In re Friedman's: Third Circuit Affirms that Postpetition Payments Do Not Affect the "New Value" Preference Defense

Practical Law Legal Update 7-558-8987 (Approx. 6 pages)

In re Friedman's: Third Circuit Affirms that Postpetition Payments Do Not Affect the "New Value" Preference Defense

by Practical Law Bankruptcy & Restructuring

Background

On January 22, 2008, Friedman's, Inc. (Debtor) filed a Chapter 7 petition, which was later converted to a Chapter 11 proceeding.

In the 90-day period preceding the petition date:

The Debtor made allegedly preferential payments to Roth Staffing (Roth) totalling $81,997.57 for prepetition services provided by Roth (Transfers).
Roth later provided $100,660.88 in additional prepetition services to the Debtor (New Value), for which it had not been paid as of the petition date.

On January 25, 2008, the Debtor filed a motion seeking permission to pay prepetition wages, compensation and related benefits to its independent contractors and employees, including Roth. The bankruptcy court entered a wage order which authorized the Debtor to pay some of Roth's prepetition invoices that constituted New Value in the amount of $72,412.71 (Postpetition Payment).

On March 5, 2009, Friedman's Liquidating Trust (Trust), the successor-in-interest to the Debtor, filed an adversary proceeding seeking to avoid and recover the Transfers as preferences under section 547(b) of the Bankruptcy Code.

Roth argued that the Transfers were protected by the new value defense of section 547(c)(4) of the Bankruptcy Code. The new value defense prohibits avoidance of a preferential transfer if, after the transfer, the creditor advanced "new value" to the debtor on an unsecured basis and the debtor did not make an "otherwise unavoidable transfer to or for the benefit of such creditor" for the new value provided. Under Roth's interpretation of section 547(c)(4), only payments made by a debtor before the petition date can defeat a creditor's new value defense. Therefore, Roth claimed that the Trust could not avoid and recover the Transfers because the New Value, which could not be offset by the amount of the Postpetition Payment, exceeded the amount of the Transfers.

The Trust responded that the New Value must be reduced by the amount of the Postpetition Payment, leaving $28,248.17 ($100,660.88 - $72,412.71) in New Value. After subtracting this amount of New Value from the Transfers, Roth would have $53,749.40 ($81,997.57-$28,248.17) of remaining preference liability. Under the Trust's interpretation of section 547(c)(4), a debtor's payment offsetting new value may occur at any time, either pre- or postpetition, as long as it is a transfer made after new value is extended.

The bankruptcy court held that the filing of a bankruptcy petition operates as a cutoff date for computing "new value" and that because the Postpetition Payment was made after the petition date, the Trust could not use this amount to reduce Roth's New Value offsetting its preference liability (see Legal Update, Bankruptcy Court in Friedman's Inc. v. Roth Staffing Companies Holds Bankruptcy Filing Fixes Preference Analysis at Petition Date). The district court affirmed and the Trust appealed to the Third Circuit.

Outcome

The Third Circuit affirmed the rulings of the lower courts, focusing its analysis of section 547(c)(4) on the statutory context of the Bankruptcy Code and the policies underlying its preference provisions, declining to dissect its specific words and phrases.

Statutory Interpretation

The Third Circuit found "numerous contextual indicators in the [Bankruptcy] Code that point to the petition date as a cutoff for analysis of the new value defense."

First, the Court noted that section 547's title, titled "Preferences," suggests that the section addresses transfers occurring during the preference period, which is by definition prepetition (the 90 days preceding the filing of the petition). Therefore, it would make sense that only transfers relating to that time period can reduce preference liability.

Second, the Court explained that the preference test known as the hypothetical liquidation test, outlined in section 547(b)(5) of the Bankruptcy Code, must be performed as of the petition date. To extend the preference analysis past the petition date would be inconsistent with this subsection of section 547.

Third, the Court observed that the statute of limitations for filing a preference action in a voluntary case begins to run on the petition date. Had Congress wanted postpetition transactions to affect the recovery of preferences, it likely would have created a different statute of limitations. This fact suggests that the calculation of preference liability should remain constant postpetition. However, allowing postpetition payments to defeat a new value defense would change the calculation of preference liability depending on when the preference action was filed.

