T h e P u b l i c at i o n F o r C r e d i t & F i n a n c e P ro f e s s i o n a l s
november/december 2010
National Association of Credit Management
$ 7. 0 0
t o p i c
Bruce Nathan, Esq.
T
The Contract Assumption
Defense to Preference Claims:
Alive and Thriving
s e l e c t e d
he onslaught of preference claims continues to
bedevil trade creditors. But creditors can search
behind every preference cloud to locate one or more
preference defenses that reduce or eliminate preference exposure. One such relatively unknown preference defense is the contract assumption defense where
the creditor had received pre-petition payments under
a contract that the debtor has assumed during the
bankruptcy case. However, the existence of the contract assumption defense has not stopped trustees
from seeking to recover the debtor’s payments, during
the 90-day preference period, in connection with
assumed contracts.
That is precisely what happened in In re Centrix Financial, LLC, a bankruptcy case pending in the United
States Bankruptcy Court for the District of Colorado. A
creditor, whose contract was assumed by the debtor and
assigned to the purchaser of substantially all of the
debtor’s assets, was sued largely for the recovery of preference payments. The court dismissed the complaint
based on the debtor’s assumption and assignment of its
contract with the creditor. The court relied on Bankruptcy Code Section 365, which contains the prerequisites for a debtor’s assumption and assignment of an
executory contract. The requirements for assumption
and assignment include the full payment of all indebtedness (both pre-petition and post-petition indebtedness)
that the debtor owed the creditor under the assumed
and assigned contract, and the full performance of all of
the debtor’s future obligations under the contract. This
requirement of making whole the non-debtor party to
an assumed contract would clearly be undermined if
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the creditor remained subject to preference liability on
account of the debtor’s payments to the creditor during
the 90-day preference period.
The Centrix court also noted that the trustee might not
satisfy Section 547(b)(5)’s requirement for preference
liability that the creditor had received more from the
alleged preference payments than the creditor would
have received in a hypothetical Chapter 7 liquidation of
the debtor. The debtor’s assumption and assignment of
its contract with the creditor elevated the creditor to a
position akin to fully secured status, thereby entitling the
creditor to full payment of its claim. This elevation in
status is attributable to Section 365(b)’s requirement
that the creditor receive full payment of its pre-petition
and post-petition claims against the debtor owing under
the assumed contract and full performance of all the
debtor’s future obligations under the contract. The cred-
itor’s right to full payment of its claim upon assumption of the
contract would have continued in the debtor’s Chapter 7 case.
This prevented the trustee from satisfying Section 547(b)(5)’s
“greater than Chapter 7 liquidation recovery” requirement and
mandated dismissal of his preference claim.
Just one more victory for goods and service providers in the
ongoing preference battle.
The Elements of a Preference Claim
Bankruptcy Code Section 547 governs preferences. A trustee
can avoid and recover a preference by proving that: (1) the
debtor transferred its property, such as by making a payment
to the creditor (Section 547(b)); (2) the payment or other
transfer was to or for the creditor’s benefit (Section 547(b)
(1)); (3) the transfer was made on account of antecedent or
existing indebtedness that the debtor owed a creditor (Section
547(b)(2)); (4) the debtor was insolvent when the payment or
other transfer was made, based on a balance sheet definition
of insolvency (liabilities exceeding assets), which Section 547
makes easier to prove by creating a presumption of the debtor’s insolvency during the 90-day preference period (Section
547(b)(3)); (5) the payment or other transfer was made within 90 days of the bankruptcy filing in the case of payments to
non-insider trade creditors, and within one year of the filing
for payments to insider creditors, such as a debtor’s officers,
directors, controlling persons and certain affiliated companies (Section 547(b)(4)); and (6) the creditor obtained a
greater recovery from the payment or other transfer than the
creditor would have received in a Chapter 7 liquidation of the
debtor in the absence of the payment. Section 547(b)(5)’s
“greater than Chapter 7 liquidation recovery” requirement
cannot be satisfied where the creditor receiving the payment
is fully secured or is otherwise entitled to full payment of its
claim in the debtor’s bankruptcy case.
