Preference Payments and The Untouchables

Executory Privilege

As many vendors are aware, perhaps the most disappointing aspect of bankruptcy law is being slapped with a preference lawsuit. Often times, vendors find it difficult to get paid at all, let alone receive a payment, and then defend it in a costly preference action. Moreover, a preference action seeks a dollar for dollar return to the estate whereas a vendor only receives a pro rata distribution under bankruptcy.

Accordingly, many of these vendors will defend the action with one of several codified exceptions to the preference action; others will control their destiny and reach settlement on terms that may be more favorable than treatment under a plan. However, certain vendors will keep their preference payment in their pockets despite the efforts for recovery of the payment by a preference plaintiff. These vendors are the "Untouchables."

The Untouchables are vendors that hold executory contracts and unexpired leases (hereinafter "executory contracts"). An executory contract is a contract under which the obligation of both the bankrupt and contracting party is so far underperformed that the failure of either to complete performance would constitute a material breach, and thus, excuse the performance of the other.

As a matter of law, transfers made during the preference period are not recoverable if the payments were made pursuant to an executory contract that was assumed by the trustee.1 This conclusion finds support in case law and the application of section 547 and 365 of the Bankruptcy Code (the "Code"). Therefore, it is essential for these vendors to demonstrate the importance of their executory contract and convince the trustee that assumption of the contract will further its efforts to reorganize.

Recovering Transfers During The Preference Period
The requirements of section 547(b) are designed to encourage an equitable distribution among similarly situated vendors.2 Accordingly, section 547(b) provides that a trustee may avoid any transfer in property of the debtor if the transfer meets five requirements.3 The preference period is 90 days prior to the filing of the petition, but may extend to one year if the transferee is an insider.

If the trustee satisfies the requirements of section 547(b), then the transfer is recoverable unless the transferee can prove that an exception is available. Generally, the exceptions are codified, however, many vendors are surprised to learn that exceptions are also generated from the interaction of certain Code provisions.

Curing Defaults As A Prerequisite To Assuming An Executory Contract
The purpose of section 365 is to allow a trustee to reject burdensome executory contracts, while at the same time, provide the trustee with a mechanism to force others to continue to do business with the debtor during its reorganization.4

Accordingly, section 365(A) states that a trustee may assume an executory contract, provided that, "if there has been a default . . . the trustee may not assume such contract . . . unless, at the time of the assumption of such contract, the trustee . . . cures, or provides adequate assurance that the trustee will promptly cure, such default."5

If the court grants a trustee's assumption of the contract, the contracting party has no choice; continued performance is required under the terms of the contract.6 However, if the debtor is delinquent under the executory contract, either prepetition and/or postpetition, then the trustee must demonstrate to the court that he can cure the default and make future payments.

Accordingly, an assumption order distinguishes the contracting party from other vendors. The contracting party is forced to continue to do business with the debtor. However, in exchange, the contracting party is entitled to payment of all amounts due under the contract. In other words, the assumption effectively gives the contracting party a secured interest in monies due, and effectively, eliminates preference actions.

Creating A Common Law Exception:
To Cure or be Cured
Viewed separately, section 547(b) and 365 appear mutually exclusive and do not pose any inconsistencies. However, the treatment of any transfers made during the preference period will depend on whether the trustee elects to assume or reject the contract. If the trustee assumes the contract pursuant to section 365, then section 547(b)(5), a requisite to recovery of a preferential transfer, will not be satisfied and no preference is deemed to have occurred.7 It is common sense.

The requisite to assuming an executory contract is to cure the prepetition default, and the payments received during the preference period would have to be paid under a cure. If these payments were recoverable as a preference, then the trustee would have to repay the preference to assume the contract. The result is a wash.

As further protection against an enthusiastic trustee, the equities of assumption cannot be made in a preference action, but must be made in an action challenging the order that approved the assumption. Courts have applied the doctrine of estoppel to preclude the trustee from receiving the benefits of an assumed contract without also assuming its obligations.8

Additionally, the congressional intent behind section 365 is decisive; a party to an executory contract must be paid all amounts due under the contract before the contract may be assumed. In drafting section 365(b)(1), Congress ensured that a contracting party is made whole before a court can force the party to continue performing with a bankrupt debtor, "[i]f the trustee is to assume a contract . . . the court will have to insure that the trustee's performance under the contract . . . gives the other contracting party the full benefit of his bargain."9

By retaining prepetition payments, a party to an assumed contract does not receive more than other similarly situated vendors.10 From the moment that the assumption order is entered, the contracting party's interest is necessarily distinct from the interests of unsecured vendors. Permitting a preference suit after an assumption order would undermine the purpose and intent of section 365. Accordingly, the assumption of an executory contract bars recovery of a preference claim.

