Bermuda’s “Triangular Netting” – Insolvency / Bankruptcy / Restructuring

While the Bermuda Triangle is a mystery that may never be resolved, the Third Circuit Court of Appeals recently settled the intriguing question of whether the contractual provisions allowing for “triangular compensation” are applicable in bankruptcy. . The third circuit concluded that such contractual provisions are inapplicable in In re Orexigen Therapeutics, Inc.1, due to the “strict bilateral reciprocity” requirement of article 553 of the Bankruptcy Code. Bilateral reciprocity simply means that debts must be owed between the same two legal entities. The Third Circuit, however, did not solve the mystery of the ships and planes missing in the Bermuda Triangle.

But what is triangular compensation? Why is this important for your business? And what can be done to protect your business interests before a counterparty to the contract goes bankrupt? You’ll have to read on to find out.

What is triangular compensation?

A traditional bilateral netting occurs when A owes a debt to B and B owes a debt to A. These two mutual debts can be set off against each other. In a bankruptcy context, a creditor’s ability to set off pre-petition mutual debts is powerful, as a creditor can collect their debt for the full amount of debt they owe the debtor. On the other hand, if a creditor cannot exercise the right of set-off, he will have to pay the debt he owes to the debtor and he can only receive pennies on a dollar for the debt owed to him.

Triangular netting occurs when A owes B debt and C owes A debt (where B and C are affiliates). In a triangular netting scenario, A offsets the debt he owes to B with the debt C ​​owes to A. Apart from bankruptcy, triangular netting is only allowed if it is allowed by the contract and the common state law. However, after the decision of the third circuit, it is clear that triangular netting, even where the parties have committed to allow it, will not be allowed in the event of bankruptcy (at least in this circuit), and it is likely that other circuits follow suit.

Orexigen’s bankruptcy and triangular compensation

Orexigen Therapeutics, Inc. (the “Debtor”), a manufacturer of pharmaceutical drugs, entered into a distribution agreement with McKesson Corporation (the “Distributor” in June 20162. The distribution agreement between [the
Debtor] and the Distributor included a provision (hereinafter, the “Compensation Provision”) which allowed “each of the [the
Distributor] and its affiliates … to set off, recover and apply any amount it owes to [the Debtor’s] affiliates against any
[and] all amounts owed by the debtor or its affiliates to any of the
[the Distributor] or its affiliates. “3 In short, the netting clause provided for broad rights of netting between the Debtor and its affiliates, and the Distributor and its affiliates.

The Debtor also entered into a service agreement with McKesson Patient Relationship Solutions (the “Affiliate”), one of the Distributor’s subsidiaries, in July 2016.4 The service agreement between Debtor and Affiliate did not refer to, incorporate or integrate the distribution agreement between Debtor and Distributor.5

Almost two years after entering into the distribution agreement with the Distributor and the services agreement with the Affiliate, the Debtor filed for Chapter 11 bankruptcy in the District of Delaware.6 At the time of the deposit, (i) the Debtor owed the Affiliate approximately $ 9.1 million, and (ii) the Distributor owed the Debtor approximately $ 6.9 million.7The Distributor and the Affiliate filed a petition with the Bankruptcy Court to set off the amounts the Distributor owed the Debtor against the amounts the Debtor owed the Affiliate.8 The net result would be that the debtor owes the affiliate $ 2.2 million.

The Bankruptcy Court disagreed with the Distributor’s position. Section 553 (a) of the Bankruptcy Code generally preserves the “right of a creditor to set off a mutual debt owed by that creditor to a debtor which arose before” the bankruptcy filing. The bankruptcy court explained that the remedy for triangular set-off of pre-petition debts did not meet the reciprocity requirement of Section 553 (a).9 The bankruptcy court ruled that contracts could not change the requirement in section 553 (a) that pre-petition debts be between the same two parties and arise under the same law.ten On appeal, the district court upheld the bankruptcy court’s decision.11

In upholding lower court decisions, the Third Circuit agreed that a contract could not create an exception to the direct reciprocity requirement in Section 553 (a).12 Instead, the Third Circuit held that the reciprocity requirement in Section 553 (a) is “a separate and limiting requirement of federal bankruptcy law.”13 In considering the effect of this limitation, the court explained that Congress did not intend to allow a contractual workaround to reciprocity when it came to a direct bilateral relationship.14Therefore, when contracts create a right of set-off between debts of a creditor or its affiliates and obligations owed by a debtor or its affiliates, the contractual relationship will not change from a triangular set of requirements to reciprocity. bilateral.

