Return of Goods Preference Issues

Return of Goods Preference Issues

Journal Issue: 
Column Name: 
Journal Article: 
Preference claims are one of the more frequently litigated issues in bankruptcy. The garden-variety preference is based on a debtor’s payment of antecedent debt. However, on rare occasions, a preference claim is based on the debtor’s return of goods to the creditor in reduction of the creditor’s claim. The few reported decisions concerning return-of-goods preference claims have dealt with the amount the debtor was entitled to recover from the creditor and the applicability of the ordinary course of business and new value defenses.

The U.S. District Court for the Western District of Virginia in Active Wear Inc. v. Parkdale Mills Inc., 331 B.R. 669 (W.D. Va. 2005), limited a chapter 11 debtor’s recovery on a return-of-goods preference claim to the amount the debtor would have realized from a liquidation sale of the goods. However, this is by no means the only approach for determining recovery on such claims.

The Facts of Active Wear v. Parkdale Mills

The debtor, Active Wear Inc., was a yarn spinner that purchased substantial amounts of yarn from Parkdale Mills Inc. The debtor owed Parkdale at least $2 million on unpaid invoices at the time the debtor closed its business. Parkdale’s claim included invoices for unused yarn that the debtor was still holding.

Following the debtor’s disclosure of the cessation of operations, Parkdale sent a reclamation demand to the debtor for recovery of yarn having the value of $11,428.88. Thereafter, Parkdale picked up all of the unused yarn it had previously sold to the debtor, and the debtor credited $134,849.50 against its outstanding indebtedness to Parkdale for the returns.

An involuntary chapter 7 petition was filed against the debtor within 90 days of Parkdale’s recovery of the yarn. An order for relief was entered, and the debtor converted the case to chapter 11. The debtor commenced a lawsuit against Parkdale for avoidance of the debtor’s pre-petition return of Parkdale’s yarn under 11 U.S.C. §547 and for recovery of the value of the yarn pursuant to 11 U.S.C. §550.1

The bankruptcy court held that returns to Parkdale were an avoidable preference for which the debtor was entitled to recover the liquidation value of the returns in an amount equal to $27,459. The debtor appealed the bankruptcy court’s order, arguing that Parkdale should have been directed to pay the fair market value of the returns equal to the amount Parkdale could have realized from reselling the returned yarn.

Interplay Between 11 U.S.C. §§547(b) and 550

11 U.S.C. §§547(b) and 550 come into play in most preference actions. Section 547(b) authorizes a trustee or debtor-in-possession (DIP) to avoid a transfer as a preference where all of the following requirements are satisfied:

1. The debtor transferred its property to or for the benefit of a creditor (a transfer includes a debtor’s return of product to the creditor).
2. The transfer was made on account of antecedent or existing indebtedness owing by the debtor to the creditor.
3. The transfer was made within 90 days of the debtor’s bankruptcy filing for payments to noninsider creditors, and within one year of the filing for payments made to insiders of the debtor (§101(31) defines an insider to include the debtor’s officers, directors, controlling shareholders and affiliated companies).
4. The transfer was made when the debtor was insolvent, based on a balance-sheet definition of insolvency (liabilities exceeding assets). See 11 U.S.C. §101(32). The debtor’s insolvency is presumed within the 90-day preference period, making it easier to prove an avoidable preference.
5. The transfer enabled the creditor to receive more from the debtor than the creditor would have recovered in the debtor’s chapter 7 liquidation. This requirement is satisfied unless un-secured creditors would have received full payment of their claims through the chapter 7 case.

Section 547(b) deals with the avoidance of a preferential transfer. Section 550(a) allows a trustee or DIP to recover the transferred property, or pursuant to court order the value of the property, from the initial transferee or the entity for whose benefit the transfer was made. Section 550(a) does not offer a court any guidance in deciding whether the recovery on a return-of-goods preference claim should be the return of the transferred property, or payment of its value, to the debtor or trustee. Section 550(a) also gives no guidance for determining the value of the return.

