Understanding and Avoiding the Perils of a Triangular Setoff

Triangular setoffs are often negotiated in contracts governing complex business dealings as a means of extinguishing debt. However, in bankruptcy proceedings they can create headaches unless certain key steps are taken to protect one’s business.

A setoff occurs when A owes B a debt, and B owes A a debt.  These mutual debts can be set-off against each other in certain circumstances.  In a bankruptcy context,1 a creditor’s ability to set-off mutual, pre-petition debts is powerful because a creditor can recover against its claim by the entire amount of the debt it owes to the debtor.  By contrast, if a creditor cannot exercise the right of setoff, it will have to pay the debt it owes to the debtor and it may only receive pennies on the dollar for the debt it is owed.

The Bankruptcy Code requires the presence of three factors to successfully assert a setoff.  First, a creditor must hold a claim that arose prior to the commencement of the debtor’s bankruptcy case.  Second, the claims or debts that are being set off must be mutual, that is, must both have arisen pre-bankruptcy.  Finally, the relevant claim and right to setoff must each constitute a valid obligation.  New Jersey courts require a showing of mutuality for a setoff to be an enforceable right.  The mutuality element does not require that a setoff arise from the same transaction as the underlying debt, only that both debts arise pre-bankruptcy.

A triangular setoff differs from a traditional setoff in that it involves a three-party transaction.  In a triangular setoff, A owes B a debt, and C owes A a debt, where B and C are affiliates.  In this scenario, A sets off the debt it owes to B against the debt that C owes to A.  Triangular setoffs are permitted only if authorized by contract and state law.

In bankruptcy, however, it is widely held that triangular setoffs, even where parties have properly agreed to it, will not be permitted.  This raises practical concerns for parties that have multiple contracts with a third party, particularly if affiliates or subsidiaries are parties to those contracts.

To the extent a business is comprised of affiliated legal entities that enter into contracts with the same counterparty (or its affiliates), avoiding triangular setoffs will be crucial to maximize recovery in the event of a counterparty’s bankruptcy filing.  Even where broad contractual provisions authorize triangular setoffs between the contract parties and affiliates, in bankruptcy there is a substantial likelihood (especially in New Jersey, New York, Pennsylvania and Delaware) that such provisions will not be enforced and a business owner may find him or herself in the unpleasant position of having one affiliate pay the entirety of a debt owed to a debtor, while another affiliate receives just pennies on the dollar on the debt owed to it.

So, how can you protect your business before a contract counterparty files bankruptcy?  Here are several options that may help protect your business.  First, a distributor can take steps to have its affiliate obtain a perfected security interest in the debtor’s accounts receivable due from the distributor to secure the debt owed to the affiliate.  Second, a distributor and affiliate can be made jointly and severally liable to the debtor with regard to their respective obligations.  Third, a business owner can authorize a contracting entity to delegate its duties to an affiliate in any contract where there is a potential risk for bankruptcy.  Although these steps may be cumbersome, thinking through the issues during  contract negotiations—particularly when there may be significant debts owed between the parties—could be the difference between a nominal and a substantial recovery in a future bankruptcy case.

1 In a non-bankruptcy context, an alternative to setoff may be the equitable remedy of recoupment. New Jersey case law defines recoupment as the “reduction of an offsetting claim arising out of exactly the same transaction.” As a result, recoupment may be utilized only to reduce or extinguish the plaintiff’s recovery and not any amount which the claimant is entitled.