Preference litigation and reconciling bankruptcy claims appear to be separate and distinct processes in the administration of a bankruptcy case. A preference claim has the dual purpose of (1) promoting fairness of treatment of pre-petition unsecured claims by discouraging a debtor from paying some, but not all, of its creditors during the debtor's slide into bankruptcy, and (2) discouraging creditors from enforcing payment of their claims that might otherwise precipitously and prematurely force a debtor into bankruptcy. An objection to a claim is filed as part of the claims reconciliation process to determine the amount of a creditor's allowed claim, which, in turn, determines the amount of the creditor's recovery in a bankruptcy case.

Section 502(d) of the Bankruptcy Code brings claims adjudication and preference claims together in one section. Section 502(d) requires the disallowance of a claim by a creditor that refuses to repay an avoidable transfer, such as a preference. There is a division of authority on whether §502(d) precludes the commencement of a preference action against a creditor following the court-ordered resolution of an objection to that creditor's claim, whether pursuant to a settlement or following a hearing. In In re LaRoche Industries Inc., 284 B.R. 406 (Bankr. D. Del. 2002), and In re Cambridge Industries Holdings Inc., 2003 W.L. 1818177 (Bankr. D. Del. April 2, 2003) and 2003 W.L. 21697190 (Bankr. D. Del. July 18, 2003), the Delaware bankruptcy court held that under §502(d), the court-approved allowance of a creditor's disputed claim (whether by reason of a settlement or adjudication) precludes any subsequent preference claim against that claimant. A new defense for preference defendants? Not so fast! Ironically, the same Delaware bankruptcy court that decided LaRoche recently reached a contrary decision in In re TWA Inc. Post Confirmation Estate, 305 B.R. 221 (Bankr. D. Del. 2004). The TWA court and other courts have rejected LaRoche and held that §502(d) does not preclude a preference action against a creditor following the court-approved resolution of an objection to that creditor's disputed claim.

More litigation and future court decisions dealing with the preclusive effect of §502(d) on preference actions will determine whether preference defendants, whose claims were previously resolved, have an additional defense that will sustain dismissal of the lawsuit.

The Interplay of §§547(b) and 502(d)

A bankruptcy trustee avoids and recovers preferences by satisfying the requirements of §§547(b) and 550(a). Preferences are frequently litigated by the filing of a complaint and the commencement of an adversary proceeding in bankruptcy court. However, there is an alternative mechanism for litigating preferences. Under §502(d) of the Code, a trustee could object to a creditor's claim, a contested matter, by alleging that the creditor had received an avoidable transfer, such as a preference. Section 502(d) requires the disallowance of the claim of the recipient of a preference that is avoided under §547 and recoverable under §550, unless the recipient has returned or repaid the preference.

The courts are divided on the interpretation and application of §502(d). The issue is whether §502(d) precludes a preference action against a creditor whose disputed claim was previously subject to objection and then settled or otherwise resolved by court order.

Conflicting Views on Preference Preclusion Under §502(d)

A. Preclusion of Preference Action Following Court-approved Resolution of Defendant's Disputed Claim. The Delaware bankruptcy court (Bankruptcy Judge John C. Akard) in LaRoche Industries Inc. v. General American Transportation Corp. (In re LaRoche Industries Inc.), 284 B.R. 406 (Bankr. D. Del. 2002), considered whether §502(d) precluded a preference lawsuit against a creditor, following the court-approved resolution of that creditor's disputed claim. The creditor had filed a general unsecured claim in the amount of approximately $117,000. Following confirmation of its chapter 11 plan of reorganization, LaRoche filed an objection to the claim, seeking reduction to an allowed amount of $104,000. The creditor did not respond to the objection, and the court allowed the claim at the reduced amount of $104,000. The creditor then received a distribution, consisting of common stock, on account of its allowed claim under the confirmed plan.

Then approximately six months later, LaRoche sued the creditor, seeking recovery of preferences totaling approximately $84,000. The defendant moved for summary judgment dismissing the preference action. The court granted the motion and dismissed the complaint. The court held that LaRoche's preference action was precluded by §502(d) because the creditor's claim had previously been allowed in a reduced amount pursuant to a court order. LaRoche should have attempted collection of the preference claim as part of the claims reconciliation process and not at a later date. Since the creditor's claim was allowed in a reduced amount based on the objection to claim, and the creditor had received a distribution under the plan, LaRoche was precluded from seeking recovery of preferences from the creditor.

