The Second Circuit Court of Appeals recently issued its decision on a question of first impression before the court: whether section 502(d) of the Bankruptcy Code applies to administrative claims arising under section 503(b) of the Bankruptcy Code. See, generally, ASM Capital, L.P. v. Ames Dept. Stores, Inc. (In re Ames Dept. Stores, Inc.), 582 F.3d 422 (2d Cir. 2009). While on the surface this decision appears to be a technical decision involving Bankruptcy Code minutiae, the outcome could provide a significant advantage to suppliers of debtors in the future, as well as lead to additional litigation over the application of the decision.

Section 502(d) of the Bankruptcy Code provides, generally, that a bankruptcy court shall disallow the claim of any entity from which property is recoverable under certain sections of chapter 5 of the Bankruptcy Code or that is a transferee of a transfer avoidable under certain other sections of chapter 5 of the Bankruptcy Code unless that entity turns over the property in question. In general, this provision is used to disallow the claims of creditors against whom the trustee or debtor-in-possession may assert avoidance actions under the Bankruptcy Code, such as claims to avoid fraudulent conveyances under sections 544 and 548 of the Bankruptcy Code, preferential transfers under section 547 of the Bankruptcy Code or unauthorized post-filing transfers under section 549 of the Bankruptcy Code.

The purpose of section 502(d) of the Bankruptcy Code is to coerce creditors into complying with orders of the bankruptcy court. See Campbell v. United States (In re Davis), 889 F.2d 658, 662 (5th Cir. 1989) cert. denied 495 U.S. 933 (1990). Section 502(d) effectively mitigates the ability of a pre-petition creditor to assert setoff against chapter 5 causes of action arising from pre-petition transactions between the debtor and the creditor. See, e.g., Comm. of Unsecured Creditors of Interstate Cigar Co. v. Interstate Distrib. (In re Interstate Cigar Co.), 278 B.R. 8, 25 (Bankr. E.D.N.Y. 2002) (section 502(d) provides statutory support for prohibition against offset). This provision also advances the overarching goal of the various chapter 5 avoidance causes of action, which is to ensure the pro rata sharing among all creditors of a debtors’ estate. Of course, from the perspective of the creditor already facing an avoidance action merely for receiving payment from a debtor who still owes that creditor money, section 502(d) can also serve to enhance the perceived arbitrary or punitive nature of the trustee’s avoidance powers.

The purpose of section 502(d) of the Bankruptcy Code is to coerce creditors into complying with orders of the bankruptcy court. The issue confronting the Second Circuit in Ames was whether section 502(d) of the Bankruptcy Code applies to administrative claims arising under section 503(b) of the Bankruptcy Code. Administrative claims are generally granted to those who provide goods or services to the debtor following the filing of the bankruptcy petition. As a preliminary matter, the facts in Ames present a cautionary tale to those who purchase the claims of others in bankruptcy cases. The creditor in Ames acquired the administrative claims of another party, which itself ultimately filed bankruptcy and liquidated. 582 F.3d at 424-26. However, the creditor either failed to obtain the authority to defend against a preference action filed against the seller, or failed to provide that defense, resulting in default judgment against the seller in favor of Ames – a judgment that was uncollectable due to the seller’s liquidation. Id. at 425. The liquidating trustee of Ames then used the judgment against the seller to assert that the creditor’s administrative claim should not be allowed under section 502(d) of the Bankruptcy Code, illustrating the importance of claims purchasers retaining the ability to address or intervene in the preference actions of those whose claims they purchase.

With regard to the application of section 502(d) disallowance to administrative claims, the Second Circuit joined a long list of other courts in holding that Congress did not intend section 502(d) to apply to administrative claims arising under section 503(b) of the Bankruptcy Code. Ames, 582 F.3d at 432. See also In re USA Labs, Inc., Case No. 04-41587-BKC-RAM, 2006 Bankr. LEXIS 2394 at * 4 (Bankr. S.D. Fla. Apr. 13, 2006); Phoenix Rest. Group, Inc. v. Proficient Food Co. (In re Phoenix Rest. Group, Inc.), 2004 Bankr. LEXIS 2186 at * 62 (Bankr. M.D. Tenn. Dec. 16, 2004); Roberds, Inc. v. Broyhill Furniture (In re Roberds, Inc.), 315 B.R. 443, 476 (Bankr. S.D. Ohio 2004); In re Durango Georgia Paper Co., 297 B.R. 326, 330-31 (Bankr. S.D. Ga. 2003); In re Lids Corp., 260 B.R. 680, 683-4 (Bankr. D. Del. 2001); Camelot Music, Inc. v. MHW Advertising and Pub. Relations, Inc. (In re CM Holdings, Inc.), 264 B.R. 141, 158 (Bankr. D. Del. 2000); Rand Energy Co. v. Del Mar Drilling Co., Inc. (In re Rand Energy Co.), 256 B.R. 712, 718-19 (Bankr. N.D. Tex. 2000). But see MicroAge, Inc. v. Viewsonic Corp. (In re MicroAge, Inc.), 291 B.R. 503, 512-13 (B.A.P. 9th Cir. 2002) (holding that because section 502(d) applies to any claim, it applies to post-petition administrative claims).

