July 30, 2021

The Third Circuit Confirms That Bankruptcy Setoff Rights Are Limited To Two-Party Obligations

The court ruled against drug distributor McKesson Corporation (“McKesson”) in its attempt to clear $6.9 million in debt owed to a pharmaceutical company by leveraging $9.1 million the drug maker owed to one of McKesson's subsidiaries. The Third Circuit affirmed lower courts' decision to reject this “triangular setoff,” indicating that the arrangement is unenforceable under the Bankruptcy Code regardless of parties' contract terms.

In a recent decision, the Court of Appeals for the Third Circuit clarified how creditors and lenders can exercise setoff rights during bankruptcy proceedings.

The court ruled against drug distributor McKesson Corporation (“McKesson”) in its attempt to clear $6.9 million in debt owed to a pharmaceutical company by leveraging $9.1 million the drug maker owed to one of McKesson's subsidiaries. The Third Circuit affirmed lower courts' decision to reject this “triangular setoff,” indicating that the arrangement is unenforceable under the Bankruptcy Code regardless of parties' contract terms.

With this decision, the court demonstrated the Bankruptcy Code's mutuality requirement, stating that the claim and debt a creditor intends to set off must exist between two parties alone. The decision highlights how corporate arrangements and affiliate agreements can impact setoff rights in a bankruptcy setting, even where contracts may allow for multi-party debt exchange.  

Case Background

Orexigen Therapeutics, Inc. (“Orexigen”) entered into an agreement with McKesson to distribute Contrave, the pharmaceutical company's weight management drug. The final contract included a provision that allowed for the setoff of all outstanding debts between McKesson, Orexigen, and any of the two companies' affiliates.

McKesson Patient Relationship Solutions (“MPRS”), one of McKesson's subsidiaries, then entered into a service agreement with Orexigen to manage its customer loyalty program. Since McKesson and MPRS are two separate legal entities, each company's agreement with Orexigen was mutually exclusive, involving no overlap, cross-referencing, or incorporation.

In March 2018, Orexigen began Chapter 11 bankruptcy proceedings in Delaware. At the time of filing, Orexigen owed MPRS $9.1 million and McKesson owed Orexigen $6.9 million under their respective agreements.  

Referencing the setoff provision in its contract with the drug maker, McKesson argued it could offset its $6.9 million debt by the amount Orexigen owed MRPS. This would reduce the affiliate's claim to around $2 million while canceling McKesson's debt in full.

The Bankruptcy Court rejected this request. It pointed to Section 553 of the Bankruptcy Code that requires setoffs include only “mutual” obligations between two parties – and ruled that the relationship between McKesson and MRPS did not meet this condition. The Third Circuit affirmed this decision, with Judge Kent Jordan signaling that the parties' existing contract terms cannot supersede the Bankruptcy Code's limitations.

The Third Circuit Clarifies Creditors' Setoff Rights

Setoff rights enable creditors to cancel out debt by trading it against a customer's claim on a dollar-for-dollar basis. Section 553(a) of the Bankruptcy Code preserves these rights within a specific context, which includes that:

  • State law upholds setoff rights
  • Setoffs can only apply to pre-bankruptcy debt recovery
  • Creditors must obtain relief from an automatic stay when a debtor files for bankruptcy
  • A creditor may only withhold funds to recoup debts related to the same transaction or mutual, two-party agreement

With its ruling, the Third Circuit reinforced this Section 553 mutuality limitation, and stated that a creditor can only exercise setoff rights within simple, two-party relationships – and that triangular arrangements created under contract terms are unenforceable in bankruptcy court.

The court reasoned that extensions beyond this mutual, bilateral obligation stand to weaken the Bankruptcy Code's foundational goals to limit priority claims, maximize creditor payouts, and ensure predictability in bankruptcy transactions.