Delaware Bankruptcy Judge Addresses Issue of First Impression Regarding Section 547(b)(5): Must a Preference Defendant Be Secured on the Transfer Date or the Petition Date?

By Evan T. Miller, Esq.

In Stanziale v. Sprint Corp. (In re Simplexity, LLC), 578 B.R. 255 (Bankr. D. Del. 2017), Delaware Bankruptcy Judge Kevin Gross addressed an issue of first impression: which was the proper date for determining the secured status of a creditor in a preference dispute under 11 U.S.C. § 547(b)(5), the petition date or the transfer date?  Ultimately, Judge Gross decided that the petition date was most proper, at least with respect to creditors secured by a purchase money security interest (“PMSI”).  Nevertheless, this aspect of the analysis under section 547(b)(5) remains highly fact-specific.

Background

The Debtors, formerly independent online activators of mobile phones, filed for bankruptcy protection under Chapter 11 on March 16, 2014.  Prior to that time, the Debtors and Defendant were parties to an agreement that let the Debtors solicit and subscribe customers to Defendant; to that end, the Debtors could either purchase products from Defendant and resell them to customers, or sell products directly from Defendant’s inventory.  Defendant received a PMSI in products the Debtors purchased on credit and proceeds from the sale of such products.  Following conversion to Chapter 7, the Chapter 7 Trustee (the “Trustee”) initiated the instant adversary proceeding to recover these payments to Defendant; the parties’ motions for summary judgment ultimately followed, raising section 547(b)(5) and subsequent new value arguments.

Must a preference defendant be secured on the transfer date or the petition date for section 547(b)(5) purposes?

In light of the PMSI, Defendant argued that the Trustee could not satisfy his burden under section 547(b)(5)’s hypothetical liquidation test.  The Trustee first countered that the burden was not on him to do so in this instance; rather, Defendant had to prove it was truly secured given its reliance upon state law.  The Court rejected this reasoning based upon the plain language of section 547(g) (placing the burden on the Trustee to establish the elements under section 547(b)).

The Court next addressed the issue of first impression referenced above and incidentally, one that had created a split among courts which had considered it—is secured status assessed at the time of the transfer or the petition date?  Defendant argued that it was entirely secured, notwithstanding that the Debtors kept their funds in commingled accounts which were swept only a few days prepetition.  Further, Defendant argued that a Supreme Court decision which had determined the petition date to be the proper date of reference (Palmer Clay Products Co. v. Brown, 297 U.S. 227 (1936)) was misplaced in the context of a secured creditor, as that case had been dealing with an unsecured creditor.  Thus, with that in mind and in reliance upon a decision by Delaware Bankruptcy Judge Peter Walsh (Forman v. IPFS Corp. of the South (In re Alabama Aircraft Indus.), 2013 WL 6332688 (Bankr. D. Del. Dec. 5, 2013) (holding the transfer date to be the proper one for assessing preference liability of a creditor pursuant to an insurance premium financing agreement), Defendant argued that the transfer date controlled.

The Court disagreed, finding the fact-specific distinctions in Defendant’s “transfer date” cases and the instant case to be determinative; i.e., the Court distinguished between a PMSI case and cases dealing with premium financing arrangements or cases with liens of diminishing value.  This was so because a PMSI is a decidedly limited and better defined interest compared to a floating lien; moreover, the collateral at issue here (headsets and proceeds from selling the same) was unlikely to undergo stark changes in valuation.  Thus, while the Court envisioned a factual scenario that may warrant deviating from the petition date analysis, the instant case did not contain such facts.  The PMSI vs. floating lien distinction likewise underpinned the Court’s holding on the propriety of the Trustee’s tracing method—i.e., the “add-back” method, used for determining a defendant’s position on the petition date in a hypothetical liquidation.

Does an earlier-than-usual payment by a preference defendant to a debtor constitute subsequent new value?

