Restructuring

Contributed by Danielle Donovan
Sometimes we breathe a sigh of relief a little too quickly after settling a pesky argument.  Unfortunately for the defendants, that was the case in In re Metal Foundations, LLC, a recent decision from the Bankruptcy Court for the Western District of Pennsylvania.  Plaintiff Stirling Energy Systems and defendant Metal Foundations maintained a cooperative business relationship at one time.  Stirling designed and developed solar power solutions for renewable energy power plants, and Metal Foundations designed and developed metal foundations to be used in the solar context. 
The parties’ relationship deteriorated in July 2009 when Metal Foundations filed a complaint against Stirling for preliminary injunction, breach of contract, false and fraudulent misrepresentation, violation of the Pennsylvania Uniform Trade Secrets Act, and unfair competition.  The litigation was pending when Metal Foundations filed for chapter 11 protection, but the parties settled the lawsuit during the case and entered into a bankruptcy court-approved settlement agreement.  In accordance with the settlement agreement, and in exchange for a full release of all Metal Foundations’ claims, Stirling tendered a check for $87,500 to the chapter 11 trustees for the Metal Foundations estate and another related estate.  Of that amount, $43,750 was deposited into an account for Metal Foundations.  
If you think this is a story about Metal Foundations’ chapter 11 case, guess again. 
Within 90 days after Metal Foundations deposited the money, Stirling filed its own chapter 7 petition, and Stirling’s chapter 7 trustee sought to recover from the Metal Foundations estate the $43,750 payment as a preferential transfer under section 547(b) of the Bankruptcy Code.  (The Stirling trustee did not name the other related estate in its complaint).  In response, the Metal Foundations trustee moved to dismiss the complaint on the grounds that the payment was not on account of an antecedent debt and alternatively, was a contemporaneous exchange for new value.  The Metal Foundations trustee argued that the settlement agreement provided new value to Stirling because it allowed Stirling to use Metal Foundations’ proprietary information.  In urging dismissal, the Metal Foundations trustee relied almost exclusively on the Third Circuit decision.  Several courts have criticized and chosen not to follow Lewis because the decision contains broad conclusory statements that are seemingly at odds with the policy objectives underlying the preference law.  Though the bankruptcy court acknowledged Lewis’s unpopularity, the court was bound by the precedent set by the Third Circuit.  The court did, however, avoid applying the decision by distinguishing the transfers in the two cases.  
In Lewis, a builder filed for bankruptcy shortly after entering into a settlement agreement with a prospective purchaser.  The prospective purchaser had sued the builder for specific performance and placed a lis pendens against the property in dispute.  The parties’ settlement agreement provided that the builder would pay the plaintiffs in exchange for the plaintiffs terminating the lawsuit and removing the lis pendens.  The Third Circuit reversed both the bankruptcy court and district court, and held that the transfer was not preferential because it did not meet the section 547(b) requirements.  The court found that the transfer was not based on an antecedent debt, and further that it was a contemporaneous exchange for new value because the builder was released from the risk of litigation, and the value of the property increased as a result of lifting the lis pendens. 
Metal Foundations structured its argument simply by comparing its settlement agreement with Stirling to the facts in Lewis.  It emphasized the similarity to Lewis because, like the plaintiff in that case, Stirling was not only freed from monetary liability, but also from the risk of litigation.  Metal Foundations also asserted that Stirling received the additional consideration of the use of Metal Foundations’ proprietary information. 
Beyond its reliance on Lewis, Metal Foundations failed to proffer any arguments as to why the payment was not based on an antecedent debt.  For section 547(b) purposes, a debt is antecedent if it was incurred before the debtor made the allegedly preferential transfer.  Although Stirling presumably disputed its liability to Metal Foundations while it was litigating the lawsuit, it argued that it was indebted to Metal Foundations for the alleged actions that occurred prior to Metal Foundations’ lawsuit, and not as a result of the settlement agreement itself.  In accepting this argument, the bankruptcy court distinguished Metal Foundations from Lewis, in which the Third Circuit found that the transfer of funds in accordance with the settlement agreement was not based on an antecedent debt.  Lewis is often criticized because the Third Circuit made such conclusory statements without providing sufficient analysis or reasoning to assist courts in applying the standard in the future. 
The Lewis court, however, based its holding primarily on the consideration received by the debtor in exchange for the settlement payment.  Because the Lewis creditor released its equitable lien on the debtor’s property in exchange for payment, the transfer would have been shielded from avoidance under section 547(b)(5) of the Bankruptcy Code.
Metal Foundations also fell flat on its argument that there was a contemporaneous exchange for new value.  Stirling denied that it ever possessed any information that belonged to Metal Foundations, and it argued that it could not have received new value for the information regarding metal foundations that it already possessed.  In support of its position, Stirling quoted the following language from the settlement agreement:

“[Stirling] possesses the unrestricted right to make, purchase, use . . . sell . . . foundations for solar dishes . . . and [Metal Foundations] [does] not and will not claim that such . . .  use of [Stirling’s] knowledge as to how to manufacture, use, install or sell such foundations, constitutes a misappropriation or infringement of [Metal Foundations’] proprietary information . . . .”

Moreover, the bankruptcy court was unable to find anything in the settlement agreement that is comparable to the release of the lis pendens in Lewis that would constitute new value beyond freedom from the risk of litigation; accordingly, the court denied Metal Foundations’ motion to dismiss.
The Metal Foundations decision only addresses the preference law in the context of a motion to dismiss.  Nevertheless, the court’s reliance upon unliquidated, disputed claims as “antecedent debts” for the purpose of recovering payments made to settle the disputed claims raises questions about whether it is possible to craft effective “preference proof” settlement agreements.  The decision certainly seems to caution plaintiffs that they can elect to take their money and run, but they better make sure they have at least a 90-day head start.