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A Victory for Preference Defendants: Third Circuit Affirms Friedman’s Holding and Holds Post-Petition Payments Do Not Affect the Calculation of a Creditor’s New Value Defense

By Evan T. Miller

On December 24, 2013, the United States Court of Appeals for the Third Circuit (the “Court”) issued an opinion in In re Friedman’s Inc., Case No. 13-1712, 2013 WL 6797958 (3d Cir. Dec. 24, 2013), affirming the District Court’s order which had affirmed the Bankruptcy Court’s holding that post-petition transfers to a creditor do not affect the calculation of that creditor’s new value defense under 11 U.S.C. § 547(c)(4).  The opinion represents a clear refutation of the positions taken in the lower courts of several other jurisdictions which held that permitting a creditor to accept post-petition payments on pre-petition liabilities while simultaneously claiming the pre-petition liabilities as new value would constitute “double-dipping”.

The facts in Friedman’s are undisputed.  Friedman’s, Inc. (the “Debtor”) filed for bankruptcy under Chapter 7 of the Bankruptcy Code on January 22, 2008 (the “Petition Date”), and thereafter the case was converted to one under Chapter 11 of the Bankruptcy Code.  In the 90 days prior to the Petition Date, the Debtor made payments to Roth Staffing (“Appellee”) totaling $81,997.57 (the “Transfers”).  After the Transfers, but before the petition was filed, Appellee provided services valued at $100,660.88 to the Debtor; the money owed for these services remained unpaid as of the date the bankruptcy petition was filed.

On January 25, 2008, the Debtor filed a motion in Bankruptcy Court seeking authority to pay its employees and independent contractors, prepetition wages, compensation, and related benefits.  The Court granted the Debtor’s motion (the “Wage Order”). Pursuant to the Wage Order, the Debtor paid $72,412.71 to Appellee on account of pre-petition staffing services.

On March 5, 2009, Friedman’s Liquidating Trust (“Appellant”), the successor-in-interest to the Debtor, commenced this action in Bankruptcy Court, seeking to avoid and recover the Transfers as preferences, pursuant to § 547(b) of the Bankruptcy Code.  In response, Appellee asserted the affirmative defense of new value under § 547(c)(4), claiming that the Transfers could not be avoided as preferences because it had provided subsequent new value to the Debtor in an amount ($100,660.88) exceeding the Transfers made ($81,997.57).  Appellant responded by arguing that Appellee’s new value defense had to be reduced by the post-petition payment of $72,412.71 made pursuant to the Wage Order. Appellant argued that this “otherwise unavoidable transfer” reduced Appellee’s new value defense to $28,248.17, and entitled Appellant to recover $53,749.40 ($81,997.57 – $28,248.17) on its preference claim.

Bankruptcy Judge Sontchi granted Appelle summary judgment, holding that because the Debtor’s payments made pursuant to the Wage Order occurred after the Petition Date, these payments could not enter into the preference calculation.  Judge Sontchi based this holding on his reading of In re New York City Shoes, Inc., 880 F.2d 679 (3d Cir. 1989) (“NYC Shoes”), specifically its language reading “the debtor must not have fully compensated the creditor for the “new value” as of the date that it filed its bankruptcy petition.”  The Bankruptcy Court found NYC Shoes to be controlling, and, therefore, held that since the otherwise unavoidable transfer was made after the Petition Date, Appellant was not entitled to recover on its preference claim.

The District Court affirmed the Bankruptcy Court’s decision.  The District Court explained that it would follow NYC Shoes, even though it found the language in New York Shoes to be dicta, because the Third Circuit referred to the NYC Shoes language as a holding in In re Winstar Communications, Inc., 554 F.3d 382 (3d Cir. 2009) (“Winstar”).  Although the District Court reasoned that the language from Winstar could also be dicta, it was reluctant to conclude that what the Third Circuit said twice, and once referred to as a “holding,” was dicta.

Appellant appealed the District Court’s decision to the Third Circuit, arguing that the lower courts erred in: (1) relying on NYC Shoes’ dicta rather than the “plain language” of § 547(c)(4); (2) allowing Appellee to “double dip” by asserting a new value defense even though it did not replenish the Debtor’s estate; and (3) failing to follow In re Kiwi International Air, Inc., 344 F.3d 311 (3d Cir. 2003) (“Kiwi”).

The Third Circuit first addressed whether NYC Shoes and/or Winstar were binding precedent, concluding that because none of the relevant transactions in those cases occurred post-petition, its statements regarding new value and the petition date was not pertinent to its analysis in those cases; thus, the statement was dicta and not binding on the Court.  The Court next concluded that the plain language of § 547(c)(4)(B) is silent as to when a payment must be made by a debtor to defeat a creditor’s new value defense, but the “fact that courts are divided in their interpretations of § 547(c)(4)(B), does not mean . . . that the provision is necessarily ambiguous.”  The Court looked at the provision in the context of the Bankruptcy Code as a whole, finding numerous indicators that point to the petition date as a cutoff for analysis of new value, such as: (i) § 547 is titled “Preferences”, suggesting it concerns transactions occurring pre-petition; (ii) the hypothetical liquidation test under § 547(b)(5) must be performed as of the petition date; (iii) the statute of limitations for filing a preference action under § 546 begins to run on the petition date; (iv) § 547(c)(5)’s “improvement in position” test includes the phrase “as of the date of the filing of the petition”; and (v) allowing post-petition payments to affect the preference analysis would be inconsistent unless they also allowed the post-petition extensions of new value to be available as a defense – a position most courts have rejected.

The Third Circuit then rejected Appellant’s arguments that the policies underlying the preference provision and new value defense support it.  Finding that Congressional records indicate the preference policy is equality of distribution, the Court held that “it makes sense that the equality should be measured, and inequalities rectified, as of the petition date.”  The policies underlying the new value defense are to “encourage trade creditors to continue dealing with troubled businesses [and] treat fairly a creditor who has replenished the estate after having received a preference”, which the Appellant argued would be defeated by Appellee’s “double-dipping” – once post-petition, and once indirectly as an offset against its preference liability.  The Court rejected this argument, however, finding that regardless of whether a creditor is paid post-petition for pre-petition new value, the creditor still replenished the debtor’s estate during the preference period, therefore aiding the debtor in avoiding bankruptcy. Moreover, the Court described the argument as misleading since it implies that the creditor is receiving payment for goods or services that were never provided.

The Court determined that Appellant’s arguments that its ruling would result in unequal treatment of creditors to be unavailing, as in the first instance, “inequality per se is not to be avoided [in bankruptcy]; indeed, reasoned and justified inequality sometimes prevails, usually based on what is in the best interest of the estate.”  The new value defense was not enacted to ensure equitable treatment of creditors, the Court found, but to encourage creditors to deal with troubled businesses.  Similarly, § 547 was designed to provide equal distribution among similarly situated creditors, not so that all creditors will be treated equally.

As a final matter, the Court addressed the applicability of Kiwi, a decision that the Appellant argued requires the Court to take into account all material post-petition events in determining preference liability.  In Kiwi, the Court held that, insofar as § 365 and § 1110 entitle creditors to receive unpaid pre-petition payments in connection with the assumption of a contract, allowing recovery of a preference payment would thwart their effect.  The Court found this holding to demonstrate that there are unique circumstances in which other provisions of the Bankruptcy Code dealing with post-petition transactions directly interact with 547 and thus “can alter the otherwise straightforward preference analysis.”  For the foregoing reasons, the Court affirmed the District Court’s order.

A copy of the opinion can be found here.

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