The Court also ruled upon part of Defendant’s subsequent new value argument under section 547(c)(4).  Specifically, Defendant argued that a payment it made to the Debtors two days before the petition date qualified as subsequent new value, as it was commission money not yet owed to the Debtors under any of their agreements; ergo, it augmented the estate.  The Trustee opposed this defense on the grounds that it was a seemingly random payment made in Defendant’s capacity as a debtor, not a creditor, and that in any event, Defendant merely substituted one asset of the Debtor for another (i.e. an A/R for cash).  To the latter point, Defendant argued that the Trustee ignored the fact that Defendant would never have paid the A/R due to Defendant’s rights under various agreements and section 553 (setoff).

The Court agreed with Defendant, finding the issue centered around determining the purposes of Defendant’s payment.  To that end, Judge Gross found that the underlying agreements and the parties’ course of dealing demonstrated that Defendant’s commission payments to the Debtors were due at the end of the month, whereas the instant payment was made mid-month; as such, Defendant was not yet a debtor, nor were the Debtors creditors of Defendant.

Furthermore, the Court found that Defendant did not merely substitute Debtor’s A/R for cash.  For one thing, the commission payment was an (out of the ordinary) advance, not a regularly scheduled payment.  For another, the A/R would have been uncollectable for the reasons argued by Defendant.  At bottom, Judge Gross found Defendant’s commission payment personified section 547(c)(4)—a “beacon of light in a dark time” that decisively enhanced the Debtors’ estate.

Conclusion

The Court’s opinion in Simplexity sheds light on how the analysis under section 547(b)(5) changes where a creditor is secured.  Particularly, the Court makes clear that the type of security interest at play will likely impact the Court’s analysis.  In that sense, the Court seemingly harmonized its opinion here with earlier, seemingly conflicting decisions, including those from the same jurisdiction.  Perhaps the greater point, however, is that these analyses will remain highly contextual determinations.

The opinion also provides support for interesting subsequent new value arguments, and incidentally, strategic considerations for defendants dealing bilaterally (i.e., relationships where the defendant may be acting as both a creditor and a debtor at times) with companies on the verge of bankruptcy.  Specifically, making a payment earlier than contractually obligated can inure to Defendant’s benefit, as the advance potentially prevents the creation of an A/R—and concurrently may prevent the bankrupt company becoming a creditor of the defendant.  This argument becomes stronger if the defendant likewise maintains setoff rights, as Defendant did here.

A copy of the Opinion can be found here..

Defining Ordinary: Judge Walrath (Bankr. D. Del.) Surveys Ordinary Course of Business Methodologies in In re Powerwave Technologies

  Thankfully, Judge Walrath recently issued a very helpful opinion, Stanziale v. Superior Technical Resources, Inc. (In re Powerwave Technologies, Inc.), Adv. No. 15-50085 (MFW) (Bankr. D. Del. Apr. 13, 2017), which touches upon all of those issues.  While the decision’s ultimate utility may be limited by the fact that the judge was merely addressing a summary judgment motion (the “Motion”) and found factual disputes precluded a decision on the merits, the opinion should still prove useful.

Background

The Powerwave cases began in January 2013 and the instant adversary proceeding was initiated approximately two years later.  Defendant in the adversary proceeding provided workforce solutions to the Debtors pursuant to an agreement, and during the Preference Period, received approximately $383,336.55 in transfers (the “Transfers”).  During the Preference Period, Defendant sent the Debtors correspondences about the Debtors’ aging accounts and ultimately changed payment terms from net 45 to net 7.  Defendant further demanded payment in full during this time.

The Parties’ Positions

            While Defendant did not contest that the predicate elements of the Transfers had been met, it argued the defenses under 11 U.S.C. §§ 547(c)(2) and (4) abrogated or eliminated its exposure.  It based these defenses on several assertions:

  • All of the Transfers were protected from avoidance by the subjective and objective OCOB defenses
    • For 547(c)(2)(A) purposes, Defendant argued in favor of using the “Range” and “Batch” Methods
  • Any portion not protected by OCOB were subject to reduction by applying the subsequent new value defense under 547(c)(4)

Plaintiff-Trustee disagreed, of course, and argued instead:

