Are Customer Funds Held by Debtor Logistics Company Property of the Debtor’s Estate? Chief Judge Ferguson (D.N.J.) Addresses Multiple Avoidance Issues in TransVantage Solutions

  Chief Judge Ferguson (Bankr. D.N.J.) recently tackled some of these issues at the motion to dismiss stage in her opinion for Giuliano v. Delta Air Lines, Inc. (In re TransVantage Solutions, Inc.), Adv. No. 15-1882, 2016 WL 5854197 (Bankr. D.N.J. Oct. 6, 2016).  In denying the motion to dismiss (hereafter, the “Motion”), the Court provides a detailed analysis of the 547(b) preference elements that may prove influential as these cases arise in the future, notwithstanding the non-binding nature of the opinion.

Background

The TransVantage cases were initiated under Chapter 7 of the Bankruptcy Code on May 3, 2013 (“Petition Date”), following which Alfred Giuliano was appointed Chapter 7 Trustee (“Trustee”).  In April 2015, the Trustee filed hundreds of preference and fraudulent transfer complaints against various defendants.  Per one of the complaints (which may differ from defendant to defendant), the Debtors were

in the business of providing freight audit and payment services on behalf of its customers (the “Customers”) to help ensure that the auditing and payment of freight invoices were done accurately and timely. TransVantage Solutions would receive freight invoices from the Customers’ common carriers/shippers . . . and then audit and determine whether those invoices were accurate and in compliance with the Customers’ agreements with the carriers/shippers, tariffs and/or regulations.  TransVantage Solutions would then remit the funds received from the Customers to the applicable carriers/shippers. The transfers that are the subject of this Complaint are the transfers described in the preceding sentence that were received by the [Carrier].

Many defendants in the case settled, but ten did not (those ten hereafter referred to as the “Defendants”) and sought to go forward with the Motion.

The Preference Counts

The Defendants based their Motion upon, inter alia, an assertion that the Trustee failed to sufficiently plead the predicate elements of section 547(b) of the Bankruptcy Code.  These points are summarized as follows:

  1. “Interest of the debtor in property”

The Defendants first contended that because the Trustee referred to the funds advanced to the Debtors by the Customers as being held in trust, there could be no property of the estate involved.  The Court, however, would not dismiss the Complaint solely because of the Trustee’s use of the word “trust”; to contrary, the Court found the usage to be conclusory at best, as “[d]etermining whether something is a true trust for bankruptcy purposes is a legal determination for the court to make, it should not be done on a motion to dismiss.” The Court found this especially true considering the early stage of the proceedings, which warrants freely permitting amendment to cure pleading deficiencies.

Having dismissed the Defendants’ “trust” language argument, the Court found that the Debtors at least had a possessory interest in the funds in its own account, which account received the transferred funds from its Customers.

  1. “To or for the benefit of a creditor”

The Court next determined that payments made to the Carriers were for the benefit of the Customers who owed the freight bills.  Customers, in the Court’s view, met the definition of “creditors” under the Bankruptcy Code, as they would have had a claim against the Debtors by virtue of the Customers advancing funds to the Debtors for payment to the Carriers.

  1. “For or on account of an antecedent debt owed by the debtor”

One of the Defendants argued that the Trustee’s failure to allege an antecedent debt owed by the Debtors to the Defendant was dispositive because its business relationship was with the Debtors’ Customers, not the Debtors.  Nevertheless, the Court found that section 547(b)(2) “does not state that the antecedent debt must be owed by the debtor to the defendant, it merely states that it must be ‘owed by the debtor’”; as such, a payment to the Defendant would have been for the benefit of a Customer (a creditor).

  1. “Made while the debtor was insolvent”

The Court found this element met by virtue of the presumption of insolvency under section 547(f) as well as the allegation of a $40 million shortfall as of the Petition Date.

  1. “Made on or within 90 days before the date of the filing of the petition”

The Court found the Complaint clearly pled that pertinent transfers were made within 90 days of the Petition Date.

  1. “Transfer enabled the creditor to receive more than it would have in a Chapter 7 but for the transfer”

The Trustee argued that the Debtors’ liabilities exceeded their assets such that all of the Debtors’ unsecured creditors would not receive full payment – i.e., the Customers whose freight carriers received either full or partial payment made out much better than those Customers whose Carriers received no payment.  The Court appeared to find this allegation sufficient.

In light of the foregoing, the Court concluded the predicate preference elements were sufficiently pled to survive dismissal.  Interestingly, one of the Defendants also raised an ordinary course of business defense under section 547(c)(2), which the Court questioned both on procedural and substantive grounds.  To the latter, “[t]aking the factual allegations in the complaint as true . . . the payments were neither made in the ordinary course of business nor made according to ordinary business terms.”  Further, “the method of payment deviated from the ordinary course of business which was supposed to have been that the funds paid by the Customers were held specifically to pay the freight bills of that Customer and only that Customer.”

