This is the second of two posts on Saracheck v. Crown Heights House of Glatt, Inc., a recent decision from the Bankruptcy Court for the Northern District of Iowa regarding an avoidance action against food distributor, Crown Heights House of Glatt, Inc. commenced in the chapter 7 bankruptcy case of Agriprocessors, Inc. Our prior post covered the court’s fraudulent transfer analysis in which the court, among other things, declined to find that the debtor’s transfers to Crown Heights constituted actual fraud. In essence, the court implied, “we have no beef with that!” But the trustee also sought to avoid the transfers as preferences under section 547 of the Bankruptcy Code. Today’s post focuses on the court’s preference analysis and, specifically, its contribution to the “remains unpaid” new value debate.

Background

The court-appointed trustee for Agriprocessors asserted that 96 checks that Agriprocessors issued to Crown Heights within one year of the debtor’s bankruptcy filing (approximating $4.4 million) should be avoided as preferential transfers. The trustee argued that the one-year look-back period under section 547(b) of the Bankruptcy Code applied because Crown Heights was an insider of Agriprocessor.

The court agreed that Crown Heights was both a statutory insider and non-statutory insider. Crown Heights’ sole shareholder was a niece of the debtor’s owner and a first cousin of the debtor’s former CEO, making Crown Heights a “relative” of an officer or person in control of the debtor, as required under sections 101(31)(B)(vi) and 101(45) of the Bankruptcy Code. The court also found that Crown Heights was a non-statutory insider, noting the close relationship Crown Heights had with the debtor and its principals and finding that Crown Heights did not deal at arm’s length with the debtor.

Crown Heights asserted the following defenses to preference liability: (i) each transfer was part of a contemporaneous exchange for new value, (ii) all transfers were in the ordinary course of business, and (iii) the transfers were supported by subsequent new value. The first two defenses were easily rejected. The transfers were credit transactions, and even if short-term, were not intended to be contemporaneous. Moreover, payments were made late, and Crown Heights did not monitor the timing of the payments. Similarly, the loans were not incurred in the ordinary course of business because they were not made in an arm’s-length commercial transaction. This was based on the atypical nature of the lending relationship – for example, the “window check” writing practice (whereby Crown Heights allowed Agriprocessors to use checks with Crown Heights’ name on them) effectively established a line of credit for the debtor. The court also observed in support of its conclusion that Crown Heights was not in the business of lending and did not make loans to other entities, and continued credit was not based on repayment.

After the court disposed of these first two issues, the court addressed whether Crown Heights was entitled to assert the “new value” defense to the insider preference action to the extent of the “new value” that it provided.

The New Value Defense

The “subsequent new value” defense under section 547(c)(4) of the Bankruptcy Codeprovides that, if the recipient of an otherwise preferential transfer subsequently extends “new value” to the transferor, the recipient’s preference liability is reduced by the amount of such new value (if the requirements of section 547(c)(4) are met) because such new value has effectively “repaid” the earlier preference in a like amount.

Specifically, section 547(c)(4) of the Bankruptcy Code provides that:

(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–

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

The Bankruptcy Code defines “new value” as:

money or money’s worth in goods, services or new credit, . . . but does not include an obligation substituted for an existing obligation.

The policy underlying the new value defense is to encourage trade creditors to continue dealing with troubled businesses and to treat fairly creditors who have replenished the estate after having received a preference. We have covered preference liability and the subsequent new value defense in prior posts, for example, herehere, and here.

The trustee asserted that Crown Heights could only use the subsequent new value set-off to the extent Crown Heights remained unpaid by the debtor. The trustee also argued that Crown Heights had not shown that the alleged “new value” given by Crown Heights during the preference period was not repaid by the debtor in full or in significant part by the millions of dollars that the debtor had paid Crown Heights during that period.

The court noted that there is a split among courts as to whether defendants in preference actions may assert the new value defense where they were subsequently paid for the new value they provided. (We previously blogged about how Delaware courts have approached the issue here.) An earlier Eighth Circuit decision had invoked a blanket rule that subsequent value should remain unpaid in order to qualify for the 547(c)(4) exception. TheAgriprocessors court, however, found that a later Eighth Circuit decision clarified this rule, so that where the payments made after new value was extended were avoidable themselves as preferences, they did not limit the subsequent new value defense. The bankruptcy court noted that there was no reason to distinguish between a creditor that was paid by an avoidable transfer and one that was never paid at all (and in fact, this seems to promote the policy of equality among creditors). The court also observed that the Eighth Circuit’s more recent decision was in line with recent decisions in other jurisdictions that have regarded the “remains unpaid” rule as an oversimplification and “shorthand” for the requirements of section 547(c)(4). To the extent the debtor’s payment on account of the new value was unavoidable, the new value defense would not apply.

The court found that all of the money Crown Heights provided to Agriprocessors as loans after the Crown Heights’ receipt of a preference could be analyzed as potential new value to offset Crown Heights’ preference exposure. This included the debtor’s direct use of Crown Heights’ money to create and pay false invoices in connection with its fraudulent scheme. The court excluded checks that were loans to the affiliated third party, Best Value – such amounts could not be considered new value because they did not replenish the estate. Ultimately, Crown Heights showed that all but $92,384.13 of the preferential transfers could be offset by the subsequent new value Crown Heights provided. Thus, the trustee could recover the $92,384.13. Adding that to the $1,297,150.68 that the court found to be constructively fraudulent, the court entered judgment in the trustee’s favor in the amount of $1,389,534.81.

Conclusion

The decision shows the importance for debtors and preference defendants of understanding their relevant jurisdiction’s approach to the “remains unpaid” debate.   Creditors should also be aware of the issue when they extend “new value” to a troubled debtor in reliance on payments received from the troubled debtor.