  • Defendant’s method for determining which Transfers were OCOB created factual disputes
    • Specifically, Plaintiff-Trustee argued Defendant used a Historical Period (“Historical Period”) that was almost 50% narrower than the one espoused by the Plaintiff-Trustee
    • Moreover, Plaintiff-Trustee argued the “Range” and “Batch” Methods for determining ordinariness are inappropriate, favoring instead the “Days Sales Outstanding” (“DSO”), “Inter-quartile”, and “Standard Deviation” methods.
  • Defendant engaged in unusual collection activity during the preference period
  • Subsequent new value defense cannot be decided before the Court determines OCOB applicability

The Court’s Decision

In denying Defendant’s Motion, the Court addressed each of the foregoing arguments and counterarguments in turn, but in sum, Judge Walrath found too many facts in dispute to render a decision at the summary judgment stage.  Nevertheless, her opinion is instructive.

The Proper Historical Period

The Court noted the Parties’ dispute over the proper Historical Period – specifically, whether Defendant’s proposed Historical Period captured enough of its history with the Debtors.  Noting that that “the Historical Period should encompass the time period when the debtor was financially healthy,” the Court found that Defendant did “not include a sustained period when the Debtor was financially sound.”  As such, a factual dispute existed.

Subjective OCOB Methodologies

Judge Walrath addressed the following five OCOB methodologies, although the lack of agreement on the Historical Period prevented her from applying any of them at this time:

  • Range
    • The Court noted that without the proper historical baseline, the Range method (in which a defendant asserts that if a given preferential transfer fell within the days to pay range seen in the Historical Period, it should be excluded from avoidance) could inappropriately include outlier payments that do not accurately reflect the Parties’ OCOB. The judge noted that simply citing to other cases that use the range method isn’t sufficient, and Defendant’s citations were factually much narrower in any event (comparing the 34-371 historical range here to other cases with ranges of 7-67 days, 35-73 days, 0-33 days, 65-168 days, 0-31 days, 28-76 days).
  • Batch
    • The Court found the Batch method (which derives a standard deviation range by taking the average age of invoices paid in each batch) likewise inappropriate, as the number of invoices paid per batch ranged from 1-133, with higher amounts paid during the Preference Period than in the Historical Period.
  • DSO
    • The DSO Method involves multiplying the total amount of an invoice by the number of days that it took to be paid. That number is then divided by the total amount of the invoices in that batch.  Defendant argued that even if the DSO method results in the 23-day spread between the historical and preference periods alleged by Plaintiff-Trustee, 23 days is not out of the ordinary between the Parties.  Again, the absence of a proper Historical Period foreclosed this method’s application.
  • Inter-quartile
    • The Plaintiff-Trustee’s proposed Inter-quartile range found that 50% of invoices were paid within a 15-day spread, with anything falling outside of that range allegedly not OCOB. Defendant objected that the Inter-quartile method has no precedent in Delaware, but the Court dismissed “lack of acceptance” of a given method as a means for precluding its use.  Judge Walrath noted that “courts may consider a variety of mathematical formulas when deciding the consistency among payments.”
  • Standard Deviation
    • The Plaintiff-Trustee’s Standard Deviation analysis resulted in a range of approximately 75 days (roughly 37 days on either side of the Historical Period average). Defendant did not address the argument, and as with the other methodologies, factual issues precluded application at this time.

As to Plaintiff-Trustee’s assertion that Defendant’s Preference Period collection activity (i.e. calling/emailing about late payments, change of payment terms, etc.) was unusual, the Court found there was a factual dispute as to whether such behavior was in fact normal between the Parties.

Objective OCOB Approaches

Defendant also asserted a defense under section 547(c)(2)(B), arguing it was classified as an employment agency in the administrative and waste management services industry; Plaintiff-Trustee countered that its classification was unclear, and thus the proper “industry” for 547(c)(2)(B) purposes was in dispute.  The Court found that while “a creditor has “considerable latitude in defining what the relevant industry is” and “expert testimony is not required”, a “sufficiently detailed basis is needed to establish the relevant industry.”  Given the classification dispute, the Court found summary judgment inappropriate.

