Is the Debtor-in-Posession Not the Debtor Post-petition Transfers and the Subsequent New-Value Defense

Journal Issue

Sep 2006

Column Name

Last in Line

Citation

ABI Journal, Vol. XXV, No. 7, p. 14, September 2006

Bankruptcy Code

1101

547

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Corporate Governance

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Imagine this all-too-familiar scenario for a trade vendor (TV): Press reports and industry
rumors speculate that Company X could be filing chapter 11 very soon. TV's credit
manager starts to have an ulcer. Company X owes TV more than $500,000 for open
invoices. Worse, after substantial pressure by TV to reduce Company X's delinquent
debt, Company X paid TV more than $1.2 million within the last 90 days to avoid
losing TV as a key supplier. If the rumors are true, TV will imminently face
the "double whammy" of a substantial claim and preference exposure
in Company X's chapter 11 case.
TV's credit manager springs into action. His first instinct is to call Company
X and try to obtain as much money as Company X can spare to reduce the $500,000
debt. This course of action has been suggested in countless bankruptcy-risk
seminars: Get the money now and worry about preference exposure later. Accordingly,
TV's credit manager immediately calls his account manager at Company X, asks
if the rumors about bankruptcy are true, and demands to be paid as much as possible.
The account manager responds (in a moment of candor that debtor's counsel would
abhor) that yes, Company X will be filing bankruptcy within the next week. The
account manager also responds: "We could pay you up to $200,000 now—that
is what we are doing for our 'important,' but not 'essential,' vendors. But
I am not sure you want us to pay you now. My bankruptcy counsel advises that
you might be much better off if we pay TV as a 'critical vendor' after it files
a bankruptcy petition and becomes a debtor in possession (DIP). There apparently
is some loophole in the Bankruptcy Code that will reduce your preference exposure
if we do it that way. Have your lawyer read In re Phoenix Restaurant Group
Inc., 317 B.R. 491 (Bankr. M.D. Tenn. 2004), and tell us what you want us
to do."
This article examines whether Company X's account manager is correct. Would
TV be better off if it was paid as a "critical vendor" by Company
X after it becomes a DIP, rather than being paid by Company X before it files
chapter 11? The answer to this question begins with an analysis of the court's
decision in the Phoenix Restaurant case.
The Phoenix Restaurant Decision 
In Phoenix Restaurant, the debtor made seven transfers to Ajilon within
90 days of the petition date. After receipt of those transfers, Ajilon provided
temporary staffing services to the debtor that the debtor did not pay for prior
to the petition date. See Phoenix Restaurant, 317 B.R. at 493. After
the petition date, however, the debtor paid Ajilon $30,545.01 on account of
pre-petition invoices, allegedly authorized pursuant to post-petition "critical
vendor"-type orders related to payment of pre-petition employee obligations.
See id. at 493, 498.

The issue before the court was whether the debtor's post-petition transfer
to Ajilon on account of pre-petition services reduced the "new value"
that Ajilon could raise in defense to the debtor's preference action pursuant
to §547(c)(4)(B) of the Bankruptcy Code. Section 547(c)(4)(B) provides
that a 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...on account of which new value the debtor did not
make an otherwise unavoidable transfer to or for the benefit of such creditor."
The court held that post-petition transfers on account of pre-petition services
rendered by a creditor do not negate the "new value" provided by such
creditor. In doing so, the court concluded that the reference in §547(c)(4)(B)
to "debtor" means only transfers by the "pre-petition debtor"
and not transfers by the post-petition DIP See id. at 496-97. The court
stated:
<blockquote>
Had Congress intended §547(c) (4)(B) to account for payments made post-petition,
the section would have included something like "an otherwise unavoidable
transfer of an interest of the estate in property to or for the benefit of
such creditor." Instead, Congress disqualified only new value paid for
by "the debtor" with an otherwise unavoidable transfer. 
Id. at 497. 
</blockquote>
In the court's view, the reference to "debtor" closes the §547(c)(4)
analysis at the petition date. Ajilon thus could rely on "new value"
that was satisfied by unavoidable, post-petition transfers by the DIP. See
id. at 498-99; see also In re Phoenix Restaurant Group Inc., 2004
WL 3113719, at *13 (Bankr. M.D. Tenn. 2004) (holding that a post-petition, critical-vendor
payment on account of pre-petition new value "was not a transfer by the
debtor for §547(c)(4)(B) purposes. Accordingly, the post-petition
payment cannot be an 'otherwise unavoidable' transfer by the debtor that defeats
the pre-petition new value for which it paid").1

