A-&-P, 1-2-3: Two Wins And One Quagmire From Recent Preference Decision – Insolvency/Bankruptcy

In January 2024, the United States Bankruptcy Court for
the Southern District of New York issued an opinion in the The
Great Atlantic & Pacific Tea Company, Inc. bankruptcy case
that tackled three fascinating preference-related issues. Trade
creditors got a couple of wins, and one interesting quagmire to
ponder over.

The two wins? First, the Bankruptcy Court held
that a preference defendant can successfully invoke the subsequent
new value defense even if the subsequent new value was paid before
the bankruptcy filing. Second, the Bankruptcy Court held the
defendant may setoff its allowed administrative expense priority
claim for the goods sold to and received by the debtor in the 20
days before the bankruptcy filing (a 503(b)(9) claim, discussed
below) against any preference liability.

The quagmire? The Bankruptcy Court rejected the
defendant’s argument that its claim arising under section
502(h) of the Bankruptcy Code for amounts recovered as a preference
should be entitled to section 503(b)(9) priority to the extent the
preference payments were on account of goods sold and delivered to
the debtor during the 20 days before the bankruptcy filing. The
court held that claim should instead be treated as a low priority,
prepetition general unsecured claim.

This begs the question: is accepting payment during what may be
the 20-day period before a bankruptcy filing worth potentially
losing a 503(b)(9) claim if the payment is recovered as a
preference? The logical answer: take the payment. A bird in the
hand is worth a 503(b)(9) claim in the bush! A creditor most likely
won’t know precisely when a customer will file for bankruptcy
and therefore may not know in real time whether the parties are in
the 20-day period before the filing, and, as such, the amount of
the creditor’s 503(b)(9) claim. Also, 503(b)(9) claims are not
always paid in full and any payment may be delayed for a
considerable amount of time after the bankruptcy filing.

THE 503(B)(9) CLAIM: A PRIMER

Section 503(b)(9) grants a trade creditor an administrative
expense priority claim (a “503(b)(9) claim”) for goods
sold on credit and received by a customer within the 20 days before
the customer’s bankruptcy filing. This elevates what would
otherwise be a general unsecured claim at the bottom of the
bankruptcy claims priority ladder to an administrative claim near
the top of the claim’s priority ladder. A debtor must generally
pay all administrative claims in order to confirm a Chapter 11 plan
and exit chapter 11.

PREFERENCE CLAIMS: THE ELEMENTS AND DEFENSES

Section 547(b) of the Bankruptcy Code establishes a statutory
cause of action by a debtor, trustee or other estate fiduciary in a
bankruptcy case to recover, as a “preference,” certain
transfers by a debtor to a creditor before the bankruptcy filing.
The plaintiff must prove all of the following to avoid and recover
a pre-petition transfer as a “preference:”

1. The debtor had transferred property of the debtor’s estate
   (such as a debtor’s payment from its bank account);




2. To or for the benefit of a creditor;




3. On account of an antecedent debt (based on credit extended to a
   debtor so cash in advance payments are not preferences!);




4. On or within the 90 days before the bankruptcy filing (or
   within a year before the filing, if the transfer was to an
   “insider”);




5. While the debtor was insolvent (which is presumed during the
   90-day preference period); and




6. Enabled the creditor to recover more than the creditor
   otherwise would have received in a hypothetical Chapter 7
   bankruptcy case.

Section 547(c) of the Bankruptcy Code arms creditors with
affirmative defenses they can assert to minimize or eliminate
preference liability where the plaintiff has otherwise proven the
elements of a preference claim (see cheat sheet below).
The affirmative defenses are intended to encourage creditors to
continue doing business with and extending credit to financially
distressed customers.

The subsequent new value defense was at issue in the
A&P case. Also at issue was the defendant’s right
to setoff unpaid and allowed administrative expense claims (the
defendant’s 503(b)(9) claim) to reduce preference liability on
a dollar-for-dollar basis. Notably, there must be
“mutuality” to effectuate a setoff—that is, the
claim owing to the creditor and the claim owing to the debtor’s
estate must have both arisen before the bankruptcy filing or must
have both arisen after the bankruptcy filing (i.e., a prepetition
claim cannot be setoff against a post-petition claim). In addition,
the Bankruptcy Court in the A&P case grappled with the
defendant’s right to invoke section 502(h) of the Bankruptcy
Code to assert a claim against the bankruptcy estate for the amount
recovered as a preference. Section 502(h) provides for the
allowance of a claim arising from such recovery as if such claim
had arisen before the date of the bankruptcy filing.

RELEVANT BACKGROUND REGARDING THE A&P DECISION

A&P and its affiliates (collectively, “A&P”)
filed Chapter 11 bankruptcy cases on July 19, 2015. McKesson
Corporation had supplied A&P with prescription and OTC drugs,
health and beauty aids, and sundries pursuant to a prepetition
supply agreement between the parties. McKesson filed a proof of
claim, asserting a 503(b)(9) claim for at least $1.75 million
against A&P. McKesson’s proof of claim also stated that
“to the extent any of the payments received by McKesson during
the Administrative Claim Period are determined to be avoidable as a
preference or otherwise, McKesson’s administrative expense
(503(b)(9)) claim should be increased by that amount.”