The Sequencing of 547(c) Defenses

Lastly, Defendant argued that its subsequent new value defense under 547(c)(4) eliminated any remaining exposure it may still have from the Transfers.  Plaintiff-Trustee argued, however, that analysis under 547(c)(4) is premature until the 547(c)(2) OCOB review is confirmed.  The Court sided with Plaintiff-Trustee, finding Defendant’s

new value calculations were based on the remaining Transfers being “otherwise unavoidable” according to its calculations under the ordinary course of business defense. However, the Court has found that there are disputes as to material facts regarding the ordinary course of business defense. Therefore, the Court must deny the Defendant’s Motion for Summary Judgment as to the new value defense until the ordinary course of business defense is determined.

In sum, the Motion was denied.

Conclusion

Even without any application of the various OCOB methodologies discussed above, this opinion provides preference practitioners (on either side) with a section 547(c)(2) road map.  Moreover, the decision reaffirms that a viable “Historical Period” should capture an ample ‘healthy period’ of a debtor’s history, though what constitutes “healthy”, of course, should remain subject to intense dispute.  In addition, the Court advises – on these facts, at least – that subsequent new value should not be applied before resolution of what constitutes OCOB.

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.

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.

Revised on Remand: Judge Walrath Reduces Defendant’s New Value Defense and Awards the Trustee Prejudgment Interest in Remanded Proceeding

  The matter was remanded from the United States District Court for the District of Delaware (the “District Court”) on appeal of the Court’s July 17, 2013 Order (the “Order”) granting judgment in favor of the Trustee’s Complaint to avoid and recover preferential transfers against Prudential.

On November 25, 2008, AE Liquidation, Inc., EIRB Liquidation, Inc., and Eclipse Aviation Corporation filed for voluntary relief under chapter 11 of the Bankruptcy Code.  On March 5, 2009, the case was converted to chapter 7 and the Trustee was appointed.  On November 23, 2010, the Trustee filed a Complaint against Prudential asserting that certain pre-petition transfers were preferential and avoidable under § 547(b) of the Bankruptcy Code.  On July 17, 2013, the Court entered the Order finding: (i) $781,702.61 of pre-petition transfers to Prudential were preferential; (ii) Prudential had a new value defense totaling $128,379.40; and (iii) the Trustee was not entitled to prejudgment interest.  On appeal, the District Court remanded the matter for the Court to reconsider: (i) the amount of Prudential’s new value defense; and (ii) whether the Trustee was entitled to prejudgment interest.*

*A blog post on this earlier opinion was published on December 1, 2015, available here.

 The Trustee argued that $71,808.83 of the new value defense was not eligible for new value credit because it related to post-petition services.  Prudential responded that the post-petition invoices were prepared solely to support its proof of claim and did not reflect the actual date the underlying services were performed.  Prudential also claimed the Trustee waived the argument by failing to raise it until post-trial briefing.  The Court found that the testimony of Prudential’s Director of Accounting was contrary to Prudential’s assertions and that the District Court already rejected Prudential’s waiver argument.  Accordingly, the Court reduced Prudential’s new value defense to $56,571.37, to reflect only services provided pre-petition.

With regard to prejudgment interest, the Trustee argued that the estate should be able to recover prejudgment interest beginning on the date the last preferential transfer was made.  Prudential contended that the Court reasonably exercised its discretion in denying prejudgment interest in the Order.  In granting prejudgment interest, the Court relied on the decision in Peltz v. Worldnet Corp. (In re USN Communications., Inc.), 280 B.R. 573, 602 (Bankr. D. Del. 2002), for the proposition that prejudgment interest is routinely granted in avoidance actions.  The Court disagreed, however, with the amount of prejudgment interest sought by the Trustee.  Relying again on USN Communications, the Court held that the prejudgment interest should be calculated from the date the action was commenced, not the date of the last avoidable transfer; further, the Court found that the appropriate rate for prejudgment interest is the federal judgment interest rate, for the calendar week preceding the filing date of the Complaint.  Therefore, the Court awarded the Trustee $5,186.97 in prejudgment interest.

A copy of the Court’s opinion is available here.

