One of the less frequently seen defenses to a bankruptcy preference is based on Section 365 of the Bankruptcy Code. We believe that there are many more opportunities to use the defense for suppliers who are aware of it and understand it.
The Kiwi Defense Concept
Section 365 allows a Chapter 11 debtor or Chapter 7 trustee to assume, with Bankruptcy Court approval, an “executory contract”. The 365 defense is simple in concept: a payment made under a contract assumed under Section 365 can not be preference payment. That defense was firmly established in a 2003 decision by the Third Circuit Court of Appeals in the bankruptcy case of In re Kiwi International Air Lines Inc., so the defense is sometimes called the Kiwi defense.
The Kiwi defense is a defense that we believe may be underutilized. The facts needed to establish the 3 most common defenses (the contemporaneous exchange defense, the ordinary course of business defense and the subsequent new value defense) are “fixed” at the time of the bankruptcy filing. There is nothing that the supplier can do to increase its odds of successfully establishing those 3 defenses other than pulling together and preserving all relevant information.
The Kiwi defense is different. It depends in part on facts that arise after the bankruptcy petition is filed.
The Elements of the Defense
The key elements of the defense are:
- The contract is in effect before the bankruptcy filing;
- The contract continues to impose material obligations on both parties after the bankruptcy filing;
- The Section 365 requirements for “assumption” are satisfied;
- There is a bankruptcy court order approving the assumption of the contract;
- The payments received during the preference period were made under that contract.
An Illustration of the Application of the Kiwi Defense
Here is a simple example to illustrate the defense:
Your company provides maintenance services on equipment. You have a maintenance contract with a customer that has been struggling financially for some time. You are supposed to be paid monthly, but payments have been late. Your customer then files bankruptcy. You have been paid $50,000 during the 90 days prior to the bankruptcy filing. Normally, you would be looking at a potential preference claim for $50,000.
But then you get a notice that your maintenance contract has been “assumed” by your bankrupt customer. Your bankruptcy preference concerns may be over. If the requirements for assumption have been met, you should not have to face a preference claim on the $50,000 in payments under the maintenance contract.
The Defense on Applies to Payments Made under the Assumed Contract
Take the above example and add a twist to illustrate the importance of the last element listed above. Of the $50,000 you got paid, only $30,000 was paid on monthly fees under the maintenance contract. You also got paid $20,000 for work not covered by the maintenance contract. The $20,000 may continue to be subject to a potential preference claim. Those payments arguably were not under the contract that was assumed.
But don’t give up hope, have your lawyer look at the contract. Find out if there is any argument that even though the work done was not covered by the monthly maintenance fee, the work was still performed and paid for under the maintenance contract.
Formalities are Important
Formalities are important to establish the Section 365 defense. The Section 365 defense requires the formality that the contract has been assumed pursuant to an order of the Bankruptcy Court. If both you and the debtor just continue to perform under the contract but there is no order approving an assumption, then you have not sealed up the Section 365 defense.
Are there ways for a supplier legally and ethically to maneuver itself into a 365 defense? We think that in many cases there are. Too often, it seems, the supplier just misses the boat because it does not know the defense is there.