Seminal Cases
In Superior Toy, the Seventh Circuit dismissed a preference action commenced against a party to an assumed contract.11 The court ruled that the cure provisions of section 365 required the trustee to cure all prepetition defaults prior to assuming the contract, and therefore, the payments during the preference period were not preferential. The court ruled that preference actions are prohibited against parties to an assumed executory contract because section 365(b) requires a trustee to cure all defaults of an assumed contract. The Seventh Circuit also concluded that the trustee was estopped from prevailing on the preference action as the trustee benefited under the assumed contract. See Id. at 1176.

In In re LCO Enterprises I, the Ninth Circuit considered whether a trustee is entitled to recapture prepetition lease payments as a preference where the trustee assumed the lease.12 The court's inquiry was the appropriate classification of the vendor. In the ordinary case, general unsecured vendors claims are fixed at the date of the bankruptcy petition and preferential transfers are subject to recapture.

However, vendors holding executory contracts and unexpired leases stand in a different position relative to general unsecured vendors. Although the prepetition default may be fixed, the status to the right to payment from the estate is not fixed because it is dependent upon whether the trustee assumes or rejects the executory contract or unexpired lease. If the trustee assumes the contract pursuant to section 365, then section 547(b)(5), a requisite to recovery of a preferential transfer, will not be satisfied and no preference is deemed to have occurred.

After distinguishing the holders of general unsecured claims from those vendors that are parties to an executory contract or unexpired lease, the Ninth Circuit considered the application of the hypothetical chapter 7 case under section 547(b)(5). The Ninth Circuit aligned the interests of party to an assumed contract or lease with that of a secured vendor.

These vendors would be entitled to prepetition payment of their claims. Accordingly, the Ninth Circuit concluded that, taking the facts as they are at the time of the assumption, the holder of an assumed contract or unexpired lease is entitled to 100% of the claim. The preference action was dismissed.

Other Code Provisions
In Seidle, the Eleventh Circuit considered whether a trustee is entitled to recapture prepetition contract payments when the parties entered into a court approved stipulation pursuant to section 1110.13 Under section 1110, a debtor may retain possession of equipment by curing defaults and making the required payments. The Eleventh Circuit concluded that a trustee is precluded as a matter of law from bringing a preference suit after the court approved the stipulation.

"A trustee's election to set aside alleged preferential payments would undermine the protection that section 1110 provides for vendors. Pursuant to the section 1110 stipulation, a vendor is entitled to unpaid prepetition payments, as defaults; a trustee may not later thwart the effect of the statute by challenging the validity of these transfers as preferences."14

Conclusions
If you are a vendor to an executory contract or unexpired lease, then carefully assess your situation. If you are exposed to a substantial preference action, then getting the trustee to assume your contract is key to eliminating your liability. The exchange, of course, is a continued relationship with the debtor throughout the term of the contract. However, if you are a vendor with an assumed contract that has already encountered a preference action, then do not give in to the trustee as you may be a member of the Untouchables.

1 The court may require the consent of the contracting party when the trustee intends to assign the contract to a third party. See In re Catapault Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999)(holding that federal patent law constitutes "applicable law" within meaning of Bankruptcy Code provision barring debtor from assuming executory contract without nondebtor's consent where applicable law precludes assignment of contract to a third party).

2 See Matter of Smith, 966 F.2d 1527, 1535 (7th Cir.) (citing H.R.Rep. No. 595, 95th Cong., 2nd Sess. 177-78 (1978); U.S.Code Cong. & Admin.News 1978 pp. 5787, 5963, 6137-6139).

3 Under § 547 (b), a trustee or debtor may avoid any transfer of an interest of the debtor in property if the transfer is: (1) to or for the benefit of the vendor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made - (A) on or within 90 days before the date of the filing of the petition; or (B) between ninety days and one year before the date of the filing of the petition, if such vendor at the time of such transfer was an insider; and (5) that enables such vendor to receive more than such vendor would receive if -(A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such vendor received payment of such debt to the extent provided by the provisions of this title. See 11 U.S.C. § 547 (b).

4 See Frito-Lay, Inc. v. LTV Steel Co., Inc. (In re Chateaugay), 10 F.3d 944, 954-55 (2d Cir. 1993).

5 See 11 U.S.C. § 365 (A).

6 See Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1310 (5th Cir.1985).

7 Alternatively, if the contract is rejected, then the transfer is subject to a preference recovery if the remaining elements of §;(b) have been satisfied.

8 See In re Matter of Superior Toy & Mfg. Co., Inc., ("Superior Toy"), 78 F.3d 1169, 1176 (7th Cir. 1996)

9 See Senate Rep. No. 989, 95th Cong., 2nd Sess. 59 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5845; H.R.Rep. No. 595, 95th Cong., 2nd Sess. 348 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6304- 05.

10 See Superior Toy, 78 F.3d at 1172.

11 See 78 F.3d 1169.

12 Alvarado v. Walsh ("In re LCO Enterprises I"), 12 F.3d 938 (9th Cir.1993)

13 See Seidle v. GATX Leasing Corp., 778 F.2d 659 (11th Cir.1985)

14 See Id. at 662.

Blakeley & Blakeley LLP Reprinted by permission
from Trade Vendor Quarterly