Chief Judge Stark (D. Del.) Issues a Pair of Opinions Addressing New Value, Ordinary Course of Business, and Earmarking Defenses (Part II)

  The pertinent facts of that case are as follows: in May 2006, the Debtor engaged the defendant/appellant, Prudential Real Estate and Relocation Services, Inc. and Prudential Relocation, Inc. (“Prudential”), to perform various relocation services for the Debtor’s employees.  The agreement contemplated that the Debtor would pay Prudential for services within 30 days of receiving an invoice.  While the Debtor was timely with its payment of invoices during the first year and a half of the parties’ agreement, the Debtor began to fall behind.  As a result, Prudential placed the Debtor on “billing review,” which implemented the following conditions: (1) Prudential would not accept new employee transfers, (2) the Debtor would begin paying Prudential on a weekly, instead of monthly, basis, (3) the Debtor would pay a $900,000 lump sum to reduce the outstanding accounts receivable balance, and (4) Prudential would eventually terminate the agreement if the conditions were not satisfied.  By January 18, 2008, the Debtor had complied with these terms and Prudential removed the Debtor from the payment plan.

In August 2008, Prudential learned that the Debtor had terminated 650 of its employees in light of financial difficulties.  That same month, Prudential again placed the Debtor on billing review due to late payments.  This second payment plan implemented the same conditions as the first plan, except for varying payment amounts.  On November 25, 2008, the Debtor filed for chapter 7 bankruptcy relief in the United States Bankruptcy Court for the District of Delaware.

In the 90 days prior to the petition date, the Debtor had made 12 payments to Prudential totaling $781,702.61, which the Trustee sought to recover as preferential transfers under 11 U.S.C. §§ 547 and 550.  Following trial, the Bankruptcy Court awarded judgment in favor of the Trustee for $653,323.20, which represented $781,702.61 of preferential transfers, reduced by $128,379.40 of “new value” that Prudential had provided under 11 U.S.C. § 547(c)(4).  Both parties filed timely appeals to the District Court.

Prudential argued on appeal that the transfers were not preferential because they occurred in the “ordinary course of business” as defined by 11 U.S.C. § 547(c)(2).  The Trustee cross-appealed, alleging that Prudential’s “new value” defense impermissibly included amounts provided after the petition date, plus the Bankruptcy Court failed to provide prejudgment interest to his judgment.

The District Court first addressed the ordinary course of business defense under 11 U.S.C. § 547(c)(2).  This defense provides that: “The trustee may not avoid under this section a transfer— (2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was— (A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms”.  Chief Judge Stark noted that courts have considered the following factors to assess if a transfer occurs in the ordinary course of business: (1) the length of time the parties engaged in the type of dealing at issue; (2) whether the subject transfers were in an amount more than usually paid; (3) whether the payments at issue were tendered in a manner different from previous payments; (4) whether there appears to be an unusual action by the debtor or creditor to collect on or pay the debt; and (5) whether the creditor did anything to gain an advantage (such as gain additional security) in light of the debtor’s deteriorating financial condition.

Prudential argued that the Bankruptcy Court erred by finding that the Debtor’s faster payments during the preference period (during which the average payment time dipped from 45.3 days historically to 28 days) meant that they were not in the ordinary course of business.  Citing In re Archway Cookies, 435 B.R. 234 (Bankr. D. Del. 2010), Chief Judge Stark found that the proper inquiry is whether the change in payment timing was significant, regardless of whether it was faster or slower, as “small deviations in the timing of payments may not be so significant as to defeat the ordinariness of such payments[,] [whereas] courts have held greater deviations . . . sufficiently significant to defeat the ordinariness of such payments.”  In this case, the District Court found that the Bankruptcy Court’s ruling that a 40% increase in payment timing was significant – especially when paired with the fact that Prudential insisted on the quicker payment schedule – was not clearly erroneous.

