Restructuring

In a recent decision, In re Orexigen Therapeutics, Inc., No. 18-10518 (KG) (Bankr. D. Del. Nov. 13, 2018), Judge Kevin Gross of the United States Bankruptcy Court for the District of Delaware held that the mutuality requirement of section 553 of the Bankruptcy Code must be strictly construed, declining to find mutuality in a triangular setoff between the debtor, a parent entity that owed the debtor money, and that entity’s subsidiary, which was a creditor.  Specifically, Judge Gross held that there is no contractual exception to the mutuality requirement and that mutuality may not be satisfied under a third-party beneficiary theory.

Background

The debtor, Orexigen Therapeutics, Inc. (the “Debtor”), was a biopharmaceutical company that manufactured Contrave, a drug that treats obesity.  The two prepetition agreements at issue were: (1) a distribution agreement between the Debtor and McKesson Corporation (“McKesson”), under which McKesson agreed to purchase and distribute Contrave to various pharmacies in the United States (the “Distribution Agreement”) and pursuant to which McKesson owed the Debtor approximately $7 million as of the petition date; and (2) an unrelated services agreement between the Debtor and MPRS, a subsidiary of McKesson, in which MPRS agreed to manage the Debtor’s LoyaltyScript program, which enabled patients to receive price discounts on Contrave from retail pharmacies (the “Services Agreement”) and pursuant to which the Debtor owed MPRS approximately $9 million as of the petition date.  The Distribution Agreement provided that McKesson could set off debts owed between the Debtor and its affiliates against debts owed between McKesson and its affiliates.

Importantly, shortly after commencing its chapter 11 case, the Debtor, McKesson and MPRS entered into several stipulations wherein, among other things, (i) McKesson agreed to pay the Debtor approximately $7 million (the “Disputed Funds”) in connection with the Distribution Agreement and preserved its right to set off the debt owed to MPRS, (ii) the Debtor allowed McKesson to file a motion seeking setoff, and (ii) the Debtor agreed to segregate the Disputed Funds paid by McKesson pending resolution of its motion.  Thereafter, McKesson filed a motion seeking to set off the Disputed Funds and sought entry of an order establishing McKesson’s contractual rights to do so.

Section 553 Requirements

Section 553 of the Bankruptcy Code recognizes a party’s right to setoff under state law — it does not create a federal right to setoff.  Setoff is a contractual or equitable right that allows entities that owe each other money to apply their mutual debts against each other.  Whether a party has a setoff right is a twofold inquiry.  First, the party seeking setoff must acquire such right prepetition under applicable nonbankruptcy law.  The parties did not dispute that McKesson had a prepetition setoff right pursuant to the Distribution Agreement under California law.  Second, once the party establishes its setoff right, the party must meet the requirements of section 553(a) of the Bankruptcy Code, namely: (1) the party seeking setoff must be a “creditor” and (2) that party must have a “mutual debt” where that party’s debt to the debtor arose prepetition and that party’s claim against the same debtor arose prepetition.

1. McKesson May Have Been a “Creditor”:  Section 101(10)(A) of the Bankruptcy Code defines a “creditor” as an entity that has a claim (i.e., under section 101(50(A)) of the Bankruptcy Code, a right to payment) against the debtor that arose prepetition.  The Debtor and the Noteholders asserted that McKesson was not a creditor of the Debtor because McKesson paid off its debt to the Debtor, extinguishing its claim.  McKesson took the opposite view, asserting that as of the petition date, it had an almost $7 million claim against the Debtor under the Distribution Agreement.  The Court held that McKesson may have been a “creditor” because the stipulations provided that McKesson’s payment in satisfaction of the Distribution Agreement was subject to its preservation of its setoff right, its ability to file the Motion, and the segregation of the Disputed Funds.  Accordingly, the Court found that McKesson likely would not have paid off its entire prepetition debt but for such reservation of rights.
2. No Mutuality: “Mutuality” or “mutual debt” is not defined in the Bankruptcy Code. However, state and federal courts have found that debts are “mutual” when they are due to and from the same persons/entities in the same capacity.  The court, citing persuasive precedent, held that McKesson did not have a mutual debt under section 553(a).   Although the Distribution Agreement may provide for mutuality between a parent and a subsidiary, there is no contractual exception to mutuality under section 553(a) of the Bankruptcy Code, the unambiguous language of which requires mutuality.  Moreover, the requirement of mutuality aligns with the fundamental bankruptcy policy of ensuring similarly situated creditors receive an equal distribution from the estate.  The court also rejected McKesson’s argument that MPRS being a third-party beneficiary of the Distribution Agreement created mutuality as being contrary to the strict mutuality requirement of section 553.

Conclusion

Orexigen reminds practitioners, who often test the boundaries of the Code, that when the Code is clear, the Code is clear — at least section 553(a) of the Bankruptcy Code, according to Judge Gross.  Triangular setoff will not satisfy the mutuality requirement and there is no contracting or theorizing around it.