The Fraudulent Transfer Counts Under State and Federal Law

The Complaint also contains fraudulent transfer allegations under sections 544 (using New Jersey law) and 548.  The Defendants attacked these counts on multiple fronts, arguing that the Trustee failed to identify “an actual creditor holding an allowed unsecured claim who could avoid the challenged transfers.”  Nevertheless, the Court found that “[w]hen analyzing the sufficiency of a complaint for purposes of Rule 12(b)(6), courts do not generally require a trustee to plead the existence of an unsecured creditor by name, although the trustee must ultimately prove such a creditor exists.”

The Court next rejected the Defendants’ argument that the Complaint is deficient with respect to Federal Rule of Civil Procedure 9(b); the Defendants asserted that the Debtors’ intent to hinder, delay or defraud creditors did not meet the rule’s heightened pleading standards. The Court, however, found that Rule 9(b) permits fraudulent intent to be alleged generally.  As such, the Court found sufficient the Complaint’s allegations that the Debtors’ insiders “were not segregating the funds in the Freight Payment Plan Account, but instead using them to pay personal and business expenses, the complaint adequately pleads actual intent to hinder, delay or defraud.”

The Defendants also argued that the Complaint fails to allege a cause of action for constructive fraud under section 548(a)(1)(B) and N.J.S.A. 25:2-27 because the Debtors received reasonably equivalent value in exchange for each alleged transfer.  In other words, each transfer “was a ‘wash’ because each payment made to the Carriers reduced a corresponding liability owed to them by [the Debtors] (on behalf of the Customers) on a dollar for dollar basis.”  While not rejecting this contention, the Court found that it was inappropriate to find as much at the motion to dismiss stage, noting how highly fact-sensitive such a determination would be.

The Court likewise found that, despite the Defendants’ assertions to the contrary, the Complaint did sufficiently allege insolvency based upon statements that the Debtors’ debts were greater than their assets and that they could operate only in reliance upon new Customer funds.

Is the Bankruptcy Code Preempted by the Federal Aviation Administration Authorization Act?

The Defendants’ last argument relied upon the Federal Aviation Administration Authorization Act, which they averred should limit any remaining fraudulent transfer claims to 18 months prior to the bankruptcy filing.  The FAAAA is designed to preempt any law “related to a price, route or service of any motor carrier, … broker, or freight forwarder with respect to the transportation of property.”  Nevertheless, the Court rejected this argument for multiple reasons: (1) the Defendants cite no supporting case law in which the Bankruptcy Code or New Jersey’s fraudulent transfer statutes were preempted by the FAAAA; (2) the state law claims are derivative of the Trustee’s federal powers in any event, making it not a purely state law issue; and (3) two federal statutes should be harmonized instead of preempting one in favor of another.  To the last point, the Court found that the statutes could be so harmonized, as “the Bankruptcy Code’s goal of equality of distribution through allowing avoidance actions in no meaningful way interferes with the goal of increased competition in interstate transportation.”  Even if it did, however, the Court found that the FAAAA should yield to Bankruptcy Code, citing to a 1994 bankruptcy decision from the Northern District of California (In re Medicar Ambulance Co.).

Conclusion

It bears repeating that the Court has designated the instant opinion as “Not for Publication”.  Nevertheless, given the relative dearth of opinions in the logistics debtors space, parties representing any party in the affected trifecta (customer, debtor/trustee, carrier) should take note of this opinion.  The issues and questions in such cases are invariably quite similar – chief among them being the determination of the trifecta’s rights as to any alleged asset of the estate.

Moreover, it obviously remains to be seen what the final outcome will be in these cases once the parties have had an opportunity to flesh their arguments out with discovery.  Until then, this will be a docket to keep an eye on, barring settlement.

A copy of the Opinion can be found here.

Can an Administrative Claim Be Used to Offset Preference Liability? Judge Carey (D. Del.) Addresses an Issue of First Impression in Quantum Foods

  In so deciding, the Court rejected the plaintiff’s arguments that such a position (i) is inapposite to the Third Circuit’s prohibition against utilizing postpetition goods or services as subsequent new value or (ii) violates Bankruptcy Code section 502(d). To the former, the Court found that the defendant’s setoff claim was distinct and could not be considered subsequent new value under 11 U.S.C. § 547(c)(4), as that defense is concerned entirely with prepetition activity; by contrast, the defendant asserted a valid setoff claim since the opposing obligations (i.e., the preference claim against the administrative claim) both arose on the same side of the bankruptcy petition date.  With respect to the plaintiff’s second argument, the Court found that administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d).