The Ames court, like previous bankruptcy courts, concluded that section 502 of the Bankruptcy Code itself applies only to claims that are required to be filed under section 501 of the Bankruptcy Code. 582 F.3d at 429. Because section 501 refers only to “creditors” of the debtor, and the term “creditor” is defined under section 101(10)(A) of the Bankruptcy Code as an entity holding a pre-petition claim, section 502(d) may be applied only to those entities that hold pre-petition claims against a debtor’s estate. Id. Moreover, the filing of requests for the payment of administrative expenses is separately governed by section 503(a) of the Bankruptcy Code, which is not referenced in section 502 of the Bankruptcy Code. Id. at 429-30. Finally, the Ames court noted that the purpose of affording higher priority to administrative claims than to certain other claims under section 503 of the Bankruptcy Code is to encourage parties to deal with the debtor post-petition and that purpose would be frustrated through the use of section 502(d) to evade administrative claims. Id. at 431.

The Ames decision is important because it resolves a critical question for creditors in the influential Second Circuit, which includes the Southern District of New York. Creditors providing post-petition goods and services to bankruptcy debtors within the Second Circuit, which accounts for a substantial number of such debtors, can now be assured that they will not subsequently face a challenge to the debtor’s payment for those goods and services as an administrative claim as a result of potential avoidance actions.

The Ames decision is important because it resolves a critical question for creditors in the influential Second Circuit, which includes the Southern District of New York.

However, the Ames decision leaves unanswered two additional questions that creditors should consider when dealing with potential debtors or responding to allegations of having received avoidable transfers. First, the Ames court failed to address the application of section 502(d) to reclamation claims arising under section 546(c) of the Bankruptcy Code, despite the fact that the creditor in that case asserted such claims. 582 F.2d at 424. While parties regularly argue that reclamation claims arising under section 546(c) are entitled to priority under the Bankruptcy Code, that priority does not arise under the express language of section 503(b) of the Bankruptcy Code (or any other explicit provision of the Bankruptcy Code). Thus, reclamation claims remain subject to litigation regarding the applicability of section 502(d) to such claims.

Moreover, the Ames court states that “section 502(d) does not apply to administrative expenses under section 503(b).” 582 F.2d at 432. Arguably, this language could be read to encompass administrative claims arising under section 503(b)(9), which provides vendors of debtors with an administrative claim for goods delivered to the debtor during the 20 days preceding the petition date. However, the Ames decision itself largely focuses on the post-petition nature of administrative claims by relying on the definition of the term “creditor” and the policy reason behind granting administrative claims to post-petition creditors of debtors. It is likely that in the future debtors will continue to argue, even in the Second Circuit, that section 502(d) applies to claims arising under section 503(b)(9) of the Bankruptcy Code. It remains to be seen whether the Second Circuit will join the growing chorus of bankruptcy courts to have decided that, notwithstanding the pre-petition nature of section 503(b)(9) claims, section 502(d) is inapplicable to those claims as well. See, e.g., In re Plastech Eng. Prods., Inc., 394 B.R. 147, 164 (Bankr. E.D. Mich. 2008); Southern Polymer, Inc. v. TI Acquisition, LLC (In re TI Acquisition, LLC), 410 B.R. 742, 751 (Bankr. N.D. Ga. 2009). But see In re Renew Energy, LLC, Case No. 09-10491, 2009 Bankr. LEXIS 3352 at * 13-15 (Bankr. W.D. Wis., Sep. 30, 2009) (disallowing a 503(b)(9) claim and declining to rule on the applicability of section 502(d) until the adversary proceeding regarding avoidable preference was resolved).