In summarily concluding that the reference to debtor in §547(c)(4)(B)
was meant to include only the pre-petition debtor and not the DIP, the court
failed to examine:
<blockquote>
• the definitions of the terms "debtor" and "DIP"
in the Code; 
• applicable Supreme Court and other precedent that reject the theory
that the DIP is a distinct entity from the pre-petition debtor; 
• other references to the debtor in the Code that indisputably include
the DIP; and 
• policy reasons that weigh against conferring additional benefits on
critical vendors and others that receive post-petition transfers from the
DIP. 
</blockquote>
The Plain Meaning of Debtor and Debtor-in-Possession

The plain language of the Code undermines the argument that the term "debtor"
does not include the DIP. See United States v. Ron Pair Enters., 489
U.S. 235, 242 (1989) (holding that the plain meaning of a statute is conclusive,
except in the rare cases in which the literal application of a statute will
produce a result "demonstrably at odds with the intentions of its drafters").
Section 101(13) of the Code provides that the term "debtor" means
"person or municipality concerning which a case under this title has been
commenced." This definition does not limit the applicability of the term
"debtor" to its status as a pre-petition entity. Indeed, if the term
"debtor" had the meaning suggested by the court in Phoenix Restaurant,
one would expect either the definition of "debtor" or the reference
to the debtor in §547(c)(4)(B) to refer specifically to pre-petition date
actions.
The Code's definition of DIP also forecloses any attempt to argue that the
term "debtor" does not include the DIP. Section 1101(1) of the Code
defines DIP as "debtor except when a person that has qualified under §322
of this title is serving as trustee in this case." Because the DIP cannot
be a pre-petition entity, limiting the term debtor to the pre-petition debtor
makes no sense in light of §1101(1). Rather, §1101(1) confirms that
the terms "debtor" and "DIP" are interchangeable in a chapter
11 case in which the debtor remains in possession of property of the estate.
Bildisco and Its Progeny 
Any attempt to argue that the term "debtor" was meant to exclude
the DIP also ignores the Supreme Court's decision in NLRB v. Bildisco &
Bildisco, 465 U.S. 513 (1984), and a number of subsequent decisions that
effectively invalidate the theory that the DIP is a new entity that is distinct
from the pre-petition debtor.
In Bildisco, in considering whether a DIP was guilty of an unfair labor
practice for unilaterally rejecting or modifying a collective bargaining agreement
before formal rejection by the bankruptcy court, the Supreme Court addressed
the issue raised by the parties of whether the DIP is a separate and distinct
entity from the pre-bankruptcy debtor:

<blockquote>
Obviously if the [DIP] were a wholly "new entity," it would be
unnecessary for the Bankruptcy Code to allow it to reject executory contracts,
since it would not be bound by such contracts in the first place. For our
purposes, it is sensible to view the DIP as the same "entity" which
existed before the filing of the bankruptcy petition, but empowered by virtue
of the Bankruptcy Code to deal with its contracts and property in a manner
it could not have employed absent the bankruptcy filing. 
Bildisco, 465 U.S. at 528. 
</blockquote>
Since Bildisco, a number of courts have found that the above-quoted
language effectively has invalidated the new entity theory. In In re Allen,
135 B.R. 856 (Bankr. N.D. Iowa 1992), the court held that when a DIP assumes
an executory contract, the debtor and the DIP are the same entity for purposes
of mutuality under §553. In so holding, the court stated that:
This court agrees with the Ontario Locomotive case that Bildisco
has "laid to rest the 'separate entity' doctrine for all time." 126
B.R. at 147. This court believes that the language of Bildisco is unambiguous
and intended to put a stop to the rather artificial and fictitious distinctions
between the DIP and the debtor. The use of the term "debtor-in-possession"
in the Bankruptcy Code supports this court's application of Bildisco.
See §1101(1) ("DIP" means "debtor"). In light
of this authority, this court cannot accept the debtor's mutuality arguments.

