Creditors that have experienced a customer filing for bankruptcy have learned that claims are paid in the order stated in the Bankruptcy Code. Generally, secured claims are paid first, followed by administrative expenses, then unsecured claims and equity. Additionally, in chapter 11, administrative expense claims must be paid in full by the confirmed plan of reorganization (unless the creditor agrees otherwise) while general unsecured claims often only receive pennies on the dollar.
In the ADI Liquidation, Inc. chapter 11 cases, the Delaware Bankruptcy Court held that the debtors could apply certain credits to reduce or eliminate a supplier's administrative claim as opposed to first applying them to the supplier's general unsecured claim.
The Debtors' Gamble
The ADI debtors serviced supermarkets and convenience stores. In the course of their business, they earned certain credits and refunds, often from COD overpayments made to suppliers, and through promotions and volume discounts.
After filing their bankruptcy petitions, the debtors sold most of their assets free and clear of all liens, claims, encumbrances and interests. However, the debtors continued to earn credits for products purchased but not received by them prior to the sale's closing date. After the closing, the debtors' suppliers filed applications for the allowance and payment of administrative claims for goods and services sold to the debtors during the 20-day period prior to the filing of their bankruptcy petitions.
In response, the debtors and unsecured creditors committee asked the Court if the debtors could, in their discretion, apply any setoff or recoupment rights (including those that accrued post-petition) to reduce the amounts of allowed secured claims, administrative claims or unsecured claims. Several suppliers objected. They argued it would be inequitable to allow the debtors to offset against a supplier's administrative claim before first offsetting against any general unsecured claim that the supplier held.
Setoffs Pay Off
The Court ruled in favor of the debtors, finding that the Bankruptcy Code treats a debtor's setoffs right more favorably than those of a creditor. A debtor may exercise prepetition setoff rights against post-petition claims but a creditor's prepetition setoff rights may only be applied to prepetition debts. As such, the Court concluded that the debtors in this case could assert their setoff rights (regardless of whether these rights accrued before or after the bankruptcy filing) and apply the credits in their discretion.
Simply stated, the Court held that the debtors' rights trumped those of its suppliers, and a supplier's administrative expense claim is not sacred. Even though these claims must be fully paid in order for debtors to confirm a Chapter 11 plan, a creative debtor may be able to use its setoff rights to navigate around the payment hierarchy and avoid cutting a check.
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