Supply Chain Bankruptcy Preference Releases: Good News for the Credit Team, But Watch for the Claim Offset, By: Scott E. Blakeley, Esq.

As originally published in the Credit Research Foundation 2Q 2018 Credit & Financial Management Review

Abstract

In managing credit risk with an insolvent customer, the seasoned credit team also appreciates not just the A/R risk, but the preference risk should the customer file bankruptcy, or an out of court liquidation such as an Assignment for Benefit of Creditors. In some settings, suppliers may have larger exposure with preferences than with A/R. The welcome news for suppliers is that a number of large Chapter 11 filings have included supplier preference releases as part of their negotiated exit from Chapter 11. But with a provision in a Chapter 11 that provides for a preference release, suppliers holding priority claims should be mindful that the debtor may take back the supplier chain preference release through a reserved claim objection.

The Bankruptcy Preference

The Bankruptcy Code vests the trustee with far-reaching powers to avoid payments to suppliers within 90 days prior to a bankruptcy filing, and is one of a debtor’s most potent weapons to discourage a supplier’s collection strategy of racing to the courthouse to seek a judgement against the insolvent customer.

Supply Chain and One-Off Preference Release

Several high-profile companies have exited Chapter 11 with a plan of reorganization that provides for release of preference actions against the supply chain. Recent case examples include Rue 21, Haggens Supermarkets, Gordmans and Central Grocers. These cases highlight the Chapter 11 exit strategy in two settings: (1) a sale of assets, with an asset purchase agreement negotiated between the debtor, the buyer and creditors’·committee, that includes a preference release; or (2) an operating plan negotiated by the debtor, secured creditor and creditors’ committee that includes in the Disclosure Statement and Plan, a preference release. In both settings, title supplier qualifies for the preference release by offering credit terms for their product or service to the buyer or reorganized debtor upon exit from the Chapter 11.

If the debtor does not propose a supply chain preference release, the supplier may seek to negotiate a preference release only for its own potential liability. The one-off preference release is commonly through a negotiation of supplier trade terms in exchange for early payment of the supplier’s 503(b)(9) claim.

With the sale of asset cases, a Trust is created for purpose of retaining the estate’s preference actions and sale proceeds. The party responsible for the Trust’s assets is often referred to as a plan administrator. The responsibilities of the plan administrator are to maximize the Trust’s assets and limit its liabilities. One way to limit liabilities against the Trust is through plan administrator objections to claims submitted by suppliers.

A claim objection can be such things as books and records-the debtor’s reconciliation of the supplier’s claim does not match, or a late filed claim. Another strategy for the plan administrator to reduce claims is object to a supplier’s claim based on the supplier having received a preference. But does such an objection have merit where the Plru1 provides for a supply chain preference waiver? Is such an objection, selective enforcement of the preference powers as these types of claim offsets are commonly asserted against suppliers, asserting 503(bX9) claims?

Claim Objection Based on Preference

A plan administrator may object to a supplier’s claim, most likely a 503(b)(9) claim, under section 502(d) of tl1e Bankruptcy Code. Section 502(d) provides, in pertinent part, that “the court shall disallow any claim of any entity from which property is recoverable “under the preference statute, unless the preference is repaid.

How might a plan administrator support a section 502(d) claim objection where a debtor under a confirmed Plan releases suppliers from preferences?

For example in In re Gordmans, the confirmed Plan (at Article VII. paragraph F) provides:

Any Claims…recoverable under section …547 of the Bankruptcy Code, shall be deemed disallowed pursuant to section 502(d) of the Bankruptcy Code…

However, Article VIII, paragraph C of the Plan provides an unconditional preference release to suppliers from preferences. Thus, the question for a supplier holding a 503(bX9) claim is whether a plan administrator may disallow the supplier’s claim under section 502(d) on the grounds of an alleged preferential payment, even though a preference action cannot be filed as a result of the preference release.

Does the Legal Authority Support the Supplier Dealing with a 502(d) Claim Objection?

In most Chapter 11 cases, suppliers holding non-priority claims generally do not receive a distribution. Rather, only those suppliers holding priority claims. Generally 503(b)(9), receive a distribution. Therefore, in most Chapter 11s, the plan administrator’s focus with claims·objections, including 502(d) objections, is against priority claimants.

