The controversial weight placed on the shoulders of debtors' lawyers by a recent line of cases from Delaware's visiting bankruptcy judges regarding the so-called "§502(d) claim preclusion defense" was lightened recently by former chief judge, Peter J. Walsh, in the court's recent opinion in TWA Inc. Post Confirmation Estate v. City and County of San Francisco Airports Commission (In re TWA Inc. Post Confirmation Estate), 2004 Bankr. LEXIS 38 (Bankr. D. Del. Jan. 20, 2004). Prior to Judge Walsh's opinion in TWA, neither of the two members of Delaware's permanent bankruptcy bench had opined as to §502(d)'s preclusive effect on certain chapter 5 causes of action, leaving many who litigate in the jurisdiction to wonder how and when either Chief Judge Mary F. Walrath or Judge Walsh would land on the issue. But as quickly as the popularity of the §502(d) claim-preclusion defense gained momentum and defendants around the country began hanging their hats on this defense, Judge Walsh weighed in against the §502(d) claim preclusion defense with a well-grounded opinion. With Judge Walsh's opinion in TWA, the precedential scales previously tipped in favor of the §502(d) claim-preclusion defense have been evened out, and the trend in favor of the §502(d) claim-preclusion defense has taken a turn.

Laroche and Cambridge

The earlier line of cases from which Judge Walsh departed began in late 2002 with Laroche Industries Inc. v. General American Transportation Corp. (In re Laroche Industries Inc.), 284 B.R. 406 (Bankr. D. Del. 2002). In Laroche, former visiting Judge John C. Ackard² dismissed a preference action brought by a debtor by permitting the creditor to use §502(d) as a complete defense to the debtor's asserted avoidance action.³ To this end, the court reasoned that "§502(d) stands for the proposition that if a claim is allowed there is no longer a voidable [sic] transfer due from the claimant." Id. at 408.

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To be sure, the §502(d) claim-preclusion defense created an apparent boon to avoidance action defendants, who began to consistently employ the defense as soon as Laroche and Cambridge were handed down.

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In so ruling, Judge Ackard, relying on the U.S. Supreme Court's opinion in Katchen v. Landy, 382 U.S. 323 (1966), held that "[a] preference action is part and parcel of the claims process...[and that the Supreme Court in] Katchen instructs that the debtors in this case should have brought the preference action before, or at the same time as, they filed their [claim] objection..." Id. at 409. In addition, the Laroche court reasoned that:

There is an issue of fairness here. All matters concerning a creditor's claim should be resolved at one time. It is clearly inequitable to allow a debtor to object to a claim while concealing a cause of action for a preference. A creditor, viewing an objection to its claim, may not feel it is worth contesting... A creditor might take a very different approach to a claim objection if it were coupled with a preference action. They should not be permitted to take unfair advantage of their creditors by attempts to manipulate the Bankruptcy Code and Rules. Concealing a preference action while engaging in a claim objection is clearly an attempt to take unfair advantage of the Bankruptcy Code and Rules.

Id. at 410. Thus, based on Judge Ackard's interpretation of Katchen and equitable concerns such as "creditor surprise," the avoidance action was dismissed, and a new statutory defense appears to have been created.

Following Judge Ackard's ruling in Laroche, former visiting Judge Lloyd King⁴ issued similar rulings in In re Cambridge Industries Holdings Inc., Ch. 11 Case No. 1919 (LK) (Bankr. D. Del. 2000). First, in July 2003 in Caliolo v. Adzel Inc. (In re Cambridge Industries Holdings Inc.), Judge King opined that "[t]he command of §502(d) is clear: The preference dispute must be resolved in tandem with the claim objection...[and that w]here there is a court order resolving a dispute over the amount of a creditor's claim, the entry of that order precludes, pursuant to §502(d), the commencement or continuation of litigation for the recovery from the creditor of allegedly avoidable transfers." Caliolo v. Adzel Inc. (In re Cambridge Industries Holdings Inc.), 2003 Bankr. LEXIS 794 (Bankr. D. Del. July 18, 2003). In Caliolo v. TKA Fabco Corp. (In re Cambridge Industries Holdings Inc.), 2003 Bankr. LEXIS 577 (Bankr. D. Del. April 2, 2003), Judge King reasoned that "the language of §502(d) and principles of fairness do not permit sandbagging of a creditor by, first, objecting to and obtaining a stipulated order allowing the claim in a reduced amount and, after the claim objection has been resolved, commencing an adversary proceeding alleging that the creditor received an avoidable preference." Finally, in the third of three rulings on the §502(d) claim-preclusion defense, Caliolo v. Saginaw Bay Plastics Inc. (In re Cambridge Industries Holdings Inc.), 2003 Bankr. LEXIS 1200 (Bankr. D. Del. Sept. 25, 2003), Judge King stayed the course by affirming the court's position on the availability of the §502(d) claim-preclusion defense in dismissing an avoidance action in that case.

Thus, together with Laroche, the Cambridge trilogy of §502(d) claim-preclusion decisions appeared to signal a trend that would accelerate avoidance action analysis so that it must always run concurrently with the claims-reconciliation process in chapter 11 cases.⁵ To be sure, the §502(d) claim-preclusion defense created an apparent boon to avoidance action defendants, who began to consistently employ the defense as soon as Laroche and Cambridge were handed down.

TWA: A Break in the Trend

In TWA, Judge Walsh departed from the reasoning employed by both the Laroche and Cambridge courts and disagreed with the availability of the §502(d) claim-preclusion defense to avoidance-action defendants. The TWA court began its analysis by noting that the reliance of the Laroche and Cambridge courts on Katchen was misplaced. In doing so, Judge Walsh pointed out that the "[t]he issue of whether a debtor who fails to object to a creditor's claim based on §502(d) is precluded from asserting a preference action against the creditor was simply not at issue in Katchen." Id. at *11 (internal citation and quotation omitted). Following an alternative line of reasoning, the TWA court relied on Peltz v. Gulfcoast Workstation Group (In re Bridge Info. Sys. Inc.), 293 B.R. 479 (Bankr. E.D. Mo. 2003), and Rhythms Netconnections Inc. v. Cisco Sys. Inc. (In re Rhythms Netconnections Inc.), 300 B.R. 404 (Bankr. S.D.N.Y. 2003), recognizing that these decisions "state a better application of §502(d), and that section should not be used to prohibit a preference action that is commenced after a claim is allowed by settlement or a hearing." Id. at *14. Reciting the position originally set forth in Bridge, Judge Walsh held that §502(d) is actually "an affirmative defense to a creditor's claim against the estate and 'is only applicable when the debtor-in-possession (DIP) actually interposes an objection to a creditor's claim under §502(d).'" Id., citing Peltz v. Gulfcoast Workstation Group (In re Bridge Info. Sys. Inc.), 293 B.R. 479, 488 (Bankr. E.D. Mo. 2003). Accordingly, it would follow that Judge Walsh views §502(d) as a shield to be invoked by the debtor, rather than a sword available for use by the creditor.

In addition to the statutory reasoning set forth in Bridge and Rhythms that was adopted by Judge Walsh, the TWA court offered additional insight as to why the rulings in Laroche and Cambridge would be detrimental in the large, sophisticated and expedited chapter 11 cases often seen in Delaware bankruptcy courts. To this end, Judge Walsh began by emphasizing that the confirmation process in many such chapter 11 cases often hinges on the resolution of numerous large claims. "This dictates the need for a claims-resolution process occurring long before any preference analysis is undertaken." Id. at *14. The court went on to reason that delaying the claims-reconciliation process because of potential avoidance-action claim preclusion would be particularly injurious in expedited-sale cases where the debtor company is recording significantly negative cash flows and the fixing of cure claims is essential to the sale and plan efforts.⁶ See Id.

Finally, Judge Walsh supported his determination that the §502(d) claim-preclusion defense was unavailable to avoidance-action defendants by outlining those situations where the claims-resolution process is crucial to a determination of whether a reorganization or liquidation of the debtors is the most appropriate course. Specifically, Judge Walsh stated that in most reorganization cases:

the debtor does not file preference actions because of the need for ongoing working relationship[s] with vendors and other creditors. In that stage of the case leading up to such a reorganization, the debtor effects settlements and otherwise resolves major claims with its creditors. Indeed, if the reorganization prospects look good, it may be a waste of estate resources to undertake a preference analysis while the estate is engaged in the claims-resolution process. However, if it turns out that a successful reorganization cannot be effected and the debtor and major creditors conclude that a liquidation is the best alternative, then preference actions most assuredly will be brought, and indeed should be brought, and I believe that the Laroche holding would hinder that process.

Id. at *15-16. As to so-called "creditor surprise," Judge Walsh dismissed such concerns, stating that "in large chapter 11 cases, sophisticated creditors typically are well aware of prospects and risks of preference litigation...Thus, it seems unlikely that creditors could be surprised or caught off-guard when such preference complaints are finally filed." Id. at *16-17.

Conclusion

With the TWA court's ruling that the §502(d) claim-preclusion defense is not viable, the weight of authority regarding that defense has been evened out, resulting in a collective sigh of relief by debtors' counsel. Pending a ruling on the defense's availability from an appellate court, the sound statutory analysis and pragmatic approach offered by Judge Walsh is likely to be considered by most debtors' counsel to be doctrinal word on the defense's availability in Delaware, while defense counsel will continue to cling to the hopes of the complete defense (or windfall, depending on one's perspective) provided by Laroche and Cambridge.⁷

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Footnotes

¹ The authors are attorneys at the Wilmington, Del., law firm of Young Conaway Stargatt & Taylor LLP, where they practice in the firm's corporate bankruptcy practice group. Return to article

² From May 17, 2001, to Oct. 11, 2002, Judge Ackard sat as a visiting bankruptcy judge from the U.S. Bankruptcy Court for the Northern District of Texas. Return to article

³ Section 502(d) of the Bankruptcy Code states in its entirety: "Notwithstanding subsections (a) and (b) of this section, the court shall disallow any claim of any entity from which property is recoverable under §542, 543, 550 or 553 of this title or that is a transferee of a transfer avoidable under §522(f), 522(h), 544, 545, 547, 548, 549 or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under §522(i), 542, 543, 550 or 553 of this title." 11 U.S.C. §502(d). Return to article

⁴ From Oct. 8, 2002, to Oct. 15, 2003, Judge King sat as a visiting bankruptcy judge from the U.S. Bankruptcy Court for the District of Hawaii. Return to article

⁵ Although Chief Judge Walrath has yet to opine as to the availability of the §502(d) claim-preclusion defense, the results in Laroche and Cambridge appear inconsistent with Chief Judge Walrath's opinion in In re Lids Corp., 260 B.R. 680 (Bankr. D. Del. April 6, 2001). In In re Lids Corp., the court ruled that "[t]o disallow a claim under §502(d) requires a judicial determination that a claimant is liable...Until the [d]ebtor obtains a judgment against [the defendant] upon which [the defendant] is liable for a preference, §502(d) is not applicable." In re Lids Corp., 260 B.R. at 684. The result then is that the marrying of the avoidance action and claims-reconciliation process mandated by Laroche and Cambridge is impossible under Lids, given that obtaining an avoidance judgment is a condition precedent to §502(d)'s availability. Return to article

⁶ It bears noting that cure claimants have a separate preference defense in light of the recent ruling by the U.S. Third Circuit Court of Appeals in Kimmelman v. Port Auth. of N.Y. and N.J. (In re Kiwi International), wherein the appeals court held that a debtor's pre-petition contractual payments to its pre-petition creditors during the 90-day preference period established by 11 U.S.C. §547(b)(4)(A) could not be recovered as preferential transfers where the debtor later assumed the contracts. See Kimmelman v. Port Auth. of N.Y. and N.J. (In re Kiwi International), 344 F.3d 311 (3d Cir. Sept. 25, 2003). Return to article

⁷ Each of the three Cambridge decisions is currently on appeal before U.S. District Judge Gregory M. Sleet in the U.S. District Court for the District of Delaware. See Caliolo v. TKA Fabco Corp. (In re Cambridge Indus. Holdings Inc.), CV-03-519 (GMS) (D. Del. May 29, 2003); Caliolo v. Azdel Inc. (In re Cambridge Indus. Holdings Inc.), CV-03-851 (GMS) (D. Del. Sept. 2, 2003); Caliolo v. Saginaw Bay Plastics Inc. (In re Cambridge Indus. Holdings Inc.), CV-03-1009 (GMS) (D. Del. Nov. 4, 2003). Return to article