Double Dipping? Section 503(b)(9) and the New Value Defense to Preference Liability

The 2005 Amendments to the Bankruptcy Code ushered in section 503(b)(9) of the Bankruptcy Code, which grants trade creditors an administrative expense for goods sold to the debtor in the ordinary course of the debtor’s business and that the debtor received within 20 days prior to the commencement date. Trade creditors also may face preference litigation for payments they received prior to the petition date, but may be able to reduce or eliminate their preference exposure by asserting a “new value” defense under section 547(c)(4) of the Bankruptcy Code (one of the more frequently raised defenses to preference liability). To reduce or eliminate preference liability under a new value defense, the creditor must have given unsecured new value to the debtor by selling goods or providing services on credit terms after the alleged preference payment but prior to the petition date. If these conditions are met, the creditor can subtract the value of those goods from the preference amount.
The overlap of these two Bankruptcy Code provisions gives rise to an interesting question: Can a creditor that holds an administrative expense under section 503(b)(9) of the Bankruptcy Code predicate a new value defense to an alleged preferential transfer under section 547(c)(4)(B) of the Bankruptcy Code on the same goods shipped 20 days before the commencement date? The Bankruptcy Court for the Eastern District of Virginia has been clarifying the law in this area, including most recently in Siegel v. Sony Electronics, Inc. (In re Circuit City Stores, Inc.), which provides guidance to trade creditors on this question.
Before it went out of business, Circuit City was a national electronic retailer operating in over 700 stores throughout the United States and Puerto Rico. In late 2008, Circuit City sought bankruptcy protection in the United States Bankruptcy Court for the Eastern District of Virginia. Though it continued to operate its business in the ordinary course following the petition, by early 2009, the bankruptcy court had authorized Circuit City to conduct going out of business sales at all of its retail locations. In the fall of 2010, the going out of business sales having been completed, Circuit City’s plan of liquidation was confirmed. The plan established a liquidating trust to, among other things, liquidate Circuit City’s assets and distribute them to its creditors. Alfred Siegel was appointed as trustee for the liquidating trust.
As part of his efforts to liquidate Circuit City’s estates, the liquidating trustee commenced numerous preference actions – one of which was brought against Sony Electronics, Inc. Prepetition, Sony and Circuit City had entered into a “Dealer Agreement” under which Sony sold goods to Circuit City and Circuit City received various funding incentives. Among other claims the liquidating trust asserted against Sony was a preference claim relating to a check made by Circuit City to Sony seven days before the petition date.
Sony asserted a number of defenses to the preference claim. Among them, Sony asked the court to find that the value of goods it delivered to Circuit City during the 20 days immediately prior to the commencement of Circuit City’s bankruptcy case could be used both to recover under section 503(b)(9) and to assert a new value defense under section 547(c)(4). Section 547(c)(4) excepts from preference liability transfers to or for the benefit of a creditor to the extent that, after such transfer, the creditor gave “new value” to or for the benefit of the debtor that, generally speaking, was unsecured and for which the debtor did not make an “otherwise unavoidable transfer.”
The court’s analysis centered on whether the debtor made an avoidable transfer to or for the benefit of a creditor on account of the new value it received from such creditor. The court concluded that, because the payment of a 503(b)(9) administrative expense is an “otherwise unavoidable transfer” under 547(c)(4)(B), the recipient of such payment is not entitled to utilize the value of those same goods as the basis for a new value defense.
The bankruptcy court relied on its recent decision (in a slightly different context) in preference litigation involving Mitsubishi Digital Electronics America, Inc., in which Mitsubishi tried to utilize the same goods delivered 20 days before Circuit City’s bankruptcy filing to recover an administrative expense and assert a new value defense in preference litigation. There, the bankruptcy court found that Mitsubishi could not include the goods that were the basis for its section 503(b)(9) claim, which was fully funded by a reserve account, in its preference defense. The court’s reasoning turned on the fact that the court had approved the postpetition establishment of the reserve fund for allowed 503(b)(9) claims, and so postpetition payment of Mitsubishi’s allowed section 503(b)(9) claim was authorized by the court and under the Bankruptcy Code, and was an “otherwise unavoidable transfer.”
Notwithstanding this precedent, Sony had urged the bankruptcy court to reconsider its ruling in Mitsubishi in light of the Third Circuit Court of Appeals’ decision in Friedman’s Liquidating Trust v. Roth Staffing Cos. (In re Friedman’s, Inc.). The bankruptcy court noted that in Friedman’s, the Third Circuit held that postpetition transfers made pursuant to a prepetition wage order did not affect the calculation of that creditor’s new value defense under section 547(c)(4). This was because the Third Circuit determined that section 547(c)(4)(B) was only meant to encompass “otherwise unavoidable prepetition transfers.” The court also noted that the Third Circuit left open the question of whether assertion of a reclamation claim should reduce a new value defense, and so the bankruptcy court was not persuaded that the holding in Friedman’s should extend to section 503(b)(9) claims. As a result, the bankruptcy court did not reconsider its holding in Mitsubishi in order to allow Sony to use its section 503(b)(9) claim as new value for purposes of section 547(c)(4), as to do so would permit Sony a “double recovery” (full payment on its section 503(b)(9) claim and reducing its preference exposure) “based on the same goods that underlie its single claim.”
Case law on this topic remains unresolved. The Bankruptcy Court for the Northern District of Georgia, like the Bankruptcy Court for the Eastern District of Virginia, has rejected a trade creditor’s attempt to assert a section 503(b)(9) claim as part of a new value defense to preference liability where the section 503(b)(9) claim at issue was fully funded or paid postpetition. However, the Bankruptcy Court for the Middle District of Tennessee has held that goods within the scope of section 503(b)(9) can form part of a new value defense to preference allegations. At the heart of the debate is whether or not a postpetition payment will disqualify the new value defense, or if the reduction to new value has to be on account of payment received prior to the commencement date.
The bottom line is that trade creditors evaluating their ability to assert a defense to preference liability should consider whether they can demonstrate that the new value extended to the debtor after the alleged preference was not repaid with an otherwise unavoidable transfer, which debtors and trustees may argue excludes postpetition payments under a critical vendor order or section 503(b)(9).