Delaware Bankruptcy Court Limits 'New Value Exception' in Preference Clawback Suits

Jeremy W. Ryan and R. Stephen McNeill
Delaware Business Court Insider

Almost nothing in bankruptcy draws more ire from business people than preference clawback lawsuits. A business suffers an injury when a bankrupt customer fails to pay for goods or services it received. The insult added to that injury is when the business is sued by the bankruptcy estate to disgorge payments the business received on other invoices. "You mean after not getting paid for product I shipped to the debtor, I also am expected to give back money for products they received?" is often the incredulous question posed by many a preference defendant.

The basic premise of the preference statute is that all creditors, at least in the 90 days prior to a bankruptcy, should be treated similarly. The Bankruptcy Code seeks to avoid the situation where some creditors, as a result of aggressive collection techniques or preferential treatment by a debtor, receive 85 percent or 90 percent of a payables balance while other creditors may recover only 15 percent. There is tension in the Bankruptcy Code, however, because there is also the desire to encourage the ordinary extension of trade credit to companies in trouble - nothing accelerates a company's demise faster than lack of access to the goods and services the company requires to operate.

The result of these competing interests is a preference statute that initially casts a very wide net. Under Section 547(b) of the Bankruptcy Code, almost all payments received in the 90 days prior to a bankruptcy on account of prior debts will potentially be considered preferential and subject to avoidance. To further the goal of encouraging the extension of trade credit, however, Congress did not leave creditors defenseless against the assertion of preference claims. Instead, Section 547(c) provides the creditor with certain affirmative defenses that, when applicable, bar recovery of the alleged preferential transfer. Among the most important of these statutory defenses is the subsequent new-value defense provided by Section 547(c)(4). This defense allows a creditor to reduce its potential preference exposure by the value of the goods and services that it provided to the debtor after receiving a preference payment - i.e., if a creditor received a payment of $10,000 on July 1, and shipped $8,000 worth of goods on July 10, it may be able to set off the $8,000 in new value against the $10,000 in preference exposure. In Delaware and other jurisdictions in the 3rd U.S. Circuit Court of Appeals, however, new value generally must remain unpaid in order to be used as a defense. In the example above, the creditor could set off the $8,000 new-value shipment only if it did not receive payment for the shipment.

One of the few unresolved issues related to the subsequent new-value defense is whether the new value is fixed as of the petition date or must be adjusted to account for post-petition transactions between the debtor and the creditor. This issue most commonly arises in one of two contexts: (1) when the creditor continues to provide goods and services to the debtor after the petition date; or (2) when the debtor receives authorization to pay the creditor for all or a portion of its unpaid pre-petition invoices at the outset of the case — transforming new value that was unpaid as of the petition date into paid invoices post-bankruptcy.

In a Nov. 30, 2011, opinion in the adversary case styled Friedman's Inc. v. Roth Staffing Companies L.P., Bankruptcy Judge Christopher Sontchi addressed the calculation of subsequent new value after the creditor had received a partial payment of its pre-petition unpaid invoices post-bankruptcy claim pursuant to an order of the Bankruptcy Court. Sontchi held that the amount eligible for the subsequent new-value defense was fixed as of the petition date, regardless of any post-petition transactions between the debtor and the creditor.

The pre-petition relationship between the debtor and the creditor in Roth was relatively straightforward and typical of the business relationship found in many preference cases. The defendant provided staffing services to the debtor, for which it received $81,997.57 in allegedly preferential transfers. After the receipt of the last transfer, the defendant provided an additional $100,660.88 of services for which it was never paid. If the facts stopped there, the defendant would have a complete defense to the preference allegations based on its subsequent new-value defense.

The debtor, however, had paid the defendant $72,412.71 on account of its unpaid pre-petition unsecured claim pursuant to a first-day wage motion, which Sontchi approved. The debtor argued that this post-petition payment to the defendant could be used to reduce the defendant's subsequent new-value defense to $28,248.17, leaving a remaining preference claim of $53,749.40. The defendant, of course, argued that its subsequent new-value defense was fixed as of the petition date and could not be reduced by its receipt of the payment under the wage order.

Sontchi held that the subsequent new-value defense should be fixed as of the petition date based on the 3rd Circuit's recitation of the elements of that defense in the case of New York City Shoes Inc. v. Bentley International Inc. Specifically, in New York City Shoes, the 3rd Circuit noted that "the debtor must not have fully compensated the creditor for the 'new value' as of the date that it filed its bankruptcy petition." Sontchi found this statement to be a clear implication that the subsequent provision or payment of new value does not affect the preference analysis. Accordingly, he held that "neither the post-petition provision of new value by the creditor nor the post-petition payment of unpaid, pre-petition new value affects the preference calculation."

By fixing the preference analysis at the petition date, Sontchi's opinion provides additional clarity to creditors analyzing their potential preference exposure. A creditor's subsequent new-value defense may not be affected by post-bankruptcy payments of pre-petition invoices. As a result, creditors can openly accept payments from the debtor under the doctrine of necessity without the fear of repercussions later in the case. Conversely, while a creditor can still assert the right to an administrative claim for its provision of post-petition goods and services to the debtor, at least the debtor knows that the creditor cannot increase its subsequent new-value defense by doing so.

Reprinted with permission from 3/7/2012 issue of the Delaware Business Court Insider© 2012 ALM Media Properties LLC. Further duplication without permission is prohibited. All rights reserved.

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