A trustee cannot prevail on a preference claim if he or she fails
to prove any of these requirements. The trustee’s inability to
satisfy Section 547(b)(5)’s “greater than Chapter 7 liquidation
recovery” requirement is one of the matters at issue in the
Centrix case. The court treated the creditor recipient of alleged
preference payments, made under a contract that the debtor
has assumed (and assigned), as a fully secured creditor with a
complete defense to preference exposure.
Executory Contracts
Section 365 of the Bankruptcy Code governs the debtor’s and
creditor’s rights under an executory contract. Neither Section
365, nor any other section of the Bankruptcy Code, defines
an executory contract. Congress has left it to the courts to
develop a definition. Most courts define an executory contract as an agreement under which both parties remain obligated to perform their obligations under the contract, and
any party’s failure to perform excuses the other party from
continuing to perform its remaining duties under the contract. Examples of executory contracts include long-term
supply agreements and purchase orders, consignment agreements and service agreements (such as advertising and subscription fulfillment contracts).
Section 365(a) of the Bankruptcy Code permits a Chapter 11
debtor to assume or reject an unexpired executory contract or
lease, subject to court approval. This provision enables the
debtor to retain, and allow the bankruptcy estate to reap the
benefits of, valuable contracts by assuming these contracts,
and jettison, and relieve the bankruptcy estate from, burdensome unprofitable contracts by rejecting those contracts.
A debtor that decides to assume an executory contract or lease
must, among other things, satisfy Bankruptcy Code Section
365(b)’s requirements. They include curing all payment and
other defaults under the contract, including fully paying the
creditor’s pre-petition and post-petition claims, and providing adequate assurance of the debtor’s ability to fully perform
all of its future obligations under the contract. According to
Section 365(f), a debtor can assign an executory contract,
subject to court approval, by satisfying all of the prerequisites
for assumption of the contract under Section 365(b) and providing adequate assurance of the assignee’s ability to fully perform all of the debtor’s future obligations under the contract.
The existence of the contract
assumption defense has not stopped
trustees from seeking to recover the
debtor’s payments, during the 90-day
preference period, in connection with
assumed contracts.
If the debtor rejects the contract, the creditor is relieved of any
future obligation to perform under the contract. Rejection
also relieves the debtor of future obligations to the creditor
under the contract. The debtor is deemed to have breached
the rejected contract as of the bankruptcy filing date, and has
an unsecured obligation to the creditor for the creditor’s damages attributable to such breach.
The Centrix Case
Prior to Centrix’s Chapter 11 filing, Centrix and one of its
creditors, Allison Payment Systems (“APS”), had entered into
a contract under which APS had agreed to provide Centrix
with postage, mailing and other professional services, including generating Centrix’s monthly payment statements. The
contract was clearly an executory contract, subject to Section
365 of the Bankruptcy Code, since both Centrix and APS had
material unperformed obligations under the contract when
the bankruptcy case was filed.
On February 6, 2007, the bankruptcy court approved the sale
of substantially all of Centrix’s assets. As part of the sale, the
court granted Centrix’s motion to assume and assign certain
of its executory contracts, including Centrix’s contract with
APS, to the buyer. That required making APS whole by curing
all of Centrix’s payment and other defaults under the contract, including paying all pre-petition and post-petition
indebtedness that Centrix owed APS, and compelling the purB u s i n e s s C r e d i t n o v e m be r / d e c e m be r 2 0 1 0
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chaser of Centrix’s assets, to whom the APS contract was
assigned, to perform all of Centrix’s future obligations under
the contract.
Thereafter, a liquidating trustee was appointed, as part of a
court-approved Chapter 11 liquidation plan, to pursue estate
claims, including preference claims. The trustee sued APS for
the recovery, in large part, of an alleged preference claim totaling approximately $500,000 and moved for summary judgment on the claim.
APS denied any liability based on the contract assumption
defense to preference claims since Centrix had assumed and
assigned its contract with APS as part of the sale of Centrix’s
assets. APS argued that Centrix was required to fully pay APS’
pre-petition and post-petition claims against Centrix, and the
purchaser of Centrix’s assets, who also took an assignment of
APS’ contract, was required to provide adequate assurance of
its ability to fully perform all of Centrix’s future obligations
under the contract, in order to comply with Section 365’s
requirement for assumption and assignment of the contract.
