In AFA Investment v. Trade Source (In re AFA Investment), 538 B.R. 237 (Bankr. D.Del. 2015), the U.S. Bankruptcy Court for the District of Delaware addressed a summary judgment motion filed by the debtor. In this case, the debtor filed a preference complaint against Trade Source Inc. seeking to avoid and recover a $25,000 payment made by the debtor to Trade Source on Feb. 23, 2012, which was within 90 days of the debtor's filing for bankruptcy. In the summary judgment motion, the debtor alleged the transfer at issue was a preference and, as such, should be avoided under Section 547(b) of the Bankruptcy Code.

In response to the summary judgment motion, Trade Source asserted the summary judgment motion should be denied because: (1) the debtor failed to establish that the transfer was made on account of antecedent debt; (2) the debtor failed to meet its burden of proof with respect to the debtor's insolvency during the preference period; and (3) the defendant did not receive more than it would have otherwise received in a hypothetical Chapter 7 liquidation.

In analyzing the summary judgment motion, the AFA court first turned its attention on whether the transfer was made on account of an antecedent debt. According to the court, in order for a "debt to be antecedent, the debtor's obligation to pay must have arisen before the challenged payment was made," citing In re Vaso Active Pharmaceuticals, 500 B.R. 384, 393 (Bankr. D.Del. 2013). In this case, the debtor presented a declaration of its chief restructuring officer, in which the CRO stated that the transfer at issue satisfied three 61-day-old invoices, each in the amount of about $8,333. Thus, the debtor contended that the transfer at issue was on account of antecedent debt and could be avoided pursuant to Section 547(b) of the Bankruptcy Code. The defendant, however, contended that the transfer was not made in satisfaction of a pre-existing obligation but, rather, was a retainer for future services. In support of this contention, the defendant offered a declaration of its president "stating that the challenged transfer was a voluntary prepayment and, thus, was not on account of antecedent debt." Both sides, however, agreed that the payment was made pursuant to a certain sales brokerage agreement by and between the debtor, AFA Foods Inc., and the defendant. Pursuant to the brokerage agreement, the defendant agreed to sell the debtor's food products in exchange for commission. The agreement also permitted the defendant to receive a monthly retainer in the amount of about $8,333.

In its summary judgment motion, the debtor argued that since the last payment made to the defendant was in December 2011, it was only logical that the transfer at issue represented three successive payments of $8,333, which were due and owing the defendant for January, February and March 2012, respectively. The debtor also argued that a prepayment to the defendant in March 2012 did not make sense given the fiscal distress that the debtor was experiencing at the time the transfer was made. Notwithstanding these arguments, the court found there were "issues of material fact with respect to whether or not the allegedly preferential transfer was made on account of an antecedent debt." First, referring to the two conflicting declarations of the debtor's restructuring officer as well as the declaration of the defendant's president, the court noted there was conflicting evidence as to whether these payments were prepayments or payments made on account of past services. The court then determined that the brokerage agreement was somewhat ambiguous, as it was unclear from the brokerage agreement whether the monthly retainers to be paid to the defendant were intended to be prepayments for future services. In reviewing the brokerage agreement, the court observed that, as a matter of law, the term "retainer" could mean a "prepayment for future services" but could also mean a "present payment" for future services, citing In re Insilco Technologies, 291 B.R. 628, 632 (Bankr. D.Del. 2003). Given the standard a court must employ when reviewing a motion for summary judgment (i.e., a court must view the facts presented in the light most favorable to the non-moving party), the court found the term "retainer" to be ambiguous and, thus, determined that there were issues of material fact that were still in dispute. As a consequence, the court held that the debtor had not met its burden with respect to whether the transfer was on account of antecedent debt.