Fortunately, the majority of courts hold that section 502(d) does not apply to 503(b)(9) claims. In re Lids Corp., 260 B.R. 680, 683 (Bankr. D. Del. 2001) (“administrative expense claims are accorded special treatment under the Bankruptcy Code and are not subject to section 502(d)”); In re Durango Georgia Paper Co., 297 B.R. 326, 331 (Bankr. S.D. Ga. 2003) (“Section 502(d) does not apply to administrative expenses that are allowable under § 503”); In re Plastech Engineered Prod. Inc., 394 B.R. 147, 161 (Bankr. E.D. Mich. 2008) (“the allowance of claims
under § 502 is entirely separate from the allowance of administrative expenses under § 503”); In re Ames Dep’t Stores. inc., 582 F.3d 422,427-432 (2d Cir. 2009) (“[w]e hold that section 502(d) does not apply to admin istrative expenses under section 503(b)”); In re Tl Acquisition, LLC, 410 8.R. 742, 750-51 (Bankr. .D. Ga. 2009) (“Section 502(d) does not contain any language or reference which would make it applicable to administrative expenses of any kind”‘); In re Momenta. inc., 455 8.R. 353. 364 (Bankr. D. .H. 20 1 1) (“Because § 502(d) is inapplicable to administrative expense claims, including an expense requested under § 503(bX9). the claim shall be allowed”); Jn re Energy Conversion Devices, Inc., 486 B.R. 872, 878 (Bankr. E.D. Mich. 2013) (“1l1e Court is persuaded that the correct reasoning and views are those taken by the Second Circuit in the Ames Dep ‘t Stores case, regarding § 503(b) administrative expenses in general, and by the courts in the Plastech and Momenta cases, regarding § 503(bX9) administrative expenses in particular”); In re Quantum Foods. UC,554 B.R. 729, 735 (Bankr. D. Del. 20 16) (“Section 502(d), by its terms, does not include administrative expense claims. Conversely, § 503, which addresses administrative expense claims, has no provision similar to 502(d) disallowing administrative claims if the administrative claimant fails to satisfy a preference liability”).

The minority position is that § 502(d) applies to all claims, including administrative expenses. In re MicroAge, Inc., 29 1 B.R. 503, 508 (B.A.P. 9th Cir. 2002)(“[W]e believe that the better analysis is that §502(d) may be raised in response to the allowance of an administrative claim”); In re Circuit City Stores, Inc.,426 B.R. 560, 571 (Bankr. E.D. Va. 20 10) (“(T)he Court concludes that § 502(d) may be used to temporarily disallow § 503(bX9) claims”).

Supplier·Strategy to Ensure Priority Claim is Free from 502(d) Objection

If the supplier has a provision in a confirmed Plan that provides for a supply chain preference release, the next step is to confirm that a 502(d) claim objection is not preserved by the plan administrator. If so, consider objecting to that provision of the Plan.

If an objection to the Plan is not lodged, the supplier still has an alternative to preserve the priority claim. The court in In re Energy Conversion ruled that a provision in a confirmed plan does not override Congressional intent. In In re Energy Conversion, the Trustee requested the court delay payment of a supplier’s 503(b)(9) administrative expense until after the preference claim against it had been determined. The Court explained that, whatever discretion a court may have to allow a Chapter 11 debtor to defer paying allowed administrative expenses before a plan is confirmed, such discretion no longer exists once a plan has been confirmed; the confirmed plan controls when allowed administrative expenses must be paid.

Supplier Takeaway

As more large Chapter 11 debtors are considering supply chain preference releases, the supplier, especially one holding a 503(b)(9) claim, should be vigilant as to whether the plan administrator seeks to retain 502(d) claim objections. lf a supplier preference release is obtained, but 502(d) claim objections are retained, consider objecting to that provision. Otherwise, case authority supports the 502(d) claim objection be overruled.

Scott Blakeley, of Blakeley LLP, advises companies regarding creditors’ rights and bankruptcy law. His email: seb@blakeleyllp.com

CMA’s Supplier Risk Credit Group to Establish Procedures for Vetting Vendors

Last year, under the leadership of Alvin Moreno of Nestle Inc., CMA launched the Supplier Risk Credit Group, a Best Practices industry exchange group for those who have been assigned the task of vetting their vendors or for those credit managers who wished to enhance their position at their company by learning this job. Who better than a credit manager to evaluate RISK from the vendor side of the chain?

The Group has had four informative discussions and has attracted members such as PepsiCo to the meetings.

On Wednesday, January 27, we are taking the information gathered at these meetings and beginning to build the platform establishing policies and procedures for those assigned this task.

If you have an interest in this or would like to pass it on to the appropriate person at your company, we would be delighted to have them join us in person in Burbank or through web conferencing.

Here is a partial agenda for the meeting:

REVIEW OF LAST MEETING
1. Members describe any enhancements they have made to their vetting process or roadblocks encountered
2. Groundwork and Decisions Required Prior to Establishing Process (including 80/20 Rule-Which vendors will you include in your process?, Has a budget been discussed and approved?, Has Staffing been arranged?, Identify critical vendors, single, sole source vendors outside of 80/20 rule, Has an acceptable chain of command been established?, Has a workable timeline to roll out, review and assess been established?)

VENDOR ONBOARDING PROCESS BEGINS
1. Receive request for NEW vendor investigation
2. Vendor fills out company questionnaire (Provide quality, safety and financial information)
3. Initiate Vendor Qualification process
4. Vendor Financial Information uploaded
5. Evaluation Process Begins (Credit investigation; Relationship: Critical, single, sole; Demographic, government, industry)
6. Vendor Approval, review schedule set
7. Q & A

Please let us know if you would like to be a guest at this meeting by contacting Larry Convoy at lconvoy@emailcma.org.