The court also relied on the U.S. Supreme Court's holding in Katchen v. Landy, 382 U.S. 323, 86 S.Ct. 467, 15 L.Ed. 2d 391 (1966). The Supreme Court stated that the predecessor to §502(d), which reads essentially the same as §502(d), required the resolution of preference claims prior to the allowance or disallowance of claims. Having failed to do so, LaRoche was precluded from commencing a preference action against the creditor.

The court also concluded that LaRoche's preference claim was barred as a matter of fairness. LaRoche did not deal fairly and forthrightly with the creditor where LaRoche had objected to and then obtained, by default, a court-approved reduction of the creditor's claim, while concealing the preference claim against the creditor. LaRoche should have resolved all matters concerning the creditor's claim, the allowed amount and all preference claims against the creditor, in one proceeding. The creditor might not have contested LaRoche's objection to reduce the amount of the claim where the only amount at stake was a distribution consisting of stock of questionable value, and the creditor had no knowledge of LaRoche's preference claim. The creditor might have contested LaRoche's objection to a claim that was coupled with a preference claim against the creditor.

The Delaware bankruptcy court (this time Bankruptcy Judge King), in Caliolo v. TKA Fabco Corp. (In re Cambridge Industries Holdings Inc.), 2003 W.L. 1818177 (Bankr. D. Del. April 2, 2003), also dismissed a preference action based on the preclusive effect of §502(d). Cambridge had filed a preference action against one of its creditors after Cambridge had previously objected to that creditor's claim and settled the objection. Cambridge and the creditor had agreed to a reduction of the claim in a stipulated court order. Again, the court relied on §502(d) and principles of fairness to hold that a debtor cannot sandbag a creditor by first objecting to and then obtaining a stipulated order settling the creditor's claim, all while concealing and afterward commencing a lawsuit to recover a preference from that creditor. See, also, Caliolo v. Azdel Inc. (In re Cambridge Industries Holdings Inc.), 2003 W.L. 21697190 (Bankr. D. Del. July 18, 2003) (preference action, commenced prior to claim objection, dismissed under §502(d) where court-approved settlement of creditor's claim occurred while preference action was pending).

B. Rejection of Preclusion Effect of §502(d). However, not all courts have followed LaRoche's upholding of the preclusive effect of §502(d) on preference actions. This division among the courts is reflected in the very same Delaware bankruptcy court that decided LaRoche and Cambridge Industries. In TWA Inc. Post Confirmation Estate v. City and County of S.F. Airports Commission (In re TWA Post Confirmation Estate), 305 B.R. 221 (Bankr. D. Del. 2004), Bankruptcy Judge Peter Walsh rejected LaRoche and held that §502(d) does not prohibit a preference action following a court-approved allowance of that creditor's claim by settlement or adjudication.

TWA had obtained confirmation of a liquidation plan. Under the plan, Post-confirmation TWA had retained all rights and assets not previously sold during the chapter 11. The city of San Francisco had filed administrative claims in the aggregate amount of approximately $98 million prior to confirmation of the plan. Following confirmation, Post-confirmation TWA objected to San Francisco's administrative claims. Thereafter, Post-confirmation TWA and San Francisco resolved the claim objection in a court-approved stipulated order. Under the stipulated order, San Francisco was granted a significantly reduced allowed administrative expense claim and an allowed pre-petition unsecured claim. Shortly after that, San Francisco received payment of its allowed administrative expense claim under the plan.

One month prior to the stipulated order, Post-confirmation TWA had sent a letter to San Francisco, demanding payment of approximately $1.3 million of alleged preferences. The city did not respond to the demand, and, following court approval, and consummation of the settlement, of the claim objection, Post-confirmation TWA commenced a preference action against San Francisco. San Francisco moved to dismiss the action based on the previous court-approved settlement of the claim objection, relying on the LaRoche decision upholding the preclusive effect of §502(d).

