Preference Double Feature: You Win Some, You Lose Some!

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1 S e l e c t e d t o p i c Preference Double Feature: You Win Some, You Lose Some! by Bruce Nathan, Esq. and David Banker, Esq. Two significant issues in preference litigations have hit the headlines once again. And as they say in baseball: you win some, you lose some. Preference defendants recently scored a victory when a bankruptcy court held that a creditor seeking distribution on its Section 503(b)(9) priority claim 1 was entitled to receive its distribution regardless of potential preference liability. Preference targets, however, suffered a blow when yet another bankruptcy court rejected a preference defendant s assertion of the subsequent new value defense, arising under Section 547(c)(4) of the United States Bankruptcy Code, to reduce its preference liability where the debtor had paid the new value after the bankruptcy filing pursuant to a bankruptcy court order approving the payment. This decision is damaging to the trade creditor community because it reduces the benefit trade creditors rely on by obtaining payment of their pre-petition claims under critical vendor and other similar orders. In addition, based on the same logic, Section 503(b)(9) priority claims that are (or will be) paid after the bankruptcy filing, may not be counted as part of a creditor s new value defense to preference liability. Preference defendants recently scored a victory when a bankruptcy court held that a creditor seeking distribution on its Section 503(b)(9) priority claim was entitled to receive its distribution regardless of potential preference liability. Overview of the Elements of a Preference Claim A trustee can recover a preference by proving that the debtor transferred its property, such as by tendering a payment, to or for the benefit of a creditor (Section 547(b)(1)); the transfer was made on account of antecedent or existing indebtedness the debtor owed the creditor (Section 547(b)(2)); the transfer was made when the debtor was insolvent, based on a balance sheet definition of liabilities exceeding assets, which is easy for a trustee to prove because it is presumed during the 90-day preference period (Section 547(b)(3)); the transfer was made within 90 days of the debtor s bankruptcy filing, in the case of a transfer to a non-insider N a t i o n a l A s s o c i a t i o n o f C r e d i t M a n a g e m e n t The Publication For Credit & Finance Professionals $7.00 creditor, and within one year of bankruptcy for a transfer to an insider, such as the debtor s officers, directors, controlling shareholders and affiliates (Section 547(b) (4)); and the creditor received more from the payment or other transfer than in a Chapter 7 liquidation of the debtor, which can be rebutted by proof that the creditor was fully secured by the debtor s assets, received payment from the proceeds of the creditor s collateral, or would have recovered 100% of its claim in the debtor s Chapter 7 case (Section 547(b)(5)). The Energy Conversion Devices Decision: Is Alleged Preference Liability a Ground for Disallowance and Non-Payment of Section 503(b)(9) Claims? In Energy Conversion Devices, Inc., the United States Bankruptcy Court for the Eastern District of Michigan addressed the applicability of Section 502(d) of the Bankruptcy Code as a basis for disallowing a creditor s Section 503(b)(9) priority claim. According to Section 502(d) of the Bankruptcy Code, on request of a party with standing, a court can disallow the claim of any entity from whom property is recoverable by the estate, including alleged preferential transfers, unless the claimant has paid the recoverable amount or returned the recoverable property. Section 502(d) clearly applies to general unsecured claims that arose prior to the bankruptcy filing, payment of which can be held up so long as the claim against the preference target remains unresolved. However, the courts are divided over Section 502(d) s applicability to Section 503(b) administrative expense claims, including Section 503(b)(9) priority claims. Section 503(b)(9) priority claims are particularly unique in that they arise pre-petition, but are afforded administrative priority status (usually reserved for claims that arise post-petition). May

