Judge Christopher Sontchi of the United States Bankruptcy Court for the District of Delaware has now weighed in on a hotly debated circuit court split. The issue of whether, under section 547(c)(4) of the Bankruptcy Code, a recovery on a preferential transfer may be reduced by subsequent new value — regardless of whether it was “paid” or “unpaid” prior to the petition date — has remained unresolved among the circuits and within the Third Circuit for years. In the recent case Miller v. JNJ Logistics LLC (In re Proliance Int’l, Inc.), Judge Sontchi found that, at least by inference, previous decisions of the Delaware bankruptcy court adopted the subsequent advance approach to this issue. That is, a party’s preference exposure may be reduced by both paid and unpaid subsequent new value. Applying this approach, Judge Sontchi held that the defendant in Proliance was entitled to full credit for all subsequent new value it provided to the debtors, even though it received payment for some of such value.

Background

Prior to the petition date, JNJ Logistics LLC, the defendant, provided freight transport services for auto parts to the debtors. Although the debtors paid $222,045.11 on account of certain JNJ prepetition invoices, JNJ invoices in the amount of $49,366.28 remained opened and unpaid as of the petition date. The trustee sought the return of $548,035.66 in preferential transfers made to JNJ in the 90-day window prior to the petition date. The parties agreed that JNJ had a subsequent new value defense to the preference claims in the amount of $49,366.28 on account of invoices that remained open and unpaid as of the petition date, but the parties disagreed about whether JNJ had a subsequent new value defense to the preference claims in the amount of $222,045.11 on account of invoices that had been paid by the debtor as of the petition date.

The Subsequent New Value Defense and the Circuit Split

Section 547(c)(4)(B) provides as follows:

The trustee may not avoid under this section a transfer . . . 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 . . . on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.

Interestingly, courts are split on the interpretation and application of the double negative in section 547(c)(4)(B). Prior to the enactment of the Bankruptcy Code, section 547(c)(4)(B)’s predecessor, § 60(c) of the Bankruptcy Act of 1898, limited the use of new value to the “amount of such new credit remaining unpaid at the time of the adjudication in bankruptcy.”   Subsequently, courts established the so-called “net result rule” whereby the courts simply totaled the preferential payments and the subsequent advances by the creditor during the preference period and offset them against each other. When Congress did not include this language in section 547(c)(4)(B), courts adopted two different approaches: the “remains unpaid” approach and the “subsequent advance” approach.

The Remains Unpaid Approach

The courts that take the “remains unpaid” approach hold that the double negative in section 547(c)(4)(B) should be read to mean that, in order to be used as a defense to a preference claim, value must remain unpaid at the end of the preference period. Why? Courts adopting the remains unpaid approach argue that the extension of new value under section 547(c)(4) is merely meant to return the preference to the estate. “The creditors have not been harmed [and] the estate has not been diminished, because new inventory has been supplied.” Where a debtor pays a subsequent advance (or the creditor retains a security interest in the advance), the preference is not returned, and the estate is not benefited. Accordingly, the remains unpaid approach puts the debtor on a C.O.D. basis — as if the creditor is being paid in advance of shipments rather than for antecedent debts. According to the Proliance court, the remains unpaid approach provides that “new value that has been paid by the debtor prior to the petition date is not eligible for offset under section 547(c)(4) because paid new value does not represent the return of a preferential transfer to the estate.”

The Subsequent Advance Approach

Other courts take the “subsequent advance” approach, holding that section 547(c)(4)(B) does not require that new value remain unpaid at the end of the preference period. Specifically, such courts hold that the “net result rule [under 60(c)] was modified [with the insertion of ‘otherwise’] so that new value could only be used to set off preferences received earlier.”Accordingly, the only way for a creditor-supplier to have a defense to a preference is to continue supplying additional new value after receiving each preference. At bottom, subsequent advance supporters find that the subsequent new value defense was intended to except from avoidance revolving credit relationships.  Moreover, the word “otherwise” refers to transfers that are avoidable under section 547(c)(4), not transfers that are avoidable under other sections of the Bankruptcy Code. This encourages trade creditors to continue dealing with troubled businesses and is designed to treat fairly creditors who have replenished the estate after having received a preference. Otherwise, a creditor who continues to extend credit to the debtor in reliance on prior payments is only increasing its bankruptcy loss.

