Last month, the Eleventh Circuit Court of Appeals clarified the circumstances under which a creditor can assert a “new value” defense to a preference action under section 547(c)(4) of the Bankruptcy Code—rejecting as dictum language in a prior decision indicating that the new value provided needed to remain unpaid in order to setoff against preference payments.  The Eleventh Circuit’s decision also had the effect of narrowing a split among the circuits.

The Background

In Kaye v. Blue Bell Creameries, Inc. (BFW Liquidation, LLC), Bruno’s Supermarkets filed a chapter 11 bankruptcy.  Blue Bell was one of Bruno’s pre-bankruptcy vendors, making regular deliveries of ice cream to Bruno’s on short-term credit.  Historically, Bruno’s paid twice per week for Blue Bell’s daily deliveries.  Eventually, due to cash flow problems, Bruno’s began paying only once per-week, and occasionally delayed payments even further.  In other words, Blue Bell received payments at irregular intervals, particularly during the 90 days preceding Bruno’s bankruptcy filing, all the while continuing to make its deliveries to Bruno’s. 

In the bankruptcy, Bruno’s was able to confirm a plan of liquidation, and a liquidating trustee was appointed to recover assets of the bankruptcy estate for distribution to creditors.  The trustee filed an adversary proceeding against Blue Bell to recover over $500,000 in payments it had received from Bruno’s in the 90-day preference period.

Under Section 547(b) of the Bankruptcy Code, a trustee has the power to avoid or “clawback” a debtor’s payments to non-insider creditors if those payments were made while the debtor was insolvent, were made within 90 days before the debtor files bankruptcy, and the creditor receives more than they would have obtained in liquidation if the payments had not been made.  Section 547(c) of the Bankruptcy Code also provides for certain defenses for creditors against such avoidance actions.  These defenses include, among others: (1) payments made contemporaneously for new value given to the debtor; (2) payments made in the ordinary course of business between the creditor and the debtor; (3) payments that include a purchase money security interest; and (4) where the creditor provides new value to the debtor after the payment is made (the “new value” defense).

In the trustee’s preference action against Blue Bell, the parties agreed that the payments at issue met the definition of preference payments under the Code.  The dispute was whether Blue Bell was entitled to keep most of the payments using the new value defense because it continued to deliver ice cream to Bruno’s on credit after receiving payment for prior deliveries.  Because Blue Bell delivered its products on unsecured short term credit, and because Bruno’s payments for those products during the 90-day preference period were irregular, the other potential preference defenses were inapplicable.

The trustee maintained that Blue Bell was only entitled to a small portion of the payments because, under the Eleventh Circuit’s decision in Charisma Inv. Co., N.V. v. Airport Sys., Inc. (In re Jet Florida Sys., Inc.), 841 F.2d 1082 (11th Cir. 1988), availability of the new value defense was only available to the extent that the new value the creditor provides to the debtor remained unpaid.  Because the majority of Blue Bell’s deliveries had been paid for, only the last deliveries—for which Bruno’s did not make payment—could be offset against the amount of payments otherwise subject to avoidance.  Blue Bell argued that the language in Jet Florida was dicta, and the “remain unpaid” requirement is not found in the Code.  The bankruptcy court held that it was bound by the Jet Florida decision, and only allowed Blue Bell to offset the relatively small amount of its deliveries that remained unpaid prior to the bankruptcy.  Blue Bell appealed and the matter was certified directly to the Eleventh Circuit Court.

The Decision and Rationale

The Eleventh Circuit’s three-judge panel agreed with Blue Bell.  The court first acknowledged that section 547(c)(4) of the Code makes no reference to any requirement that the new value provided by a creditor remain unpaid.  The court held that the statutory language is unambiguous on this point, and also explored the differences between the language in the former Bankruptcy Act, which did expressly require new value to remain unpaid to defend against a preference claim, and the language of section 547(c)(4) of the Code, which does not include such language.  The material change in the provision’s language, the court held, further bolstered its determination that the new value defense does not require the new value to remain unpaid.

Nevertheless, the court acknowledged that, in Jet Florida, it relied on other bankruptcy decisions to state that the new value defense generally requires: (1) extension of new value after receiving the challenged payments; (2) the new value must be unsecured; and (3) the new value must remain unpaid.  However, while the court in Jet Florida stated those general requirements, the actual decision turned only on the first one:  the creditor in question did not actually provide anything of value to the debtor after payment was made.  Neither of the latter two stated requirements played any role in the court’s decision in Jet Florida.  And so, that aspect of the Jet Florida decision was dictum and the court rejected it in BFW Liquidation.

From a public policy perspective, the court determined that requiring new value to remain unpaid in order to defend against a preference action would likely result in vendors either stopping deliveries to customers suspected of financial distress to avoid racking up avoidable preference payments or requiring cash on delivery.  Either way, the practical effect would be to only worsen the financial situation of a customer already facing problems.  The court reversed the bankruptcy court and remanded for recalculation of the avoidable preference amount.

The Take-Away

In discarding the “remain unpaid” requirement, the Eleventh Circuit joined with precedent in the Fourth, Fifth, Eighth, and Ninth Circuits.  See Hall v. Chrysler Credit Corp. (In re JKJ Chevrolet, Inc.), 412 F.3d 545, 551-52 (4th Cir. 2005); Laker v. Vallette (In re Toyota of Jefferson, Inc.), 14 F.3d 1088, 1090-93 (5th Cir. 1994); Jones Truck Lines, Inc. v. Cent. States, S.E. & S.W. Areas Pension Fund (In re Jones Truck Lines, Inc.), 130 F.3d 323, 329 (8th Cir. 1997); Mosier v. Ever-Fresh Food Co. (In re IRFM, Inc.), 52 F.3d 228, 231-33 (9th Cir. 1995).  Only the Third and Seventh Circuits have included the requirement in its decisions.  See N.Y.C. Shoes, Inc. v. Bentley Int’l, Inc. (In re N.Y.C. Shoes, Inc.), 880 F.2d 679, 680 (3d Cir. 1989); In re Prescott, 805 F.2d 719, 727-28 (7th Cir. 1986).  And, while the Seventh Circuit appears to be steadfast in its application, the court in BFW Liquidation questioned whether the Third Circuit would really embrace the requirement because—like in Jet Florida—the Third Circuit’s adoption of the requirement was only found in dicta.

In light of the lopsided circuit split, businesses and bankruptcy counsel within the majority of circuits can feel relatively secure that continuing to support a debtor’s pre-bankruptcy business by selling products and services on short term credit will not result in substantial preference exposure.  While the First, Second, Tenth, and D.C. Circuits appear not to have addressed the issue, given the number of circuits that do not require new value to remain unpaid to assert a defense under section 547(c)(4), it would seem unlikely that these circuits would sign on to the minority position taken by the Seventh (and maybe the Third) Circuit.  While it is always good practice to consult with experienced bankruptcy counsel when confronted with a customer encountering financial difficulties, for those doing business in the minority circuits and in those where the issue has not been decided, it is especially important to consult with counsel to explore vehicles available to protect against preference actions, whether through purchase money security interests, requiring cash on delivery, or other available protective measures.