2 In Energy Conversion Devices, Bankruptcy Judge Thomas Tucker sided with the Section 503(b)(9) claimants and ruled that Section 502(d) does not apply to Section 503(b)(9) claims and Section 503(b)(9) claims should be neither disallowed nor denied payment based on potential creditor preference liability. Background On February 14, 2012 (the ECD petition date), Energy Conversion Devices, Inc. (ECD) filed a voluntary bankruptcy petition under Chapter 11 of the Bankruptcy Code. Ameri- Source Specialty Products had sold goods totaling approximately $185,000 to ECD that ECD received within 20 days of its bankruptcy filing. Ameri-Source was, therefore, entitled to an administrative priority claim under Section 503(b)(9) of the Bankruptcy Code. On June 14, 2012, Ameri-Source timely filed a proof of claim for the Section 503(b)(9) priority claim amount, pursuant to procedures approved in the case that allowed creditors to assert their Section 503(b)(9) claims by filing a proof of claim. On July 30, 2012, a Chapter 11 plan was confirmed in ECD s Chapter 11 case that, among other things, authorized payment of all administrative claims, a pre-requisite for confirmation of a Chapter 11 plan. A liquidating trust was created under the plan and a liquidating trustee was appointed. On December 12, 2012, in light of ECD s non-payment of Ameri-Source s Section 503(b)(9) claim, Ameri-Source filed a motion seeking allowance and immediate payment of the claim. The liquidating trustee, who stepped into the shoes of the debtor once the debtor s Chapter 11 plan went effective, objected to Ameri-Source s motion. The trustee invoked Section 502(d) as grounds for disallowing Ameri-Source s Section 503(b)(9) claim since Ameri-Source had received approximately $85,000 within 90 days of the ECD petition date that constituted potentially avoidable and recoverable preferential transfers under Section 547. The liquidating trustee argued in the alternative that the court should exercise its discretion to delay payment of Ameri-Source s Section 503(b)(9) claim until the adjudication of the alleged preference, so as to assure that the trustee would collect on any judgment the trustee might obtain. Alleged Preference Liability Will Not Hold Up Payment of Section 503(b)(9) Claims Judge Tucker held that just as Section 502(d) should not act as a bar to payment of Section 503(b) administrative claims, it should not apply to Section 503(b)(9) priority claims, which are included as administrative claims. Section 502(d) states as follows: Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under section 542, 543, 550 or 553 of this title or that is a transferee of a transfer avoidable under section 522 (f), 522 (h), 544, 545, 547, 548, 549 or 724 (a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522 (i), 542, 543, 550 or 553 of this title. The ECD decision cited a number of cases holding that claims arising under Section 503 (which, according to the Bankruptcy Code, require a creditor to move allowance and payment of an administrative claim) do not fall within the scope of Section 502(d). Instead, Section 502(d) relates to claims that must be asserted by the filing of a proof of claim. 2 These cases include opinions by the U.S. Court of Appeals for the Second Circuit in Ames Department Stores, Inc. and by the U.S. Bankruptcy Court for the Southern District of Georgia in Durango Georgia Paper Co., each of which were filed prior to the enactment of Section 503(b)(9). These courts held that Section 502(d) does not apply to Section 503(b) post-petition administrative priority claims. Other courts have held that Section 502(d) does not apply to Section 503(b)(9) claims, including a 2008 decision in Plastech Engineered Products, Inc. (also decided by the U.S. Bankruptcy Court for the Eastern District of Michigan, by Judge Shefferly), a 2009 decision in TI Acquisition, LLC by the U.S. Bankruptcy Court for the Northern District of Georgia and a 2011 decision in Momenta Inc. by the U.S. Bankruptcy Court for the District of New Hampshire. Judge Tucker held that just as Section 502(d) should not act as a bar to payment of Section 503(b) administrative claims, it should not apply to Section 503(b)(9) priority claims. Judge Tucker also referred to a decision of the United States Bankruptcy Court for the Eastern District of Virginia in Circuit City Stores, Inc. that went the other way and held that Section 503(b)(9) priority claims are subject to disallowance under Section 502(d) because they arose pre-petition. The ECD court noted that Momenta rejected the Circuit City decision, reasoning as follows: According to the Circuit City case, if a creditor wishes to be granted an administrative priority under 503(b)(9), then the creditor must, first, file a proof of claim under 501, second, have the claim allowed under 502, and then third, request administrative expense priority under 503(a). The Circuit City court s framework adds a requirement to allowance of administrative expense claims that is in conflict with the Bankruptcy Code. The Circuit City court s holding ignores the distinct processes allowing 503 administrative expenses and 501 claims discussed earlier in this opinion. Subsection (a) of 503 states an entity must request an administrative expense claim, not file a proof of claim. Section 503(b) clearly states that an administrative expense requested under one of the nine categories listed in subsection (b) shall be allowed and contains no language that makes allowance conditional on 2