The Preferential Transfers and Administrative Expense Claim

Quantum Foods, LLC, et al. (the “Debtors”) initiated these bankruptcy cases on February 18, 2014 (the “Petition Date”).  In the ninety days prior to the Petition Date, Tyson Fresh Meats, Inc and Tyson Foods, Inc. (collectively, “Defendant”) received approximately $14 million in transfers (the “Transfers”) from the Debtors.  Postpetition, Defendant provided the Debtors with approximately $2.6 million in products, an amount which was accorded administrative status by the Court (the “Admin Claim”) but was never paid by the Debtors.

On March 25, 2015, the official committee of unsecured creditors (the “Committee”) appointed in these cases commenced the instant avoidance action seeking to avoid and recover the Transfers under Bankruptcy Code sections 547, 548, and 550, and to disallow any of Defendant’s claims until the voided Transfers were returned.  Defendant answered and asserted counterclaims and third-party claims against the Debtors. The Committee filed a FRCP 12(c) Motion for Judgment on the Pleadings with respect to Count I of the counterclaims and third-party complaint.  Oral argument among the Committee, the Debtors, and Defendant took place on February 3, 2016.

The Arguments

Defendant contended that the Committee’s claims to recover avoidable preferential transfers are post-petition causes of action and that Defendant is entitled to set off any recovery claims by the amount of its allowed postpetition Admin Claim.  Defendant argued that its Admin Claim is an extrinsic setoff claim, wholly unrelated to the concept of any new value defense or to the section 547 preference analysis generally.

In response, the Committee and the Debtors argued that Defendant’s setoff claim is really a “disguised” or “renamed” postpetition new value defense because, like a new value defense, it would have the effect of reducing the total amount of preferential transfers restored to the estate. According to the Committee and the Debtors, such a result would also violate section 502(d), which prohibits courts from allowing claims by preference defendants until after they have paid the amount for which they are liable.  The Committee and Debtors further argued that Defendant’s position is forbidden by the Third Circuit’s seminal Friedman’s Liquidating Tr. v. Roth Staffing Co. (In the Friedman’s, Inc.), 738 F.3d 547 (3d. Cir. 2013).*

*For a contemporary article by the author about the importance of the Friedman’s decision, click here

The Court’s Ruling on an Issue of First Impression

The Court began by recognizing that the question presented was one of first impression: Whether an allowed post-petition administrative expense claim can be used to set off preference liability?  The Court noted that there is no provision in the Bankruptcy Code that deals expressly with postpetition setoff.

Setoff or Disguised New Value?

The Court first found that Defendant’s setoff claim was not a “disguised subsequent new value” defense.  The Friedman’s decision makes clear that the preference calculation should be cut off at the petition date, which limits the utility or applicability of “new value” to the preference period.  Ergo, the Court found that it made no sense to refer to any claim arising outside of the preference period as a new value defense.  The Admin Claim is “comprised exclusively of post-petition activity; a section 547(c)(4) new value defense is limited to pre-petition activity.”  Judge Carey further held that Defendant’s claim fit squarely into the definition of “setoff”, as it is a “counterclaim demand which defendant holds against plaintiff, arising out of a transaction that is extrinsic of plaintiff’s cause of action.”  As such, the setoff claim does not affect the calculation of the preference, “only the amount paid to the estate.”

Analyzing the Setoff

Having found that Defendant’s claim is an assertion of setoff rights and not new value, the Court provided further analysis of the setoff claim.  Noting that “setoff is only available in bankruptcy when the opposing obligations arise on the same side of the… bankruptcy petition date,” the Court found that the Admin Claim is “clearly a post-petition obligation of Debtor” and  that a “preference claim can be asserted only after the filing of a bankruptcy petition.”  As such, setoff is permissible in this case since the opposing obligations arose postpetition.

Prohibited by Section 502(d)?

Finally, the Court addressed whether Bankruptcy Code section 502(d) – which “states broadly that “the court shall disallow any claim of any entity… that is a transferee of a transfer avoidable under… [§ 547]… unless such entity or transferee has paid the amount… for which such entity or transferee is liable” – prohibited setoff of Defendant’s Admin Claim against any preference liability.  In short, the Court found that it did not.  Observing that courts routinely recognize that “administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d)”, Judge Carey found no support in the Code for disallowing administrative claims if the administrative claimant fails to satisfy a preference liability.  In rejecting the Committee and the Debtors’ emphasis on the equality of distribution, the Court found that Judge Walrath had rejected a similar argument in In re Communication Dynamics, Inc. because “[e]quity does not mandate that one creditor lose rights it has under state law and the Bankruptcy Code simply because other creditors will benefit by that loss.”  Moreover, Friedman’s recognized that “[if] it is a rule in bankruptcy that all creditors must be treated equally, surely the exceptions swallow the rule.”

