Congressional intent in adopting Section 503(b)(9) is being Subverted by Disallowance Based on Debtor Section 547 Bankruptcy Preference Claims

Grede Foundries – Debtors’ Bankruptcy Preference vs Administrative Expense Ploy – A Tactic that Needs to be Stopped

In adding Section 503(b)(9) in the 2005 amendments to the Bankruptcy Code, did Congress intend that the supplier beneficiaries of the new section would wear a sign saying “BANKRUPTCY PREFERENCE TARGET – HIT ME”? This article challenges the growing use of bankruptcy preference actions under Section 547 to defeat and delay the allowance of Section 503(b)(9) administrative expense requests. As discussed below, the ploy subverts Congressional intent in adopting Section 503(b)(9). More fundamentally, the ploy ignores a basic tenet of the Bankruptcy Code that also is embodied in the prima facie requirements for bringing a bankruptcy preference action – “First Determine Priority.”

A Worst Case Scenario Becomes Reality

The Grede Foundries bankruptcy demonstrates the end result when debtors are motivated to bring bankruptcy preference actions under Section 547 in order to disallow or to delay allowance of Section 503(b)(9) administrative expenses. Consider the following:

Bankruptcy preference adversary proceedings were only brought against suppliers seeking administrative expenses under Section 503(b)(9).
The debtor filed the preference actions after the motion for approval of Section 363 sales procedures had been filed but before those sale procedures had been approved and before any auction to be conducted pursuant to those sale procedures had been held. Because the auction had not been conducted and the amount of the proceeds from the action could not be determined, the debtor could not have known whether it could meet its burden of proof under Section 547(b)(5) – i.e. that the supplier had received more than the supplier would have received in a Chapter 7 liquidation.
One supplier who sought allowance of an $812 administrative expense was hit with a $114,000 preference claim. Seven other suppliers, each seeking less than $1,000 in administrative expenses, are facing an average of $20,000 in preference claims.
The debtor included in its preference actions certain payments that the debtor referred to as “prepayments” in concurrently filed objections to the suppliers’ 503(b)(9) administrative expense requests. By definition, “prepayments” can not be preferences.
One preference action is for $4,676, which is below the required statutory threshold of $5,475 for bringing preference actions. Eight preference actions are less than the $10,950 threshold for determining if the Western District of Wisconsin is the appropriate venue.
The form of asset purchase agreement attached to the 363 sale procedures motion provided that all avoidance actions would be sold to the purchaser. The asset purchase agreement only was amended after its initial filing with the court to give the debtor a contingent right to ½ of recoveries in excess of 503(b)(9) administrative expense setoffs if the purchaser decided to pursue those recoveries.

Background of Section 503(b)(9)

Section 503 is entitled “Allowance of Administrative Expenses” and Section 503(b) details nine types of expenses that are to be allowed as administrative expenses and therefore are entitled to priority under Section 507(a)(2). In 2005, Congress added Section 503(b)(9), which provides administrative expense status for “the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.”

The legislative history surrounding the adoption of Section 503(b)(9) is limited. Articles discussing Section 503(b)(9) generally make two inferences of congressional intent. Congress intended to encourage suppliers to continue the flow of goods to a customer even when a customer’s bankruptcy was immanent. Congress recognized that the continued flow of goods immediately before a bankruptcy preserved the value of the debtor’s business just as much as goods sold to a debtor after the bankruptcy filing.

Section 503(b)(9) Raises the Stakes for Debtors in the Retail and Manufacturing Industry Segments

The absence of any substantial legislative history allows only speculation about Congress’ understanding of the practical impact of Section 503(b)(9). In the high volume retail and “just in time” manufacturing industries, the impact has been severe. In these two industry segments, the rapid turnover of goods has meant that the 20 day pre-petition period covers a large percentage of the bankrupt debtor’s overall trade payables. This change took from debtors in these industry segments a major source of post-petition funding of operations – the collection of accounts receivable with out the necessity of payment to the suppliers who provided the goods generating those receivables.

