Eastern District of Virginia Bankruptcy Judge Kevin R. Huennekens, in a December 1, 2010 opinion in Circuit City Stores, Inc. v. Mitsubishi Digital Electronics America, Inc. (AP No. 10-03068), held that the preference claim defendant could not utilize a new value defense (Section 547(c)(4) defense) if the defendant receives a transfer for its § 503(b)(9) administrative claim predicated upon the same instance of new value.  In reaching the conclusion, the Court methodically and with remarkable precision parses through the complexities of Section 547(c)(4).  Given the Court’s reasoning, the next question is “What about payments post petition under critical vendor, warehouseman, carrier and wage motions.”

Background – Defendant’s 20 Day Shipments and Preference Period Receipts

Circuit City Stores, Inc. (the “Debtor”) filed under Chapter 11 of the Bankruptcy Code on November 10, 2008 (the “Petition Date”).  The Debtor quickly obtained an order establishing a bar date December 19, 2008 for filing of administrative expense payment requests under Section 503(b)(9).  (For a discussion of these administrative priority payments click this link.)

Mitsubishi timely filed an administrative priority expense payment request for goods delivered to the Debtor in the 20 days preceding the Petition Date. This administrative expense ultimately was reduced to an amount agreed to by the Debtor of approximately $5 million.  On May 11, 2010, the Court entered an order approving a settlement agreement between the Debtor and Mitsubishi establishing a fully funded reserve for the exclusive benefit of Mitsubishi for the payment of the 503(b)(9) expense request (the “Mitsubishi Reserve Account”).

On April 1, 2010, the Debtor filed an adversary proceeding complaint against Mitsubishi and its credit insurer, The Insurance Company of Pennsylvania, who was the transferee of a portion of the Mitsubishi administrative expense payment request and prepetition unsecured claims.   The Debtor sought avoidance and recovery of transfers made during the 90 days preceding the Petition Date (the “Preference Period”) totaling approximately $7 million (the “Preference Payments”).

Framing the Issue –  Is there “New Value” in the $5 Million in Goods for which Payment is Held in the Mitsubishi Reserve Account

In its answer, among other defenses, Mitsubishi asserted that it had a subsequent new value defense under Section 547(c)(4) that reduced the Preference Payments otherwise avoidable.  Mitsubishi included in its claimed “new value” the $5 million in goods that were the basis for its 503(b)(9) claim.

The Debtor filed a motion for partial summary judgment on August 2, 2010, requesting that “Mitsubishi be precluded from availing itself of the new value defense under section 547(c)(4) of the Bankruptcy Code with respect to any goods for which it receives payment on account of its 503(b)(9) Claim.”

The Court framed the issue as:  “whether Mitsubishi can utilize a New Value Defense if it also receives payment for its § 503(b)(9) administrative claim where both its New Value Defense and its administrative claim are predicated upon that same recitation of value.”

Parsing through the Subsequent New Value Defense of 547(c)(4)

Section 547(c)(4) provides that a transfer is not avoidable as a preference:

to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor–

(A) not secured by an otherwise unavoidable security interest; and
(B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor;

The Court found that the only element of the defense at issue was whether “the debtor did not make an otherwise unavoidable transfer”.

The first question the Court answered was whether the establishment of the Mitsubishi Reserve Account was a “transfer”:

The establishment of the reserve fund is absolute. The Debtors have parted with their interest in the monies that have been set aside in the reserve fund for the exclusive “benefit of Mitsubishi. The stipulated settlement creating the reserve fund for the exclusive benefit of Mitsubishi guarantees that the total amount of Mitsubishi’s 503(b)(9) Claim, as ultimately allowed by this Court, will be paid in full. The creation of the reserve fund constitutes a “transfer” “for the benefit of Mitsubishi within the meaning of § 547(c)(4)(B) of the Bankruptcy Code … .

The Court then looked to the third and final element – i.e. whether the 503(b)(9) transfer was “not … otherwise unavoidable”.

The Court acknowledged the split in the circuits on the proper application of this defense between the “remains unpaid” approach and the “subsequent advance” approach.  The Court noted that the Fourth Circuit Court of Appeals (which encompasses Virginia) had adopted the subsequent advance approach in Hall v. Chrysler Credit Corp. (In re JKJ Chevrolet, Inc.), 412 F.3d 545 (4th Cir. 2005).   Under this approach:

[a] creditor is entitled to offset preference payments through the extension of new value to the debtor so long as the debtor does not make an otherwise unavoidable transfer on account of the new value. Thus, even if [debtor] repaid all of the new value, under the plain terms of the statute whether those payments deprive [creditor] of its new value defense depends on whether the payments were otherwise unavoidable.”

