United States: Administrative Claim May Be Set Off Against Preference Liability

In Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016), a Delaware bankruptcy court held in a matter of apparent first impression that a creditor's allowed administrative expense claim may be set off against the creditor's potential liability for a preferential transfer. The ruling is an important development for prepetition vendors that continue to provide goods or services to a bankruptcy trustee or chapter 11 debtor-in-possession.

Setoff and Avoidance of Preferential Transfers

Section 553(a) of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code "does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case." Section 553 does not create setoff rights—it merely preserves any such rights that exist under contract or applicable nonbankruptcy law. Debts are considered "mutual" when they are due to and from the same persons or entities in the same capacity.

Even though section 553 expressly refers to prepetition mutual debts and claims, many courts, including the Fifth and Tenth Circuits, have held that mutual postpetition obligations may also be offset. See Zion First Nat'l Bank, NA. v. Christiansen Bros., Inc. (In re Davidson Lumber Sales, Inc.), 66 F.3d 1560 (10th Cir. 1995); Palm Beach Cty. Bd. of Pub. Instruction v. Alfar Dairy, Inc. (In re Alfar Dairy, Inc.), 458 F.2d 1258 (5th Cir. 1972). Accord Zerodec Mega Corp. v. Terstep of Tex., Inc. (In re Zerodec Mega Corp.), 59 B.R. 272 (E.D. Pa. 1986); In re Pub Dennis of Cumberland, Inc., 142 B.R. 38 (Bankr. D.R.I. 1992); Mohawk Indus. v. United States (In re Mohawk Indus., Inc.), 82 B.R. 174 (Bankr. D. Mass. 1987); Elsinore Shore Assoc. v. First Fidelity Bank, NA (In re Elsinore Shore Assoc.), 67 B.R. 926 (Bankr. D.N.J. 1986).

However, setoff is available in bankruptcy only "when the opposing obligations arise on the same side of the . . . bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015); see also generally Lee v. Schweiker, 739 F.2d 870 (3d Cir. 1984). Thus, prepetition obligations may not be set off against postpetition debts and vice versa. See In re Enright, 2015 BL 261143 (Bankr. D.N.J. Aug. 13, 2015); In re Passafiume, 242 B.R. 630 (Bankr. W.D. Ky. 1999); In re Ruiz, 146 B.R. 877 (Bankr. S.D. Fla. 1992).

Section 547(b) of the Bankruptcy Code provides for avoidance of transfers made by an insolvent debtor within 90 days of a bankruptcy petition filing (or up to one year, if the transferee is an insider) to or for the benefit of a creditor on account of an antecedent debt where the creditor, by reason of the transfer, receives more than it would have received if, assuming the transfer had not been made, the debtor were liquidated in chapter 7.

Section 547(c)(4) contains a "subsequent new value" defense in preference litigation. It provides that, with certain exceptions, the trustee may not avoid a transfer "to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor." For purposes of section 547, "new value" includes, among other things, "money or money's worth in goods, services, or new credit." Thus, even where a creditor has received a preferential transfer, the transferee may offset against the preference claim any subsequent unsecured credit that was extended to the debtor. Goods or services provided to the debtor postpetition cannot qualify as "subsequent new value" because the petition date marks the end of the preference analysis period. See Friedman's Liquidating Tr. v. Roth Staffing Co., LP (In re Friedman's, Inc.), 738 F.3d 547 (3d Cir. 2013)).

Section 502(d) of the Bankruptcy Code penalizes any creditor that is the recipient of a preferential transfer but refuses to return transferred assets to the estate. It provides that "the court shall disallow any claim of any entity . . . that is a transferee of a transfer avoidable under section . . . 547 . . . of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable."

Quantum Foods

Tyson Foods, Inc. ("Tyson") regularly delivered meat products to Quantum Foods, LLC ("Quantum"). During the first two months after Quantum filed for chapter 11 protection in February 2014, Tyson supplied roughly $2.6 million in meat products to Quantum for which it was not paid. The bankruptcy court later granted Tyson an administrative expense claim in that amount under section 503(b)(1)(A) of the Bankruptcy Code.