Id. at 868 (quoting In re Ontario Locomotive & Industrial Ry.
Supplies Inc., 126 B.R. 146, 147 (Bankr. W.D.N.Y. 1991)); see also United
States v. Gerth, 991 F.2d 1428, 1436 (8th Cir. 1993) (relying on Bildisco
and §1101(1) in holding that "when a DIP assumes an executory contract,
the debtor and the DIP are the same entity for purposes of mutuality under §553");
In re Mohawk Indus. Inc., 82 B.R. 174, 177 (Bankr. D. Mass. 1987) (holding
that after Bildisco the new entity theory "is no longer supportable");
In re Affiliated Food Stores Inc., 123 B.R. 747, 748-49 (Bankr. N.D.
Texas 1991) (relying on Bildisco and numerous other cases in rejecting
the new entity theory in a §553 analysis).

Use of the Term "Debtor" in Other Parts of the Code 
The statutory language in §§101(13) and 1101(1) of the Code and the
Supreme Court's decision in Bildisco and its progeny provide ample support
for the argument that the reference to the debtor in §547(c)(4)(B) includes
the DIP. The Supreme Court, however, has counseled that the words of the Code
are not to be read in isolation; rather, statutory interpretation is a holistic
endeavor. United Sav. Ass'n. of Texas v. Timbers of Inwood Forest Associates
Ltd., 484 U.S. 365, 371 (1988). In light of that admonition, it is important
to consider the numerous other sections of the Code that use the term "debtor"
when the term clearly refers to the post-petition DIP.
<blockquote>
 •Several provisions in §1121 refer to the debtor's exclusive
right to file a reorganization plan. Of course, this reference to the debtor
includes the DIP, the proponent of most chapter 11 plans. 
•Section 1112(a) sets forth when a debtor may convert a case from chapter
11 to chapter 7. That the term "debtor" includes DIP is made clear
by §1112(a)(1), which precludes the debtor from converting from chapter
11 to chapter 7 in cases where the debtor is not a DIP.

•Section 1129(a)(4) refers to the duty of disclosing any payments made
by the debtor for services and costs associated with the case, which includes
payments to professionals employed by the DIP. 
•Section 343 requires the debtor to appear for an examination under
§341(a). This reference to the debtor includes the DIP in chapter 11
cases. 
•Section 521 and Bankruptcy Rule 1007 require the debtor to file schedules
and a statement of financial affairs within 15 days of the petition date.
This reference to the debtor also includes the DIP in chapter 11 cases. 
•Section 1142(a) requires the debtor (including the DIP) to carry out
a chapter 11 plan. 
</blockquote>
Moreover, there does not appear to be a single provision in the Code in which
the term "debtor" excludes the debtor as DIP. Thus, not only is the
separate entity theory no longer supportable in light of Bildisco, it
also finds no support in the text of the Code.
The Right Result—The Login Bros. Decision

Although there is scant authority on the subject, Phoenix Restaurant
was not the first decision analyzing the issue of the post-petition payment
of pre-petition new value under §547(c)(4)(B). In In re Login Bros.
Book Co., 294 B.R. 297 (Bankr. N.D. Ill. 2003), the court held that a creditor's
new-value defense was reduced by the amount of a post-petition transfer from
the debtor's estate to the creditor. See id. at 300. The alleged new
value provided was books that were shipped by the creditor to the debtor following
a preferential payment, which were later returned to the creditor, post-petition,
pursuant to court order. See id. at 298. The court held that because
the post-petition transfer (return of the books) was made pursuant to court
order, it was "an otherwise unavoidable transfer" under subsection
547(c)(4)(B) and reduced the creditor's new-value defense by the amount of that
transfer. Id. at 300. In so holding, the court stated that:
<blockquote>
[B]oth the plain language and policy behind the statute indicate that the
timing of a repayment of new value is irrelevant. The statutory requirement
that new value not be repaid—set out at §547(c)(4)(B)—contains
no limitation on the time that the repayment or return of new value (the "otherwise
unavoidable transfer to or for the benefit of such creditor") must occur...
And the policy behind the new-value exception—that the estate be replenished
by the new value—would be defeated if a creditor were allowed to keep
a preferential payment of its debt on account of a new-value contribution
to the estate and also receive repayment of that contribution, regardless
of whether the repayment occurred before or after the commencement of the
bankruptcy case.

