Delaware Bankruptcy Judge Rules That Payment Does Not Prevent Use of New Value Defense in Favorable Opinion for Vendors

May 1, 2010

Many businesses will at some point find themselves a defendant in a preference action commenced by or on behalf of a debtor in a bankruptcy case. A preference action may arise, for example, when creditors of a company that goes into bankruptcy claim that some of the payments made by the company just prior to the bankruptcy should be returned and distributed equitably among all creditors.

Generally speaking, a debtor declaring bankruptcy (or one acting on behalf of a debtor’s estate) may recover a payment or other transfer made to (or for the benefit of) someone not an insider of the debtor, for a debt outstanding at the time the payment/transfer is made, if: (1) the payment or transfer was made within the ninety (90) day period before the bankruptcy case was filed; (2) the debtor was insolvent at the time the payment or transfer was made; and (3) the payment or transfer enabled the creditor to receive more than it would have received in a liquidation of the debtor under chapter 7 of the Bankruptcy Code.

The new value defense is frequently employed by vendors who have found themselves a defendant in an action seeking to recover an alleged preferential transfer. New value is defined in the Bankruptcy Code as “money or money’s worth in goods, services or new credits…” 11 U.S.C. § 547(a) (2).

In In re Pillowtex Corp., 416 B.R. 123 (D. Del. Bankr. 2009), the Chief Judge of the Bankruptcy Court for the District of Delaware (Judge Carey) held that in order to successfully assert a subsequent new value defense to a preference claim, the new value need not remain unpaid on the date the bankruptcy case was filed as long as it has not been repaid with an otherwise unavoidable transfer.  For example, let’s say company A delivered widgets to company B, now a debtor in bankruptcy, in January on 30 day terms and the invoice was not paid until March, and company A also delivered widgets to company B, now a debtor in bankruptcy in February on 30 day terms, which invoice was paid in March within the 30 day terms.  Company B files for bankruptcy in April and seeks to “avoid” and recover the two payments made in March.  Assuming that the second payment is protected by an “ordinary course of business” defense, company A may still use the value of the widgets delivered in February as a setoff of the first payment.  The decision marks a change in what many understood to be the law previously in the Third Circuit, namely that a subsequent transfer could only be used to shield a preference payment if it was unpaid as of the date that the bankruptcy case was filed (the so-called “remains unpaid” approach).

In Pillowtex, the trustee of a liquidating trust sought to avoid certain transfers made by the debtor during the preference period.  The vendor-transferees asserted a subsequent new value defense under section 547(c)(4) of the Bankruptcy Code based upon the transferees’ continued shipment of goods to the debtors through the preference period that were paid by the debtor. Judge Carey, recognizing a split among the circuits, noted that the interpretation followed by courts that have rejected the “remains unpaid” interpretation is both the emerging and more doctrinally sophisticated view. Citing In re Maxwell Newspapers, Inc., 192 B.R. 633 (Bankr. S.D.N.Y. 1996), he noted that courts following the “remains unpaid” analysis have not actually held as much but only repeated this rule of interpretation in dicta.

With the issue squarely before him, the Court examined the plain language of the statute and found that a creditor raising a new value defense under section 547(c)(4) has the burden of proving that:  (1) new value was extended after the preferential payment sought to be avoided; (2) the new value is not secured with an otherwise unavoidable security interest; and (3) the new value has not been repaid with an otherwise unavoidable transfer. Following the plain language of the statute, Judge Carey rejected the “remains unpaid” approach. Applying the subsequent advance rule, the court found each extension of new value by a creditor can be used as a defense against a preferential transfer even if the extensions of new credit were paid during the preference period so long as the transfers are not otherwise unavoidable.  The Court observed that such an interpretation also comports with the purpose of the statute, which is designed to encourage trade creditors to continue to deal with a troubled business and to treat such creditors fairly who have replenished the estate after having received a preference.

For trade vendors and/or service suppliers of companies that file for bankruptcy in the Third Circuit, this decision offers a favorable analysis of new value in defending preferences.