The court also found that, as a matter of law, the debtor had not met its burden in demonstrating that the transfer at issue enabled the defendant to receive more than it would have received in the hypothetical Chapter 7 liquidation. In its summary judgment motion, the debtor argued that this element of Section 547(b) was "presumptively satisfied" because the defendant was an unsecured creditor and unsecured creditors, in this case, were receiving less than 100 percent pursuant to the debtor's confirmed plan. The defendant, however, argued that this was an unusual case as the defendant was determined to be "an essential supplier" during the course of the bankruptcy case. In this case, the court had entered a prior order that provided, among other things, that essential suppliers were to be paid, in full, on account of their prepetition claim if they agreed to continue to provide post-petition services and goods to the debtor. In light of the essential-services order, the defendant argued that even in a Chapter 7 liquidation, it still would have received 100 percent payment of its claim pursuant to the court's essential-suppliers order.

In its decision, the court agreed with the defendant and found that as a matter of law "an unsecured creditor whose claim is paid in full post-petition pursuant to a court order, or a court-approved stipulation, cannot then be compelled in a preference action to turn over amounts related to prepetition payments," citing In re Kiwi International Air Lines, 344 F.3d 311, 321 (3d Cir. 2003). While Kiwi dealt with a contract that had been assumed by the debtor, the AFA court found that pursuant to the essential-services order, the U.S. Court of Appeals for the Third Circuit's reasoning in Kiwi was applicable to this case. In particular, the court found that had the preferential transfer at issue not been made, this obligation would have been rolled into or rolled up as part of the defendant's prepetition claim and it would have been paid, in full, pursuant to the essential-services order. In response, the debtor argued that a critical-vendor order, in and of itself, is insufficient to defend against a preference claim within the District of Delaware, and cited the cases of Zenith Industrial v. Longwood Elastomers (In re Zenith Industries), 319 B.R. 810, 814 (D. Del. 2005), and HLI Creditor Trust v. Export (In re Hayes Lemmerz International), 313 B.R. 189, 193 (D. Del. 2004), in support of this contention. In rejecting this argument, the court found the facts of both the Hayes Lemmerz case and the Zenith case were distinguishable from the facts of this case. According to the court, the Hayes Lemmerz court based its holding, in part, on the fact that the creditor at issue had not been identified in the critical-vendor order as a "critical vendor." In addition, the court observed that the critical-vendor order in Hayes Lemmerz was permissive (i.e., the debtor had the ability, but not the obligation, to pay critical vendors) whereas in AFA, the debtor identified the defendant as a critical vendor, executed a separate agreement obligating the debtor to pay the defendant's prepetition claim, entered into that agreement post-petition and obtained a specific order from the court specifically approving this agreement. Thus, the court observed that the Hayes Lemmerz decision was inapplicable to the facts on hand.

With respect to the Zenith decision, the court also found that it was distinguishable from this case. According to the court, in Zenith, it was "pure speculation" that had the preference payment not been made, the vendor would have been included as a critical vendor and the Zenith court would have entered the critical-vendor order. Indeed, the AFA court noted the alleged preference in Zenith was a very significant claim and given the relatively modest amount of "cap" in the critical-vendor order in that case, there could have been significant objections filed to the proposed critical-vendor motion had the preference claim become part of the critical-vendor order. Unlike Zenith, however, the amount of the alleged preference in AFA was a fraction of the amount of the critical-vendor cap and, therefore, even if the transfer had not been paid and had been included as part of the prepetition claim, there would have been a very strong likelihood that the court would have approved the essential-services order.

In light of the debtor's failure to establish that the transfer was made on account of antecedent debt, coupled with the fact that the defendant did not receive more than it would have received in the hypothetical Chapter 7 liquidation, the AFA court did not address the issue of whether the debtor met its burden to establish insolvency, finding that there were sufficient grounds for the court to deny the debtor's summary judgment motion.

This decision is instructive to counsel on both sides of a preference case as, contrary to prior Delaware precedent, it suggests that there may be an absolute deference to a preference claim if the defendant was previously treated as a critical vendor.

Lawrence J. Kotler is a partner at Duane Morris who practices in the area of reorganization and finance, representing Chapter 11 debtors-in-possession, Chapter 11 trustees, Chapter 7 trustees, liquidating trustees, creditors committees, secured creditors and large institutional unsecured creditors in all facets of bankruptcy.

Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.