The District Court’s Decision in Active Wear v. Parkdale

The district court limited recovery on the debtor’s return of goods preference claim to the sums the debtor could have realized from a liquidation sale of the returns. The court, relying on the pre-Bankruptcy Code decision of the U.S. Court of Appeals for the Fourth Circuit in Virginia Nat’l. Bank v. Woodson (In re Decker), 329 F.2d. 836 (4th Cir. 1964), noted that the recovery from Parkdale should be based on the extent to which the return had depleted the debtor and its bankruptcy estate. The yarn’s value to the debtor was the amount the debtor could have realized from a liquidation sale of the yarn. The court refused to give the debtor any credit for any greater recovery Parkdale derived from its disposition of the returned yarn, which the court attributed to Parkdale’s expertise, time, goodwill and advertising.

Other Approaches to Recovery on Return-of-Goods Preference Claims

The court’s holding in Active Wear v. Parkdale Mills is by no means the only way to determine the recovery on a return-of-goods preference claim. For instance, in In re First Software Corp. (Ferrari v. Computer Assocs. Int’l. Inc.), 84 B.R. 278 (Bankr. D. Mass. 1988), aff’d., 107 B. R. 417 (D. Mass. 1989), the court entered a judgment in the amount of $1,500,026 against the creditor on a return of goods preference claim. The court relied on a credit memorandum in the above amount issued by the creditor in reduction of its claim.2 The credit memorandum was deemed the creditor’s contemporaneous determination of the market value of the returns, which the creditor could not rebut. See, also, In re Albers (Derryberry v. Albers), 67 B.R. 530 (Bankr. N.D. Ohio 1986) (credit of $6,500 defendant had issued in exchange for return was best evidence of its value).

The court in In re American Furniture Outlet USA Inc. (American Furniture Outlet USA Inc. v. Woodmark Originals Inc.), 209 B.R. 49 (Bankr. M.D.N.C. 1997), refused to base the recovery on a return-of-goods preference claim on a credit the creditor had issued for all past due invoices owing by the debtor. The court limited recovery to the net amount, after deducting expenses, that the creditor had realized from its commercially reasonable resale of returns.

Other courts dealing with a return-of-goods preference claim have ordered the creditors to return the goods. For instance, in In re King Arthur Clock Co. (Widemire v. Siddiki Bros. Inc.), 105 B.R. 669 (Bankr. S.D. Ala. 1989), the court directed the return of goods instead of entering judgment against the creditor in the amount of a credit memorandum for $17,265.54 the creditor had issued in favor of the debtor. The credit memorandum was not proof of the value of the returns, and in the absence of any proof of their value, the only remedy under §550(a) for a return-of-goods preference claim was the creditor’s return of the goods. See, also, In re General Indus. Inc. (General Indus. Inc. v. Shea), 79 B.R. 124 (Bankr. D. Mass. 1987) (return of goods ordered based on conflicting evidence of value of returns).

Applicability of the Ordinary-Course-of-Business Defense to Return-of-Goods Preference Claims

There are several defenses that can reduce or eliminate liability on a preference claim. One of the more frequently litigated preference defenses is the ordinary-course-of-business defense arising under 11 U.S.C. §547(c)(2). This defense is designed to encourage creditors to continue doing business on normal credit terms with a financially distressed company.

In bankruptcy cases filed prior to Oct. 17, 2005, a creditor must prove all of the following to satisfy the ordinary-course-of-business defense:

1. The indebtness paid by the alleged preference was incurred in the ordinary course of business of the debtor and creditor;
2. The payment was made in the ordinary course of business of the debtor and the creditor (the subjective prong); and
3. The payment was made according to ordinary business terms (the objective prong).3

Only a few cases have considered whether the ordinary-course-of-business defense can reduce exposure on a return-of-goods preference claim. In Graphic Prods. Corp. v. WWF Paper Corp. (In re Graphic Prods. Corp.), 176 B.R. 65 (Bankr. S.D. Fla. 1994), the court held that a debtor’s return of excess paper to its supplier during the preference period was not an avoidable preference. The supplier had a valid reclamation claim under 11 U.S.C. §546(c) for the returns. The supplier also satisfied the ordinary-course-of-business defense. The supplier proved the subjective prong of the defense where the debtor had previously returned goods to the supplier in reduction of the latter’s claim and the returns were not prompted by any unusual collection activity by the supplier. The supplier also proved the objective prong of the defense where, in the paper industry, a buyer frequently returns product to the seller for a credit against the invoice value of the goods and the seller usually accepts the return on these terms.4

Applicability of New-Value Defense to a Return-of-Goods Preference Claim

Another frequently invoked preference defense is the new-value defense contained in 11 U.S.C. §547(c)(4). The new value defense reduces preference exposure where, subsequent to the preference, the creditor granted new value, such as a sale of goods or provision of services on credit terms, to or for the benefit of the debtor. The new value cannot be secured by an otherwise unavoidable security interest in the debtor’s assets and cannot be paid by an otherwise unavoidable transfer to or for the creditor/preference recipient’s benefit.