Therefore, the Motion was denied.

Conclusion

This is at least the second important 2016 preference opinion issued by Judge Carey which cuts in favor of defendants. See also Forman v. Moran Towing Corp. (In re AES Thames, LLC, et al.), summarized hereFor vendors maintaining a high level of postpetition business with a debtor, the ruling takes on added importance.

Notwithstanding, it is interesting to question how certain tweaks to the fact pattern would have affected the Court’s analysis, if at all – i.e. what if the Debtors had paid Defendant’s Admin Claim earlier in the case (which, in a sense, is indirectly addressed in this opinion)?  What if, at the time the avoidance action was brought, no order had been entered granting the administrative expense?

A copy of the Opinion can be found here.

Are Invoice Terms Alone Sufficient to Establish Contemporaneous Exchange for New Value or Ordinary Course of Business Defenses? In Cousins Fish Market, Second Circuit Offers Guidance

 Defendant offered no testimony or contractual terms in support of its section 547(c)(1) defense, nor did it provide sufficient pre-Preference Period evidence to establish a defense under section 547(c)(2).  The Second Circuit’s ruling is in the form of a summary order, so certain facts are pulled from the District Court’s opinion, available at 539 B.R. 205 and here.

Lower Court Activity

This action was initiated in October 2011.  Pertinent to this post, Defendant offered 44 invoices and checks in support of its affirmative defenses under section 547(c)(1) and (2).  To the latter, the bankruptcy court found – and the District Court affirmed – that the invoices and checks were primarily from within the Preference Period, meaning no “baseline of dealings” could reasonably be discerned.  Moreover, there was no evidence to establish when payments were due under any of the invoices or whether the Debtor typically paid them early or late, although Defendant argued that the invoice term “COD Check” implied otherwise.  The District Court noted that notwithstanding the “COD” term, it was readily apparent – even by the limited evidence offered – that the Debtor did not pay the invoices COD.  That fact, combined with the absence of any context for the timing of payments, rendered it impossible to determine what was ordinary between the parties.

As to the contemporaneous exchange for new value defense under section 547(c)(1), the bankruptcy court found that the documents alone could not show the subjective intent required.  The District Court found that the bankruptcy court’s findings in this regard were not clear error, adding that intent can be established through testimony or through surrounding circumstances, but could not be established in this case simply by the invoices and checks alone.  This amounted to mere innuendo, according to the District Court.

The Second Circuit Appeal

The Second Circuit affirmed the Lower Courts in all respects.  As to section 547(c)(1), the court found that Defendant produced no testimony or contractual terms governing the transfers, and “although reasonable inferences of intent can be drawn from the invoices and corresponding checks between the parties, we cannot say in these circumstances that the Bankruptcy Court’s finding that [Defendant] failed to prove intent was clearly erroneous.”

As to section 547(c)(2), the Second Circuit agreed with the Lower Courts, finding that although Defendant “had submitted 44 invoices, . . . 37 of these were dated within the preference period . . . and the remaining 7 were dated within the week before the preference period; and that only 2 of the checks tendered by [the Debtor] were dated before the preference period.”  This “paucity of evidence”, combined with the lack of any indication as to when payments were due during the pre-Preference Period, led the Second Circuit to affirm the Lower Courts.

Conclusion

Not discussed in this post are some of the reasons why Defendant failed to provide sufficient evidence in support of its section 547(c) defenses, which were also subject to a portion of the appeals.  Both the Second Circuit and Lower Courts suggest that had Defendant been in position to offer such evidence, the outcome here may have been different.

Nevertheless, the Second Circuit’s Summary Order is useful in delineating what is inadequate for purposes of evidence in support of a section 547(c)(1) or (2) defense: subjective intent can likely not be shown based on invoices and checks alone, nor can the terms of the invoice establish what constituted “ordinariness” between a debtor and a preference defendant – even with the introduction of 7 pre-Preference Period invoices and 2 pre-Preference Period checks as guidance.  The distinguishing factor as to the relevance of the pre-Preference Period invoices appears to be their nearness in time to the Preference Period.

A copy of the District Court and Second Circuit rulings can be found here and here, respectively.

Quarterly Newsletter, Volume I, Issue 2 – 2016

Click here to view the blog’s second Quarterly Newsletter, summarizing all posts issued from April through June in 2016.

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Does a Recent Change of Ownership Impact a Preference Defendant’s Ordinary Course of Business Defense? Judge Davis (Bankr. W.D. Tex.) Provides an Answer in In re Sterry Industries, Inc.

