Rules of the third circuit according to which the parties cannot contract around the mutuality requirement for compensation in bankruptcy – Insolvency / Bankruptcy / Restructuring
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On March 19, in a first impression case, the Third Circuit Court of Appeal (Court) ruled that triangular netting is not allowed in bankruptcy due to the reciprocity requirement of Section 553 (a) of the Bankruptcy Code, and that the parties cannot avoid this requirement. by contracting around it. See In re Orexigen Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021).
McKesson Corporation, Inc. (McKesson) and Orexigen Therapeutics, Inc. (Orexigen) were parties to a distribution agreement, under which Orexigen would sell the drug Contrave to McKesson, and McKesson in turn would sell the drug to pharmacies. The distribution agreement also contained a provision (netting provision) that stated that McKesson could reduce any amount owed to Orexigen by any amount Orexigen owed to McKesson or any of its subsidiaries. Separately, Orexigen and McKesson Patient Relationship Solutions (MPRS), a subsidiary of McKesson, entered into a services agreement whereby MPRS would manage a customer loyalty program for Orexigen. The distribution agreement with McKesson and the service agreement with MPRS were completely separate documents that did not reference, incorporate or integrate.
On March 12, 2018, Orexigen filed for Chapter 11 bankruptcy. At that time, Orexigen owed MPRS $ 9.1 million under the services agreement, and McKesson owed Orexigen $ 6.9 million under the Services Agreement. of the distribution agreement. McKesson claimed that she had rights of set-off under Section 553 of the Bankruptcy Code on the basis of the set-off clause, and because of those set-off rights McKesson owed Orexigen nothing, but Orexigen owed 2 , $ 2 million to MPRS. The Delaware District Bankruptcy Court (Bankruptcy Court) disagreed, relying on its earlier ruling in In re SemCrude, LP, 399 BR 388 (Bankr. D. Del. 2009). The bankruptcy court held that although the netting clause was an enforceable contractual right that permitted triangular netting under state law, such a relationship did not provide “the strict reciprocity required” for netting. under section 553. The bankruptcy court ruled that a contract cannot transform non-mutual debts into mutual debts subject to set-off under the Bankruptcy Code. McKesson appealed the bankruptcy court ruling, which the Delaware District District Court upheld.
On appeal to the Third Circuit Court of Appeals, the Court upheld the lower court rulings, noting that this was a matter of first impression and that, although other circuit courts have ruled on the meaning of “mutuality”, they had not ruled on “” whether a contract can create an exception to the requirement of direct reciprocity.
The Court first held that the term “mutual” in section 553 imposes a separate limit. McKesson argued that Section 553’s reciprocity requirement was defined by state law and that Section 553 did not impose any limitations on independent reciprocity. McKesson argued that Congress would have listed reciprocity among the many exceptions listed to set-off rights in Section 553 if it had intended that reciprocity to serve as a separate limitation. The Court disagreed, concluding that McKesson’s reading of the law would render the term “mutual” in section 553 redundant. The Court further observed that the requirement in Section 553 that the debtor’s claim against the creditor and the creditor’s claim against the debtor both arise before the petition is not specifically enumerated – at this time, “[t]This requirement is systematically considered as a separate limitation of the ability to assert a right to compensation…. Thus, the Court explained, “there is no compelling reason to treat the requirement of reciprocity differently”.
The Court then concluded that reciprocity under section 553 excluded triangular offsets, such as that of the offsets provision. “Congress understood by reciprocity only debts owed between two parties, in particular those owed by a creditor directly to the debtor and, in turn, owed by the debtor directly to that creditor” and did not intend to include as mutual “no contractual elaboration on this kind of simple and bilateral relationship.”
However, McKesson further argued that the set-off provision changed the debts between Orexigen and MPRS and the debts between McKesson and Orexigen from a triangular debt agreement to a mutual debt. Again, the Court disagreed, citing the SemCrude decision. There, the bankruptcy court ruled that contractual arrangements could not turn a triangular set of obligations into bilateral reciprocity. The bankruptcy court ruled that “mutuality cannot be provided by a multi-party agreement contemplating triangular compensation” and noted that Congress had been very specific in drafting Section 553, articulating exactly who should have a debt to exercise the rights of set-off. the SemCrude the court also observed that “[o]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 enjoy equal distribution from a debtor in the absence of ‘a compelling reason to depart from this principle. Triangular offsets would undermine this objective.
The Court endorsed the SemCrude holding. The Court noted that “[i]f McKesson wanted mutuality for the debts in question, he should have taken over the customer loyalty support he had instead his subsidiary MPRS manage for Orexigen ”, or MPRS could have perfected a security on the receivables Orexigen owed to McKesson, giving it priority akin to compensation. From a political point of view, the Court observed that “the result desired by McKesson, in which contractual netting agreements can incorporate multiparty debts in § 553, would discourage public disclosure of senior debts, undermining a fundamental objective of the Code. “. In contrast, the Court found that “a rule which excludes non-mutual debts from the clearing privilege of § 553 promotes predictability of credit transactions” and that “[a]n unambiguous rule regarding the scope of § 553 maximizes payment for all parties by avoiding litigation costs.
Finally, the Court rejected McKesson’s argument that it held a direct claim against Orexigen through the set-off provision, observing that McKesson’s interpretation of the term “claim” ignores the rest of the wording of the article. 553, and that “”[i]If McKesson’s definition of claim were to be placed in this context, § 553 would state that “this title does not affect any right of a creditor to set off a mutual debt … against [a setoff right] of this creditor. “The Court quickly rejected this interpretation, noting that”[t]to try to set off a debt with a right of set-off seems absurd to us.
The Court’s decision in Orexigen is a reminder of the importance of considering the implications of bankruptcy when drafting contracts. The court prioritized the policies reflected in Section 553 over the parties’ agreement to establish a contrary triangular netting agreement. In addition, the Court has done its utmost to highlight other trade arrangements that can be made to achieve a result similar to that of triangular compensation – for example, taking perfect security or restructuring trade agreements to maintain a bipartite relationship. Parties that intend to draft a triangular netting provision in their contracts should instead consider bankruptcy-compliant alternatives to avoid being deprived of otherwise agreed rights if their counterparty files for bankruptcy.
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