The new-value defense is also intended to encourage creditors to continue doing business with and extending credit to financially distressed customers. The defense protects a creditor that replenished the debtor and its bankruptcy estate by extending new credit subsequent to the preference.

There is little case law on whether returned goods can be considered new value for purposes of §547(c)(4). In In re Furr’s Supermarkets Inc. (Gonzales v. Nabisco Div. of Kraft Foods Inc.), 317 B.R. 423 (BAP 10th Cir. 2004), the creditor defending a preference action asserted the new-value defense based on the invoice price of food products that were delivered to the debtor after the alleged preferences, but were then subsequently returned to the creditor. The returns were damaged, stale, out of date, and otherwise unsaleable and of no value. Despite that fact, the creditor had issued a credit memo in the amount of $90,180.74 for the full invoice price of the returned goods that reduced the amount of the creditor’s outstanding claim against the debtor. The Tenth Circuit Bankruptcy Appellate Panel considered whether the creditor lost the protection of the new-value defense for goods delivered to the debtor subsequent to the preference and then subsequently returned to the creditor.

The court allowed the creditor to use the full invoice value of the returns as deductible new value under §547(c)(4).5 The goods had a value of $90,180.74 when the creditor delivered them to the debtor subsequent to the alleged preference, and should therefore count as new value. The creditor did not lose the benefit of the new-value defense as a result of the debtor’s subsequent return of the goods because they were not saleable and were of no value to the debtor, and their return to the creditor did not diminish the debtor’s assets. It did not matter that the creditor had granted the debtor full credit for the unpaid invoice amounts of the returns.

The court distinguished another case, Moglia v. American Psychological Ass’n. (In re Login Bros. Book Co.), 294 B.R. 297 (Bankr. N.D. Ill. 2003), that dealt with the impact of post-petition returns on the new-value defense. The debtor’s chapter 7 trustee had sought to recover the debtor’s payment of approximately $74,000 to the creditor during the preference period. The creditor asserted a full new-value defense based on the creditor’s sale and delivery of books to the debtor, invoiced at approximately $96,000, subsequent to the alleged preference and remaining outstanding when an involuntary petition was filed against the debtor. The trustee contested the new-value defense based on the debtor’s post-petition return of the books claimed as new value, pursuant to a court-approved arrangement between the trustee and the creditor. The bankruptcy court denied the creditor’s motion for summary judgment on the applicability of the new-value defense.6

However, the court in Login Bros. did not address whether the invoice price of the books the creditor had sold and delivered to the debtor after the alleged preference could still be deducted as new value if the books were valueless upon their return to the creditor. This contrasted with Furr’s Supermarket, where the court counted the returns as new value because they were stale, obsolete, out of date, not readily saleable and therefore of no value to the debtor when they were returned.

 

Footnotes

1 The preference claim did not include the value of the yarn subject to Parkdale’s reclamation claim.
2 The court also refused to direct the creditor’s return of goods to the debtor because the goods had depreciated after their receipt by the creditor. See, also, In re Computer Universe, 58 B.R. 28 (Bankr. M.D. Fla. 1986).
3 As a result of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, in bankruptcy cases filed on and after Oct. 17, 2005, the ordinary-course-of-business defense will be easier to prove because the creditor must prove its debt was incurred in the parties’ ordinary course of business and then satisfy either the subjective or objective prongs of the defense.
4 But see In re Martin County Custom Pools Inc. (Gennet v. Coastal Wholesale Inc.), 37 B.R. 52 (Bankr. S.D. Fla. 1984) (defendant had no ordinary-course-of-business defense based on debtor’s pre-petition return of inventory to supplier after cessation of debtor’s business).
5 The returns were not an avoidable transfer because they had no value at the time of their return to the creditor.
6 But see In re Energy Cooperative Inc. (Energy Cooperative Inc. v. Cities Service Co.), 130 B.R. 781 (Bankr. N.D. Ill. 1991) (new-value defense not lost despite its repayment by post-petition offset).

Bankruptcy Code: 
Journal Date: 
Wednesday, February 1, 2006