  According to Judge Davis in Satija v. Cen-Tex Plaster, Inc. (In re Sterry Industries, Inc.), 2016 WL 3357266 (Bankr. W.D. Tex. June 9, 2016), the answer is yes, with the pertinent comparison being made between the “new ownership” pre-preference period and the preference period.  Using this approach, the Court held that the trustee (“Trustee”) could not avoid the subject transfers to the defendant.

The Parties’ Prepetition Relationship and Defendant’s Ownership Change

Prior to the September 2013 petition date (“Petition Date”), Sterry Industries, Inc. (“Debtor”) utilized Hines/Harvey Interests, LLC dba Cen–Tex Plaster, Inc. (“Defendant”) in their pool construction business. The Debtor did so by faxing a work order to Defendant, following which Defendant fulfilled the work order and sent an invoice to Debtor.  The Debtor would then finish the pool construction and seek payment from the owner.

Until six months prior to the Petition Date, Defendant’s invoices were on “Net 30” terms, pursuant to which the Debtor would typically mail Defendant a check, but sometimes a representative from Defendant would pick up the check at the Debtor’s offices.

About six months pre-prepetition, however, Defendant was sold to a new owner, which changed the business practice between Defendant and the Debtor in two ways: (1) the invoice payment deadline changed from “Net 30” to “Due upon Receipt,” although witnesses for both parties testified that this still meant due within 30 days; (2) instead of waiting for the Debtor to mail the check, Defendant would send a representative to pick up each check at Debtor’s offices.  This pattern was consistently observed for three transfers (“Transfers”) Defendant received in the Preference Period and the three months immediately prior to the preference period (the “Prior Period”).

 The Preference Action

The Court began its analysis by comparing the preference period, the Prior Period, and the period beyond the Prior Period (the “Historical Period”):

Factor  Historical Period  Prior Period

Preference Period

Payment Range (Days) 53-112 days 1-17 days 14-22 days

In light of this, the Court found as follows:

  • payments were generally late until the Prior Period, at which time the new owner took over
  • payments during the Prior Period and the Preference Period itself were substantially the same: Defendant would pick up the check within a few weeks of the invoice date.

Interestingly, the Court found that if it looked at the entire payment history between Defendant and the Debtor (i.e. the Prior Period and the Historical Period), “without considering the ownership change, the payments at issue might look preferential because [the Debtor] began paying its invoices timely only three months before the preference period.”  The Court refused to ignore the ownership change, because “with that change came an agreed change in the business relationship between the two entities. Since this new business relationship began three months prior to the preference period, that three-month period of time is the relevant baseline to compare to the preference period.”

In addition to the fact that the parties’ practices were similar in the Preference Period and the Prior Period, the Court noted that the time period between the invoice and check dates actually increased during the Preference Period.  The Court also found that the invoice language changing from “Due upon Receipt” instead of “Net 30” did not remove the Transfers from the ordinary course of business, as the Parties understood “Due upon Receipt” to mean the same thing as “Net 30”: the Debtor had to pay the invoice within 30 days.  Lastly, the Court found that while the practice of personally picking up the check is more coercive than simply mailing an invoice and demanding a check, it was not out of the ordinary in the context of their relationship under a subjective analysis and possibly under an objective analysis as well – the latter because there was testimony that other vendors picked up checks from time to time as well.

Thus, the Court found that the Transfers were within the ordinary course of business between the Debtor and Defendant, and thus protected from avoidance.

Conclusion

This case provides a unique look at a preference defendant’s ordinary course of business defense and the ramifications of an internal ownership shift.  In the Western District of Texas, at least, the baseline of dealings established in the pre-preference period/new ownership timeframe can override or take precedence over a course of business evidenced by older business dealings.  It is interesting to consider how the analysis would change if the Preference Period dealings in Sterry had been consistent with the older business dealings (i.e. before the Prior Period), but inconsistent with the Prior Period.

The opinion is also important for its suggestion that payments coming later in the preference period are less indicative of preferential status than the contrary.  The Court also recognized that certain practices that may appear coercive in normal circumstances (such as personally collecting an invoice payment or changing terms to “Due upon receipt”) may not be in the particular context of the parties’ course of dealings.

A copy of the Sterry Opinion can be found here.

Seventh Circuit Reverses Bankruptcy and District Courts in Delineating the Ordinary Course of Business’s Baseline of Dealings Requirement  in In re Sparrer Sausage Co.

