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A New Defense to Preference Litigation

By Thomas S. Onder

No one likes to give back money, especially if you had a hard time collecting it in the first place. For collection practitioners, this situation frequently occurs at the intersection of bankruptcy and collection law. It starts off with a bankruptcy trustee’s letter demanding that money previously collected must be returned as a "preferential transfer." And it often ends with the collection practitioner telling a bewildered client that, through no fault of their own, the collected funds must be returned pursuant to Bankruptcy Code § 547(b).

Section 547(b) allows the trustee to avoid transfers of a debtor’s interest in property if the transfers are to or for the benefit of a creditor on account of an antecedent debt while the debtor was insolvent and made within 90 days before the bankruptcy petition was filed.

Although the bankruptcy trustee has great power to reclaim the property, there are a number of defenses to the trustee’s claim, including the usual defenses of ordinary course of business, transfers outside the 90-day preference period, contemporaneous exchange and new value.

A defense that has recently gained much discussion in a number of courts is based on whether the claim had previously been allowed through either settlement or the claims allowance process. Section 502(d) of the Bankruptcy Code provides that court shall: "disallow any claim of any entity from which property is...a transferee of a transfer avoidable under...Section 547…of the title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity is liable..."

This defense was explicated in In re LaRoche Industries, Inc., 284 B.R. 406 (Bankr. D. Del. 2002). In LaRoche, a creditor filed a lease rejection damage claim, and the debtor objected to the amount of the claim. The creditor did not respond to the objection, and the court allowed the claim in a lesser amount. After confirmation of the plan, the debtor brought a preference action against the creditor.

The creditor argued the allowance of the claim under Bankruptcy Code Section 502(d) bars the debtor from seeking to recover the preference claim. The LaRoche court agreed with the creditor and held that the preference claim should have been litigated as part of the claims process. The court held that: "§ 502(d) stands for the proposition that if a claim is allowed there is no longer a voidable transfer due from that claimant. In essence, a voidable transfer, such as a preference, must be determined, as part of the claims process and not at a later time, especially after distribution under the plan has been made." Id., at 408-09.

The LaRoche court also noted that it would be inequitable to allow a creditor to object to a claim while concealing a cause of action. The court reasoned that creditors might approach the claims resolution process differently if they knew that a preference action were available even after resolution of certain claims. Id., at 410.

However, other courts have held § 502(d) should not be used to prohibit a preference action that is commenced after a claim is allowed by settlement or hearing. [e.g., In re Rhythms NetConnections, 300 B.R. 404 (Bankr. S.D.N.Y. 2003); In re TWA Inc. Post Confirmation Estate, 305 B.R. 221 (Bankr. D.Del. 2004)].

In Rhythms NetConnections, the debtor—a telecommunications broadband company—was struggling with an urgent sale of assets, termination of service and emergency petitions to the Federal Communications Commission, and generally trying to conserve what resources were being siphoned away. Only two months after the petition date, the debtor entered into a settlement agreement with a creditor in order to resolve issues related to an asset sale commenced simultaneously. The settlement also included no release of claims against the creditor. Two years later, the debtor then brought a preference action to recover property of the estate.

The Rhythms court stated that although § 502(d) was intended to coerce creditors to comply with judicial orders, it was designed to be triggered after a creditor had been afforded reasonable time to return property of the estate. The court concluded that § 502(d) is an affirmative defense to a creditor’s claim against the estate. Id., at 409. The court further distinguished the cases that had allowed § 502(d) to bar claims, from its own, reasoning that in other cases, debtors had been allowed ample time to negotiate claims and perform a preference claims analysis. Id., at 409-410. Whereas in the Rhythms case, the debtor had only two months from the petition date when it settled claims as part of a process to keep the company afloat. Thus, the court allowed the preference action.

The court in TWA Inc. Post Confirmation Estate reaffirmed the RhythmsNetConnections holding that allowing a preclusive effect of barring all claims under § 502(d) would be detrimental to large Chapter 11 cases. In TWA, the debtor had made payments to the City of San Francisco for airport operation payments such as gate rentals, security and parking, 90 days before filing. Eight months into the case, the debtor filed an objection to the city’s claim. The claim was resolved by a stipulation a few months later. Two months after the stipulation, the debtor filed a preference action to recover the transfer for airport operations.

The TWACourt held that, like Rhythms, its debtors were far from a point to be expected to commence an adequate preference analysis. Id., at 4. Further, in dicta, the court stated the practical side of most large Chapter 11 bankruptcies often puts preference analysis on the back burner to be handled by a claims administrator after a plan is confirmed. Id., at 4-5. Thus, the court concluded that to allow preference claims to be precluded based on § 502(d) would seriously affect case administration.

More courts have leaned toward these latter cases’ position that § 502(d) is not a bar to preference claims filed after settlement or allowance. However, neither LaRoche nor TWA, both Delaware cases, have been overruled. There still is plenty of room for interpretation, depending on the particular facts of your case and the court in which your case is commenced. For example, whether the size of a Chapter 11 proceeding, the number of creditors or the complexity of the case bears any weight on whether § 502(d) would be applicable, is still open to discussion.

No matter what your facts or where your case is heard, these three cases provide insight into a rather unordinary and often overlooked course for a possible preference defense.

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