Section 502(d) Can Be Used to Delay Payment of §503(b)(9) Administrative Expenses

In In re Circuit City Stores Inc.[1]the U.S. Bankruptcy Court for the Eastern District of Virginia weighed in on the increasingly contested issue of whether §503 administrative expense claims can be disallowed under 11 U.S.C. §502(d) of the U.S. Bankruptcy Code.[2] The Second Circuit recently addressed the issue in ASM Capital v. Ames Department Stores Inc. (In re Ames Department Stores Inc.),[3] and answered the question in the negative; concluding that §502(d) does not apply to §503 administrative expense claims. The Second Circuit’s ruling reversed the rulings of both the bankruptcy court and district court, and stood in stark contrast to existing authority in the Ninth Circuit.[4] Before the ink was even dry on the Ames decision, however, the Circuit City court reached an opposite conclusion rooted largely in Fourth Circuit precedent and a distinguishable fact pattern.

Procedural History
Section 501(a) provides that a “creditor or indenture trustee” may file a proof of claim, and provides the authority for creditors to assert prepetition claims against a debtor’s estate.[5] A claim or interest filed under §501 is deemed allowed unless a party in interest, including a creditor, objects.[6] If a party objects, the court must determine the claim after notice and a hearing.[7] Some of what §§501 and 502(a) and (b) giveth, however, §502(d) taketh away—at least temporarily. More specifically, §502(d) states that: 

Notwithstanding subsections (a) and (b) of this subsection, the court shall disallow any claim of any entity from which property is recoverable…of this title or that is a transferee of [an avoidable transfer] unless such entity or transferee has paid the amount or turned over such property, for which such entity or transferee is liable.

In essence, §502(d) enables a debtor to offset a specific creditor’s claim by any amounts the creditor received from and owes or may owe to the estate by virtue of an avoidable transfer. As a result, payment of administrative expenses to the same defendant are forestalled and delayed until the avoidable-transfer issue is litigated and resolved, and any amounts found owing to the estate are paid. Not surprisingly, §502(d) provides an extremely useful and powerful administrative tool for debtors seeking to marshal and maximize estate assets before paying creditors’ claims.

While §501 pertains to claims that arose prepetition, §503(a) and (b) provide that the court shall allow payment of certain “administrative expenses” (i.e., costs associated with administering, maintaining, preserving and operating the estate during the bankruptcy filing, the absence of which would impair or allow the estate’s value to diminish) upon request by an “entity” for payment of such an expense, and after notice and hearing. Herein lies the dilemma, which the Code does not clearly answer: Does §502(d)—sandwiched between §§501 and 503—apply only to allow setoff of §501 claims only, or does it afford the estate similar protection against entities requesting payment of §503(b) administrative expenses?

Second Circuit in Ames: §502(d) Cannot Be Applied to Delay §503(b) Claims
The Second Circuit recently addressed the issue and concluded that §502(d) does not apply to, and therefore cannot forestall, payment of §503 administrative expense claims.[8] After a lengthy textual and statutory-construction analysis, the bankruptcy court concluded that §503 must be read independently from §§501 and 502. Underlying its decision was the fundamental policy behind payment of administrative expenses, namely that “the Bankruptcy Code gives a higher priority to requests for administrative expenses than to prepetition claims in order to encourage third parties to supply goods and services on credit to the estate, for the benefit of all the estate’s creditors.”[9] Notably, the §503 administrative expense claim at issue in Ames seems to have related exclusively to the value of goods delivered by the creditor post-petition.

Circuit City: Section 502(d) Can Be Applied to Delay Payment of §503(b)(9) Claims
Mere months after Ames, Circuit City was decided. In this case, the debtors objected when various claimants moved for payment of §503(b)(9) expenses. They raised §502(d) as a defense and requested a ruling on the threshold question of whether §502(d) can be applied, as a matter of law, to temporarily disallow §503(b)(9) claims to the extent that offsetting amounts could be recoverable as preferential transfers.[10]The claimants opposed an initial determination of the issue, arguing that (1) preliminary consideration of §502(d)’s applicability would deny them of due process, (2) debtors were requesting an advisory opinion and (3) the issue could only be properly raised upon the debtors’ filing of an adversary proceeding.[11] Thus, before considering the fundamental issue of whether §502(d) could be applied to §503(b)(9) claims,[12] the bankruptcy court first addressed certain procedural issues that could otherwise have preempted its substantive analysis and holding and responded seriatim to each point. 

First, regarding the claimants’ due process arguments, the bankruptcy court noted that “due process is not a ‘technical conception’ of inflexible procedures…it is a delicate process of adjustment and balancing of interests.”[13] The court then noted:

In this case…parties were given ample notice that the threshold legal issue regarding whether §502(d) could be applied to temporarily disallow a §503(b)(9) claim would be the topic of the first hearing on two omnibus motions” and “certainly exercised their opportunity to be heard.”[14]

Insofar as all parties had and exercised their right to be heard, and since the debtors’ were merely seeking to delay, not to presently deny payment of the administrative expense claims, the bankruptcy court rejected the claimants’ due-process arguments.