  The case, Committee v. Jason’s Foods, Inc. (In re Sparrer Sausage Co.), 2016 WL 3213096 (7th Cir. June 10, 2016), found that the Bankruptcy Court’s application of the defense arbitrarily used a narrower range of payments as a historical “baseline of dealings” than was warranted.  The Seventh Circuit found that under the Bankruptcy Court’s application, only 64% of the invoices that the Debtor paid would be captured; by contrast, the Seventh Circuit ruled that a minimal expansion of this range would have captured 88% of the invoices that the Debtor paid during the Historical Period – a figure that the Seventh Circuit found to be much more in line with case law on the subject.  Using this revised range, and taking into account Defendant’s subsequent new value defense, Defendant’s preference exposure was entirely offset.

The Parties’ Prepetition Relationship

For more than two years prior to February 7, 2012 (the “Petition Date”), Jason’s Foods (“Defendant”) had supplied unprocessed meat products to Chapter 11 debtor Sparrer Sausage Company (“Debtor”), a sausage manufacturing company.  During the ninety (90) days prior to the Petition Date (the “Preference Period”), the Debtor had paid 23 invoices from Defendant, totaling $586,658.10 (the “Transfers”).

In September 2013, the Unsecured Creditors Committee (“Plaintiff”) filed a complaint (“Complaint”) to recover the Transfers.  Defendant raised defenses to the Complaint under sections 547(c)(2) (ordinary course of business) and (c)(4) (subsequent new value).

Bankruptcy and District Court Decisions

The Bankruptcy Court first considered the ordinary course of business defense, making the following comparison between the Parties’ practices during the Historical and Preference Periods:

Factor Historical Period

Preference Period

Payment Range (Timing) “generally” 16 to 28 days 14 to 38 days
Average Invoice Age 22 days 27 days

The Bankruptcy Court found that only 12 of the 23 invoices that the Debtor paid during the Preference Period fell within the 16 to 28 day range the court found to be the baseline of dealings in the Historical Period.

As to new value, the Bankruptcy Court fund that the Debtor had not paid for $63,514.91 worth of product during the Preference Period, which acted as an offset against any preference liability.  As such, the Bankruptcy Court ruled in favor of Plaintiff in the amount of $242,595.32.  The District Court affirmed on appeal.

The Seventh Circuit Appeal

On appeal to the Seventh Circuit, Defendant argued that the Bankruptcy Court (i) improperly used an abbreviated Historical Period rather than the companies’ entire payment history and (ii) that the “baseline of dealings” comprised a too-narrow range of days surrounding the average invoice age during the historical period.

(i) The Historical Period

The Seventh Circuit noted that in establishing the Historical Period, “some cases may require truncating the historical period before the start of the preference period if the debtor’s financial difficulties have already substantially altered its dealings with the creditors… [and] in other cases it will be necessary to consider the entire pre-preference period… but in all cases the contours of the historical period should be grounded in the companies’ payment history rather than dictated by a fixed or arbitrary cutoff date.”

In the instant case, the parties stipulated to a Historical Period spanning February 2, 2010 to November 7, 2011, which encompassed all 235 invoices that the Debtor paid pre-Preference Period; the stipulated history reveals a payment range (timing) of 8 to 49 days, with an average days to pay of 25 days.  The Bankruptcy Court apparently disregarded the Parties’ stipulation, changing the payment range (timing) to 8 to 38 days, and an average days to pay of 22 days.  The Seventh Circuit, however, rejected Defendant’s contention that the Bankruptcy Court’s truncation was clearly erroneous, as the seven-month period immediately pre-Preference Period “did not accurately reflect the norm when [the Debtor] was financially healthy,” by evidence of a steady increase in days to pay during that time.  Thus, notwithstanding the lack of other indicia of the Debtor’s financial distress, it was not clear error for the Bankruptcy Court to find said distress began seven months pre-Preference Period.

(ii) The Baseline of Dealings

As to the baseline of dealings during the (truncated) Historical Period, the Bankruptcy Court had taken the average invoice age during that time and added six days on either side of that average, resulting in a range of 16 to 28 days.  Defendant argued that the total range of invoices was more appropriate, or 8 to 38 days.

The Seventh Circuit noted that “[b]ankruptcy courts typically calculate the baseline payment practice between a creditor and debtor in one of two ways: the average-lateness method or the total-range method. The average-lateness method uses the average invoice age during the historical period to determine which payments are ordinary, while the total-range method uses the minimum and maximum invoice ages during the historical period to define an acceptable range of payments.”  After citing to a Southern District of New York decision which utilizes the average lateness method (In re Quebecor World (USA), Inc.) and a District of Delaware opinion which utilizes the total-range method (In re Am. Home Mort. Holdings, Inc.), the Seventh Circuit found no need to disturb the Bankruptcy Court’s decision to use the former method.