The anticipated movement of huge dollars from the unsecured creditor bucket to the administrative expense bucket can end (or preclude any effort to start) a debtor’s plans to reorganize. The Bankruptcy Code requires that all administrative expenses must be payable in full under any Chapter 11 bankruptcy plan of reorganization or Chapter 11 plan of liquidation. For a debtor seeking bankruptcy court approval of a sale of all or a substantial portion of its operations under Section 363, the inability to satisfy Section 503(b)(9) administrative expenses out of sale proceeds means that the debtor’s only options following the 363 sale are a conversion of the case to Chapter 7 or dismissal of the bankruptcy proceedings.

What do Administrative Expenses Have to Do with Bankruptcy Preferences?

On its face, Section 503(b)(9) requires a bankruptcy court to allow an administrative expense to any supplier that meets the requirements contained within the four corners of that section. The section does not condition allowance on resolution and payment of bankruptcy preference or return of other avoidable transfers. So where is the link between Section 503(b)(9) and Section 547? Debtors cite Section 502(d).

Like all statutes, Section 502 should be read from top to bottom. The section is titled “Allowance of claims or interests”. Section (a) clarifies that the phrase “claims or interests” in the section heading means “[a] claim or interest, proof of which is filed under section 501 …” Section (b) deals with objections to Section 501 claims made under subsection (a). Section (c) only refers to “allowance” under Section 501. Once subsection (d) is reached, it is clear that Section 502 deals only with unsecured claims for which a proof of claim is filed under Section 501. Section 503(b)(9) administrative expense requests are not made by filing a proof of claim under Section 501.

Debtors argue that bankruptcy courts should skip right to Section 502(d) and ignore the context provided by the earlier sections. Debtors rely on the Section 502(d) requirement that the bankruptcy court disallow “any claim” by a creditor if that creditor is found to be liable for a bankruptcy preference. Once a debtor convinces the bankruptcy court to jump right to Section 502(d), it is a simple matter to direct the court to the definition of “claim” in Section 101(5). That definition covers any “right to payment” and bankruptcy preferences therefore must be defenses to payment of administrative expense “claims”.

For a Majority of the Bankruptcy Courts Section 502(d) Does Not Apply

A majority of the courts considering the issue have refused to disallow a creditor’s administrative expenses simply because the debtor may be entitled to recovery of an avoidable transfer. One of the most recent and best reasoned decisions was handed down by Judge Mary Grace Diehl, in In re TI Acquisition, LLC, 410 B.R. 742 (Bankr.N.D.Ga.2009).

Judge Diehl concluded that a supplier’s “§ 503(b)(9) administrative expense claim is not subject to disallowance pursuant to § 502(d).” This decision primarily was based on 4 observations:

Section 502(d) does not contain any language or reference which would make it applicable to administrative expenses of any kind. More specifically, the language of § 502(d) does not imply or create a defense to a § 503(b)(9) claim.
The procedural distinctions between the allowance of claims pursuant to § 501 as compared to the allowance of administrative expenses pursuant to § 503 also supports § 502′s limited applicability to § 501 claims.
[T]he mandatory language of allowance in § 503, “there shall be allowed,” as contrasted with the mandatory disallowance language of § 502(d), “the court shall disallow,” does not give the Court authority to presume one mandatory provision trumps another. Citing In re Durango Ga. Paper Co., 297 B.R. 326, 330-31 (Bankr.S.D.Ga.2003).
“If trade vendors felt that a preference could be used to prevent the payment of their administrative claims, they would be extremely reluctant to extend post-petition credit to a chapter 11 debtor.” Citing In re Lids Corp., 260 B.R. 680, 683-4 (Bankr.D.Del.2001).

Judge Robert D. Martin, the Bankruptcy Judge in the Grede Foundries case, cited the TI Acquisition decision favorably in his decision in the case of In re Renew Energy, LLC 2009 WL 3320420 (Bkrtcy.W.D.Wis.), which was decided on September 30, 2009. In Renew Energy, Judge Martin considered the allowance of a Section 503(b)(1)(A) administrative expense in light of a pending bankruptcy preference claim. Judge Martin noted that the bankruptcy preference adversary proceeding was scheduled for trial in February 2010 and held that allowance of the § 503(b)(1)(A) claim would be postponed until that adversary proceeding was resolved. The decision has been appealed by the supplier.