</blockquote>
Id. at 300-01; see also In re MMR Holding Corp., 203 B.R. 605,
609 (Bankr. M.D. La. 1996) ("an unavoidable post-petition transfer on account
of new value extended subsequent to a preference should limit the use of §547(c)(4)
by the amount of the unavoidable transfer, as without a reduction in the new
value offset, the transferee would be receiving double use of the new value...");
In re JKJ Chevrolet Inc., 412 F.3d 545, 553 n.6 (4th Cir. 2005) (citing
Login Bros. for the proposition that post-petition transfers may be considered
under §547(c)(4)(B)); Cf. In re Energy Coop., 130 B.R. 781 (N.D.
Ill. 1991) (holding that post-petition transfers do not negate pre-petition
new value under §547(c)(4)(B); court did not make debtor vs. DIP distinction).
Policy Analysis 
Sound bankruptcy policy also leads one to reject the interpretation of §547(c)(4)(B)
adopted by the court in Phoenix Restaurant. The purpose of the new-value
defense is to avoid punishing a creditor who has replenished the estate after
receiving a preferential transfer. However, when a creditor receives an unavoidable
post-petition transfer on account of that new value, there is no replenishment.
The estate still has the "hole" created by the original preferential
transfer. In effect, as suggested in some of the cases cited above, the creditor
is able to "double count" the new value—first for purposes of
getting paid post-petition—and second for purposes of defending against
the preference claim brought by the estate.

The prospect of double-counting is particularly acute when we consider the
hypothetical situation TV and Company X raised at the beginning of this article
and the issue of critical vendors. The critical-vendor era is not over in chapter
11 cases. Indeed, requests to pay critical vendors appear to have found new
life since the enactment of the Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 (BAPCPA). Under new §503(b)(9) of the Code, there shall be
an allowed administrative expense claim for "the value of any goods received
by the debtor within 20 days before the date of commencement of a case under
this title in which the goods have been sold to the debtor in the ordinary course
of business." Chapter 11 debtors have already begun to seize upon §503(b)(9)
as a way to justify critical-vendor treatment. See, e.g., In re Pliant Corp.,
Case No. 06-10001 (Bankr. D. Del. Jan. 4, 2006) (interim order); In re J.L.
French Automotive Castings Inc., Case No. 06-10119 (Bankr. D. Del. March
6, 2006) (interim order). Similar to the payment of employee wages under former
§507(a)(3), critical-vendor motions under §503(b)(9) could become
commonplace in the post-BAPCPA environment.
Section 503(b)(9) already provides "critical vendors" with administrative
expense treatment and an excuse to obtain critical-vendor status.2
Under these circumstances, it is even more important to reign in the additional
benefits conferred upon these "critical vendors." As the court recognized
in In re Fultonville Metal Products Co., 330 B.R. 305 (Bankr. M.D. Fla.
2005):
<blockquote>
Because the proposed payments involve an exception to such a fundamental
bankruptcy principle, it is clear courts should view requests to pay "critical
vendors" with circumspection... It follows, therefore, that any rights
claimed by a creditor as attendant to its "critical vendor" status
should also be viewed with circumspection. 
Id. at 313.

</blockquote>
Conclusion
 We are back to TV and the credit manager's quandary. Relying on Phoenix
Restaurant is tempting, but it is a bad bet. The combination of (a) the
definitions of debtor and DIP in the Code, (b) the decisions in Bildisco
and its progeny, (c) the use of the term "debtor" throughout the Code
and (d) sound bankruptcy policy lead to the conclusion that unavoidable post-petition
transfers on account of pre-petition new value negate that new value under §547(c)(4)(B).
The DIP is the debtor. So, while TV's credit manager should take any money he
can (safely) get, prudence suggests that TV reserve for the potential, if not
probable, demand for the return of the payments.
<blockquote> </blockquote>

<hr>
<h3>Footnotes</h3>
 1 The court also relied on the cases that have held that post-petition services
by a creditor cannot qualify as new value because they are services provided
to the DIP and not the debtor See id. at 496. These cases, however, focus
on the administrative priority treatment for post-petition vendors and the ability
of such vendors to behave strategically post-petition if a new value defense
were recognized for such services. See, e.g., In re Bellanca Aircraft Corp.,
850 F.2d 1275, 1284 (8th Cir. 1988); In re Tennohio Transp. Co., 255
B.R. 307, 310 (Bankr. S.D. Ohio 2000).

2 Indeed, critical vendors may attempt to take it a step further by incorporating
a complete release from future preference exposure into the negotiated terms
under which they will continue to ship to the debtor. This would accomplish
more directly what Phoenix Restaurant attempts to sneak in through the
back door.

Journal Authors

Derek Leland Wright

Geoffrey S. Goodman

Journal Date

Friday, September 1, 2006 - 12:00

Bankruptcy Rule

2006

none