Return of Goods Preference Issues

Journal Issue

Feb 2006

Column Name

Last in Line

Citation

ABI Journal, Vol. XXV, No. 1, p. 18, February 2006

Bankruptcy Code

546

547

Topic Tags

Asset Sales

Preferences

Journal HTML Content

Preference claims are one of the more frequently
litigated issues in bankruptcy. The garden-variety preference is based
on a debtor’s payment of antecedent debt. However, on rare
occasions, a preference claim is based on the debtor’s return of
goods to the creditor in reduction of the creditor’s claim. The
few reported decisions concerning return-of-goods preference claims have
dealt with the amount the debtor was entitled to recover from the
creditor and the applicability of the ordinary course of business and
new value defenses. The U.S. District Court for the Western District
of Virginia in Active Wear Inc. v. Parkdale Mills Inc., 331
B.R. 669 (W.D. Va. 2005), limited a chapter 11 debtor’s recovery
on a return-of-goods preference claim to the amount the debtor would
have realized from a liquidation sale of the goods. However, this is
by no means the only approach for determining recovery on such
claims. The Facts of Active Wear v. Parkdale Mills The
debtor, Active Wear Inc., was a yarn spinner that purchased substantial
amounts of yarn from Parkdale Mills Inc. The debtor owed Parkdale at
least $2 million on unpaid invoices at the time the debtor closed its
business. Parkdale’s claim included invoices for unused yarn
that the debtor was still holding. Following the debtor’s
disclosure of the cessation of operations, Parkdale sent a reclamation
demand to the debtor for recovery of yarn having the value of
$11,428.88. Thereafter, Parkdale picked up all of the unused yarn it had
previously sold to the debtor, and the debtor credited $134,849.50
against its outstanding indebtedness to Parkdale for the returns.

An involuntary chapter 7 petition was filed against the debtor within 90
days of Parkdale’s recovery of the yarn. An order for relief was
entered, and the debtor converted the case to chapter 11. The debtor
commenced a lawsuit against Parkdale for avoidance of the
debtor’s pre-petition return of Parkdale’s yarn under 11
U.S.C. §547 and for recovery of the value of the yarn pursuant to
11 U.S.C. §550.1 The bankruptcy court
held that returns to Parkdale were an avoidable preference for which
the debtor was entitled to recover the liquidation value of the returns
in an amount equal to $27,459. The debtor appealed the bankruptcy
court’s order, arguing that Parkdale should have been directed
to pay the fair market value of the returns equal to the amount
Parkdale could have realized from reselling the returned yarn.
Interplay Between 11 U.S.C. §§547(b) and 550 11
U.S.C. §§547(b) and 550 come into play in most preference
actions. Section 547(b) authorizes a trustee or debtor-in-possession
(DIP) to avoid a transfer as a preference where all of the following
requirements are satisfied: 1. The debtor transferred its property to
or for the benefit of a creditor (a transfer includes a debtor’s
return of product to the creditor). 2. The transfer was made on
account of antecedent or existing indebtedness owing by the debtor to
the creditor. 3. The transfer was made within 90 days of the
debtor’s bankruptcy filing for payments to noninsider creditors,
and within one year of the filing for payments made to insiders of the
debtor (§101(31) defines an insider to include the debtor’s
officers, directors, controlling shareholders and affiliated
companies). 4. The transfer was made when the debtor was insolvent,
based on a balance-sheet definition of insolvency (liabilities
exceeding assets). See 11 U.S.C. §101(32). The debtor’s
insolvency is presumed within the 90-day preference period, making it
easier to prove an avoidable preference. 5. The transfer enabled
the creditor to receive more from the debtor than the creditor would
have recovered in the debtor’s chapter 7 liquidation. This
requirement is satisfied unless un-secured creditors would have received
full payment of their claims through the chapter 7 case. Section
547(b) deals with the avoidance of a preferential transfer. Section
550(a) allows a trustee or DIP to recover the transferred property, or
pursuant to court order the value of the property, from the initial
transferee or the entity for whose benefit the transfer was made.
Section 550(a) does not offer a court any guidance in deciding whether
the recovery on a return-of-goods preference claim should be the
return of the transferred property, or payment of its value, to the
debtor or trustee. Section 550(a) also gives no guidance for determining
the value of the return. The District Court’s Decision in
Active Wear v. Parkdale The district court limited recovery on
the debtor’s return of goods preference claim to the sums the
debtor could have realized from a liquidation sale of the returns. The
court, relying on the pre-Bankruptcy Code decision of the U.S. Court
of Appeals for the Fourth Circuit in Virginia Nat’l. Bank v.
Woodson (In re Decker), 329 F.2d. 836 (4th Cir. 1964), noted
that the recovery from Parkdale should be based on the extent to which
the return had depleted the debtor and its bankruptcy estate. The
yarn’s value to the debtor was the amount the debtor could have
realized from a liquidation sale of the yarn. The court refused to
give the debtor any credit for any greater recovery Parkdale derived
from its disposition of the returned yarn, which the court attributed
to Parkdale’s expertise, time, goodwill and advertising.