Judge Martin also addressed the same 503(b)(9) “pre-payment” objection made by the debtor in Grede Foundries. Any supplier in that case faced with that objection definitely should be familiar with Judge Martin’s Renew Energy decision.

Policy Considerations

The policy consideration noted in Judge Diehl’s opinion is especially important in view of the tactics in Grede Foundries. The action taken by Congress in 2005 should not be negated by rendering Section 503(b)(9) claimants front line targets for bankruptcy preference actions.

Consider the supplier in Grede Foundries who sought allowance of an $812 administrative expense and was rewarded with a $114,000 preference claim. Is creditors counsel going to have to do a bankruptcy preference exposure analysis before advising a client whether or not to file an administrative expense request? How many suppliers will just to stop shipping in the case of an imminent customer bankruptcy because Section 503(b)(9) is considered just an invite to the debtor’s bankruptcy preference party?

Besides, It Just Won’t Work

The ploy of using bankruptcy preference actions to defeat or diminish Section 503(b)(9) administrative expenses leads to a circular, nonsensical result. Like most provisions of the Bankruptcy Code, determining if a bankruptcy preference exists first requires a determination of the supplier’s priority of payment for pre-petition obligations.

Section 547(g) provides that the debtor “has the burden of proving the avoidability of a transfer under sub-section [547](b)… .” In order for payments under Section 547(b) to qualify as preference payments, the total payment amount must be more than what the supplier would have gotten in a Chapter 7 liquidation.

Consider the following example:

Supplier AAA sells and ships to its customer $2 million in goods on the 19th day prior to the filing of the customer’s bankruptcy. Payment terms normally are net 30 days, but because AAA is nervous about the customer’s viability, AAA demands payment for this shipment net 10 days. On the 9th day preceding the bankruptcy filing AAA gets paid $2 million. No other payments or shipments were made in the 90 day preference period.

Several months into the bankruptcy the debtor files a plan of liquidation. Under the debtor’s plan of liquidation, administrative expenses will be paid in full. The unsecured creditors will receive $.30 on the dollar.

Can a preference claim be brought against supplier AAA?

Alternative 1 –

The court previously has allowed AAA an administrative expense for $2 million. Because AAA was not paid more than the administrative expense that is payable in full under the plan of liquidation, the debtor can not meet it burden of proof under Section 547(a)(5). No preference action can be brought. AAA keeps the $2 million.

Alternative 2 –

The court previously disallowed AAA an administrative expense claim because the goods actually were services. Under this alternative, AAA received payment of $2 million during the preference period in payment of a general unsecured claim. Unsecured claims only are being partially paid under the plan of liquidation so the debtor has no problem proving that AAA received more than it would have in a Chapter 7 liquidation. The Debtor brings a preference action against AAA.

AAA now looks at its defenses: ordinary course – doubtful since terms were normally 30 days; subsequent new value – nope, no services after the payment. AAA has to pay back the $2 million and will get a distribution of $600,000 as an unsecured creditor under the plan of liquidation.

Alternative 3 – The court is convinced by the debtor to delay allowance of the Section 503(b)(9) claim until after the bankruptcy preference claim is resolved. The following dialogue ensues between the debtor and AAA:

Debtor: “I have brought a preference action against AAA to recover the $2 million payment. AAA has no defenses. Pay up.”

AAA: “Not so fast. Under Sections 547(b)(5) and 547(g), the debtor bears the burden of proof that AAA has received more than it would have in a Chapter 7 liquidation. AAA has a pending administrative expense request. If that administrative expense request is granted, AAA has not received a preference payment.”

Debtor: “AAA, your administrative expense claim is on hold. I get to treat the claim as an unsecured claim in meeting my burden of proof under Sections 547(b)(5) and 547(g). ”

AAA: “You can’t say I don’t have an administrative expense claim until you meet your burden of proof that the payment was avoidable.”

Debtor: “AAA bears the burden of proof that AAA is entitled to an Section 503(b)(9) administrative expense.”

AAA: “How can AAA meet its burden of proof – the administrative expense proceedings are stayed.”

Debtor: “The judge is going to have to figure this one out.”

The following are links to additional articles about the Grede Foundries bankruptcy:

Last Modified: August 29, 2011

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