In a 56 page opinion published June 9, 2011, Judge Walsh ruled that a method of operating in which all of the credits and debits between two companies were netted out allows this same method to be used in calculating a set-off defense in preference litigation. Judge Walsh’s opinion is available here (the “Opinion”).
American Remanufacturers, Inc. (the “Debtor”), was in the business of remanufacturing, or restoring, used automobile parts. The Debtor would purchase broken and non-functioning parts, or “Cores,” from the defendant in this case, AutoZone Inc. (“AutoZone”), remanufacture the Cores, and sell the item back to AutoZone for sale to the final consumer.
When AutoZone purchased items from the Debtors, AutoZone would pay an item cost and an additional Core cost. Opinion at *6. When at item is sold to a consumer, the consumer pays a price that includes the Core cost. The consumer can then return to AutoZone a Core, often the broken part they are replacing, to receive a partial refund from AutoZone. AutoZone will then ship the Core to the Debtor and receive a credit for the Core cost. Opinion at *7. In my experience as a consumer, one of the more common situations where this occurs is when buying a car battery. You pay for the new battery and can bring in your old battery, often a different brand or model, for a partial refund. Similarly, AutoZone bought items from the Debtor and returned a slightly different version of the same item for a credit. Opinion at *8. In all, AutoZone and the Debtors created over 14 gigabytes of data relevant to their relationship. Id. at *16. Periodically AutoZone would net out the credits and debits between it and each of the Debtors and a single check would be cut for each Debtor. Id. at *18.
AutoZone and the Debtors had a very complex system of credits and payments. AutoZone was entitled to various credits and deductions, Opinion at *11, including monthly promotional allowances, warranty claim payments, fill rate penalties, Id. at *11, Core devaluation credits, Id. at *13, and credits for returns, Id. at *12. There was no tracking of individual sales or returns, as the quantity of product moving between AutoZone and each Debtor was too massive and each item was not individually identified. Id. at *20. In all, AutoZone owed the Debtors $4,557,476, Opinion at *23, and the Debtors owed credits to AutoZone totaling $9,003,690, Opinion at *30.
The Debtors filed for chapter 11 bankruptcy on November 7, 2005, and the case converted to a chapter 7 on November 17, 2005. At that same time, Montague S. Claybrook was appointed as the chapter 7 Trustee (the “Trustee”). The Trustee filed a preference action against AutoZone for the roughly $4.5 million AutoZone owed to the Debtors. The Trustee’s claim hinged on the fact that the credits owed to AutoZone were owed by a different Debtor than that to which AutoZone was indebted. Opinion at *37. Following discovery and a two-day trial, Judge Walsh issued the Opinion.
Judge Walsh’s Opinion
After an initial discussion of jurisdiction and venue, Judge Walsh turned to a Third Circuit opinion that held “that bankruptcy courts are courts of equity that apply equitable principles in the administration of bankruptcy proceedings.” In re Kaiser Aluminum Corp., 456 F.3d 328, 339 (3d Cir, 2006). Judge Walsh held that in the interest of equity, the Debtors would be treated as a single entity in considering the Debtors’ claims against AutoZone and AutoZone’s claims against the Debtors. Opinion at *34-38.
Judge Walsh then detailed each of AutoZone’s claims against the Debtors in holding that AutoZone was entitled to the entire $9,003,690 of credit it claimed. Opinion at *38-49. Judge Walsh also held that the various contracts binding the Debtors to AutoZone should be treated as a single contractual relationship, governed by Tennessee law. Opinion at *34. Under Tennessee law, recoupment was applicable here since the obligations and credits arose under the same contractual relationship. Opinion at *50-51. Judge Walsh also recognized that although recoupment may be available, in order for it to apply in a bankruptcy, “both debts must arise out of a single integrated transaction so that it would be inequitable for the debtor to enjoy the benefits of the transaction without also meeting its obligations.” Opinion at *52, quoting Univ. Med. Ctr. V. Sullivan (In re Univ. Med. Ctr.), 973 F.2d 1065, 1081 (3d Cir. 1992).
Judge Walsh ultimately held that the credits “were an integral part of the parties’ overall relationship and constituted a component of an integrated transaction between the parties.” Opinion at *53-54. Because the credits were applied to AutoZone’s total balance in the ordinary course of the companies’ business, Judge Walsh held that they would all be applied against the preference claim brought by the Trustee. Opinion at *55-56. Judge Walsh thus held that the preference claim would be reduced to zero and that the remaining claims of AutoZone against the Debtors in the bankruptcy case would be allowed.
The “Ordinary Course of Business” defense is, when applicable, one of the strongest and most easily proved defenses to a preference action. This is, however, just one of numerous defenses to a preference action. In situations where a business is the defendant in a preference action, it is highly advisable that it engage the services of an attorney experienced in preference defense to ensure that every available defense is considered.