The trustee’s recovery of preferences from APS under the
assumed and assigned contract contradicts Section 365’s
requirement of full payment of APS’ claim and full performance of all of Centrix’s obligations under the contract. Bottom line, the Centrix estate cannot have its cake and eat it too;
it could either assume its contract with APS and assign the
contract to the buyer of Centrix’s assets and make APS whole,
or reject its contract with APS and then pursue preference
claims against APS for payments that Centrix had made to
APS under the contract. The trustee rejected the contract
assumption defense as a bar to preference exposure.
The Centrix Court’s Decision
The Centrix court granted summary judgment in APS’ favor
and dismissed the preference complaint. The court upheld the
contract assumption defense as a complete defense to preference liability. The court relied on the majority view of the
courts that have recognized this defense. Many of these courts
concluded that a creditor’s right to be made whole under Section 365(b), as a condition for the debtor’s assumption of an
executory contract, takes precedence over a trustee’s right to
recover preference claims. The debtor’s obligation under Section 365 to make a creditor whole, as part of the debtor’s
assumption and assignment of its contract with the creditor,
would be nullified by the trustee’s ability to recover preference
claims against the creditor based on payments the debtor had
previously made under the assumed contract.
The court also noted that the Centrix trustee might not satisfy
Bankruptcy Code Section 547(b)(5)’s “greater than Chapter 7
liquidation recovery” requirement, one of the prerequisites
for proving a preference. APS was entitled to full payment of
its claim against Centrix and full performance of Centrix’s
future obligations to APS based on assumption and assignment of Centrix’s contract with APS. That put APS in a position akin to a fully secured creditor entitled to full payment of
its claim, thereby preventing the trustee from satisfying Section 547(b)(5).
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Other courts, including several U.S. Courts of Appeals, have
upheld the contract assumption defense to preference claims.
One such court is the United States Seventh Circuit Court of
Appeals, in Superior Toy Manufacturing Co. The Superior Toy
case illustrates the tension between Bankruptcy Code Sections
365 and 547 when a trustee seeks to recover preference payments that were previously made under an executory contract
assumed by the debtor. The debtor had assumed a licensing
agreement during its Chapter 11 case that was later converted
to a Chapter 7 liquidation. The Chapter 7 trustee sued the
licensor to recover, as preferences, amounts that the debtor/
licensee had paid to the licensor prior to the debtor’s/licensee’s Chapter 11. The Seventh Circuit upheld dismissal of the
trustee’s preference action against the licensor based on the
debtor’s/licensee’s assumption of the license during the Chapter 11 case, explicitly holding that Section 365, dealing with
assumed executory contracts, takes precedence over Section
547, dealing with preference claims. Section 365(b)(1) conditioned the debtor’s/licensee’s assumption of its contract with
the licensor upon the debtor’s paying all amounts owing to
the licensor prior to assumption, and guaranteeing the debtor’s/licensee’s future performance of the contract. Permitting
the trustee to recover a preference from the licensor where the
debtor had previously assumed the license would have undermined Section 365(b)’s assumption requirements.
The United States Court of Appeals for the Third Circuit, in
Kiwi Int’l Air Lines, similarly upheld the contract assumption
defense as a full defense to preference liability. The Third Circuit noted that the non-debtor party is entitled to full payment of all amounts due under a contract that the debtor had
assumed. That includes the debtor’s full payment of the creditor’s pre-petition claim against the debtor. As such, the creditor had priority status and should not be subject to preference exposure.1
Conclusion
So the Centrix court has spread some more good cheer to
trade creditors. The court has followed the overwhelming
majority view that a creditor has a complete defense to preference liability with respect to a debtor’s pre-petition payments
made on an assumed contract. More good news that the trade
likes to hear! ●
1. Other courts, including the United States Court of Appeals for the
Ninth Circuit, in LCO Enterprises, have similarly upheld the contract
assumption defense as a full defense to preference liability.
Bruce Nathan, Esq. is a partner in the New York City office of the law
firm of Lowenstein Sandler PC. He is a member of NACM and is on
the Board of Directors of the American Bankruptcy Institute and is a
former co-chair of ABI’s Unsecured Trade Creditors Committee. He
can be reached via email at [email protected].
This is reprinted from Business Credit magazine, a publication of the
National Association of Credit Management. This article may not be
forwarded electronically or reproduced in any way without written
permission from the editor of Business Credit magazine.