The District Court went on to reject Prudential’s arguments, based on In re Global Tissue L.L.C., 106 F. App’x 99 (3d Cir. 2004) and In re AE Liquidation, Inc., 2013 WL 5488476 (Bankr. D. Del. Oct. 2, 2013) respectively, that (i) 6 “extremely late” invoices out of 3,500 may have improperly skewed the average payment time and (ii) that the Bankruptcy Court was inconsistent in finding a 40% increase in payment time was significant whereas a 10-15% increase in payment  time (as found in the earlier, unrelated AE Liquidation case) was not.  To the former, the District Court found that the late payment pattern in Global Tissue was established consistently over two months, while in this case, it was comparatively minimal.  As to the earlier AE Liquidation case, Chief Judge Stark saw nothing inconsistent with finding a 40% deviation significant and 10-15% insignificant, given the subjective nature of these types of cases.

The District Court next found that Prudential had knowledge of the Debtor’s financially deteriorating condition and subsequently used this knowledge to extract better repayment terms.  Chief Judge Stark rejected the relevance of the parties’ past payment plans, a holding which he found to be congruent with In re Hechinger Inv. Co. of Delaware, Inc., 489 F.3d 568 (3d Cir. 2007).  He found that the payment plans were a deviation from the “baseline” relationship the parties had established; i.e., once the conditions that precipitated the payment plan went away, the parties returned to their baseline relationship.  Thus, they were not representative of the parties’ normal, ordinary arrangement.

Chief Judge Stark then turned to the Trustee’s appeal, specifically whether an improper amount of new value was allocated to Prudential.  For this position, the Trustee argued that approximately $71,000 of Prudential’s $128,000 new value was provided after the petition date, which violates the precedent issued by the Third Circuit in In re Friedman’s Inc., 738 F.3d 547 (3d. Cir. 2013); see also Evan T. Miller, “The Third Circuit Draws a Line in the Sand on New Value in Friedman’s,” ABI Unsecured Trade Creditors Committee Newsletter, Vol. 12, No. 1, April 2014.  Since the Bankruptcy Court did not distinguish between prepetition and postpetition payments for new value purposes, the District remanded the matter for a determination of the same.

The District Court likewise remanded the Trustee’s prejudgment interest claim to the Bankruptcy Court, so that the lower court could – as consistent with the Hechinger opinion – explain its reasoning for denying an award of prejudgment interest.

Copies of both opinions can be found here.  Stay tuned to Avoidance Action Update for any further developments in these cases.

Chief Judge Stark (D. Del.) Issues a Pair of Opinions Addressing New Value, Ordinary Course of Business, and Earmarking Defenses (Part I)

  The opinions, both penned by Chief Judge Leonard P. Stark, make clear that the arrangement of a “payment plan” between the debtors and defendant may not necessarily render transactions made pursuant thereto “ordinary” for purposes of § 547(c)(2); furthermore, they confirm that the “earmarking doctrine” will be strictly construed.  In both cases, the District Court held for the appellee/plaintiff on the substantive issues of the appeals.

“Earmarking” Strictly Construed

The earlier of the two opinions, Masiz v. Burtch (In re Vaso Active Pharmaceuticals, Inc.), 537 B.R. 182 (D. Del. 2015), involved an adversary proceeding brought by a plan-appointed trustee to recover $776,363 from the defendant, John Masiz (“Masiz”).  Masiz founded the Debtor approximately nine years prior.  Following a 2004 lawsuit by the Securities and Exchange Commission in connection with an initial public offering of the Debtor’s equity, Masiz agreed to resign as CEO and board member of the Debtor, but remained as a “strategic consultant”.  In 2006, the Debtor, as represented by Kelley Drye & Warren, LLP (“KDW”) filed a malpractice lawsuit against Robinson & Cole, LLP (“R&C”), the firm that had provided legal representation in connection with the IPO.  Concurrently, the Debtor arranged for Masiz to begin working on an unpaid basis, but if the Debtor succeeded in its malpractice suit, Masiz would be paid retroactively.  For these purposes, the Debtor agreed to compensate Masiz at $175,000 per annum.

R&C settled the malpractice suit for $2.5 million, although not before firing KDW.  Following disbursement of the settlement funds, KDW asserted an attorney’s lien in the same, which further prompted the Debtor to enter into a separate settlement with KDW, whereby KDW agreed to accept $595,000 in satisfaction of its fees.  The KDW settlement “acknowledged” that the Debtor intended to release $598,000 of the R&C settlement to Masiz in satisfaction of his accrued unpaid wages.  Subsequent to that transfer, but before the bankruptcy, the Debtor made an additional $178,363 payment to Masiz on account of his continued employment.