The Creditors’ Committee appointed in the Chapter 11 cases
filed a complaint seeking to avoid and recover approximately $67.8
million in alleged preference payments by A&P to McKesson
during the 90 days before the Chapter 11 filing.

After McKesson filed an answer and the parties engaged in an
initial round of discovery, McKesson filed a motion for summary
judgment seeking a ruling that the alleged preference payments were
shielded by various preference defenses, including the subsequent
new value and setoff defenses. At a hearing held on September 16,
2019, the court granted the motion, in part, holding that McKesson
had the right to setoff any allowed 503(b)(9) claim against any
judgment for avoidance and recovery of preferential transfers.

After further discovery, McKesson filed another motion for
summary judgment. McKesson argued that:

• Subsequent new value during the preference period totaling
  approximately $58.8 million protected all but six of the alleged
  preference period payments; and




• Of the six remaining alleged preference payments, five were on
  account of goods delivered to A&P during the 20 days before the
  bankruptcy filing, and McKesson’s 503(b)(9) claim should be
  increased by the amount avoided as a preference pursuant to section
  502(h) of the Bankruptcy Code. McKesson then sought to set off this
  additional 503(b)(9) priority claim dollar-for-dollar against any
  preference liability.

The Committee opposed summary judgment, arguing that:

• The subsequent new value defense should not be available to
  McKesson because A&P had paid many of the invoices relating to
  the subsequent new value provided. The Committee also argued that
  McKesson was inequitably seeking a “double payment” by
  asserting the subsequent new value defense while simultaneously
  seeking full payment of its 503(b)(9) claim arising from the
  subsequent new value McKesson had provided during the 20 days
  before the bankruptcy filing.




• McKesson could not setoff any of its 503(b)(9) claim against
  its preference liability because there is no mutuality where
  McKesson’s 503(b)(9) claim arose prepetition while the
  preference claim arose post-petition.




• McKesson could not assert a 503(b)(9) claim as part of its
  claim under section 502(h) for payments recovered as a preference
  on account of goods delivered during the 20 days before the
  bankruptcy filing. Section 502(h) states that the claim for
  recovered payments is treated as if it had arisen
  prepetition—therefore, 502(h) creates a low priority general
  unsecured claim.

THE BANKRUPTCY COURT’S RULING

The Bankruptcy Court distilled the dispute down to three
issues:¹

1. Could McKesson include new value that was paid prepetition as
   part of its subsequent new value defense?




2. Could McKesson setoff its 503(b)(9) claim against preference
   liability?




3. Was McKesson’s section 502(h) claim for amounts recoverable
   as a preference entitled to 503(b)(9) priority to the extent the
   preference payments were on account of goods sold and delivered
   during the 20 days before the bankruptcy filing?

The Bankruptcy Court held that subsequent new value need not
remain unpaid in order to be applied against preference liability.
The U.S. Court of Appeals for the Second Circuit (which governs the
Southern District of New York, where the A&P case is
pending) has not ruled on the issue, and there is a split on the
issue among the lower courts in the Second Circuit. So, the
Bankruptcy Court was persuaded to follow the majority of
Circuit-level courts that have addressed the issue (the Fourth,
Fifth, Eighth, Ninth and Eleventh Circuits), which hold the
subsequent new value defense may include paid new value.

The Bankruptcy Court declined to revisit its earlier ruling that
McKesson could setoff an allowed 503(b)(9) claim against any
judgment for avoidance and recovery of preferential transfers. The
court relied on prior decisions by the Delaware bankruptcy court
that mutuality exists between an administrative expense claim
(e.g., a 503(b)(9) claim) and a preference claim because both
claims arise post-petition by operation of the Bankruptcy Code
(even though the facts that gave rise to a 503(b)(9) claim and
preference claim occur prepetition).

However, McKesson wasn’t as fortunate regarding its section
502(h) claim. The Bankruptcy Court focused on the language of
section 502(h) in holding that a claim asserted pursuant to section
502(h) is not entitled to 503(b)(9) priority. The Bankruptcy Court
relied heavily on the fact that section 502(h) states that the
allegedly preferred creditor is entitled to a prepetition
claim, not a post-petition claim, for any preference recovery. The
Bankruptcy Court held that while it is “sympathetic” to
the argument that section 502(h) should put McKesson in the
position it would have been in had the preference payment not been
made (holding a 503(b)(9) claim), the court could not contradict
its own holding with respect to setoff—if a 503(b)(9) claim
is a post-petition claim for purposes of mutuality for setoff, then
it cannot also be a prepetition claim in the context of section
502(h).

Footnote

1. The Bankruptcy Court only
addressed the issues discussed in this article. The Bankruptcy
Court did not rule on various issues of fact, such as the amount of
McKesson’s subsequent new value defense, the allowed amount of
McKesson’s 503(b)(9) claim, and the amount of any setoffs
A&P may assert. The Bankruptcy Court also did not rule on
McKesson’s ordinary course of business defense to the
preference claims.

Originally published in Business Credit magazine, a
publication of the National Association of Credit Management, April
2024

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.