The court explained that its decision was in line with the policies underlying the Bankruptcy Code: “one of the main objectives, if not the main objective, of the Code is to ensure that creditors in a similar situation are treated fairly and benefit from an equitable distribution by a debtor in the absence of a compelling reason to depart from this principle.15 The court ruled that “[t]angular offsets undermine this objective. “16 If allowed in this case, Affiliate would in effect have received a 100% distribution on $ 6.9 million of its $ 9.1 million claim as well as a pro-rata distribution on its remaining claim of 2 , $ 2 million, and the Debtor would not have received anything from the Distributor. from which to make distributions to creditors. In short, the Affiliate’s recovery would be much higher than that of unsecured creditors in the same situation. On the other hand, if the triangular set-off was not authorized, (i) the Debtor will receive $ 6.9 million from the Distributor, (ii) the Affiliate will have a claim against the Debtor for $ 9.1 million, and ( iii) any distribution that the Affiliate receives will be pro-rated and identical to any distribution received by another creditor in the same situation. By strictly applying the reciprocity requirement of Article 553 (a), the Third Circuit considered that the objective of equal treatment of creditors would be better served.

Why is triangular compensation important for your business?

As your business is made up of affiliated legal entities that each enter into contracts with the same counterparty (or its affiliates), it will be crucial to avoid triangular offsets to maximize your recovery in the event of a counterparty’s bankruptcy. . As described in Orexigen, even the general contractual provisions allowing triangular netting will not be applied and your business may find itself in the unpleasant position of having one affiliate pay all of a debt owed to a debtor while another affiliate does not. receives only pennies per dollar on the debt owed to it. So, it’s best to prepare for the possibility that a counterparty goes bankrupt and take action now to maximize your business recovery.

What can be done to prevent your business from falling victim to Bermuda’s “triangular netting”?

While the option to contract for Triangular Compensation within the Third Circuit seems to have vanished without a trace, there are still ways that your business can come out of Bermuda’s “Triangular Compensation” unscathed. Indeed, the
Orexigen the court suggested a few options. First, the Distributor could have taken steps to ensure that the Affiliate obtains perfect security on the Debtor’s account receivable owed by the Distributor to secure the debt owed to the Affiliate. Second, the court suggested that the Distributor and the Affiliate be made jointly and severally liable to the Debtor. Another option, which was not raised by the court, is to have one of your business entities enter into most of the material contracts with a counterparty where there is a risk of bankruptcy, but expressly allow your procuring entity to delegate its functions to an affiliated company. While these steps can be cumbersome, thinking about these issues when entering into the contract, especially when there may be significant debts between the parties, can make the difference between a nominal recovery and a substantial recovery in the future. bankruptcy case.

Footnotes

1 990 F.3d 748 (3d Cir. 2021)

2 Identifier. to 751.

3 Identifier.

4 Identifier.

5 Identifier.

6 Identifier.

7 Identifier.

8 Identifier.

9 In re Orexigen Therapeutics, Inc., 596 BR 9, 12 (Bankr. D. Del. 2018).

ten Username. at 18 years old.

11In re Orexigen Therapeutics, Inc., n ° BR 18-10518-KG, 2020 WL 42824 (D. Del. January 3, 2020).

12 In re Orexigen Therapeutics, Inc., 990 F.3d at 753-54.

13 Identifier. to 754.

14 Identifier.

15 Identifier. at 755. (Internal citation and citation omitted).

16 Identifier.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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