Despite contractual provisions to the contrary, Third Circuit disallows triangular setoffs in bankruptcy

Consider the following scenario: A franchisee owes $25,000 in royalty payments to its franchisor under the franchise agreement. Separately, the franchisor’s affiliate (who runs the system’s gift card program) owes the franchisee $15,000 in gift card reimbursement for the franchisee’s share of funds from gift cards purchased at the franchisee’s location. The gift card program agreement includes a provision that permits each of the franchisor and its affiliates to setoff, recoup and apply any amounts owed by it to franchisee’s affiliates against any and all amounts owed by franchisee or its affiliates to any of franchisor or its affiliates. This contractual provision provides for what is known as a “triangular setoff” of the parties’ obligations. In this scenario, the affiliate would owe nothing to the franchisee for the gift card liability; while the franchisee would only owe the franchisor $10,000 in royalty payments.

As a business arrangement, this seems like a reasonable way for parties to contract their way into an efficient resolution of outstanding obligations because triangular setoffs are generally valid under state law. However, an intervening bankruptcy filing complicates the situation. What happens in this scenario if the franchisee files for bankruptcy? Can the parties still effect a triangular setoff as contemplated by their contractual agreements? In a recent opinion, the United States Court of Appeals for the Third Circuit follows the trend of other circuit courts in rejecting triangular setoffs in bankruptcy despite contractual provisions to the contrary. McKesson Corp. v. Orexigen Therapeutics Inc. (In re Orexigen Therapeutics Inc.), Case No. 20-1136 (3d Cir. March 19, 2021). Although the facts of that case did not specifically include franchise issues, the Third Circuit’s holding and related principles are instructive in the franchise context.

Setoffs are permissible in bankruptcy. Indeed, the doctrine of setoff gives a creditor the right to offset a mutual debt owing by such creditor to the debtor, provided that both debts arose before commencement of the bankruptcy action and are in fact mutual. The McKesson court held that triangular setoffs are disallowed in bankruptcy because they lack “mutuality” as expressly required by section 553(a) of the Bankruptcy Code. The Third Circuit found that Congress intended for “mutuality” to mean only debts owing between two parties, specifically those owing from a creditor directly to the debtor and, in turn, owing from the debtor directly to that creditor. Moreover, the McKesson court found that Congress “did not intend to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.”

As such, the Third Circuit joins the Second Circuit, Fifth Circuit, and Seventh Circuit in holding that triangular setoffs – in which party A owes party B who next owes party C who then owes party A – are not “mutual” by definition, regardless of any contractual attempt to turn non-mutual debts into mutual debts. The Third Circuit also noted that the policies underlying the bankruptcy process disfavored a contractual exception to mutuality. For example, the court determined that triangular setoffs undermine the fundamental bankruptcy goal that similarly-situated creditors are treated fairly and enjoy an equality of distribution from a debtor. The McKesson court also maintained that excluding triangular setoffs in bankruptcy promoted predictability in credit transactions.

So, looking at the example above, what could the parties have done to mitigate a challenge to the contractual triangular setoff? The Third Circuit provides some suggestions. First, if the franchisor wanted mutuality for the debts in question, it should have taken on the gift card program with the franchisee rather than its affiliate, which clearly would have satisfied the mutuality requirement. Second, the parties could have perfected a security interest in the account receivable due from the franchisee.

While triangular setoffs are permissible under state law – and parties should freely contract among themselves to promote efficiency in their business relationships – one should keep a critical eye on the impact of those relationships should one of the parties need to seek bankruptcy protection. Now with the Third Circuit reaching a similar holding as three other circuit courts, it seems unlikely that courts in other jurisdictions would reach a different conclusion on the propriety of triangular setoffs in bankruptcy.