Many experienced business people are now familiar with the process by which their valid and successful debt collection efforts result in liability under the preference provisions of the Bankruptcy Code. As a result, once a company with which a vendor has been conducting business files for bankruptcy, one of the first questions becomes, “How will actions from this point forward impact my liability for the payments I’ve already received?” Based on a recent decision from the Bankruptcy Court for the District of Delaware, the postpetition payment of pre-petition debts will not impact the creditor’s ability to raise the “new value” defense to a preference claim.

Under Sections 547 and 550 of the Bankruptcy Code, a Trustee may avoid certain transfers made to creditors in the 90 days leading up the filing of the debtor’s bankruptcy petition. Section 547 sets forth the six elements to the Trustee’s prima facie case (1) the debtor must make a transfer; (2) the transfer must be on account of an antecedent debt; (3) the transfer must be to or for the benefit of the creditor; (4) the transfer must have been made while the debtor was insolvent; (5) the transfer must have been within 90 days of the filing of the petition; (6) as a result of the transfer, the creditor must have received more than it would have received if the transfer had not been made and the creditor had asserted a claim in a hypothetical liquidation of the debtor’s estate under Chapter 7 of the Bankruptcy Code.  

If the Trustee can prove its prima facie case, the Bankruptcy Code provides the creditor with several defenses. One such defense is found in Section 547(c) (4), the so-called “new value” defense. The “new value” defense provides that a creditor’s liability for preferential transfers is reduced by the amount of goods or services delivered to the debtor subsequent to the preferential transfer. Specifically, Section 547(c)(4) provides:  

(c) The trustee may not avoid under this section a transfer

…  

(4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor—  

(A) not secured by an otherwise unavoidable security interest; and

(B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor…  

11 U.S.C. § 547(c)(4).  

Like many provisions of the Bankruptcy Code, the new value defense is designed to create an incentive for creditors to continue to do business with a troubled company. Trade partners are encouraged to provide additional value to the debtor rather than cut their losses and discontinue the relationship, thereby putting additional strain on an already troubled enterprise and potentially hastening the debtor’s slide into bankruptcy. As experienced preference defendants know, application of subsequent new value is often the first step in the analysis of the creditor’s preference exposure. Trustees will often acknowledge the new value offset without dispute once both sides agree on the accuracy of the amounts delivered. Therefore, it may be in the creditor’s best interest to continue to make deliveries to the troubled company, even as bankruptcy looms on the horizon.  

Courts do not agree as to the effect of post-petition payment of those deliveries. Under Section 547(c)(4)(B), a creditor is not entitled to new value if the debtor later paid for it with an “otherwise unavoidable” transfer. If a debtor, without court authorization, pays a prepetition debt after filing its bankruptcy petition, it is likely the transfer would be avoidable under Section 549 of the Bankruptcy Code, which prohibits unauthorized postpetition transactions. See Wallach v. Vulcan Steam Forging Co., Inc. (In re D.J. Management Group, Inc.), 164 B.R. 831, 836 (Bankr. W.D.N.Y. 1994) (noting that such a “postpetition preference” would be avoidable and therefore creditor would be entitled to credit for the new value the transfer repaid).

However, courts often authorize debtors-in-possession to pay creditors for prepetition debts in order to preserve the business during the bankruptcy. For example, prepetition creditors are often paid pursuant to a “critical vendor” order. Such post-payments are therefore unavoidable.  

Several courts have concluded that post-petition unavoidable payments made by a debtor reduce the amount of new value that a creditor payee can claim. See Wallach, 164 B.R. at 836; MMR Holding Corp. v. C&C Consultants, Inc. (In re MMR Holding Corp.), 203 B.R. 605, 609 (Bankr. M.D. La. 1996); Moglia v. Amer. Psychological Assoc. (In re Login Bros. Book Co., Inc.), 294 B.R. 297, 300-01 (Bankr. N.D. Ill. 2003). These courts reason that the plain text of the Bankruptcy Code reduces the amount of a creditor’s new value setoff to the extent the new value was paid with an unavoidable transfer, regardless of the timing of the transfer. Furthermore, one of the policies behind the new value exception is the replenishment of the estate by the creditor’s delivery of the new value. That policy, some courts contend, would be defeated if the creditor were allowed to keep the original preferential payment of its debt on account of the subsequent new value contribution to the estate and also receive repayment of that contribution. Moglia, 294 B.R. at 301; MMR Holding, 203 B.R. at 609.