The Trustee alleged in his complaint that the two payments to Masiz were either preferential payments under 11 U.S.C. § 547 or fraudulent transfers under 11 U.S.C. § 548.  Ultimately, the Bankruptcy Court (Judge Sontchi) issued two opinions granting summary judgment in the Trustee’s favor with respect to the §§ 547 and 548 claims.  Masiz appealed both to the District Court, arguing the Trustee lacked standing; that the “earmarking doctrine” excluded the transfers from avoidance; that several issues of disputable fact were impermissibly decided at the summary judgment stage (including whether § 547(b)(5) had been established); and that while the Bankruptcy Court was correct in finding Masiz had established a new value defense, it erred in the calculating the amount of that new value.

The District Court quickly dismissed the contention that the Trustee had not yet acquired standing to bring the instant action, pointing to specific language in the confirmation order.  Moving on to Masiz’s “earmarking” argument and pertinent to this post, Chief Judge Stark noted that the doctrine targets one of the fundamental elements of a preference action under 547(b) – e.g., that a voidable preference first requires some interest of the debtor in property.  He cited the “earmarking” standard elucidated in past Third Circuit and Delaware Bankruptcy Court Opinions as follows: “[w]hen … funds are provided by [a] new creditor to or for the benefit of the debtor for the purpose of paying the obligation owed to [an existing] creditor, the funds are said to be ‘earmarked’ and the payment is held not to be a voidable preference.” In re Winstar Commc’ns, Inc., 554 F.3d 382, 400 (3d Cir. 2009).  The District Court went to say that in “order to invoke this doctrine, a party must demonstrate ‘(1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt, (2) performance of that agreement according to its terms, and (3) the transaction viewed as a whole … does not result in any diminution of the [debtor’s] estate.’” Id. “The central inquiry is ‘whether the debtor had the right to disburse the funds to whomever it wished, or whether the disbursement was limited to a particular old creditor or creditors under the agreement with the new creditor.’” In re AmeriServe Food Distribution, Inc., 315 B.R. 24, 30 (Bankr.D.Del.2004) (quoting In re Superior Stamp and Coin Co., Inc., 223 F.3d 1004, 1009 (9th Cir.2000)).

The Bankruptcy Court found that the R&C settlement did not direct any funds to Masiz, nor did it mention the KDW settlement.  The District Court agreed, and rejected the contention that the KDW settlement should be the operative document for “earmarking” purposes.  Chief Judge Stark found that KDW did not have control over or disburse any funds, and pursuant to the AmeriServe decision, a party must both disburse funds and direct those funds for the “earmarking doctrine” to apply.  Thus, the District Court rejected Masiz’s argument.

The District Court subsequently dismissed Masiz’s argument that summary judgment was inappropriate since the Trustee had not established § 547(b)(5).  This element requires that the transfer in question: “enables such creditor to receive more than such creditor would receive if— (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.”  Chief Judge Stark found that § 547(b)(5), as measured from the time of the bankruptcy filing, simply requires that the creditor in question would have received less than a 100% payout of its claim in a Chapter 7 liquidation.  Given the substance of the plan and disclosure statement, the District Court found that circumstance was met.

Lastly, the District Court found that the Bankruptcy Court did not err in the calculation of Masiz’s “new value” defense.  This defense, as codified in § 547(c)(4), provides that a trustee may not avoid any transfer: “to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor—(A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.”  Chief Judge Stark found that Masiz’s new value contribution was properly valued at 72 days of service, which translated to $34,520.55 when converted to a percentage of the annual $175,000 salary he agreed to.  The District Court found that Masiz pointed to no other method of calculation and that his claiming the new value amount to be disputed does not render it so for summary judgment purposes.

Note that on October 2, 2015, Masiz appealed Chief Judge Stark’s order and opinion to the Third Circuit Court of Appeals.  The appeal remains pending as of this writing.

Part II of this post will be up tomorrow.