date for filing claims.

The doctrine of recoupment is similar to setoff, but there are material distinctions between them. Recoupment is a defensive tool used by a creditor to cancel a claim asserted against it by a debtor where the creditor has a mutual claim against the debtor. Recoupment may only be used to net mutual obligations incurred in connection with the same transaction. In contrast, setoff rights can be used more broadly to cancel mutual obligations arising out of wholly unrelated transactions/contracts so long as they are still between the same parties. Unlike setoff, recoupment is not subject to the automatic stay.

From the creditor's viewpoint, the ability to offset mutual debts is just. Setoff rights encourage creditors not to terminate their business relationship with a financially distressed counterparty pre-bankruptcy. Because the right of setoff opens the door to potential abuse that could lead to preferential treatment for certain creditors, section 553 imposes strict requirements for a creditor to take any offset.

In bankruptcy, first the creditor must establish a right to setoff under state law. Then, the prepetition right of setoff is preserved by section 553 only if: 1) both the creditor's claim against the debtor and its indebtedness to the debtor arose prepetition; 2) the offsetting debts are "mutual" (i.e., they run between the same parties); and 3) both the claim and the debt are valid and enforceable. These requirements are construed narrowly. For example, a creditor cannot offset a prepetition debt owed to the debtor against a postpetition obligation owed by the debtor because the prepetition debtor and postpetition debtor are not deemed to be the same entity for mutuality purposes.

In line with the narrow construction of section 553, courts have found that the "mutuality" requirement prohibits multiparty or "triangular" setoffs even where the party holding the claim against the debtor is an affiliate of the party who owes a debt to the debtor. From a commercial perspective, the creditor may consider its global (affiliated) transaction with the same debtor to be one economic relationship worthy of netting. However, as discussed below, the separateness of the affiliates destroys the availability of setoff, mandating that the creditor pay its debt to the debtor's estate even though it (or a related entity) has a claim against the debtor (or its affiliate).

Caught In a Triangle

In Orexigen, the Delaware Bankruptcy Court denied a triangular setoff involving affiliates and, in doing so, walked through a variety of reasons why the federal bankruptcy policy of fair and equitable treatment mandated denial. And the Orexigen court denied the creditor's attempt to execute a triangular setoff despite its unambiguous right to do so under its contract with the debtor. While the court recognized that setoff rights originated under state law, it followed a line of similar cases in finding that Bankruptcy Code requirements not only limit but — with respect to triangular setoffs — prohibit such rights altogether.

Let's review the facts: The Debtor, a drug manufacturer, was party to a core distribution agreement (the Distribution Agreement) with McKesson Corporation (McKesson), under which McKesson purchased and distributed the Debtor's drug to pharmacies. The Debtor was also party to a services agreement (the Services Agreement) with McKesson Patient Relationship Solutions (MPRS), a wholly owned subsidiary of McKesson, under which MPRS managed a program that allowed patients to obtain price discounts on the Debtor's drug.

The Distribution Agreement and the Services Agreement were separate transactions. Under the Distribution Agreement, however, McKesson had a right to set off the debts it owed to the Debtor against the debts owed by the Debtor to McKesson or its affiliates. Fast forward, the Debtor files for bankruptcy. The two debts at issue in the case were: 1) approximately $6.9 million that McKesson owed to the Debtor under the Distribution Agreement; and 2) approximately $9.1 million that the Debtor owed to MPRS under the Services Agreement.

The Orexigen court's analysis began with the traditional two-pronged inquiry under section 553: 1) whether the party seeking a setoff has the right to exercise a setoff under "applicable nonbankruptcy law"; and 2) whether such party meets the requirements of section 553 of the Bankruptcy Code. The court noted that McKesson satisfied the first prong because it had a prepetition right to setoff under both the Distribution Agreement and California law. With respect to the second prong, however, the court examined the key requirements of section 553 and, applying them to the facts of the case, found that the proposed triangular setoff ran afoul of the bankruptcy policy in favor of equitable treatment of similarlysituated creditors.

Let's unpack the arguments. First, under section 553, the court recognized that a party seeking to effectuate a setoff against a debtor must be a "creditor" at the time of the offset. McKesson had based its standing as a "creditor" on the fact that it had a $6,932,816.40 prepetition claim against the Debtor pursuant to the Distribution Agreement. The Debtor opposed McKesson's right to setoff arguing that McKesson was no longer a "creditor" because it previously paid the Debtor the full amount owed under the Distribution Agreement in connection with certain postpetition stipulations (the Stipulations).

It could have been game over for McKesson when it made the payment (making this article irrelevant). Importantly, however, the Stipulations regarding McKesson's payment to the Debtor specifically provided that such payments were made subject to the express preservation of McKesson's setoff right and that the paid funds should be maintained in a segregated account pending the outcome of its motion to effectuate a setoff. In light of the Stipulations, the court found that McKesson had "no intent to extinguish" the liability it was seeking to offset and, on that basis, distinguished it from cases where the payment of indebtedness rendered a party no longer a "creditor" and thus ineligible to exercise a setoff.