The court denied the motion to dismiss the preference action. The court rejected LaRoche, and held that §502(d) does not preclude a preference action following a claims-objection process that had resulted in a court-approved allowance of the defendant's claim.

The court felt that upholding the preclusive effect of §502(d) on preference actions would be detrimental to the chapter 11 process. In many chapter 11s, a debtor must address claims far earlier in the case than the time frame for investigating and prosecuting preference claims. That was precisely what happened in the TWA case. TWA and its creditors' committee had to first address and resolve numerous large claims, including significant administrative claims, in order to establish the administrative solvency of the TWA bankruptcy estate and move forward with a plan. Any decision that upheld §502(d)'s preclusive effect on preference claims and required that a debtor deal with claims reconciliation and preferences at the same time would discourage debtors from initially focusing on claims reconciliation, which might be a necessary predicate for a sale or plan process.

A chapter 11 debtor that is continuing its business and seeking to reorganize also frequently has no incentive to pursue preference claims. The debtor needs to maintain ongoing working relationships with its vendors and other creditors that would be hindered by pursuing preferences. It would also be a waste of estate resources to force a debtor seeking to reorganize to reconcile claims and simultaneously investigate and pursue preference claims. The LaRoche holding would force a debtor and its professionals, already engaged in the claims-reconciliation process, to unnecessarily and prematurely commence preference actions in order to preserve preference claims in the event of a liquidation.

Preference actions would most likely be pursued if the reorganization fails and the debtor is liquidated. The debtor or a plan-designated entity then usually investigates and prosecutes preference claims. They frequently (though not necessarily properly) wait until the very last minute, often on the eve of the §546(a) statute of limitations, to commence preference actions en masse against preference recipients. If a court upholds the preclusive effect of §502(d) espoused by LaRoche, the bankruptcy estate would lose the benefit of significant preference recoveries where claims were previously reconciled.

The TWA court also felt that sophisticated creditors are well aware that they could be targets of preference claims. TWA's creditors should have not been surprised or caught off-guard by the subsequent commencement of preference actions following the reconciliations of their claims.

The TWA court relied on other court decisions that have similarly rejected the preclusive effect of §502(d) on preference actions, following the court-approved resolution of an objection to the preference defendant's claim by settlement or adjudication. See Rhythms NetConnections Inc. v. Cisco Systems Inc. (In re Rhythms NetConnections Inc.), 300 B.R. 404 (Bankr. S.D.N.Y. 2003); Peltz v. Goldcoast Workstation Group (In re Bridge Information Systems Inc.), 293 B.R. 479 (Bankr. E.D. Mo. 2003).

The court in the Bridge Information Systems case found that §502(d) is only applicable when a debtor objects to a claim. Section 502(d) operates as an affirmative defense to a creditor's claim. Section 502(d) does not bar a subsequent preference action against the creditor. The court further rejected LaRoche's and Cambridge's reliance on the U.S. Supreme Court's holding in Katchen v. Landy. Katchen did not deal with the preclusion of a preference action against a creditor whose claim was previously subject to an objection to claim and was then settled or otherwise allowed by court order.

The Rhythms court followed Bridge and refused to rely on §502(d) to preclude a preference action against a creditor, following a court-approved settlement of the creditor's claim. Section 502(d) is designed to induce creditors to comply with court orders for the avoidance and recovery of voidable transfers. It precludes preference recipients from obtaining a recovery on their claims until they return all avoided transfers. It does not require a debtor or other party prosecuting an objection to claim to raise preference claims as a compulsory counterclaim. The court also noted that the reconciliation of claims was integral to consummating the sale of the debtor's assets. Prosecuting preference claims would have hindered the prospects for resolving claims and thrown the sale in jeopardy.

Conclusion

There are conflicting court decisions on the preclusive effect of §502(d) on preference actions following the resolution of an objection to a preference defendant's disputed claim. If courts follow the "gotcha" approach of the LaRoche line of cases, preference defendants, whose disputed claims were previously resolved by court process, might have an additional defense to a preference action. However, the contrary decisions in TWA, Rhythms and Bridge suggest plenty of future litigation on this issue. Stay tuned for more developments!