Contributed by Debra McElligott
The new value defense set forth in section 547(c)(4) of the Bankruptcy Code allows a creditor to use the value of goods and services provided by a creditor to a debtor after a debtor’s preferential payment for which the creditor has not been paid to offset preference liability. In Friedman’s Liquidating Trust v. Roth Staffing Cos. (In re Friedman’s Inc.), the United States Court of Appeals for the Third Circuit considered an issue of first impression: does a postpetition payment to a creditor on account of such goods and services reduce the amount of the new value provided to the debtor?
In Friedman’s, the debtor made preferential payments to a staffing company totaling $81,997.57. After these transfers, but before the bankruptcy petition was filed, the staffing company provided services to the debtor valued at $100,660.88 for which the staffing company had not been paid as of the petition date. In the debtor’s chapter 11 case, the bankruptcy court entered a wage order, which allowed the debtor to pay employees and independent contractors for prepetition services, and the debtor paid $72,412.71 to the staffing company.
More than a year later, Friedman’s Liquidating Trust, the successor-in-interest to the debtor, sought to avoid and recover the prepetition payments made to the staffing company as preferences under section 547(b) of the Bankruptcy Code. The staffing company asserted the new value defense, leading the liquidating trust to respond that the defense must be reduced by the debtor’s postpetition payment of $72,412.71.
The United States Bankruptcy Court for the District of Delaware ruled against the trustee, relying on the new value test outlined in the Third Circuit’s opinion in In re New York City Shoes, Inc., which used the petition date as a cutoff for preference analysis. The United States District Court for the District of Delaware affirmed the bankruptcy court’s order, and the liquidating trust appealed. The Third Circuit affirmed, focusing its analysis on an examination of section 547 within the statutory context of the Bankruptcy Code and the policies motivating the preference provisions of the Bankruptcy Code.
The Third Circuit determined that the new value test outlined in New York City Shoes was dicta and therefore, it needed to consider whether the plain language of section 547(c)(4)(B) is ambiguous. The court noted a number of “contextual indicators” in the Bankruptcy Code suggesting that the petition date should be the cutoff for analysis of the new value defense. Three of these involved preference liability tests. First, the Third Circuit asserted that the “hypothetical liquidation test” outlined in section 547(b)(5) should be performed as of the petition date. As such, extending preference analysis past the petition date for the new value test outlined in 547(c)(4)(B) would result in an inconsistent interpretation of these two subsections. Second, section 547(c)(5), which outlines the “improvement-in-position” defense, includes the phrase “as of the date of the filing of the petition.” Finally, the majority of courts that have considered the issue presented in this case have concluded that new value advanced after the petition date should not be considered in the analysis. Although 547(c)(4) only specifies that new value be given to a debtor subsequent to a preference payment, courts have read the petition date into the statute as a cutoff.
The court also cited to two other statutory indicators supporting its holding. One is the fact that section 547 is entitled “Preferences,” which suggests that it concerns transactions occurring during the prepetition preference period. The other is that the statute of limitations for filing a preference avoidance action under section 547 in a voluntary case begins to run on the petition date, supporting the notion that the cause of action accrues as of that date.
In addition to the statutory context of section 547(c)(4), the Third Circuit explored the policies underlying section 547, which are to discourage creditors from a “race to the courthouse” and to facilitate the policy of equality of distribution among creditors. The new value defense in particular is motivated by similar policies: to encourage trade creditors to continue dealing with troubled businesses and to fairly treat creditors who have replenished the estate after having received a preference. The court rejected the trustee’s arguments that a creditor cannot replenish the debtor’s estate when it is paid postpetition and that a creditor would unfairly receive double payment if postpetition payments are not considered in the preference analysis. The court noted that even if a creditor is paid postpetition for new value it provided prepetition, the creditor still replenished the estate during the preference period and therefore aided the debtor in avoiding bankruptcy. Additionally, where all of the money the creditor receives is for goods and services actually provided, there is no “double-dipping” issue.
Finally, the court noted that while some creditors may be treated differently as a result of using the petition date as the cutoff date for the preference analysis, the policy of equal treatment of creditors under the Code does not mean inequality per se must be avoided. Rather, “reasoned and justified inequality sometimes prevails.” The main goal of section 547, in the opinion of the Third Circuit, is to prevent the race of creditors to the courthouse.
Notably, although Friedman’s takes a strong position that the section 547 analysis should ignore postpetition facts, the Third Circuit previously has allowed one important exception to this rule. To the extent the debtor in possession or trustee assumes an executory contract or unexpired lease under which a creditor may have received preferential payments, the Third Circuit in Kimmelman v. Port Authority of New York and New Jersey (In re Kiwi Air) clearly held that such assumption is a complete defense to the recovery of prepetition payments under such a contract because section 365(b) of the Bankruptcy Code requires the debtor in possession or trustee to cure defaults as a condition to assumption, and, therefore, such payments would have been made postpetition as part of the contract or lease assumption. Although the liquidating trust in Friedman’s used Kiwi Air to argue that the court must take into account all material postpetition events in the preference analysis, the Third Circuit brushed aside this apparent conflict with statements that the case “only examines the ‘unique set of rights’ created by section 365” and “teaches that postpetition events can cast the payment in a different light in order to effectuate the purposes and provisions” of the Bankruptcy Code. It is important to bear in mind, though, that the Third Circuit has not put complete blinders on with respect to postpetition events in the context of preference actions, and it will be interesting to see if the Third Circuit is ever called upon to reconcile the apparent policy conflict within its own circuit it created with its reasoning and analysis in Friedman’s.