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More Bad News for Suppliers to Companies That End Up in Bankruptcy

May 2015

A recent court decision may severely limit—if not eliminate altogether in some cases—a supplier’s entitlement to 100% payment for deliveries made in the weeks before a bankruptcy filing.

Sellers of products to buyers that later file for bankruptcy protection have long suffered from the strong likelihood that their outstanding debts would never be repaid or, at best, would receive only partial repayment through the bankruptcy case—the proverbial “pennies on the dollar.” Absent careful prebankruptcy transaction planning with counsel (and sometimes in spite of it), the claims of trade creditors generally occupy the lowest rung among the hierarchy of debts that may be repaid through a bankruptcy case: Creditors holding security interests are paid first from their collateral; certain claims arising during and relating to the administration of the bankruptcy case (administrative expenses) enjoy the highest priority in repayment among unsecured claims, followed by certain governmental, wage-related, and other specified claims (priority claims); and, finally, unsecured claims having no statutory basis for priority payment (general unsecured claims) may be repaid. See 11 U.S.C. § 507(a). 

In 2005, as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), Congress amended the United States Bankruptcy Code to reward sellers of goods to an entity in bankruptcy (called the “debtor”) with an administrative expense if certain criteria are met. Section 503(b)(9) provides for the allowance of an administrative expense in the amount of “the value of any goods received by the debtor within 20 days before the date of commencement of [its bankruptcy] case . . . in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.” 11 U.S.C. § 503(b)(9). With the addition of this provision, suppliers that deliver goods shortly before the filing of the debtor’s bankruptcy case reasonably could expect repayment of their debts in full. See, e.g., 11 U.S.C. §§ 507(a)(2), 1129(a)(9)(A). However, a recent decision may severely limit—if not eliminate altogether in some cases—a supplier’s entitlement to 100% payment for deliveries made in the weeks before a bankruptcy filing.

AWI Delaware, Inc. and its affiliates (collectively, the “Debtors”) were cooperative food distributors providing grocery, meat, produce, dairy, frozen foods, general merchandise/health, and beauty care products to 800 supermarkets, specialty stores, convenience stores, and other member retailers. The Debtors filed voluntary chapter 11 petitions on September 14, 2014, and within approximately two months, sold substantially all of their assets to C&S Wholesale Grocers, free and clear of all liens, claims, and encumbrances, including rights of setoff. By the end of April 2015, 120 of the Debtors’ trade creditors filed motions in the cases claiming administrative expenses pursuant to section 503(b)(9) of the Bankruptcy Code in the aggregate amount of $15.7 million. Creditors also filed proofs of claim asserting 503(b)(9) administrative expenses in the aggregate amount of $37.7 million. 

The Debtors and the creditors’ committee appointed in the Debtors’ cases filed a joint motion authorizing, among other actions, the Debtors to offset trade credits, vendor overpayments, and other amounts owed by the creditors to the debtors against any claims asserted by the trade creditors, including 503(b)(9) administrative expenses. In the joint motion, the Debtors alleged that, in the ordinary course of their business, they were entitled to credits and refunds from trade creditors arising from their vendor supply agreements or other arrangements with their vendors, including overpayments they made to vendors on a COD basis for products not received before the business was sold to C&S, as well as promotions, volume discounts, advertising and warehouse allowances, rebates, or similar refunds. The Debtors argued that they were entitled to exercise their discretion in offsetting such credits and refunds against claims owed to trade creditors, including administrative expenses payable under section 503(b)(9), regardless of whether such credits/refunds and claims arose before the bankruptcy petitions were filed (“prepetition”) or after (“postpetition”). In response, the trade creditors (which included large food-related enterprises such as Kellogg Company, Kraft Food Group, Pepsi-Cola Advertising and Marketing, Frito-Lay North America and ConAgra Foods) argued, among other things, that the Debtors should not be able to offset against 503(b)(9) administrative expenses in their discretion because to allow such activity would undermine the legislative purpose of the provision, infringe on creditors’ setoff rights, and fail to recognize restrictions on the Debtors’ setoff rights arising from contractual provisions or prior courses of dealing.