Fourth, the Court found that extending the preference analysis past the petition date would be inconsistent with the analogous improvement-in-position test found in section 547(c)(5) of the Bankruptcy Code, which specifically states that the petition date is the cutoff for liability purposes.

Finally, the Court noted that if it allowed postpetition payments to affect the preference analysis, it would seem logical to also consider postpetition extensions of new value to be available as a defense. However, a majority of courts that have considered the issue have held that new value advanced after the petition date should not be considered in a creditor's new value defense.

Policy Issues

From a policy perspective, the Third Circuit found the two main policies underlying section 547 of the Bankruptcy Code are to:

Discourage creditors from "the race to the courthouse" to dismantle a debtor prepetition.
Facilitate the policy of equality of distribution among creditors.

The Court then explained that the new value defense as part of the preference analysis is specifically designed to:

Encourage trade creditors to continue dealing with troubled businesses.
Treat fairly a creditor who has replenished the estate after having received a preference.

The Court rejected the Trust's arguments that a creditor will receive a "windfall" if postpetition payments are not considered in the preference analysis and that a debtor's estate is not replenished when a debtor makes a postpetition payment to a creditor. The Trust argued that this results in the creditor unfairly receiving double payment, one postpetition and one indirectly as a setoff against its preference liability to the estate. The Court disagreed, explaining that even if a creditor is paid postpetition for new value it provided prepetition, the creditor still replenished the debtor's estate during the preference period and therefore aided the debtor in avoiding bankruptcy. Further, the creditor does not receive double payment because all of the money it received was for goods and services actually provided.

The Court also rejected the Trust's argument that ignoring postpetition payments for the purpose of calculating preference liability results in unequal treatment of creditors. Instead, the Court explained that "[i]nequality per se is not to be avoided; indeed, reasoned and justified inequality sometimes prevails, usually based on what is in the best interest of the estate." The Court opined that the main goal of section 547 is not "replenishment" and "equality" but rather to deter the race of creditors to the courthouse. Further, because the Bankruptcy Code contains numerous postpetition mechanisms for ensuring that similarly situated creditors are treated equally, the preference analysis does not need to include postpetition activity.

Finally, the Third Circuit noted that the bankruptcy court deemed it in the Debtor's best interests to issue a wage order. However, allowing payments made under the wage order to increase Roth's preference liability would undermine the purpose of the wage order.

Practical Implications

The Third Circuit is the first Circuit Court to address whether the timing of repayment of new value is relevant in a preference analysis. Bankruptcy courts have been split on this issue, and it remains to be seen whether other Circuit Courts will adopt the Third Circuit's reasoning.

By reaching the conclusion that timing is relevant, this decision furthers the bankruptcy policy of encouraging creditors to continue to do business with troubled companies on the verge of bankruptcy. A stronger new value defense provides creditors with more of a basis to accept and retain postpetition payments received for prepetition goods and services provided, and shows that creditors will not be penalized for acting in good faith when dealing with a troubled company before bankruptcy.

Finally, while the Third Circuit emphasized that preference analysis should ignore postpetition facts, it considered postpetition events in Kimmelman v. Port Authority of New York and New Jersey (In re Kiwi Air), in which it held that the postpetition assumption of an executory contract was a complete defense to recovering any preferential payments the creditor received under the contract (see 344 F.3d 311 (3d Cir.2003)). Under section 365(b) of the Bankruptcy Code, debtors must cure defaults as a condition to assumption, but allowing debtors to recover these preferential payments would conflict with this requirement. Therefore, postpetition facts must be considered in these circumstances because the ability to assume contracts serves the purpose of enabling debtors to continue to operate. The Third Circuit reconciled its holdings in Friedman's and Kiwi Air by explaining that "Kiwi Air teaches that postpetition events can cast the payment in a different light in order to effectuate the purposes and provisions of the [Bankruptcy] Code" and that the case "only examines the 'unique set of rights' created by section 365."

For more information on preferences, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors.

In re Friedman's: Third Circuit Affirms that Postpetition Payments Do Not Affect the "New Value" Preference Defense | Practical Law