Second, the court rejected the notion that ruling on §502(d)’s applicability would constitute an advisory opinion. Rather, the bankruptcy court noted that: 

The Court is merely making a partial ruling in an interlocutory fashion on a very real controversy, and is reserving the adjudication regarding the underlying liability for any alleged preferential Transfers for a later determination to be made in the context of an adversary proceeding.[15]

In addressing the claimants’ third and final procedural argument, the court rejected the notion that the applicability of §502(d) could only be considered in the context of an adversary proceeding. Since the debtors asserted §502(d) as an affirmative defense and not to seek affirmative relief, “Bankruptcy Rule 7001 is not implicated and an adversary proceeding is not necessary.”[16]

Having considered and rejected each of the claimants’ procedural arguments, the bankruptcy court next substantively considered the debtors’ objection to the claimants’ §503(b)(9) administrative expense claims and of whether §502(d) could be used to delay payment of such expenses. Like many of the courts before it, the first consideration was whether §503(b)(9) expenses constituted “claims” as defined in §101(5)(A).[17] It first noted that “[t]hroughout the Bankruptcy Code, the term ‘claim’ is used to refer to administrative expenses,” and then that “§503(b) itself uses the terms ‘claims’ and ‘expenses’ interchangeably.” On these bases, the bankruptcy court preliminarily leaned toward following the MicroAge line of cases and even stated that a “[f]rom a plain reading of the text of §502(d), it appears that §502(d) can be involved to disallow a claim for an administrative expense under §503(b).”[18]

Cognizant of a nationwide split of authority among courts on the applicability of §502(d) to §503(b) expenses, however, the court turned its attention Durham v. SMI Industries,[19]a Fourth Circuit precedent, that ultimately helped cast the deciding vote. Quoting from Durham, the court noted the Fourth Circuit Court of Appeals’ holding that:

Section 502(d) provides, in pertinent part, that ‘the court shall disallow any claim of any entity from which property is recoverable under section…550, unless such entity…has paid the amount…for which such entity or transferee is liable.’ Since a court can only disallow a claim after one has been filed under 11 U.S.C.A. 501(a), ‘claim’ in section 502(d) includes only one for which proof has been filed.

On this basis, the bankruptcy court held that despite the expansive language of §101(5)(A) and a plain reading of §502(d), “the law in this Circuit is that §502(d) can only be used to bar “claims” where the “claims” are filed under §501(a).”

The claimants next argued that unlike most §503(b) administrative-expense claims that arise post-petition, §503(b)(9) claims arise from the delivery of goods in the 20 days prior to the bankruptcy filing, and claimants must, as pre-petition creditors, file a §501(a) proof of claim. The argument was only partially valid because ordinarily creditors of a chapter 11 debtor need not file a proof of claim unless their claim is not scheduled, or is scheduled but as disputed, contingent or unliquidated.[20] In Circuit City, each of the §503(b)(9) claimants’ pre-petition §503(b)(9) claims were either not scheduled, or were scheduled as disputed, contingent or unliquidated.[21] As a result, each of the claimants was required to and did in fact file a proof of claim under §501(a).[22] Applying the rule of law from Durham, and because each of the claimants had filed a §501(a) proof of claim, the bankruptcy court held that “§502(d) may be applied to disallow the Claimants’ Claims until the Claimants have paid into the estate any Preferential Transfers for which they may be held liable.”[23]

Conclusion
While the bankruptcy court in Circuit City reached a holding contrary to that in Ames, the relevant and specific procedural circumstances (i.e., the precedent of Durham) and factual distinctions (i.e., that (1) the Circuit City claimants each held §503(b)(9) claims, (2) each of their claims was either unscheduled by the debtor or scheduled as disputed, contingent or unliquidated (and none of the other proof of claim filing exceptions afforded by the Code or Rules applied), and (3) each filed a proof of claim in accordance with §501(a) and Rule 3002) should narrow the decision’s impact. For instance, §503(b)(9) claimants outside of the Fourth Circuit and those claims that are scheduled by the debtor as undisputed (or that fall within some other exception to the mandates of §501(a) and Rule 3002) will not need to file a proof of claim and could, under the logic of Circuit City, avoid the delays occasioned by §502(d). Query whether debtors cognizant of the Circuit City decision will (1) fail to schedule §503(b)(9) claimants’ claims or (2) schedule them as disputed, in a calculated effort to force a proof of claim filing and enable a §502(d) disallowance as articulated by Circuit City. Only time will tell.