Notwithstanding, the Seventh Circuit found the Bankruptcy Court’s application of the average-lateness method to be more problematic.  First, the Seventh Circuit was skeptical that the 5-day difference in days to pay between the Historical and Preference Periods is material, citing to, inter alia, In re Archway Cookies, 435 B.R. 234 (Bankr. D. Del. 2010) for support, but was ultimately deferential to the Bankruptcy Court’s contextual finding.

Even so, the Seventh Circuit found clear error in the Bankruptcy Court’s decision to deem invoices paid more than 6 days on either side of the 22-day average outside the ordinary course. The problem lay in the Bankruptcy Court’s application of Quebecor World – in that case, the bankruptcy court identified a range that captured the debtors’ payment of 88% of its invoices during the historical period, then added 5 days as the outer limit of “ordinariness”.  By contrast, the Bankruptcy Court’s baseline range captured just 64% of the invoices that the Debtor paid during the Historical Period, when adding just 2 days to either end of the range would have brought the percentage much more in line with Quebecor World.  The Seventh Circuit was further concerned by the lack of explanation for the Bankruptcy Court’s “arbitrary” narrowness.

Establishing a revised baseline of 14-to-30-days, the Seventh Circuit found all but two invoices were paid within or just outside the range.  The two invoices excluded were paid 37 and 38 days after they were issued, “substantially outside the 14-to-30-day baseline.”  Thus, the Seventh Circuit limited the liability to those two payments.

(iii) New Value

The Seventh Circuit lastly applied Defendant’s new value defense under section 547(c)(4).  Unlike some jurisdictions, in the Seventh Circuit, creditors are given credit for extending new value to the debtor without receiving payment, as the creditor “has effectively replenished the bankruptcy estate in the same way that returning a preferential transfer would.”  In this case, all of Defendant’s remaining exposure (i.e. after application of the ordinary course of business analysis) was offset by the value of products supplied to the Debtors.

Thus, the Court reversed and remanded the Lower Courts’ judgments.

Conclusion

For jurisdictions or courts following the average-lateness approach, this opinion is instructive as to where an appropriate percentage should fall for purposes of establishing a baseline of dealings.  Even with the subjectivity of the ordinary course defense, any concrete figure like this can be helpful in preparing a 547(c)(2) analysis.

This opinion also serves as a reminder that in the Seventh Circuit, the standard remains that subsequent new value must remain unpaid as of the petition date; in other jurisdictions, including Delaware, new value need not remain unpaid to utilize section 547(c)(4).

A copy of the Sparrer Sausage Opinion can be found here.

Third Circuit Addresses Issue of First Impression in Finding the Payee Irrelevant for Purposes of Applying Section 547(c)(9)’s Aggregate Value Threshold in In re Net Pay Solutions, Inc.

  The Court rejected the Trustee’s argument as one that would render 11 U.S.C. § 547(c)(9) superfluous and ineffective.  The Court also rejected the Trustee’s argument with respect to the one remaining transfer that surpassed the Bankruptcy Code’s $5,850 preference action threshold*, finding the payment qualified as a “trust fund tax” that was not an interest of the debtor in property.  In the context of the latter ruling, the Court provides a detailed analysis of the Supreme Court’s Begier v. Commissioner, 496 U.S. 53 (1990) decision.

*since the time the adversary proceeding was initiated, the threshold has been increased to $6,225

The Bankruptcy and District Court Cases

Debtor’s business involved managing its clients’ (the “Clients”) payrolls and employment taxes. The arrangement authorized Debtor to transfer funds from Client bank accounts into Debtor’s account and to remit those funds to the Clients’ employees, the IRS, and other taxing authorities.  At issue in this case were five transfers (the “Transfers”) Debtor made to the IRS on behalf of the Clients in the ninety days leading up to August 2, 2011 (the “Petition Date”) – four of which were less than the $5,850 preference action threshold established by 11 U.S.C. § 547(c)(9).  The fifth transfer was for $32,297 (the “Remaining Transfer”).

The Trustee sought to avoid the Transfers on the basis that, in the aggregate, the Transfers exceeded $5,850, and thus, the threshold was not a barrier.  The District Court for the Middle District of Pennsylvania (“District Court”) disagreed, granting summary judgment to the IRS and finding the Transfers could only be aggregated if they are “transactionally related” to the same debt; in this case, the District Court found that the four sub-$5,850 Transfers were separate and unrelated transactions in satisfaction of independent antecedent debts to different creditors.  The Remaining Transfer was found to fall outside the bounds of “property of the estate”, as it was protected by the Internal Revenue Code (“IRC”) provision which creates a statutory trust in favor of the United States for taxes withheld from employee paychecks.  Trustee appealed.