Other courts have held that the new value analysis “freezes” as of the petition date. Consequently, payments made by the debtor post-petition, even though they are unavoidable, will not reduce a creditor’s new value defense. Most recently, in Friedman’s Inc. v. Roth Staffing Co., L.P. (In re Freidman’s), Judge Christopher Sontchi held that post-petition payment of new value does not affect the preference analysis, even if the debtor completely compensates the creditor for its pre-petition claim. Adv. No. 09-50364 (CSS) slip op. (Bankr. D. Del. Nov. 30, 2011).

In Friedman’s, Roth Staffing Co. (“Roth”) provided staffing personnel to Friedman’s Inc. (“Friedman’s”). Prior to the petition date, Friedman’s had paid $81,997.57 to Roth. Subsequent to those payments but prior to the petition date, Roth provided additional staffing services in the amount of $100,660.88 which remained unpaid as of the petition date. On or about the petition date, Friedman’s moved the court to pay Roth’s employees in order to preserve the business during the bankruptcy. Otherwise, Roth’s personnel would have either walked off the job or created an unacceptable morale problem. Friedman’s paid $72,412.71 post-petition to Roth pursuant to a bankruptcy court order.

Friedman’s later sued Roth, seeking to recover $81,997.57 as a preference. Roth asserted a new value defense to the suit. Friedman’s filed a motion for partial summary judgment, seeking to have Roth’s new value defense reduced by the amount of the post-petition transfer.  

After reviewing preference actions, the new value defense, and post-petition payments generally, the court noted that both parties relied on “plain meaning” arguments which were fundamentally flawed. Roth argued the term “debtor” in Section 547 referred exclusively to the prepetition entity. Therefore, according to Roth, since new value must be “… to or for the benefit of the debtor,” and the new value cannot be paid by a debtor with an otherwise unavoidable transfer, the preference calculation is fixed on the petition date at which point a debtor ceases to exist. Similarly, Friedman’s argued that Section 101 of the Bankruptcy Code defines “debtor” as “… a person or municipality concerning which a case under this title [11] has been commenced.” Therefore, according to Friedman’s, a debtor does not exist until the case has been commenced. The court rejected both of these arguments by concluding that a debtor and a debtor-in-possession are not separate legal entities. According to the opinion, a debtor is a corporate entity that exists both pre- and post-petition.  

However, the court noted that the Third U.S. Circuit Court of Appeals in New York City Shoes, Inc. v. Bentley Int’l Inc., 880 F.2d 679 (3d Cir. 1989), had “…held that the subsequent new value defense under section 547(c)(4) has three elements: (1) the creditor must have received a transfer that is otherwise voidable as a preference under section 547(b); (2) after receiving the preferential transfer, the preferred creditor must advance ‘new value’ to the debtor on an unsecured basis; and (3) the debtor must not have fully compensated the creditor for the ‘new value’ as of the date that it filed its bankruptcy petition.” Id at *10 (emphasis in original). Therefore, the court concluded that the new value defense is “frozen” as of the petition date. Subsequent transfers of new value, as well as subsequent repayment of prepetition new value, do not affect a creditor’s liability.  

In conclusion, a creditor who has provided subsequent new value to a debtor prior to the petition date faces the possibility that post-petition payments can reduce its new value defense. The decision by the Delaware bankruptcy court is one of the few opinions to squarely address this problem and provides some comfort and ammunition to creditors that payments received post-petition might not impact the new value defense.