In re Pillowtex, Delaware Embraces the Subsequent New Value Approach

The most accessible defense to a preference claim is the “new value” defense codified at 11 U.S.C. §547(c)(4). If the requirements of §547(c)(4) are met, this defense enables a creditor to avoid preference liability where it has already received a preferential transfer by subsequently providing new value to the debtor. The new value defense need not be proven with the assistance of expert testimony and is generally subject to analysis in a trade creditor’s credit department before the claim is referred to outside bankruptcy counsel. Indeed, many claim agents and financial advisers boast of their software that calculates “new value” and incorporates into payment demands prior to the institution of preference litigation. Section 547(c)(4) provides:

The trustee may not avoid under this section 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—

(A) not secured by an otherwise unavoidable security interest; and

(B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.

Notwithstanding the comparatively mathematical applicability of this defense, courts and the circuits disagree as to its application, particularly that of §547(c)(4)(B). Focusing on such issues as whether the new value “replenished” the estate, some circuits have determined that the new value may not be used to reduce the creditor’s preference liability unless the new value remains unpaid at the end of the preference period. This “remains unpaid” approach is said to be adopted in the Third, Seventh and Eleventh Circuits.[2] Three others, the Fourth, Fifth and Ninth Circuits,[3] have refused to read such a requirement into the statutory language, preferring the so-called “plain meaning” approach, under which the new value need not remain unpaid, but may only be paid for by an otherwise unavoidable transfer.

The difference between the two approaches can be illustrated through a hypothetical example: A creditor receives otherwise preferential payments of $1,000 from a debtor on the first, 11th and 21st of a month, and the creditor then gives new value worth $1,000 to the debtor on the fifth, 15th and 25th of the same month. Under the “remains unpaid” approach, the creditor’s preference exposure would be $2,000, while under the “plain meaning” approach, there is no preference exposure. Predictably, trustees and creditor trusts prefer the outcome generated under the former approach, while creditors tend to prefer the more generous outcome stemming from the latter.

Although, as previously noted, the Third Circuit is usually cast in the camp requiring new value to remain unpaid in order to be deserving of the benefits of §547(c)(4), but the U.S. Bankruptcy Court in Delaware recently challenged such categorization in In re Pillowtex.[4]

Pillowtex arose out of motions for summary judgment brought by the defendants in two separate adversary proceedings, American & Efdrid Inc. and Xymid LLC. Both defendants filed motions for partial summary judgment on the issue of the §547(c)(4) and the subsequent new value defense, which the bankruptcy court considered together. At the outset of his opinion, Hon. Kevin J. Carey reviewed the applicable statutory language, and the court revisited the Third Circuit Court of Appeals’ summary of the elements of §547(c)(4) as set forth in New York City Shoes Inc. v. Bentley Int’l Inc. (In re New York City Shoes Inc.):[5]

The three requirements of §547(c)(4) are well established. First, the creditor must have received a transfer that is otherwise voidable as a preference under section 547(b). Second, after receiving the preferential transfer, the preferred creditor must advance “new value” to the debtor on an unsecured basis. Third, the debtor must not have fully compensated the creditor for the “new value” as of the date it filed its bankruptcy petition.[6]

The court then noted that the issue at stake in New York City Shoes was the second element, whether unsecured new value was extended after the preferential transfer at issue. Nowhere in New York City Shoes does the Third Circuit address the third element of the test or refer to a requirement that the subsequent transfer(s) “remain unpaid.”

Subsequent to New York City Shoes, the Third Circuit again considered the §547(c)(4) defense in Schubert v. Lucent Technologies Inc. (In re Winstar Commc’n Inc.).[7] Judge Carey noted that, just as in New York City Shoes, the Winstar opinion did not directly address the third element of the new value defense. Looking closer to home, the court stated that the only Delaware bankruptcy court decision that dealt with the third element of §547(c)(4) was visiting Hon. Paul B. Lindsey’s decision in Hechinger Investment Co. of Delaware Inc. v. Universal Forest Products Inc. (In re Hechinger Investment Co. of Delaware Inc.).[8] Regrettably, the Hechinger decision side-stepped New York City Shoes by finding the facts of each case distinguishable and instead relied on case law from outside the Third Circuit (i.e., Boyd v. The Water Doctor (In re Check Reporting Services Inc.),[9] and Laker v. Vallette (In re Toyota of Jefferson Inc.[10])) to support its finding that payments in a rolling or revolving account need not remain unpaid in order to qualify for the new value defense.

Judge Carey went to great pains to emphasize that he recognized his obligation to follow the Third Circuit precedent and pointed out he did not feel his conclusion was inapposite to New York City Shoes.Indeed, in a footnote to the opinion, Judge Carey stated:

"To be clear, while I express the elements of §547(c)(4) defense somewhat differently than was stated in New York City Shoes, I do not consider this formulation to be either materially different or inconsistent with what was expressed by the Court, by whose decisions I am certainly bound. But, in the absence of controlling law on the discreet issue of the proper interpretation of §547(c)(4)(B) (for the reasons described above), after taking into account the subsequent development of decisional law and other scholarship in the 20 years since New York City Shoes was decided, and with the §547(c)(4)(B) issue squarely before me, I conclude that the so-called "third element" of the subsequent advance defense should be understood as: “the new value has not been repaid with an otherwise unavoidable transfer.”

Finding no clear application of Third Circuit or district court precedent addressing the third element of the §547(c)(4) defense, the court then turned to an examination of the statutory language. The third element of the new value defense states “on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.” There is simply no statutory predicate requiring that the new value remain unpaid, only that it is paid for that such payment be avoidable itself. Citing law review articles,[11] the court noted the fundamental fairness in strictly following the statutory language. On the one hand, an otherwise unavoidable transfer, such as a COD transfer, should not be included in the equation as a preference defense because it is already exempt from avoidance and would permit the creditor something of a “double-dip” benefit. On the other hand, imprinting on an avoidable transfer the requirement that such transfer remain unpaid may yield a similar “double-dip” benefit to the trustee or estate.

Having found that the clear language of the statute did not support a requirement that the new value remain unpaid, the court also reasoned that its conclusion was consistent with the general principles espoused in New York City Shoes (i.e., encouraging trade creditors to continue dealing with troubled businesses and treating fairly those creditors who have replenished the estate after having received a preferential transfer).

The Pillowtex decision is important for a number of reasons. Delaware is one of the busiest chapter 11 venues in the nation and one from which a great many preference claims emanate, and creditors may take some comfort in the knowledge that the more generous subsequent new value approach enjoys clear authority in this district. In addition, based on Judge Carey’s analysis, there is some justification for the view that the Third Circuit should no longer be cast as one of the circuits in the “remain unpaid” camp. Finally, by adopting the “plain meaning” approach to the new value defense, Pillowtex provides support for the argument that this approach is the emerging and more doctrinally sophisticated view.[12]