Remains unpaid supporters have argued that the subsequent advance approach “may give lip service to the statutory goal of encouraging continued dealings with distressed businesses, but it does so at the cost of tipping the statutory balance of economic considerations over to the creditor-supplier’s side.

Application of Both Approaches

In Proliance, Judge Sontchi provided the following chart to illustrate a defendant’s preference exposure under both the remains unpaid and subsequent advance approach:

Click here to view table

The Parties’ Positions

JNJ argued that its preference exposure should be reduced by its subsequent new value defense under the “subsequent advance” approach, which would reduce JNJ’s preference by both paid and unpaid invoices. The trustee argued that the court should adopt the “remains unpaid” approach and only reduce JNJ’s preference exposure by the amount of unpaid invoices.

Trustee’s “Remains Unpaid” Approach

Alleged Preference:                                                         $548,035.66

Undisputed SNV Defense for Unpaid Invoices:       ($49,366.28)

Total Preference Exposure:                                 $498,669.38

JNJ’s “Subsequent Advance” Approach

Alleged Preference:                                                          $548,035.66

Undisputed SNV Defense for Unpaid Invoices:       ($49,366.28)

Disputed SNV Defense for Paid Invoices:                 ($222,045.11)

Total Preference Exposure:                                 $276,624.27

Judge Sontchi Adopts the Subsequent Advance Approach

After sifting through several decisions on both sides of the split, Judge Sontchi noted that, to date, the Third Circuit has not weighed in on this dispute. In reliance on the Delaware bankruptcy court’s statements in In re Sierra Concrete Design and In re Vaso Active Pharmaceuticals, Inc., Judge Sontchi held that the rulings in such cases have, at least by inference, adopted the subsequent advance approach.

In Sierra, the Delaware bankruptcy courtheld that “in order to invoke successfully the subsequent new value defense in [the Third Circuit] the creditor must establish two elements: (1) after receiving the preferential transfer, the creditor must have advanced ‘new value’ to the debtor on an unsecured basis; and (2) the debtor must not have fully compensated the creditor for ‘new value’ as of the date that it filed its bankruptcy petition.” The Sierra Court explained that

[t]he statute’s language is difficult to decipher containing, among other things, a double negative. Nonetheless, it correctly invokes the underlying economic principle—the creditor made subsequent shipment of goods only because the debtor was paying for the earlier shipments. Thus, one should and does look at the net result—the extent to which the creditor was preferred, taking account of the new value the creditor extended to the debtor after repayment on old loans.

In adopting this approach, the Sierra Court also noted that the defense is not available to give a creditor a “credit” for new value in excess of its preference exposure. This ruling was reiterated by the Delaware bankruptcy court in Vaso.

In Proliance, Judge Sontchi found that, although Sierra and Vaso did not explicitly adopt the subsequent advance approach, the essence of their holdings provided, at least by inference, that the court had adopted the subsequent advance approach. Applying such rulings inProliance, JNJ was entitled to a full credit for all subsequent new value it provided to the debtors, including paid and unpaid invoices. Thus, the court reduced JNJ’s preference exposure by $271,411.39.

Although the jurisdictional split on the new value defense continues, Judge Sontchi, in adopting the tests set forth in Sierra and Vaso, has provided some clarity on this issue for cases within Delaware. Only time will tell, though, when the Third Circuit will crystalize its position on section 547(c)(4)(B). Until then, creditors rejoice. The creditor-friendly Proliancetest appears to be the persuasive rule in Delaware for now.