The Trustee’s Arguments on Appeal

On appeal, the Trustee argued that the Bankruptcy Code allows the aggregation of transfers that individually fall below the threshold, as long as they were all to the same transferee, citing 11 U.S.C. § 102(7) for the concept that “the singular includes the plural” in interpreting 11 U.S.C. § 547(c)(9).  The Trustee further argued that section 547(c)(9) is internally contradictory, because the term “aggregate” implies a summation of various transfers, while the language “such transfer” implies the defense should be applied on a payment by payment basis.

As to the Remaining Transfer, the Trustee contended that Debtor was an intermediary that withheld and paid taxes on behalf of the Client, and that the “obvious meaning of the statute is that in order for a trust to be created, a person who is required to collect the tax must actually withhold the tax.”  Trustee argues that because the Clients, not Debtor itself, were required to withhold the taxes at issue, those withholdings escape the statute’s limitations.

The Third Circuit’s Opinion

The Threshold Dispute

The Court first noted that it had not yet had the opportunity to examine section 547(c)(9), which states that a “trustee may not avoid … a transfer … if, in a case filed by a debtor whose debts are not primarily consumer debts, the aggregate value of all property that constitutes or is affected by such transfer is less than $5,850*.”

*see note above regarding the revised threshold amount

As applied to the four sub-threshold Transfers, the Court found that Trustee’s argument made little sense.  It held that by Trustee’s logic, an individual creditor’s ability to invoke the minimum threshold as a defense “would depend not only upon whether the transfer from which it benefitted was less than $5,850, but also on whether the debtor had made any transfers (large or small) for the benefit of other creditors, and whether all transfers taken together exceed the statutory threshold . . . this cannot be the law.”  The Court found that the language of section 547(c)(9) requires a transfer by transfer analysis and that creditors be considered independently, meaning creditors who have received the benefit of a prepetition transfer less than the threshold may invoke the defense regardless of what other creditors have received.  The Court noted that “ostensibly distinct transfers may nevertheless be aggregated if they are, in effect, a single transfer on account of the same debt.”

As to Trustee’s reliance on the “singular includes the plural” maxim, the Court found that it “simply means that (1) a creditor may invoke the defense for multiple, independently qualifying transfers (i.e., it’s not a “one-and-done” defense) and (2) a party may defeat the defense where the challenged transfers are strategically divided yet transactionally related.”  Since each sub-threshold Transfer involved a different Client, unrelated antecedent debts, and distinct tax liabilities, they could not be aggregated to exceed the threshold.

The Property of the Estate Dispute

The Court next addressed whether the Remaining Transfer involved the transfer of an interest of the debtor in property, as required by 11 U.S.C. § 547(b).  It began this analysis by a thorough review of the Begier decision, which established the benchmark for trust fund taxes.  Importantly, that decision found that the trust was created at the moment the relevant taxes were withheld, and that “[w]ithholding … occurs at the time of payment to the employee of his net wages.”  Furthermore, no common law tracing was required in these trust fund cases, as the applicable IRC provision “creates a trust in an abstract ‘amount’—a dollar figure not tied to any particular assets—rather than in the actual dollars withheld.”  Ergo, “any voluntary prepetition payment of trust-fund taxes out of the debtor’s assets is not a transfer of the debtor’s property” and “the debtor’s act of voluntarily paying its trust-fund tax obligation … is alone sufficient to establish the required nexus between the ‘amount’ held in trust and the funds paid.”

Applying Begier to the instant case, the Court found that the fact that Debtor was an intermediary that withheld and paid taxes on behalf of the clients – the sole relevant distinction here from the facts of Begier – was irrelevant.  To the contrary, the applicable IRC provision “does not say that clients themselves must be the only ones involved in the withholding process in order for trust principles to be implicated.”  Nothing “suggests that an employer may avoid the fact that an amount required by law is being held in trust for the United States merely by outsourcing payroll processing to a third party.”  The Court conceded that Trustee cited one non-jurisdictional bankruptcy court decision that directly supported his argument, but found that opinion to be “devoid of analysis”, a defect that was not corrected by a subsequent opinion from the pertinent Court of Appeals.

The Court adds, in an interesting footnote, that even without the preemption of federal law in this case, Pennsylvania law (which governed Debtor’s agreements with the Clients) would mandate that the Transfers be held in a resulting trust, as the IRS produced ample evidence to show that there was no intention by the Clients to give Debtor the beneficial interest in the Transfers.

Thus, the Court affirmed the District Court’s judgment in all respects.

Conclusion

Aside from this being a matter of first impression in the Third Circuit with respect to aggregation dispute, the Court provides a detailed breakdown of the Begier decision and its continued vitality in tax-related preference issues.  Given the involvement of the IRC, the ultimate utility of this decision (as to its trust component) in other contexts remains to be seen.

A copy of the Net Pay Opinion can be found here.