Moving on to the headlining act, the court then addressed that the two debts the creditor seeks to offset must be "mutual." While the concept of mutuality is not defined in the Code, the court, citing numerous cases, reasoned that state and federal courts have coalesced around the view that debts are mutual only if "they are due to and from the same persons in the same capacity."

Applying this definition to the facts of the case, the court determined that mutuality was lacking between the debts at issue and, as a result, barred McKesson from taking the triangular setoff. The court relied primarily on the Delaware District Court's decision in In re Sem- Crude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), and the bankruptcy court decision it affirmed, to support the conclusion that section 553 prohibits triangular setoffs, and unless the corporate veil is pierced, a parent's debt may not be set off against the credit of its subsidiary.

McKesson recognized that SemCrude and other cases prohibit triangular setoffs but argued that those decisions inappropriately disregarded that setoff is a creature of state law. Specifically, McKesson cited to the seminal U.S. Supreme Court case, Butner v. United States, 440 U.S. 48, 55 (1979), for the principle that courts must look only to applicable state law to determine whether mutuality exists. As an initial matter, while McKesson cited cases in support of its view that, under California law, the definition of mutuality permits triangular setoffs involving a parent and its subsidiary, the court disagreed with this interpretation and instead found that the California Supreme Court has denied the exercise of triangular setoffs. Moreover, to the extent the Seventh Circuit In re Berger Steel Co., 327 F.2d 401 (7th Cir. 1964) decision and its progeny suggest there may be a "contractual exception to mutuality," the court agreed with the conclusion Judge Shannon reached in SemCrude — that the plain language of section 553(a) is clear and no such state law exception exists.

Importantly, in balancing state law property rights and the Bankruptcy Code's polices, the court held that federal bankruptcy law supersedes any contractual or state law right to setoff held by McKesson. Congress specifically drafted section 553 to promote a federal interest — that is, "the fundamental bankruptcy policy of ensuring similarly-situated creditors receives an equal distribution from the debtor's estate." It is this important federal policy, the court opined, that section 553 and its strict mutuality requirement were intended to address, and which therefore takes precedence over state law.

Finally, the court addressed McKesson's argument that mutuality existed because MPRS was a third-party beneficiary of the Distribution Agreement. The court disagreed with McKesson's citation to two cases in support of the argument that a third-party beneficiary to a contract possessed the necessary mutuality under section 553(a). The court again rejected this argument as a matter of federal bankruptcy policy, positing that a third-party beneficiary exception to section 553 would encourage parties to circumvent the Code's mutuality requirement by conferring third-party beneficiary status on persons or entities unconnected to a contract.

Boxed In By the Triangle

Orexigen reflects bankruptcy's fundamental policy that creditors should be treated fairly and equitably. The court prohibited McKesson from using its affiliation with MPRS to affect a setoff and enhance its position relative to that of the estate's other creditors. In doing so, the court made abundantly clear that while setoff rights are created by state law, any attempt to exercise such rights in a way that contravenes federal bankruptcy policy fails.

Nonetheless, Orexigen offers some useful practice pointers. First, the court opined that a creditor's postpetition payment to a debtor, in satisfaction of its prepetition obligation to the debtor, could be fatal to that creditor's right of setoff. Had McKesson not entered into the Stipulations that made explicit its intent to preserve its right to assert a setoff, McKesson's payment of its debt to the debtor would have foreclosed any possible right to setoff. (This would have applied whether or not the setoff was triangular.).

A best practice for a creditor who elects to make a payment to the debtor's estate while a disputed setoff is outstanding is to obtain a court ordered stipulation that: 1) the creditor explicitly reserves its right to assert a setoff claim notwithstanding its payment of the debt; and 2) the funds paid to the debtor should be deposited into an escrow account or held in reserve under the order while the determination of the creditor's setoff right is pending. A second potential practice pointer arising out of Orexigen relates to the structuring of contracts and payment mechanics to seek to preserve mutuality. Where distinct affiliated creditor parties are engaged in a business relationship with a single counterparty (or group of affiliated counterparties), consideration should be given to structuring the governing contract in a way that best preserves the argument that there is mutuality between the counterparties. While the Orexigen court ultimately ruled that parties may not contract around the mutuality requirement through third party beneficiary language, in Orexigen the operative contracts were still distinct and among separate affiliates. McKesson's debt and MPRS's claim (i.e., the two debts McKesson sought to offset) arose under different contracts providing for the performance of different services.

While it may not always be practical to do so for non-bankruptcy reasons, creditors seeking to preserve their right to setoff might fare better if the transactions are structured as one integrated master agreement that explicitly permits setoff of the various obligations under the single agreement. These may still not be sufficient to establish mutuality under section 553 in light of SemCrude and Orexigen. However, if the parties can institute a mechanism for consolidated payments between the creditor affiliates, on the one hand, and the debtor entities on the other — perhaps building a netting reconciliation process into the contract, they may just preserve mutuality. Nonetheless, creative structuring of contracts may not always be feasible for non-bankruptcy reasons. If that is the case, Orexigen reaffirms the prohibition on triangular setoffs, highlighting that its narrow interpretation of the mutuality requirement is necessary to maintain the wellestablished bankruptcy policy of fair treatment of creditors.

Originally published in Bankruptcy Strategist in March 2019.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions