In what has become an increasingly common scenario, an administratively insolvent chapter 11 debtor stiffs its post-petition administrative priority creditors. Adding insult to injury, either the chapter 11 debtor's unsecured creditors' committee or a subsequently appointed bankruptcy trustee sues the same administrative claimant for a pre-bankruptcy preferential transfer.

Rough equity and the law of setoff, which has been recognized since Roman times, appear to preclude the bankruptcy estate from recovering on its preference claim to the extent that the administrative claimant provided post-bankruptcy petition goods and services to the chapter 11 estate.² This would appear to be consistent with the favored position administrative expense claimants have traditionally enjoyed in bankruptcy law. Administrative expense claimants receive priority treatment because they provide goods and services "designed to facilitate survival during, and emergence from, bankruptcy to the benefit of all creditors."³

A small minority of the courts have concluded that goods or services provided post-petition may constitute subsequent "new value" within the meaning of §547(c)(4). They hold that an administrative expense claim reduces the amount of any preference claim.⁴ Surprisingly, however, a majority of courts have held that an administrative expense claimant may not reduce its preference liability to the bankruptcy estate based on a setoff for the value of post-petition goods or services provided to the estate.⁵ These cases have narrowly focused on the statutory requirement that a transfer of subsequent new value be "to or for the benefit of the debtor," and found that the new value under §547(c) excludes post-petition transfers to the debtor-in-possession (DIP). This article questions the distinction that the courts have drawn between the pre-petition debtor and the post-petition DIP when analyzing the subsequent new value defense under §547(c)(4). In addition, even if these cases are correctly interpreting the statute, this article questions whether the courts are ignoring well-established principles of setoff.

The courts provide two rationales for prohibiting a setoff against a preference claim. First, they most often conclude that an administrative expense claimant may not offset its claim against a preference claim because the pre-petition debtor is not the same entity as the post-petition DIP. In a secondary holding, a few courts have stated that permitting such an offset would encourage the DIP and its creditors to engage in collusive, nonordinary-course transactions after the date of the bankruptcy petition for the purpose of manufacturing setoffs which reduce the creditor's preference liability.⁶ Neither argument justifies precluding an administrative expense claimant from reducing its preference liability to the estate based on goods or services it provided to the estate.

First, the distinction between the pre-petition debtor and the post-petition DIP seems unjustified. The Supreme Court found it to be a distinction without a difference in National Labor Relations Bd. v. Bildisco.⁷ The Bildisco court rejected the argument that a bankruptcy debtor becomes a "new entity" merely because it filed a bankruptcy petition. "[I]t is sensible to view the DIP as the same 'entity' which existed before the filing of the bankruptcy petition, but empowered by virtue of the Bankruptcy Code to deal with its contracts and property in a manner it could not have employed absent the bankruptcy filing."⁸

Following Bildisco, the courts have rejected the "new entity" theory and held that the pre-petition debtor and the DIP are the same entity.⁹ The courts have refused to recognize a distinction between the debtor and DIP when analyzing setoffs under §553.¹⁰ Significantly, the Eighth Circuit, whose pre-Bildisco decision in Bellanco Corp. is the primary authority cited by the courts in refusing to permit administrative expense claimants an offset against preference liability, has rejected the "separate-entity" theory in the context of setoff.11 Therefore, it appears that the artificial distinction that the courts have observed in precluding a creditor from claiming that it provided post-petition "new value" no longer exists.

More importantly, in light of Bildisco, no apparent justification exists for preventing a setoff or a counterclaim by the administrative expense claimant. An administrative expense claimant has a right to payment from the bankruptcy estate. In turn, the bankruptcy estate has asserted a preference complaint against the administrative expense claimant. The claims are mutual.¹² The claims by and against the estate are asserted in the same right or capacity, i.e., by and against the bankruptcy estate. The administrative expense claimant has a right of setoff based on its administrative expense claim. Permitting such a setoff does nothing to hinder the primary goals of preference law (1) facilitating equality of distribution among pre-petition unsecured creditors, and (2) preventing creditors from racing to the courthouse to dismember the debtor prior to the filing of the bankruptcy petition.

No empirical support exists for certain bankruptcy courts' expressed concern that the DIP and its creditors will design post-petition transactions simply for the purpose of reducing a particular creditor's preference exposure. While DIPs may conduct business in the ordinary course, they are constrained from entering into nonordinary-course transactions by §363(b)(1) of the Code which requires them to provide prior notice to creditors. Additionally, any asserted administrative priority claim or counterclaim must withstand court scrutiny, which only permits allowance of an administrative expense claim based on a demonstrable benefit to the estate.

Furthermore, anyone that counsels a creditor doing business with a chapter 11 debtor understands the creditor's primary goal—getting paid. Creditors simply do not design credit transactions with DIPs and provide additional value to the estate in order to create setoffs against future preference liability. Post-petition credit transactions typically occur long before anyone has done an analysis of potential preference claims.

Lastly, even though §502(d) of the Code is inapplicable by its terms, a minority of courts have seen this as an additional procedural hurdle to setoff. Section 502(d) prohibits pre-petition unsecured creditors, and limited categories of post-petition creditors, from recovering anything on their claim until they disgorge any preference. A majority of the courts hold that §502(d) does not operate to disallow administrative expense claims.¹³ "[T]he [statutory] language expressly exempts administrative expense claims from the section's scope...."¹⁴

Nevertheless, even if §502(d) factors into the setoff analysis, its impact is procedural, not substantive. As the Fifth Circuit has observed, "§502(d) is designed to assure an equality of distribution of the assets of the bankruptcy estate, not create penalties for asserting setoff rights."¹⁵ An administrative expense claim may be brought as a counterclaim to the estate's preference action. Even the cases holding §502(d) applicable to administrative expense claims find this to be the proper result.¹⁶

Despite the majority of cases holding that a preference defendant may not use post-petition goods and services provided to the estate as a "new value" offset against any preference liability, nothing in the Code requires such a result. Moreover, even if §547(c)(4) does not permit a creditor to assert "post-petition new value" as a defense, the statute should not be read to preclude the separate defense of setoff. Permitting a setoff represents the only logical alternative to avoid "the absurdity of making A pay B when B owes A."¹⁷ Therefore, to the extent that Bellanca Corp. and its progeny appear to preclude a setoff by an administrative claimant against a preference claim brought by the estate, they should be rejected.

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Footnotes

¹ Stuart Larsen, a partner at Kahn Kleinman LPA, represents both debtors and creditors in commercial bankruptcy proceedings. He focuses a significant portion of his practice on representing secured creditors, unsecured trade creditors, commercial landlords and asset purchasers in chapter 11 reorganization cases. Return to article

² As the U.S. Supreme Court has observed, "[t]he right of setoff (also called "offset") allows entities that owe each other mutual debts to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A." Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995). In order to effect a setoff, the debts must be (1) mutual, i.e., incurred by the same parties, and (2) in the same right or capacity. Return to article

³ Camelot Music Inc. v. McHue Advertising and Public Relations Inc. (In re CM Holdings Inc.), 264 B.R. 141, 159 (Bankr. D. Del. 2001). Return to article

⁴ KDT Indus. Inc. v. C&C Cumbrella (In re KDT Indus. Inc.), 57 B.R. 416, 417 (Bankr. S.D.N.Y. 1985) ("reference to the debtor in Code §547(c)(4) would include a reference to the DIP"). See, also, Thomas L. Garland Inc. v. Nooney Co. (In re Thomas L. Garland Inc.), 28 B.R. 87, 90 n. 7 (Bankr. E.D. Mo. 1983) (permitting setoff). Return to article

⁵ Bergquist v. Anderson-Greenwood Aviation Corp. (In re Bellanca Corp.), 850 F.1d 1275, 1284 (8th Cir. 1988) (concluding that the phrase "for the benefit of the debtor...impli[ed] that subsequent advances of new value are only those given pre-petitition, because post-petition advances are given to the debtor's estate, not to the debtor"]; Roberds Inc. v. Broyhill Furniture (In re Roberds Inc.), 315 B.R. 443. 472-73 (Bankr. S.D. Ohio 2004); Frield v. Maryland Motor Truck Assoc Workers Compensation Self-Insurance Group (In re George Transfer Inc.), 259 B.R. 89, 96 (Bankr. D. Md. 2001) ("unfortunately for the defendant, its refund to the debtors does not qualify under §546(c)(4) as 'new value' because it was made post-petition. Indeed, this court has found no case decided under §547(c)(4) that permitted a transferee to successfully defend an action for the recovery of a preference based upon a subsequence advance that was made post-petition.") (citing Schwinn Plan Comm. v. AFS Cycle & Co. Ltd. (In re Schwinn Bicycle Co.), 205 B.R. 557 (Bankr. N.D. Ill. 1997); Clark v. Frank B. Hall & Co. of Colo. (In re Sharoff Food Serv. Inc.), 179 B.R. 669, 678 (Bankr. D. Colo. 1995) ("[T]he specific language 'to or for the benefit of the debtor' [indicates] that the subsequent advances of new value are only those given pre-petition, because any post-petition advances are given to the debtor's estate, not the debtor"); In re Tenn Ohio Transportation Co., 255 B.R. 307, 310 (Bankr. S.D. Ohio 2000); Wallach v. Vulcan Steam Forging (In re D.J. Mgmt. Group), 161 B.R. 5 (Bankr. W.D.N.Y. 1993); Wolinsky v. Central Vermont Teachers Credit Union (In re Ford), 98 B.R. 669 (Bankr. D. Vt. 1989); Warsco v. Ryan (In re Richards), 92 B.R. 369 (Bankr. N.D. Ind. 1988); Cullen v. TDK Elec. Corp. (In re Antinarelli Enter. Inc.), 76 B.R. 247 (Bankr. D. Mass. 1987); Official Labor Creditors Comm. v. Jet Florida Sys. Inc. (In re Jet Florida Sys. Inc.), 80 B.R. 544 (S.D. Fla. 1987). Return to article

⁶ Phoenix Restaurant Group Inc. v. Proficient Food Co. (In re Phoenix Restaurant Group Inc.), 2004 WL 311719 at *10 (Bankr. W.D. Tenn. 2004) ("to permit such offsets notwithstanding possible prejudice to other creditors would ignore the orderly mechanism established by Congress to protect all interested parties concerned") (quoting Jet Florida Sys. Inc., 59 B.R. 886, 890 (Bankr. S.D. Fla. 1986)). Return to article

⁷ 465 U.S. 513, 528 (1983). Return to article

⁸ Id. Return to article

⁹ See United States v. Gerth, 991 F.2d 1428, 1436 (8th Cir. 1993) (concluding that the pre-bankruptcy petition debtor and the post-bankruptcy petition debtor were the same legal entity for setoff purposes under §553); In re Affiliated Food Stores Inc., 123 B.R. 747, 748-49 (Bankr. N.D. Tex. 1991). Bildisco has "laid to rest the 'separate entity' doctrine for all time." In re Allen, 135 B.R. 856, 868 (N.D. Iowa 1992) (quoting Ontario Locomotive, 126 B.R. 146, 147 (Bankr. W.D.N.Y. 1991)). Compare Data Systems Inc., 327 F.3d 242 (3rd Cir. 2003) (citing Bildisco for the proposition that a DIP is not a new entity in concluding that license agreements that were never assumed by the debtor, as DIP, were nevertheless property of the bankruptcy estate); In re Cellnet DiSalvo v. DiSalvo (In re DiSalvo), 219 F.3d 1035, 1038 (9th Cir. 2000) (rejecting individual chapter 11 debtor's argument that post-petition judgment against him individually in a dischargeability action was not binding on him in his capacity as a DIP; "in the chapter 11 context a debtor and DIP are not to be treated as separate legal entities"); In re Lil' Things Inc., 22 B.R. 583 (Bankr. N.D. Tex. 1998) (rejecting the theory that the pre-petition debtor and the DIP are different entities); Enstar Group Inc. v. Bank of New York (In re Amvet Inc.), 174 B.R. 315, 320 (Bankr. M.D. Ala. 1994) ("new entity" theory did not render pre-petition subordination agreement unenforceable after the date of the bankruptcy petition); In re Ontario Locomotive & Ins. Ry. Supply, 126 B.R. 146, 147 (Bankr. W.D.N.Y. 1991). Return to article

¹⁰ Id. Although §362(a) of the Code stays a creditor's setoff of a pre-petition debt and §553 of the Code limits a creditor's right of setoff during the 90-day preference period, the Code does not otherwise limit setoff. Return to article

¹¹ Gerth, 991 F.2d at 1435-36. Return to article

¹² Gerth, 991 F.2d at 1435-36. Return to article

¹³ Roberds Inc. v. Broyhill Furniture (In re Roberds Inc.), 315 B.R. 443, 476 (Bankr. S.D. Ohio 2004); In re LIDS Corp., 260 B.R. 680, 682-84 (Bankr. D. Del. 2001); Camelot Music Inc. v. MHW Adver. and Pub. Relations Inc. (In re CM Holdings Inc.), 264 B.R. 141, 157-59 (Bankr. D. Del. 2000); In re Durango Georgia Paper Co., 297 B.R. 326, 327-31 (Bankr. S.D. Ga. 2003); In re Rand Energy Co., 256 B.R. 712, 718-19 (Bankr. N.D. Tex. 2000). But see In re Microage Inc., 291 B.R. 503 (9th Cir. B.A.P. 2002) (stating that §502(d) applies to administrative expense claims, holding that §502(d) defense was waived by failure to assert it); In re Georgia Steel Inc., 38 B.R. 829, 839-40 (Bankr. M.D. Ga. 1984). A number of courts have also held that §502(d) requires a prior judicial determination of liability on the preference claim. In re Ampace Corp., 279 B.R. 145, 163 (Bankr. D. Del. 2002); In re Southern Air Transport Inc., 293, 294 B.R. (Bankr. S.D. Ohio 2003). Return to article

¹⁴ CM Holdings, 264 B.R. at 158. Return to article

¹⁵ Campbell v. United States (In re Davis), 889 F.2d 658, 662 (5th Cir. 1989); In re Allegheny Health Education and Research Foundation, 292 B.R. 68, 94 (Bankr. W.D. Pa. 2003). See, also, Seta Corp. of Boca Inc. v. Atlantic Computer Systems (In re Atlantic Computer Systems), 173 B.R. 858, 861-62 (S.D.N.Y. 1994). Return to article

¹⁶ In re MicroAge Inc., 291 B.R. 503, 512 (9th Cir. BAP 2002) (stating that the offset of an administrative priority claim would provide another source of repayment of preferences owed to the estate). Return to article

¹⁷ Strumpf, 516 U.S. at 18. Return to article