Is a Payment of a 503(b)(9) Administrative Expense an Avoidable Transfer?

The Court’s inquiry was boiled down to a simple application of the seven sections of the Bankruptcy Code that define the universe of potentially avoidable transfers:  §§ 544, 545, 547, 548, 549, 553(b) and 724(a).   The Court summarily eliminated six of these provisions:  Sections 544, 547, 548 and 553(b) only apply to prepetition transfers and Section 545 and 724(a) apply only to fixing of liens.

The Court was left with Section 549.  Section 549 allows for avoidance of post petition transfers that are neither authorized by the Bankruptcy Code nor the Bankruptcy Court.  The Court then observed that the Mitsubishi Reserve Account had been “both authorized by the Court and the Bankruptcy Code”.  The Court then reached the core of its decision:

Because the Transfer for the Benefit of Mitsubishi to facilitate payment of Mitsubishi’s 503(b)(9) Claim is not avoidable through the use of §§ 544, 545, 547, 548, 549, 553(b) or 724(a) of the Bankruptcy Code, it is an “otherwise unavoidable transfer” that § 547(c)(4)(B) of the Bankruptcy Code negates for qualification as new value. Mitsubishi can get credit only once for the goods it supplied to the Debtors in the twenty-day period preceding the Petition Date.

What Wiggle Room is Left for Post Petition Transfers against Prepetition Claims?

If the Courts analysis is accepted, what post petition transfers in satisfaction of pre-petition claims will not reduce “new value”?  After 503(b)(9) payments, the most common type of post-petition transfers in satisfaction of pre-petition claims are payments made pursuant to first day motions to select creditors.  The motions include  “critical vendor”, “warehouse and carrier” and “wages” motions.  How do these payments fair under the Court’s analysis?

The Court indicates that such payments are distinguishable from payments made under 503(b)(9).  The Court favorably discusses the Northern District of Georgia Bankruptcy Court decision in TI Acquisition, LLC v. Southern Polymer, Inc. (In re TI Acquisition, LLC), 429 B.R. 377 (Bankr. N.D. Ga. 2010).  See note on this website discussing in depth TI Acquisition:  “Subsequent Advance” Approach to Subsequent New Value May Still Live in the Eleventh Circuit… and Payment of 503(b)(9) Administrative Expense Claim Held to Reduce Subsequent New Value Defense to Bankruptcy Preference.

In TI Acquisition, Judge Mary Grace Diehl similarly concluded that 503(b)(9) payments precluded the corresponding goods from being “new value”.  In reaching this decision, however, Judge Diehl distinguished 503(b)(9) payments and payments made pursuant to a critical vendor motion, observing:

Payment pursuant to a critical vendor order differs markedly from the statutory priority accorded to § 503(b)(9) claims. An order designating an unsecured creditor as a “critical vendor” accords the debtor-in-possession a great deal of latitude in negotiating the terms and conditions of “critical vendor” status while conditioning the designation as a “critical vendor” on the creditor’s agreement to provide post-petition credit to the debtor-in-possession. See, e.g., In re Phoenix Rest. Group, 373 B.R. at 544-545 (describing how parties negotiated for critical vendor terms).

Judge Huennekens in his Circuit City decision acknowledges this distinction and agreed (although relegated to a footnote):

The court in TI Acquisition noted that it did not agree with the analysis contained in Commissary Operations v. DOT Foods Inc., (In re Commissary Operations), 421 B.R. 873, 877-79 (Bankr. M.D. Tenn. 2010), in which the court found that reclamation claims and claims made pursuant to § 503(b)(9) were dissimilar and should be treated differently for purposes of § 547(c)(4) analysis. Additionally, the court in TI Acquisition distinguished critical vendor claims from § 503(b)(9) claims, whereas the court in Commissary Operations had analogized the two. This Court agrees with the analysis of the court in Tl Acquisition in both of these regards.

This is a small bone to throw to defenders of bankruptcy preference claims.  Judge Huennekens does not explain why a critical vendor payment would pass the analysis he applied to the 503(b)(9) transfer.  Simply, the analysis Judge Huennekens employs is so tight as to leave no apparent wiggle room.

The issue of disqualification of subsequent new value due to payments made pursuant to “critical vendor” and like orders should be of substantial concern to those in the process of defending preference claims.  Indeed, it is an issue already fully briefed and pending decision before the Delaware Bankruptcy Court, Judge Christopher S. Sontchi in Freedman’s Inc v. Roth Staffing Companies, L.P. (In re Friedman’s Inc.) .  There is not long to wait for a decision on this point out of Delaware.