As part of a continued effort in Europe to reform insolvency legislation, the British government issued a paper in March 2018 as a response to a draft directive published by the European Commission in November 2016. The Response proposed highly significant reforms to the current insolvency legislation which–interestingly, in this era of Brexit–if adopted, would bring the British insolvency policies closer in line with the current policies of the European Union. Learn more about the proposed reform from this recent restructuring alert, which breaks down the new proposed restructuring plan, analyzes a possible implementation timeline and compares the potential legislation to the current policies in place in the European Union.

Another decision has been issued that reinforces that section 553 does not allow setoff without mutuality, or “triangular setoff.” On November 13, 2018, Judge Gross of the United States Bankruptcy Court for the District of Delaware denied a motion in In re Orexigen Therapeutics, Inc. to affect a triangular setoff under section 553 of the Bankruptcy Code due to the lack of mutuality.[1] The Court found that even though a contractual right allowing McKesson Corporation and its subsidiary corporation to affect a prepetition triangular setoff was enforceable under state law, the arrangement did not comport with the strict mutuality required under the Bankruptcy Code.

Section 553

Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case.” The setoff provision of the Bankruptcy Code does not create right of setoff; it preserves for creditor’s benefit any setoff right that it may have under applicable non-bankruptcy law and imposes additional restrictions that must be met in order for the creditor to impose a setoff against a debtor in bankruptcy.[2] Specifically, the Bankruptcy Code requires that the debts and credits must both have arisen before bankruptcy and that there would be “mutuality” between the debiting and crediting parties.[3] While the Bankruptcy Code does not define “mutuality,”[4] courts interpreting this provision find debts to be mutual only where the debts exist between the “same parties” in the “same capacity.”[5] Mutuality is strictly construed against the party seeking setoff.

Analysis

Here, McKesson sought to effectuate a triangular setoff by offsetting it’s almost $7 million debt to the Debtor against the Debtor’s approximately $9 million debt to McKesson’s subsidiary. McKesson argued that because the Debtor owed its subsidiary in excess of the amount owed to McKesson, section 553(a) enables McKesson to set off the subsidiary’s claim against McKesson’s payment.

The Court’s review of the relevant case law and underlying policies behind section 553 made it clear that “[m]utuality is the lynchpin of setoff under section 553(a).”[6] McKesson did not have a mutual debt under section 553(a) because the debt was owed to its subsidiary – a separate and distinct legal entity. Judge Gross found that McKesson ran into “fatal contrary bankruptcy precedent” that found triangular setoffs to be impermissible under section 553(a) without mutuality.[7] Without such mutuality between McKesson and the Debtor, the Court could not allow the setoff.

Judge Gross further explained that “section 553(a) aligns with the fundamental bankruptcy policy of ensuring similarly-situated creditors receive an equal distribution from the debtor’s estate.” The Court refused to read a contractual exception to the strict mutuality requirement of section 553 because that would create the situation where creditors could receive a greater distribution than other equal-footed creditors and thus dilute the bankruptcy estate to the detriment of all creditors.[8]

McKesson also tried to argue that the subsidiary was a third-party beneficiary under the contract between McKesson and the Debtor, and that the contractual third-party beneficiary doctrine provides the required mutuality.[9] The Court found this argument to be another attempt by McKesson to validate a contractual exception to mutuality. The Court found this “unavailing” because “if there w[as] a contractual third-party beneficiary status exception, parties would merely add language intending that a third-party be a third-party beneficiary of a contract allowing for triangular setoff.” The Court refused to provide an avenue for deliberate circumvention of the Bankruptcy Code.

Takeaways

The decision is another upset for the accessibility of triangular setoffs in bankruptcy. Setoff under section 553 of the Bankruptcy Code requires real mutuality; the Court’s decision makes it abundantly clear that mutuality requires the “same parties” in the “same capacity.” This case supports the trend that parent companies cannot simply argue triangular setoff to mix and match the debits and credits arising from discrete contracts held by the individual entities within its organizational structure.

[1] No. 18-10518 (KG), 2018 Bankr. LEXIS 3579, at *1 (Bankr. D. Del. Nov. 13, 2018).

[2] In re SemCrude, L.P., 399 B.R. 388, 393 (Bankr. D. Del. 2009), aff’d, 428 B.R. 590 (D. Del. 2010).

[3] The Court also discussed how section 553(a) requires the party seeking setoff to be a “creditor.” In re Orexigen Therapeutics, Inc., 2018 Bankr. LEXIS 3579, at *9. The Court found that McKesson was a creditor only because the parties treated McKesson as a creditor in its’ stipulations; the Court noted that it would not have otherwise deemed McKesson as a creditor because McKesson had paid off its debt to the Debtor, extinguishing its claim. Id.

[4] 5 Collier on Bankr. ¶ 553.03 (16th 2018).

[5] See In re SemCrude, 399 B.R. at 393 (“[T]he authorities are also clear that debts are considered ‘mutual’ only when ‘they are due to and from the same persons in the same capacity.’” (quoting Westinghouse Credit Corp. v. D’Urso, 278 F.3d. 138, 149 (2d Cir. 2002)).

[6] Id. at *24.

[7] In re Orexigen Therapeutics, Inc., 2018 Bankr. LEXIS 3579, at *9 (citing In re SemCrude, L.P., 399 B.R. 388, 393 (Bankr. D. Del. 2009) and In re Lehman Bros. Inc., 458 B.R. 134, 139 (Bankr. S.D.N.Y. 2011)).

[8] Id.

[9] A third-party beneficiary to a contract is a party who directly or incidentally benefits from a contract between two other parties.

