Regular Monitor contributor Lesley Anne Hawes offers insight into Bankruptcy Code preference provisions. Using underpinnings of the Eighth Circuit’s recent decision in the case In re LGI Energy Solutions, Inc., she details the exceptions and defenses to preference recovery, noting that the analysis and rationale of the statute must be applied in a manner consistent with the policies and purposes it was intended to promote.
Lesley Anne Hawes, Partner, McKenna, Long & Aldridge
The preference provisions of the Bankruptcy Code advance key policy goals of (1) promoting equality of distribution among unsecured pre-petition creditors and (2) encouraging creditors to continue to maintain normal business relations with the debtor, and the corollary of discouraging creditors from attempting to collect their claims as the debtor’s financial condition deteriorates. The preference statutes promote those goals by generally allowing a trustee in bankruptcy to recover payments made by the debtor during the 90 days prior to bankruptcy if the payments are made on account of an antecedent debt, while the debtor is insolvent, and allowing the creditor to recover more than it would have otherwise obtained in a Chapter 7 liquidation.
The statute includes exceptions or defenses to preference recovery, which also promote these same policy goals by limiting or eliminating preference liability for those creditors who have continued to maintain ordinary business relationships with the debtor, and who have helped to keep the debtor’s ship afloat with the prospect that the debtor can avoid bankruptcy if not pressured by creditors. These policies became the underpinnings of the Eighth Circuit’s recent decision in the case In re LGI Energy Solutions, Inc. (Stoebner v. San Diego Gas & Electric Co.), 2014 WL 1063209 at *1 (8th Cir. March 20, 2014), addressing preference issues of first impression for the circuit. The court held that two utility companies that were sued for recovery of preferences were entitled to offset against the Chapter 7 trustee’s claims the amount of subsequent payments made to the debtor by the underlying utility customers, eliminating any preference liability for one utility company defendant and substantially reducing the other utility company defendant’s liability on the trustee’s preference claim.
Prior to the commencement of their Chapter 7 bankruptcy cases, the debtor LGI Energy Solutions, Inc. and its related entity LGI Data Solutions Company, LLC (collectively LGI) provided bill payment services for their customers. LGI had contractual agreements with its customers pursuant to which the customers engaged LGI to receive invoices from utility companies for utility services provided to the customers, to submit a summary schedule of the utility bills received on the customer’s behalf, and to make payments to the utility companies for the customers/utility service end users. When LGI collected a series of invoices for its customers for utility service to the customers’ businesses, LGI prepared a spreadsheet summarizing the invoices and listing an aggregate total due for the utility services covered by those invoices. The LGI customer would then make a single payment to LGI for those utility services, and LGI was obligated contractually to its customer to remit the payment to the utility company for the covered invoices. LGI had no contracts or agreements with the utility companies; however, the utility companies directed the utility bills for the utility end user/LGI customer to LGI.
LGI made a payment to the utility companies within the 90 days prior to its bankruptcy on behalf of two of its customers, each of which were large restaurant chains. The utility companies continued supplying utility service to LGI’s customers after the payment, and the utility companies issued additional invoices to LGI for those customers for those subsequent services. LGI billed its customers/utility end users, providing them with its customary spreadsheets for the later invoices received for utility services to those customers, and the customers paid LGI for those later invoices consistent with their ordinary business practices. LGI’s financial condition was deteriorating, however, and LGI never remitted payment to the utility companies from the funds received from its customers for the later set of invoices.
The Preference Statute and Defenses
Section 547 of the Bankruptcy Code makes a payment made by the debtor within 90 days of the debtor’s bankruptcy filing preferential and subject to recovery by the trustee if the payment was made on account of an antecedent debt, while the debtor was insolvent and if the payment, if retained by the creditor, would allow the creditor to receive more than it would otherwise have received in a Chapter 7 liquidation of the debtor. The Bankruptcy Code creates a rebuttable presumption that the debtor is insolvent at all times during the 90-day period leading up to the bankruptcy filing. Payments made to general unsecured creditors who have no collateral for their claim will generally be preferential as they usually allow them to receive more than they would otherwise obtain through a Chapter 7 liquidation. The debtor’s assets generally are insufficient to pay unsecured creditors’ claims in full.
Section 547(c) sets forth a number of exceptions to the trustee’s right to recover a preference, defenses which limit or eliminate liability of a preference defendant even if the elements of a preference are otherwise met. For example, these exceptions protect from recovery payments made in connection with a substantially contemporaneous exchange of new value and payments made in the ordinary course of business of the debtor and the creditor under ordinary business terms. 11 U.S.C. §547(c)(1) and 11 U.S.C. §547(c)(2).
