Protecting What You Have, Pursuing What You're Owed: Eleventh Circuit Rules That Distributions On Section 503(b) (9) Claims Do Not Reduce The New Value Defense To Preferences

• Published date: 28 September 2022
• Subject Matter: Litigation, Mediation & Arbitration, Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy, Trials & Appeals & Compensation
• Law Firm: Kelley Drye & Warren LLP
• Author: Mr James S. Carr and Dana P. Kane

There can be no doubt that the current economic landscape is challenging and forces businesses to make difficult choices. The trade creditor's unenviable task during these times is to maintain valuable business relationships in the hopes of sustaining profitability, which often requires the continued extension of credit terms to customers despite the heightened risk of those customers being unable to satisfy their debts.

When your customer's financial distress reaches the point of filing for bankruptcy, you know from the outset that collection of outstanding receivables will be significantly reduced, if not eliminated entirely. In any event, you diligently file your proof of claim, dutifully monitor the progress of the case and hope for a minimal distribution. Then, your already bad situation is exacerbated when you receive a demand letter that asks for return of payments that your company was able to collect from the debtor before it filed for bankruptcy. At that point, your job shifts from maximizing your company's recovery to protecting what it already has been paid. Fortunately, the Eleventh Circuit Court of Appeals' recent decision in Auriga Polymers Inc. v. PMCM 2, LLC¹ allows you to accomplish both goals.

Background: The Intersection of Preferences, New Value and 503(b)(9) Claims

Being sued for a preference is a bitter pill to swallow. From your perspective, you got paid by the customer on account of trade debt that the customer legitimately incurred and owed. However, in furtherance of two fundamental objectives woven throughout the Bankruptcy Code - preventing a race to the courthouse to dismantle a financially troubled debtor and promoting the equality of distributions among similarly situated creditors² - section 547 of the Bankruptcy Code allows a trustee to avoid payments made by a debtor (1) to or for the benefit of a creditor; (2) on account of an antecedent debt; (3) while the debtor was insolvent; (4) during the 90-day period before the petition date³ ; and (5) that enables the creditor to receive more than it would in a hypothetical Chapter 7 case.⁴

The Bankruptcy Code also recognizes some affirmative defenses to the avoidance of allegedly preferential transfers, certain of which are designed to promote the equally important policy of encouraging creditors to continue conducting business, on terms, with a financially troubled counterparty. Prominent among the affirmative defenses is the "subsequent new value" defense embodied in section 547(c)(4). By allowing creditors to offset their potential liability, the new value defense rewards those creditors that received an avoidable 90-day payment from the debtor, but thereafter, replenished the debtor's estate by shipping new product to the debtor.

Specifically, section 547(c)(4) provides that a creditor's exposure on preferential transfers can be reduced where, subsequent to one or more of those transfers, the creditor provided unsecured new value "on account of which new value the debtor did not make an otherwise unavoidable transfer to . . . such creditor."⁵ Despite its plain language, the application of section 547(c)(4) is not very straightforward in practice and has sparked significant litigation over the years. Of particular importance to the vendor community, one of the divisive issues has been the question of whether a creditor's asserted new value defense can be used if the creditor receives payment of its section 503(b)(9) administrative claim.⁶ Until recently, only three courts had issued published decisions addressing this precise question.⁷

Bankruptcy courts in the Northern District of Georgia and the Eastern District of Virginia have aligned with plaintiffs on this issue, ruling that creditors cannot count as "new value" goods supplied on credit terms that are also included in a 503(b)(9) claim. Otherwise, plaintiffs argue that the result is an impermissible "double dip" allowing the creditor to recover twice on the same extension of value.⁸ They also assert that, more generally, allowing creditors to use so-called "section 503(b)(9) new value" undermines the policy reasons for the existence of the new value defense: to encourage continuity of business on credit terms with a financially troubled entity, thus replenishing the estate with product. That objective is not achieved where the amount by which the estate was enhanced leaves the estate in the form of a distribution on...