Can an Administrative Claim Be Used to Offset Preference Liability? Judge Carey (D. Del.) Addresses an Issue of First Impression in Quantum Foods

By Evan T. Miller, Esq.

Addressing an issue of first impression, Judge Kevin Carey (Bankr. D. Del.) ruled that a preference action defendant could use their allowed administrative expense claim as a setoff against any preferential transfer exposure.  In so deciding, the Court rejected the plaintiff’s arguments that such a position (i) is inapposite to the Third Circuit’s prohibition against utilizing postpetition goods or services as subsequent new value or (ii) violates Bankruptcy Code section 502(d). To the former, the Court found that the defendant’s setoff claim was distinct and could not be considered subsequent new value under 11 U.S.C. § 547(c)(4), as that defense is concerned entirely with prepetition activity; by contrast, the defendant asserted a valid setoff claim since the opposing obligations (i.e., the preference claim against the administrative claim) both arose on the same side of the bankruptcy petition date.  With respect to the plaintiff’s second argument, the Court found that administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d).

The Preferential Transfers and Administrative Expense Claim

Quantum Foods, LLC, et al. (the “Debtors”) initiated these bankruptcy cases on February 18, 2014 (the “Petition Date”).  In the ninety days prior to the Petition Date, Tyson Fresh Meats, Inc and Tyson Foods, Inc. (collectively, “Defendant”) received approximately $14 million in transfers (the “Transfers”) from the Debtors.  Postpetition, Defendant provided the Debtors with approximately $2.6 million in products, an amount which was accorded administrative status by the Court (the “Admin Claim”) but was never paid by the Debtors.

On March 25, 2015, the official committee of unsecured creditors (the “Committee”) appointed in these cases commenced the instant avoidance action seeking to avoid and recover the Transfers under Bankruptcy Code sections 547, 548, and 550, and to disallow any of Defendant’s claims until the voided Transfers were returned.  Defendant answered and asserted counterclaims and third-party claims against the Debtors. The Committee filed a FRCP 12(c) Motion for Judgment on the Pleadings with respect to Count I of the counterclaims and third-party complaint.  Oral argument among the Committee, the Debtors, and Defendant took place on February 3, 2016.

The Arguments

Defendant contended that the Committee’s claims to recover avoidable preferential transfers are post-petition causes of action and that Defendant is entitled to set off any recovery claims by the amount of its allowed postpetition Admin Claim.  Defendant argued that its Admin Claim is an extrinsic setoff claim, wholly unrelated to the concept of any new value defense or to the section 547 preference analysis generally.

In response, the Committee and the Debtors argued that Defendant’s setoff claim is really a “disguised” or “renamed” postpetition new value defense because, like a new value defense, it would have the effect of reducing the total amount of preferential transfers restored to the estate. According to the Committee and the Debtors, such a result would also violate section 502(d), which prohibits courts from allowing claims by preference defendants until after they have paid the amount for which they are liable.  The Committee and Debtors further argued that Defendant’s position is forbidden by the Third Circuit’s seminal Friedman’s Liquidating Tr. v. Roth Staffing Co. (In the Friedman’s, Inc.), 738 F.3d 547 (3d. Cir. 2013).*

*For a contemporary article by the author about the importance of the Friedman’s decision, click here

The Court’s Ruling on an Issue of First Impression

The Court began by recognizing that the question presented was one of first impression: Whether an allowed post-petition administrative expense claim can be used to set off preference liability?  The Court noted that there is no provision in the Bankruptcy Code that deals expressly with postpetition setoff.

Setoff or Disguised New Value?

The Court first found that Defendant’s setoff claim was not a “disguised subsequent new value” defense.  The Friedman’s decision makes clear that the preference calculation should be cut off at the petition date, which limits the utility or applicability of “new value” to the preference period.  Ergo, the Court found that it made no sense to refer to any claim arising outside of the preference period as a new value defense.  The Admin Claim is “comprised exclusively of post-petition activity; a section 547(c)(4) new value defense is limited to pre-petition activity.”  Judge Carey further held that Defendant’s claim fit squarely into the definition of “setoff”, as it is a “counterclaim demand which defendant holds against plaintiff, arising out of a transaction that is extrinsic of plaintiff’s cause of action.”  As such, the setoff claim does not affect the calculation of the preference, “only the amount paid to the estate.”

Analyzing the Setoff

Having found that Defendant’s claim is an assertion of setoff rights and not new value, the Court provided further analysis of the setoff claim.  Noting that “setoff is only available in bankruptcy when the opposing obligations arise on the same side of the… bankruptcy petition date,” the Court found that the Admin Claim is “clearly a post-petition obligation of Debtor” and  that a “preference claim can be asserted only after the filing of a bankruptcy petition.”  As such, setoff is permissible in this case since the opposing obligations arose postpetition.

Prohibited by Section 502(d)?

Finally, the Court addressed whether Bankruptcy Code section 502(d) – which “states broadly that “the court shall disallow any claim of any entity… that is a transferee of a transfer avoidable under… [§ 547]… unless such entity or transferee has paid the amount… for which such entity or transferee is liable” – prohibited setoff of Defendant’s Admin Claim against any preference liability.  In short, the Court found that it did not.  Observing that courts routinely recognize that “administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d)”, Judge Carey found no support in the Code for disallowing administrative claims if the administrative claimant fails to satisfy a preference liability.  In rejecting the Committee and the Debtors’ emphasis on the equality of distribution, the Court found that Judge Walrath had rejected a similar argument in In re Communication Dynamics, Inc. because “[e]quity does not mandate that one creditor lose rights it has under state law and the Bankruptcy Code simply because other creditors will benefit by that loss.”  Moreover, Friedman’s recognized that “[if] it is a rule in bankruptcy that all creditors must be treated equally, surely the exceptions swallow the rule.”

Therefore, the Motion was denied.

Conclusion

This is at least the second important 2016 preference opinion issued by Judge Carey which cuts in favor of defendants. See also Forman v. Moran Towing Corp. (In re AES Thames, LLC, et al.), summarized hereFor vendors maintaining a high level of postpetition business with a debtor, the ruling takes on added importance.

Notwithstanding, it is interesting to question how certain tweaks to the fact pattern would have affected the Court’s analysis, if at all – i.e. what if the Debtors had paid Defendant’s Admin Claim earlier in the case (which, in a sense, is indirectly addressed in this opinion)?  What if, at the time the avoidance action was brought, no order had been entered granting the administrative expense?

A copy of the Opinion can be found here.

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