Another defense to a preference action is the “subsequent new value” exception to preference recovery 11 U.S.C. §547(c)(4). Generally, to qualify for that defense, the creditor must demonstrate that after the preferential payment was made, “such creditor gave new value to or for the benefit of the debtor” that was (a) unsecured, and (b) on account of which “the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor,” 11 U.S.C. §547(c)(4) (emphasis added). The defense essentially allows the creditor to offset the value paid or transferred to the debtor after the preferential transfer is made so long as that subsequent transfer of new value is not subject to a later avoidable/preferential transfer. Generally, if new value is transferred and is not repaid or collateralized, then the subsequent new value will be able to be offset against the prior voidable preferential transfer.
The facts before the bankruptcy court were undisputed. The key issues to be addressed in the trustee’s preference action were (a) whether the defendants were “creditors” of the debtor, and therefore proper targets for preference recovery under §547, and (b) if the utility companies were creditors of the debtor, could the utility companies use the subsequent payments made by the restaurants to the debtor after the preferential transfers as “subsequent new value” to reduce or eliminate their preference liability under §547(c)(4). The bankruptcy court concluded the utility companies were creditors of the debtor on two theories:
Specifically, that the debtor received and held payments from the restaurant’s utility end users in trust for the utilities companies, giving them a claim against the debtor for those funds, and alternatively, that the utility companies were third party beneficiaries of the contracts between the debtor and the restaurants. In either case, each utility company would hold a “claim” against the debtor and would be a “creditor” of the debtor under the broad definitions of those terms in the Bankruptcy Code. The bankruptcy appellate panel held the findings by the bankruptcy court as the creditor status of the utilities were not clearly erroneous. The Eighth Circuit affirmed that ruling, while nevertheless expressing some doubt as to whether that court would have found the utility companies to be creditors of the debtor at all under the circumstances.
The bankruptcy court next analyzed whether the utility companies had met the subsequent new value defense. The bankruptcy court ruled that the utilities could not use the payments subsequently made by the restaurants to the debtor to offset the preferential payments as the language of §547(c)(4) required “such creditor,” i.e., the creditor sued for the preference recovery, to be the creditor that provided the subsequent new value. It was the restaurants that had made the new payments, not the utility companies. The bankruptcy court allowed the utility companies to use the value of the utility services they supplied to the restaurants after the preferential transfer as the new value they could offset against the preferential transfer.
The bankruptcy appellate panel reversed that ruling, holding that “in tripartite relationships where the transfer to a third party benefits the primary creditor, new value can come from that creditor, even if the third party is a creditor in its own right.” In re LGI Solutions, Inc., 482 B.R. at 820. As the bankruptcy appellate panel explained, “as trust beneficiaries and third-party beneficiaries, the defendants [utilities] are creditors of the debtors precisely because the payments made to them were intended to benefit the creditor(s) that provided the new value [the restaurants].” Id. As a result, one utility had no preference liability at all and the other utilities’ preference liability was substantially reduced. The Eighth Circuit affirmed the decision of the bankruptcy appellate panel.
The Eighth Circuit’s decision focuses more specifically on the policies underlying the preference statute and the subsequent new value exception. The court noted that the trustee sued the utility companies in the first place because he would have had no viable preference claim at all against the restaurants for several reasons. The Eighth Circuit noted that allowing the utility companies to apply the subsequent payments made by the restaurants to offset the prior preferential transfers to the utilities was consistent with the purpose of the subsequent new value exception, since after the debtor made the preferential payments, the debtor received significant payments from the restaurants, which the debtor retained for use in its business. “[I]t both serves the purposes of §547 and honors the statute’s text to construe ‘such creditor’ in the §547(c)(4) exception as including a creditor who benefited from the preferencial transfer and subsequently replenished the bankruptcy estate with new value.” In re LGI Solutions, Inc., 2014 WL 1063209 at *5.
While tri-partite payment and services relationships are less common than the usual bilateral debtor-creditor relationship, tripartite relationships can arise in the context of employment and insurance arrangements (see e.g., Jones Truck Fires, Inc. v. Full Sew. Leasing Corp., 83 F.3d 253 (8th Cir. 1996) (employment). As the LGI Solutions case illustrates, they can also arise in circumstances where a middleman entity processes payments from one party for goods or services provided by a different party. The LGI Solutions case is also helpful to creditors for its focus on a policy analysis of the preference statute and its rationale that the statute must be applied in a manner consistent with the policies and purposes it was intended to promote.
Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the FTC and SEC.
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