Judge Kevin J. Carey found that the Debtors’ right to assert its setoff rights in its discretion is a “personal defense” preserved in section 558 of the Bankruptcy Code, which reads:

The [bankruptcy] estate shall have the benefit of any defense available to the debtor as against any entity other than the estate, including statutes of limitation, statutes of frauds, usury, and other personal defenses.  A waiver of any such defense by the debtor after the commencement of the case does not bind the estate.

11 U.S.C. § 558. He noted that, although a creditor’s setoff rights in bankruptcy are restricted by statute to applying prepetition debts against prepetition claims, section 558 contains no such restriction and, as such, a debtor is free to offset amounts owed to it against prepetition or postpetition claims of creditors. See In re ADI Liquidation, Inc., No. 14-12092, mem. at 7-8 (Bankr. D. Del. May 5, 2015); 11 U.S.C. §§ 553 (providing that, with certain exceptions, the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case . . . against a claim of such creditor against the debtor that arose before the commencement of the case . . . .”)(emphasis added), 558. Moreover, he found that this distinction between provisions governing a creditor’s and debtor’s setoff rights, respectively, and the underlying objectives of the Bankruptcy Code suggested that a debtor’s setoff rights should “trump” those of a creditor because such application would be “most likely to result in equal distributions to the Debtors’ creditors as a whole.” ADI at 8 (citing In re Circuit City Stores, Inc., 2009 WL 4755253 at *4 (Bankr. E.D. Va. Dec. 3, 2009)). (In fact, the day after he issued his memorandum deciding the joint motion, Judge Carey issued a memorandum order denying motions of another supplier, Western Foods, Inc., which sought relief from the automatic stay to exercise its setoff rights and an order of the court prohibiting the Debtors’ exercise of their setoff rights, among other relief. Again, the court sided with the Debtors and denied the supplier’s motions.)

The court discounted the objecting trade creditors’ arguments that permitting a debtor to have wide discretion in applying credits and refund rights against the creditors’ 503(b)(9) administrative expenses violates the Bankruptcy Code’s requirement that such expenses be paid in full upon the effective date of a chapter 11 debtor’s plan and “provides a disincentive for trade vendors to continue to supply an entity that is struggling financially.”ADI at 8; see 11 U.S.C. § 1129(a)(9)(A). Although the court acknowledged that “these arguments reinforce the [Bankruptcy] Code’s recognition that § 503(b)(9) Claims deserve priority payment over general unsecured claims, they do not provide a basis for stripping a debtor’s defenses in determining the allowed amount of a § 503(b)(9) Claim.” ADI at 9.

The court also considered the creditors’ arguments that the Debtors’ setoff rights are subject to contractual limitations or the prior course of dealings between the parties and must be determined on a case-by-case basis. It held:

For the matter currently before me, I conclude that there is a presumption that the claimants’ prior course of dealing, industry standards and contract[s] do not operate as a waiver of the Debtors’ equitable remedies. However, if a claimant believes that its course of dealing or contractual language provide a good faith basis for arguing that the Debtors have waived their equitable remedies, then the claimant shall have the right to a hearing on the merits of their claim to rebut the presumption.

Id. at 11. The basis for imposing such a blanket presumption is unclear (and not explained by the court), although, with respect to substantiating any administrative expense, the burden of proving entitlement to its allowance is always on the creditor and must be demonstrated by a preponderance of the evidence. In re Grand Union Co., 266 B.R. 621, 628 (Bankr. D.N.J. 2001).

The court ultimately found “that the Bankruptcy Code, case law and policies underlying the Bankruptcy Code support acknowledging the Debtors’ discretion to apply the Credits against secured claims, administrative claims (including § 503(b)(9) Claims) or general unsecured claims . . . .” ADI at 11.

The stature of the ADI Liquidation judge and the venue of the case—Delaware, which, together with New York, are popular venues for business bankruptcy filings—assure its widespread impact, especially in the bankruptcy cases of retailers and manufacturers, where the amount of 503(b)(9) administrative expenses may be substantial and determine the overall solvency of the case. Suppliers delivering goods to debtors in the few weeks before a bankruptcy filing must be prepared to address arguments that their 503(b)(9) administrative expenses should be reduced or eliminated due to credits, refunds. or other amounts that may be payable to the debtor, regardless of when such amounts arise.