Quantum's official unsecured creditors' committee (the "committee"), which had been authorized by the court to prosecute the estate's avoidance claims, sued Tyson, alleging that Tyson had been the recipient of fraudulent and preferential transfers and seeking avoidance of the transfers under sections 547 and 548 of the Bankruptcy Code. The committee also sought recovery of the transfers under section 550 and provisional disallowance of Tyson's administrative expense claim under section 502(d).

Tyson argued that it was entitled to set off any potential preference recovery against its allowed administrative claim. The committee countered that Tyson's setoff defense was in reality a " 'disguised' or 'renamed' postpetition new value defense." According to the committee, such a defense is invalid because it would reduce the total amount of value restored to Quantum's estate and would therefore violate section 502(d) by allowing Tyson's claim in part, even though it had not returned allegedly fraudulent or preferential transfers. The committee moved for judgment on the pleadings.

The Bankruptcy Court's Ruling

Bankruptcy judge Kevin J. Carey acknowledged that "[t]here is no provision in the Bankruptcy Code that deals expressly with post-petition setoff," noting that "[w]hether an allowed post-petition administrative expense claim can be used to set off preference liability" is a question of first impression in the Delaware bankruptcy court.

Relying on the Third Circuit's decision in Friedman's, Judge Carey ruled that the setoff at issue was "not a new value defense but rather an ordinary setoff claim" and should therefore be permitted. He explained that a new value defense can arise only in the context of a preference analysis, which, according to Friedman's, looks only to the preference period, which begins prepetition and ends on the petition date:

I am not persuaded by the Committee's argument that Tyson's claim is a disguised new value defense because it has the effect of reducing the amount of preferential transfers returned to the estate. Tyson's setoff claim does not affect the bottom line of the preference calculation; rather, setting off Tyson's Administrative Claim affects only the amount paid to the estate. Tyson's Administrative Claim affects the preference claim externally, not internally. This distinction is not merely semantic but rather evinces the nature of Tyson's claim.

According to Judge Carey, because the (postpetition) administrative claim was independent of the committee's preference action (which was necessarily based upon prepetition activity), Tyson properly characterized its claim as a setoff.

Judge Carey ruled that the setoff of Tyson's administrative claim against its potential preference liability was permissible. He acknowledged that "[t]he judicial consensus is that 'setoff is only available in bankruptcy when the opposing obligations arise on the same side of the . . . bankruptcy petition date' " (citations omitted). Even so, Judge Carey concluded that a preference "claim" (defined by the Bankruptcy Code as a "right to payment") of the estate necessarily arises only postpetition. For guidance on this point, he looked to In re Tek-Aids Indus., Inc., 145 B.R. 253, 256 (Bankr. N.D. Ill. 1992), in which the court wrote:

The estate's causes of action for the preferences did not exist before the filing of the Chapter 11 petition. If the Debtor had never filed bankruptcy, none of the preference actions could ever have been brought by anybody . . . . The fact that the trustee's ability to recover a given transfer as a preference depends on prepetition actions is irrelevant. A preference action can only be initiated in the context of a bankruptcy case after the filing of a bankruptcy case.

Finally, Judge Carey rejected the committee's argument that Tyson's administrative expense claim should be disallowed under section 502(d). This argument, he wrote, "overlooks case law recognizing that 'administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d)' " (quoting In re Lids Corp., 260 B.R. 680, 683 (Bankr. D. Del. 2001)). According to Judge Carey, if vendors perceived that preference liability would be used to block payment of their administrative expense claims, they would be extremely reluctant to extend postpetition credit.

Outlook

Quantum Foods provides comfort to vendors that continue doing business with debtors in bankruptcy. In addition, the decision provides guidance on four important points: (i) there is no such thing as a postpetition new value preference defense because the preference analysis ends as of the petition date; (ii) mutual postpetition obligations may be set off if the setoff otherwise complies with section 553 and the law governing setoffs; (iii) a preference claim arises postpetition even though the preference itself necessarily occurred prepetition; and (iv) administrative expense claims cannot be disallowed under section 502(d). These guiding principles provide an added layer of certainty to vendors, which may rely on administrative expense treatment of their claims for the value of goods or services provided postpetition and, by virtue of section 503(b)(9), the value of goods received by a debtor in the ordinary course of business within 20 days before filing for bankruptcy.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Mark G. Douglas
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