Have Your Cake and Eat It Too: Defendants in Insider Preference Actions under State Law May Doubly Benefit from the New Value Defense

Contributed by Doron P. Kenter.

“What I got I double / I swear I’m keepin’ out of trouble / I’m lookin’ for … new value” – Iggy Pop

The “new value” defense to certain preference actions may have just become a lot more valuable, allowing some preference defendants to earn a double-benefit from new value that they advance to a troubled company.
One of the goals of bankruptcy is to ensure equality of distributions to similarly situated creditors.  To prevent certain creditors from gaining a windfall simply because they happen to receive payments shortly before a debtor commences a bankruptcy case, section 547 of the Bankruptcy Code confers on the trustee (or the debtor, or creditors, standing in the shoes of the debtor) a right to “avoid” certain preferential payments made to creditors, thereby recovering those payments for the benefit of all creditors.  This “preference period” is either 90 days prior to the commencement of the debtors’ bankruptcy case or, in the case of payments to insiders, a full year prior to the petition date (as there is a presumption that a debtor will have unfairly favored its insiders, or that insiders were privy to nonpublic information about the debtor’s financial well-being).  Similarly, section 548 of the Bankruptcy Code empowers trustees (or debtors) to avoid as actually or constructively fraudulent payments which were made to or for the benefit of particular creditors, so as to distribute those funds equally among the debtor’s creditors.
Many states have comparable statutes permitting debtors to avoid certain preferential and fraudulent transfers, including payments to insiders.  For example, section 5 of the Uniform Fraudulent Transfer Act (which has been adopted in whole or in part in 43 states) empowers a debtor to avoid payments made by an insolvent entity to an insider, on account of antecedent debt, where the insider had reasonable cause to believe that the debtor was insolvent.  This “insider preference” is deemed to be a fraudulent transfer under state law, which may be recovered for the benefit of a debtor’s estate.  In turn, section 544 of the Bankruptcy Code empowers debtors to avoid and recover payments that may be avoided under applicable state law.
The “new value” exception under section 547(c)(4) of the Bankruptcy Code and under various state statutes provides that, if the recipient of an otherwise preferential transfer subsequently advances “new value” to the transferor, the recipient of the preference is entitled to offset its preference exposure to the extent of the new value because such new value has effectively “repaid” the earlier preference in a like amount.  In other words, the new value defense prevents the transferee from being doubly harmed by being forced to both (i) pay back the preference and (ii) render unsecured and unpaid “new value” to the debtor.  This defense is designed to encourage creditors to deal with troubled businesses.  Under the Bankruptcy Code, the inquiry ends there, but, as Musicland Holding Corp. v. Best Buy Co., Inc. (In re Musicland Holding Corp.) (Bankr. S.D.N.Y. Dec. 30, 2011) illustrates, defendants in preference actions sometimes are entitled to assert the new value defense even where they were subsequently paid for that new value, yielding a “double-payment” to the preference defendant (i.e., (i) the payment for the new value and (ii) the value of the new value defense in the preference action).
Until 2003, The Musicland Group (TMG) was an indirect wholly-owned subsidiary of Best Buy Co., Inc.. On June 16, 2003, Musicland Holding Corp. (MHC) bought all of TMG’s shares from TMG’s parent company (which was, in turn, a wholly-owned subsidiary of Best Buy).  On the same day, TMG paid Best Buy $35 million, allegedly on account of antecedent debt.  Also on the same day, MHC entered into a Transitional Services Agreement with Best Buy Enterprise Services (BBE), another wholly-owned subsidiary of Best Buy), pursuant to which BBE agreed to provide transitional services to MHC in exchange for payments over time.  Ultimately, MHC paid approximately $75 million to BBE and Best Buy (which had agreed to be jointly and severally liable for the performance of BBE’s obligations under the Transitional Services Agreement) for services performed pursuant to the TSA.
MHC, TMG, and their other affiliates subsequently filed for chapter 11 relief, after which the unsecured creditors’ committee (and subsequently, the liquidating trustee) alleged that the $35 million payment to Best Buy constituted an insider preference under Minnesota state law.  After the court disposed of all other issues, the only remaining question turned on whether Best Buy was entitled to assert the “new value” defense to the insider preference action to the extent of the “new value” of the services that it provided under the TSA.
Under the Bankruptcy Code, Best Buy would be entitled to assert the new value defense if it provided new value to TMG, and TMG did not subsequently pay for that value with an “otherwise unavoidable transfer.”  The bankruptcy court’s inquiry, however, did not end there.  Unlike section 547(c)(4) of the Bankruptcy Code, which requires that the debtor not have paid for the “new value” with an otherwise unavoidable transfer, section 513.48 of the Minnesota Statutes (which is identical to the corresponding section of the UFTA) provides that “[a] transfer is not voidable under section 513.45(b) [pertaining to insider preferences] . . . to the extent the insider gave new value to or for the benefit of the debtor after the transfer was made unless the new value was secured by a valid lien.”  Importantly, the statute omits the provision that such new value cannot have been paid for with an “otherwise unavoidable transfer.”  In lay man’s terms, this would allow the recipient of an insider preference to reap the benefits of the new value defense even if the debtor had already reimbursed the preference defendant for the “new value.”
Though the bankruptcy court implied that this result is nonsensical (tactfully stating that “[t]he result is difficult to justify in light of the purpose of preference law in general and the new value exception in particular”), it stated that it had no choice but to recognize this wrinkle in the UFTA’s version of the new value defense (which was adopted verbatim in the Minnesota Statutes) and to conclude that Best Buy would be entitled to assert the new value defense even though it had already been paid for the new value and the result would have the effect of diminishing the estate by the amount of the new value (by providing a double credit to Best Buy, which could keep (i) the $35 million payment to the extent of the new value and (ii) the full amount of the payments made under the TSA).  Notably, though, this “double-benefit” of the new value defense only applies to insider preferences brought under state law.
In interpreting the UFTA (at least as applied in Minnesota) to yield this puzzling result, the court noted that “[a]ny necessary fix” lies with the state legislature, which should, presumably, take steps to correct a glaring inconsistency between the purpose of the new value defense and the rules for its application in state law preference actions.  In the meantime, though, parties to insider preference actions under state law should be aware of this wrinkle in the UFTA and would be well-advised to take these rights and defenses into account.
(Interestingly, Best Buy ultimately did not benefit from the statutory wrinkle.  The court found that Best Buy was precluded from asserting the new value defense because it was the recipient of the insider preference, but BBE had provided the so-called “new value.”  Under both the Bankruptcy Code and the Minnesota statute, the recipient of the preferential transfer and the provider of the new value must be one and the same.  This result was likely not music to Best Buy’s “ears.”)