3 filing a proof of claim [which would make 503(b) claim subject to a 502(d) objection]. The ECD court also rejected the trustee s request for a delay of the allowance and payment of Ameri-Source s Section 503(b)(9) priority claim, based on the court s discretionary power, the request of which was made to assure that the trustee could collect on any preference judgment against Ameri- Source. The court denied the request, relying in part on the fact that payment of all allowed administrative priority claims, including Section 503(b)(9) claims, was a pre-requisite for confirmation of the plan in the ECD case. It would be contrary to that requirement to now direct that certain allowed administrative claims, such as Ameri-Source s Section 503(b)(9) priority claim, not be paid. The Furr s Decision: The Inapplicability of the New Value Defense to New Value Paid Post-Petition Pursuant to Court Order In Furr s Supermarkets, Inc., Judge James Starzynski of the United States Bankruptcy Court for the District of New Mexico authored a lengthy opinion addressing whether a creditor loses the ability to assert the new value defense for any new value that was paid post-petition pursuant to a court order? When a debtor or trustee satisfies all of Section 547(b) s preference requirements, the burden shifts to the preference defendant to prove one or more of the preference defenses contained in Section 547(c) of the Bankruptcy Code. The Section 547(c)(4) subsequent new value defense is one such preference defense. The new value defense reduces a creditor s preference liability to the extent the creditor had provided new goods and/or services on credit terms subsequent to the preference for which the creditor did not receive an otherwise unavoidable transfer. The ECD court also rejected the trustee s request for a delay of the allowance and payment of Ameri- Source s Section 503(b)(9) priority claim, based on the court s discretionary power, the request of which was made to assure that the trustee could collect on any preference judgment against Ameri-Source. Judge Starzynski ruled that new value paid post-petition pursuant to a court order is not counted to reduce preference liability. Background On February 8, 2001(the Furr s petition date), Furr s Supermarkets, Inc. filed a voluntary bankruptcy petition under Chapter 11 of the Bankruptcy Code. On December 19, 2001, the Furr s Chapter 11 bankruptcy case was converted to a Chapter 7 case. The plaintiff prosecuting the preference action at issue was appointed the Chapter 7 trustee on that date. Both before and after the Furr s petition date, defendant, Sun Life Insurance Company, provided insurance, funded by Furr s, for the benefit of certain of Furr s employees. During the 90-day period prior to the Furr s petition date (Furr s preference period), Furr s made premium payments, totaling approximately $180,000, to Sun. During the Furr s preference period, following the alleged preference payments, Sun provided insurance to Furr s employees, for which Furr s had failed to pay the premiums as of the Furr s petition date. Furr s alleged preference exposure would have been reduced to approximately $55,000 based on the new value defense if the story had ended here (calculated at approximately $125,000 of unpaid new value, in the form of unpaid premiums for continued insurance coverage, credited against the $180,000 of alleged preferences). However, after the Furr s petition date, Furr s made payments to Sun totaling approximately $60,000 applied toward payment of certain unpaid premiums that Furr s owed Sun on the Furr s petition date and that Sun had claimed as new value. All parties acknowledged that Furr s payments to Sun were authorized by one or more bankruptcy court orders, including an employee benefits order entered in the case that authorized the payment of employees insurance premiums. In January 2003, the Chapter 7 trustee of the Furr s estate filed a complaint against Sun seeking to recover the approximately $180,000 of premium payments that Sun had received from Furr s during the Furr s preference period. Sun asserted a new value defense to the preference claim based on the $125,000 of unpaid premiums on the Furr s petition date for continued insurance coverage provided to certain of Furrs employees during the period subsequent to the alleged preference payments. Dueling summary judgment motions were filed that addressed, among other things, whether Sun was entitled to count as new value the entire $125,000 of insurance premiums that remained unpaid prior to the Furr s petition date, or whether the $60,000 of insurance premiums that was ultimately paid post-petition may not be counted as new value. The Chapter 7 trustee argued that Furr s post-petition payment of $60,000 to Sun reduced the amount of Sun s eligible new value from approximately $125,000 to $65,000, leaving a net preference exposure of approximately $115,000 (calculated as $180,000 of potential preference liability minus $65,000 of eligible new value). This contrasts with the $55,000 of remaining preference liability claimed by Sun when counting the entire approximately $125,000 of new value on account of unpaid insurance premiums as of the Furr s petition date. The trustee asserted that if Furr s paid the $60,000 of new value pre-petition, it would not have counted as new value. If that is the case, it should not be counted as new value when it was paid post-petition. 3