Other Approaches to Recovery on Return-of-Goods Preference
Claims The court’s holding in Active Wear v. Parkdale
Mills is by no means the only way to determine the recovery on a
return-of-goods preference claim. For instance, in In re First
Software Corp. (Ferrari v. Computer Assocs. Int’l.
Inc.), 84 B.R. 278 (Bankr. D. Mass. 1988), aff’d., 107 B. R.
417 (D. Mass. 1989), the court entered a judgment in the amount of
$1,500,026 against the creditor on a return of goods preference claim.
The court relied on a credit memorandum in the above amount issued by
the creditor in reduction of its claim.2 The
credit memorandum was deemed the creditor’s contemporaneous
determination of the market value of the returns, which the creditor
could not rebut. See, also, In re Albers (Derryberry v.
Albers), 67 B.R. 530 (Bankr. N.D. Ohio 1986) (credit of $6,500
defendant had issued in exchange for return was best evidence of its
value). The court in In re American Furniture Outlet USA Inc.

(American Furniture Outlet USA Inc. v. Woodmark Originals
Inc.), 209 B.R. 49 (Bankr. M.D.N.C. 1997), refused to base the
recovery on a return-of-goods preference claim on a credit the
creditor had issued for all past due invoices owing by the debtor. The
court limited recovery to the net amount, after deducting expenses,
that the creditor had realized from its commercially reasonable resale
of returns. Other courts dealing with a return-of-goods preference
claim have ordered the creditors to return the goods. For instance, in
In re King Arthur Clock Co. (Widemire v. Siddiki Bros.
Inc.), 105 B.R. 669 (Bankr. S.D. Ala. 1989), the court directed
the return of goods instead of entering judgment against the creditor
in the amount of a credit memorandum for $17,265.54 the creditor had
issued in favor of the debtor. The credit memorandum was not proof of
the value of the returns, and in the absence of any proof of their
value, the only remedy under §550(a) for a return-of-goods
preference claim was the creditor’s return of the goods. See,
also, In re General Indus. Inc. (General Indus. Inc. v.
Shea), 79 B.R. 124 (Bankr. D. Mass. 1987) (return of goods ordered
based on conflicting evidence of value of returns). Applicability
of the Ordinary-Course-of-Business Defense to Return-of-Goods
Preference Claims There are several defenses that can reduce or
eliminate liability on a preference claim. One of the more frequently
litigated preference defenses is the ordinary-course-of-business
defense arising under 11 U.S.C. §547(c)(2). This defense is
designed to encourage creditors to continue doing business on normal
credit terms with a financially distressed company. In bankruptcy
cases filed prior to Oct. 17, 2005, a creditor must prove all of the
following to satisfy the ordinary-course-of-business defense: 1. The
indebtness paid by the alleged preference was incurred in the ordinary
course of business of the debtor and creditor; 2. The payment was
made in the ordinary course of business of the debtor and the creditor
(the subjective prong); and 3. The payment was made according to
ordinary business terms (the objective
prong).3 Only a few cases have considered
whether the ordinary-course-of-business defense can reduce exposure on
a return-of-goods preference claim. In Graphic Prods. Corp. v. WWF
Paper Corp. (In re Graphic Prods. Corp.), 176 B.R. 65
(Bankr. S.D. Fla. 1994), the court held that a debtor’s return of
excess paper to its supplier during the preference period was not an
avoidable preference. The supplier had a valid reclamation claim under
11 U.S.C. §546(c) for the returns. The supplier also satisfied
the ordinary-course-of-business defense. The supplier proved the
subjective prong of the defense where the debtor had previously
returned goods to the supplier in reduction of the latter’s
claim and the returns were not prompted by any unusual collection
activity by the supplier. The supplier also proved the objective prong
of the defense where, in the paper industry, a buyer frequently
returns product to the seller for a credit against the invoice value
of the goods and the seller usually accepts the return on these
terms.4 Applicability of New-Value
Defense to a Return-of-Goods Preference Claim Another frequently
invoked preference defense is the new-value defense contained in 11
U.S.C. §547(c)(4). The new value defense reduces preference
exposure where, subsequent to the preference, the creditor granted new
value, such as a sale of goods or provision of services on credit
terms, to or for the benefit of the debtor. The new value cannot be
secured by an otherwise unavoidable security interest in the
debtor’s assets and cannot be paid by an otherwise unavoidable
transfer to or for the creditor/preference recipient’s benefit.

