Judge Carey in the District of Delaware recently ruled on an intriguing question—can a defendant in a preference action reduce the amount of a recoverable preference by setting off the value of an allowed administrative expense claim?. Though not late-breaking news, this case provides a thorough examination of the essential character of administrative expense claims.

Quantum Foods, LLC was a meat packaging and processing company that conducted business with many of the nation’s largest meat suppliers. After filing for bankruptcy in 2014, the Court granted standing to the Committee to prosecute various claims and causes of action, including avoidance actions.  The Committee filed a complaint against Tyson Foods to recover prepetition preferences and fraudulent transfers and to disallow Tyson’s claim under section 502(d) of the Bankruptcy Code.  Prior to the Committee filing its complaint against Tyson, the Court had entered an order granting Tyson an allowed administrative expense claim for the post-petition deliveries of products.

Tyson asserted that its allowed administrative expense claim should be used to offset any preference liability. The Committee argued that such a setoff would amount to applying the “subsequent new value” preference defense to the post-petition delivery of goods—expressly prohibited in the Third Circuit per Friedman’s Liquidating Trust v. Roth Staffing Co., LP (In re Friedman’s, Inc.), 738 F. 3d 547 (3d. Cir. 2013). After analyzing Friedman’s and other authority, the Court recognized a difference between the subsequent new value defense, which impacts the calculation of preference exposure, and setting off an allowed administrative expense claim.  Setting off the administrative expense claim, as Tyson suggested, deals only with post-petition activity and impacts only the amount paid to the estate, not the underlying amount of exposure.  Accordingly, the Court held that Tyson’s counterclaim for setoff was well pled and not a post-petition new value defense.

The court was also unpersuaded by the Committee’s argument that section 502(d) of the Bankruptcy Code, which states that “the court shall disallow any claim of any entity…that is a transferee of a transfer avoidable under . . . [§547] . . . unless such entity or transferee has paid the amount . . . for which such entity or transferee is liable,” would prohibit set off of Tyson’s administrative claim against any preference liability.

The Court noted that such an argument overlooks case law recognizing that administrative expense claims are to be accorded special treatment. Indeed, section 502(d) does not include administrative expense claims and section 503, which addresses administrative expense claims, does not contain a provision similar to section 502(d).  Citing Judge Walrath in In re Lids, Corp., 206 B.R. 680, 683 (Bankr. D. Del 2001), the Court addressed the potentially hazardous impact of applying section 502(d) to administrative expense claims, noting that if trade vendors felt preference exposure would be used to prevent payment of administrative claims, those vendors would be reluctant to continue to supply a debtor.  Such a result, the Court reasoned, would threaten a debtor’s ability to reorganize.

Ordinarily, this dispute would likely not have arisen because the Debtor and the creditor would simply true-up amounts owing between them based on avoidance action and administrative claims because both claims would be valued at 100% of their face amount.  Here, however, under the terms of the DIP Order, after the cost of recovering on avoidance actions, the first $1.3 million recovered was to be applied for the benefit of administrative, priority and general unsecured creditors and the remainder presumably would be paid to the secured lender.  Therefore, it would be in the best interest of general unsecured creditors to maximize the amount of avoidance recoveries so that as much of the $1.3 million as possible could be paid to general unsecured creditors.

This ruling should serve to put trade creditors at ease and preserve the status quo. The bankruptcy code contains several provisions designed to incentivize creditors to continue business relationships both during the debtor’s slide into bankruptcy (see e.g. 11 U.S.C. § 503(b)(9)) and after the debtor has commenced a proceeding (see e.g.11 U.S.C. § 503).  This ruling supports that ideal by protecting the sanctity of the administrative expense claim.