4 Sun, on the other hand, argued that the pre-petition debtor and the post-petition debtor-in-possession were two separate and distinct entities. Since the pre-petition debtor did not pay for the new value as of the Furrs petition date, the new value remained unpaid for purposes of calculating Sun s new value defense, regardless of whether the new value was ultimately paid post-petition by the debtor-in-possession. In essence, in order to calculate eligible new value, the Furr s petition date was the snapshot in time to determine whether or not the new value remained unpaid. In essence, in order to calculate eligible new value, the Furr s petition date was the snapshot in time to determine whether or not the new value remained unpaid. New Value Paid Post-Petition Does Not Count in Reducing Preference Liability The Furr s court ruled in favor of the trustee and against Sun. The court sided with several other courts that made no distinction for whether the pre-petition debtor had paid the new value as of the petition date or alternatively, whether the debtor-in-possession had paid the new value post-petition. Judge Starzynski relied on the harm to general unsecured creditors in reaching his decision. It should not matter whether the pre-petition debtor or the post-petition debtor in possession had paid the new value and the court should not make that distinction. A post-petition payment depletes the return to unsecured creditors just the same as if it were made prepetition and not recovered as a preference. Therefore, cutting off the calculation of new value when a bankruptcy case is filed makes no economic sense. The courts that Furr s sided with also do not count new value in light of the debtor s post-petition payment of such new value, regardless of the fact that the new value had remained unpaid when the bankruptcy case commenced. These courts applied their rationale to not only payments made pursuant to post-petition critical vendor and other similar orders, but also to Section 503(b)(9) priority claims that are (or will) be paid in connection with the bankruptcy case, or other orders approving payment of a creditor s pre-petition claim. 4 The Furr s decision is in sharp contrast to the decision by the United States Bankruptcy Court for the District of Delaware in Friedman s Inc. v. Roth Staffing Companies L.P., a victory for preference defendants. The Friedman s court ruled that a creditor can, in fact, count subsequent new value to reduce preference exposure that was ultimately paid for post-petition, pursuant to a court order. Bankruptcy Judge Christopher Sontchi determined new value as of the bankruptcy filing date. As such, the court included all new value extended pre-petition and unpaid on the bankruptcy filing date as part of the creditor s new value defense, regardless of the debtor s post-petition payment of such new value. By the same token, a creditor gets no new value credit for any post-petition new value provided to the debtor because the new value did not exist as of the bankruptcy filing date. The Friedman s holding, in contrast to the Furr s decision, is helpful to the trade creditor community by allowing new value that was (or will be) paid post-petition pursuant to a court order. The effect of this holding is to thereby increase the amount of new value available to reduce preference liability. Other earlier decisions agreed with the holding in Friedman s. The United States Bankruptcy Court for the Eastern District of Tennessee in Phoenix Restaurant Group, Inc. v. Ajilon Professional Staffing LLC, ruled that Section 547(c)(4) (B) focuses on actions of the debtor...and [t]hroughout 547, the debtor refers to the prepetition entity that transferred property or engaged in business with the preference defendant...