Third Circuit Rejects Triangular Setoff: The Feeling Is Not Mutual

A trade creditor has many tools in its risk mitigation arsenal when its financially distressed customer files for bankruptcy. One such tool is a creditor’s right to set off its claim against the customer to reduce any indebtedness the creditor owes the customer, dollar-for-dollar. This right of “setoff“ is conditioned on the creditor and debtor owing mutual obligations to one another. However, creditors have sought to contract around and expand this “mutuality” requirement by negotiating “triangular” setoff agreements with their customers that permit a creditor to setoff a debt the creditor owes the customer against a debt the customer owes an affiliate of the creditor.

Unfortunately for trade creditors, several courts, including courts in Delaware and the Southern District of New York, have held that a triangular setoff cannot satisfy the mutuality requirement set forth in the Bankruptcy Code’s setoff statute, section 553(a)—despite the enforceability of the triangular setoff under state law. The United States Court of Appeals for the Third Circuit (Third Circuit), in the Chapter 11 cases In re Orexigen Therapeutics, Inc., has now joined this growing majority of courts. In Orexigen Therapeutics, the Third Circuit affirmed the lower courts’ decisions to reject a creditor’s exercise of triangular setoff rights (by crediting a debt the creditor owed the debtor against a debt the debtor owed to the creditor’s affiliate), even though the parties’ contract authorized the triangular setoff, because the creditor could not satisfy section 553(a)’s mutuality requirement.