The Fifth Circuit Court of Appeals reminded the plaintiff that standing is “determined as of the commencement of the suit” and post filing claims purchases will not suffice to establish standing. Here, the plaintiff, [also the debtor’s owner], sought to appeal appointment of special counsel. The Bankruptcy Court found that the plaintiff lacked standing to object because he was not a creditor and did not have a stake in the estate and then approved the Trustee’s application to employ SBPC over the improper objection. The plaintiff filed an appeal and then purchased a proof claim in order to obtain creditor status. The Fifth Circuit agreed with the Bankruptcy Court and noted that “[o]nly those directly, adversely and financially impacted by a bankruptcy order may appeal it.” Standing is “determined as of the commencement of the suit and a plaintiff cannot belatedly claim creditor status and establish standing retroactively.”

The Ninth Circuit Court of Appeals recently held that a secured creditor’s purchase of general unsecured claims to block confirmation of a Chapter 11 plan did not in itself constitute bad faith. In In re Fagerdala USA, the debtor owned real property on which Pacific Western Bank held the senior secured claim. The debtor’s plan of reorganization sought to impair Pacific Western’s claim by using an interest rate lower than the penalty interest rate for its loan, and modifying the length of the term and other loan provisions. Under section 1129(a)(10) of the Bankruptcy Code, in order to approve a plan over the objections of impaired creditors, a debtor is required to obtain the consent of at least one impaired class. In order to ensure that this debtor would not receive such consent, Pacific Western attempted to strategically buy up a sufficient amount of general unsecured claims—the only other impaired class—to block the plan. While Pacific Western did not seek to buy every general unsecured claim, it was able to purchase “one-half in number” of the general unsecured class, and was thus able to block the approval of the plan.

After the plan vote, the debtor moved to designate the votes Pacific Western cast on behalf of its general unsecured claims, arguing that Pacific Western purchased those claims in bad faith. To “designate” means the votes for the claims will not be counted in voting to accept or reject the plan. The bankruptcy court granted the debtor’s motion, concluding that “designation is appropriate in this case because [Pacific Western] will have an unfair advantage over the unsecured creditors who did not receive a purchase offer and who hold the largest percentage of claims…in terms of amount.” The district court affirmed this ruling, but the Ninth Circuit reversed it and remanded the case to the bankruptcy court.

The Ninth Circuit reasoned that “merely protecting a claim to its fullest extent cannot be evidence of bad faith. There must be some evidence beyond negative impact on other creditors.” Looking to case law, the court enumerated several clear examples of bad faith such as where a competitor purchases claims to destroy the debtor’s business or further its own or a non-preexisting creditor purchasing claims only to block the plan and then stated “[d]oing something allowed by the Bankruptcy Code and case law, without evidence of ulterior motive, cannot be bad faith. Not offering to purchase all the claims in a class (to later use those claims to block a plan) is not—alone—sufficient to evidence the bad faith necessary to designate votes under § 1126(e).”

The Delaware Bankruptcy Court recently voided the transfer of bankruptcy claims where the seller failed to obtain the debtor’s prior written consent, as required by the underlying promissory notes.

Both the promissory notes and the related loan agreement included anti-assignment language providing that any transfer would be null and void unless the debtor provided its prior written consent. In spite of this restriction, the note holders transferred the notes to buyer without obtaining the debtor’s consent. When buyer filed a proof of claim based on the transferred notes, the debtor objected, arguing that the transfer was null and void because the debtor never consented.

Buyer first argued that the anti-assignment clause could not invalidate the transfer as a matter of Delaware law. In holding to the contrary, the court distinguished between anti-assignment clauses that merely limit a party’s “right” to assign from clauses that limit a party’s “power” to assign. Delaware courts will invalidate transfers under a contract where such contract includes an anti-assignment clause that provides any assignment made in violation of the clause will be null and void (e.g. limitation of “power” to assign), but will not invalidate transfers where the contract’s anti-assignment clause does not so provide (e.g. limitation of “right” to assign). The court held that the anti-assignment clauses in Woodbridge properly restricted the noteholders’ power to assign the notes because they provided for voiding any transfer made in violation thereof. Thus, invalidation of the transfers pursuant to the anti-assignment clauses was proper.

Buyer next argued that the anti-assignment clauses unenforceable either because of debtor’s breach of the agreement or because of UCC §9-408. The court disagreed holding “it is axiomatic that a non-breaching party may not emerge post-breach with more rights than it had pre-breach.” Accordingly, the anti-assignment clause remained attached to the promissory notes because “neither the [assignors] nor any assignee were able to emerge post-breach with more rights than they had pre-breach.” The Court then found UCC §9-408, which invalidates provisions restricting assignment in grants of security interests, inapplicable because Contrarian was not granted a security interest in the promissory notes.

Buyer then asserted that even if the anti-assignment clauses were both valid and enforceable they did not apply because the noteholders only transferred their rights under the notes and not the notes themselves. The court disagreed holding that “[t]he language of both the Anti-Assignment Clause and the Loan Agreement manifests both a clear intention to forbid the assignment of the Promissory Note itself, and any rights thereunder.”

While not breaking new ground, the case reinforces the court’s view that “claim purchasers are sophisticated entities that are capable of both assessing the risk of disallowance through due diligence, and mitigating that risk through contractual provisions, such as indemnities.” It also serves as a reminder that reviewing the underlying documents for transfer restrictions is a critical part of a claim purchaser’s due diligence. While not clear from the decision whether settling the transfer via participation would have overcome the disability, it is good practice to include a “participation savings clause” that takes effect if an assignment is deemed invalid. Finally, what is also not clear is whether the result would have been different if the seller had filed a proof of claim before or in conjunction with the transfer.