[h]ad Congress intended for post-petition payments to be counted when determining new value, it would have made that clear. Consistent with the Phoenix decision is the decision of the United States Bankruptcy Court for the Middle District of Tennessee in Commissary Operations, Inc., that counted new value entitled to Section 503(b)(9) priority, that was ultimately paid post-petition. The Friedman s court ruled that a creditor can, in fact, count subsequent new value to reduce preference exposure that was ultimately paid for post-petition, pursuant to a court order. Regrettably, however, there is authority supporting the Furr s holding, and countering the Friedman s decision. The United States Bankruptcy Courts for the Eastern District of Virginia, in the Circuit City Stores case, and for the Northern District of Georgia, in TI Acquisition, refused to include a trade creditor s Section 503(b)(9) priority claim that was fully paid or funded post-petition, as part of the creditor s new value defense. Other courts have similarly disqualified new value that was provided pre-petition and paid post-petition pursuant to a critical vendor or other order. In Phoenix Restaurant Group, Inc. v. Proficient Food Company, the United States District Court for the Middle District of Tennessee held that a creditor cannot include a valid reclamation claim as part of its new value defense to preference liability. Similarly, in the Login Brothers Book Company case, the United States Bankruptcy Court for the Northern District of Illinois ruled that new value could not be counted where after the bankruptcy filing, pursuant to a court order, the trustee had returned the books, that the creditor had sold and delivered to the debtor during the preference period and had claimed as new value. The estate was not replenished by the return of the goods (contrary to the policy behind the new value defense) and it should not matter whether the repayment or return of goods 4

5 had occurred before or after the commencement of the bankruptcy case. In short, a creditor s exposure to preference liability depends on whether or not the court follows the Furr s, Circuit City, TI Acquisition, Phoenix v. Proficient Food and Login Brothers holdings. Conclusion The Energy Conversion Devices decision, that bars a trustee s reliance on Bankruptcy Code Section 502(d) to disallow and deny payment of Section 503(b)(9) priority claims based on the creditor s exposure to preference liability, is a victory for trade creditors. On the other hand, the Furr s decision serves as a warning to creditors who receive post-petition payments of their pre-petition claims pursuant to critical vendor or Bruce S. Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler LLP. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI s Unsecured Trade Creditors Committee. Bruce is also the co-chair of the Avoiding Powers Advisory Committee working with ABI s commission to study the reform of Chapter 11. He can be reached via at bnathan@lowenstein.com. David M. Banker, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler LLP. He can be reached at dbanker@lowenstein.com. *This is reprinted from Business Credit magazine, a publication of the National Association of Credit Management. This article may not be forwarded electronically or reproduced in any way without written permission from the Editor of Business Credit magazine. The Friedman s holding, in contrast to the Furr s decision, is helpful to the trade creditor community by allowing new value that was (or will be) paid post-petition pursuant to a court order. other court orders. A creditor with potential preference exposure should make every effort to include language in critical vendor and other orders approving payment of their pre-petition claims that either releases them from preference liability or preserves their new value defense. If that is not possible, creditors should consider early on the applicability of other possible preference defenses beyond the new value defense. 1. Goods sellers have an administrative priority claim under Section 503(b)(9) of the Bankruptcy Code for the value of the goods they had sold to the debtor in the ordinary course of business that the debtor received within 20 days of bankruptcy. 2. Even though the ECD court allowed Section 503(b)(9) claims to be asserted by the filing of a proof of claim, that did not change the nature of the claim from an administrative claim, governed by Section 503(b), to a general unsecured claim that may be filed pursuant to Section 501 and allowed under Section There is a dissenting view embodied by the decision of the Ninth Circuit Bankruptcy Appellate Panel in In re MicroAge, Inc. that administrative claims are subject to disallowance based on the creditor s exposure to preference risk. 4. Note that the Furr s court made clear that Furr s agreements with Sun had not been assumed by virtue of the employee benefits order entered in the case (that implicitly authorized the post-petition payments to Sun). Accordingly, Sun could not argue that the alleged preferences it had received were fully insulated from preference liability on account of Furr s assumption of the agreements. Indeed, the employee benefits order explicitly did not approve Furr s assumption of the agreements and in no way waived Sun s potential preference liability. 5