The new-value defense is also intended to encourage creditors to
continue doing business with and extending credit to financially
distressed customers. The defense protects a creditor that replenished
the debtor and its bankruptcy estate by extending new credit
subsequent to the preference. There is little case law on whether
returned goods can be considered new value for purposes of
§547(c)(4). In In re Furr’s Supermarkets Inc.
(Gonzales v. Nabisco Div. of Kraft Foods Inc.), 317 B.R. 423 (BAP
10th Cir. 2004), the creditor defending a preference action asserted
the new-value defense based on the invoice price of food products that
were delivered to the debtor after the alleged preferences, but were
then subsequently returned to the creditor. The returns were damaged,
stale, out of date, and otherwise unsaleable and of no value. Despite
that fact, the creditor had issued a credit memo in the amount of
$90,180.74 for the full invoice price of the returned goods that
reduced the amount of the creditor’s outstanding claim against the
debtor. The Tenth Circuit Bankruptcy Appellate Panel considered
whether the creditor lost the protection of the new-value defense for
goods delivered to the debtor subsequent to the preference and then
subsequently returned to the creditor. The court allowed the creditor
to use the full invoice value of the returns as deductible new value
under §547(c)(4).5 The goods had a value
of $90,180.74 when the creditor delivered them to the debtor
subsequent to the alleged preference, and should therefore count as
new value. The creditor did not lose the benefit of the new-value
defense as a result of the debtor’s subsequent return of the
goods because they were not saleable and were of no value to the debtor,
and their return to the creditor did not diminish the debtor’s
assets. It did not matter that the creditor had granted the debtor
full credit for the unpaid invoice amounts of the returns. The
court distinguished another case, Moglia v. American Psychological
Ass’n. (In re Login Bros. Book Co.), 294 B.R. 297
(Bankr. N.D. Ill. 2003), that dealt with the impact of post-petition
returns on the new-value defense. The debtor’s chapter 7 trustee
had sought to recover the debtor’s payment of approximately
$74,000 to the creditor during the preference period. The creditor
asserted a full new-value defense based on the creditor’s sale
and delivery of books to the debtor, invoiced at approximately $96,000,
subsequent to the alleged preference and remaining outstanding when an
involuntary petition was filed against the debtor. The trustee
contested the new-value defense based on the debtor’s
post-petition return of the books claimed as new value, pursuant to a
court-approved arrangement between the trustee and the creditor. The
bankruptcy court denied the creditor’s motion for summary
judgment on the applicability of the new-value
defense.6 However, the court in Login
Bros. did not address whether the invoice price of the books the
creditor had sold and delivered to the debtor after the alleged
preference could still be deducted as new value if the books were
valueless upon their return to the creditor. This contrasted with

Furr’s Supermarket, where the court counted the returns
as new value because they were stale, obsolete, out of date, not
readily saleable and therefore of no value to the debtor when they
were returned.<blockquote> <blockquote> 
</blockquote></blockquote><hr><h3>Footnotes</h3>1 The preference
claim did not include the value of the yarn subject to Parkdale’s
reclamation claim. 2 The court also refused to direct the
creditor’s return of goods to the debtor because the goods had
depreciated after their receipt by the creditor. See,
also, In re Computer Universe, 58 B.R. 28 (Bankr. M.D.
Fla. 1986). 3 As a result of the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005, in bankruptcy cases filed on and
after Oct. 17, 2005, the ordinary-course-of-business defense will be
easier to prove because the creditor must prove its debt was incurred
in the parties’ ordinary course of business and then satisfy
either the subjective or objective prongs of the defense. 4 But

see In re Martin County Custom Pools Inc. (Gennet v. Coastal
Wholesale Inc.), 37 B.R. 52 (Bankr. S.D. Fla. 1984) (defendant
had no ordinary-course-of-business defense based on debtor’s
pre-petition return of inventory to supplier after cessation of
debtor’s business). 5 The returns were not an avoidable
transfer because they had no value at the time of their return to the
creditor. 6 But see In re Energy Cooperative Inc.
(Energy Cooperative Inc. v. Cities Service Co.), 130 B.R.
781 (Bankr. N.D. Ill. 1991) (new-value defense not lost despite its
repayment by post-petition offset).

Journal Authors

Bruce S. Nathan

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

550

none