In a case of apparent first impression, U.S. Bankruptcy Judge Christopher S. Sontchi considers whether post-petition “critical vendor” payments of pre-petition claims reduced “new value”. Judge Sontchi holds that such post petition payments do not reduce the amounts available for the subsequent new value defense under 11 U.S.C. § 547(c)(4).  [The decision is currently on appeal to the United States Third Circuit Court of Appeals in In re Friedman's Inc. Appeal Docket No. 13-1712.   Briefing before the Court of Appeals is complete and oral argument is scheduled for October 17, 2013.]

Within the context of the facts before the Court, Judge Sontchi’s holding is of narrow import. However, it reaching this narrow holding, Judge Sontchi cuts a broad swath. First, Judge Sontchi rejects the notion that there is a distinction between payments by the “debtor” and the “debtor in possession” for purposes of preference analysis. Second, he holds that the filing of the bankruptcy “fixes” the preference analysis as of the petition date. “Neither the post-petition provision of new value by the creditor nor the post-petition payment of unpaid, pre-petition new value affects the preference calculation.”

The Facts

The facts before Judge Sontchi were undisputed. In the months preceding the bankruptcy of Friedman’s Inc. (“Friedman’s”), defendant Roth Staffing Companies, L.P. (“Roth”) provided temporary staffing services to Friedman’s. In the 90 days before its bankruptcy filing (the “Preference Period”), Roth received preferential payments totaling $81,997. Roth also provided in the Preference Period an additional $100,660 in services for which Roth was not paid.

Friedman’s did not dispute that Roth’s additional services during the preference period qualified as “subsequent new value” on the petition date. However, Friedman’s had moved the Court for authority to pay the prepetition wage claims of Friedman’s employees, including Roth’s staffers (the “Wage Motion”). The Court granted the Wage Motion, and Friedman’s paid Roth $72,412 for its pre-petition staffing services. This payment, Friedman’s now argued, reduced the $100,660 in subsequent new value provide by Roth to only $28,248, leaving a preference claim of $53,749.

Debtor “in Possession” – An Adjective not a Temporal Restriction

Roth sought to make, and Friedman’s sought to refute, the argument that a there is a fundamental distinction between a pre-petition payment made by a “debtor” and a post-petition payment made by a “debtor in possession”. Roth claimed that a post petition payment by a “debtor in possession” could not reduce subsequent new value provided pre-petition to the “debtor”. The payments, in essence, were made by different entities. In response, Friedman’s argued that the no debtor can exist until the bankruptcy petition is filed, and accordingly, a debtor cannot be a pre-petition entity.

Judge Sontchi rejected both parties’ arguments as being “based upon a fallacious assumption, i.e. that the debtor and the debtor in possession are separate entities.” He concluded that the qualification “in possession” is an adjective and not a temporal limitation – i.e. a payment by a debtor and a payment by a debtor in possession are made by the same entity. However, Judge Sontchi expressly reserved any holding on this issue. The answer was far simpler.

The Third Circuit Favors The “Fixed” Approach

Judge Sontchi held that, in the Third Circuit, preference analysis becomes fixed on the petition date. In support, he relied on an unlikely source – the Third Circuit decision in New York City Shoes, Inc. v. Bentley Int’l Inc., 880 F.2d 679 (3d Cir. 1989) (“NYC Shoes“). In that decision, the Third Circuit articulated the following three part test for determining the availability of the subsequent new value defense.

First, the creditor must have received a transfer that is otherwise voidable as a preference under § 547(b). Second, after receiving the preferential transfer, the preferred creditor must advance “new value” to the debtor on an unsecured basis. Third, the debtor must not have fully compensated the creditor for the new value as of the date that it filed its bankruptcy petition.

Judge Sontchi focused upon the phrase “as of the date that it filed its bankruptcy petition” in the third test. This language in NYC Shoes, as well as the identical formulation in Schubert v. Lucent Techs, Inc. (In re Winstar Comm’n., Inc.), 554 F.3d 382, 402 (3d Cir. 2009), are the basis for Judge Sontchi’s conclusion that:

The clear implication of the Circuit’s inclusion of “as of the date that it filed its bankruptcy petition” is that subsequent provision or payment of new value does not affect the preference analysis even if the debtor completely compensates the creditor for its pre-petition claim. This is consistent with the purpose of the preference law-to reduce damaging, pre-petition opt out behavior and to level the pre-bankruptcy playing field for all creditors. Once the bankruptcy is filed the preference law becomes unnecessary. The automatic stay steps in to stop the race to the assets and the supervision of the case by the court, among other things, ensures that similar claims receive similar treatment.

Is there Another Shoe Yet to Drop?

Judge Sontchi’s opinion would seem, at first read, to be good news. The opinion certainly provides new defensive ammunition for those few preference claim defendants who received post petition payments on pre-petition claims whether by reason of administrative expense claims under Section 503(b)(9), critical vendor payments or otherwise. However, the decision also may breath new life into language from the same NYC Shoes decision that, for years, was frequently cited as the basis for the argument that the Third Circuit required the use of the restrictive “remains unpaid” approach to the analysis of subsequent new value. For this reason, Judge Sontchi’s embracing of NYC Shoes is discomforting.