Paying With Other People’s Money: A Close Look at Avoidance Actions

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Section 502(d) Typically Applies to Avoidance Actions By the Debtor

One of the weapons in a debtor’s arsenal is its ability to disallow a vendor’s claim until the vendor satisfies any fraudulent transfer or preference exposure it might have.

The court shall disallow any claim of an entity . . . that is a transferee of a transfer avoidable under section . . . 548 . . . unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section . . . 550 . . . of this title.”  –11 U.S.C. § 502(d).

Broadly speaking, Section 502(d) has two purposes. First, it is about fundamental fairness. It prevents certain creditors who owe money to the bankruptcy estate from sharing in distributions until their debt is paid. Second, it incentivizes parties to comply with court orders by allowing the debtor to withhold distributions until those debtTypical.PNGs are satisfied.

This makes a lot of sense in your typical situation, where a debtor seeks to recover prepetition payments that it made to one of its vendors. In practice, preference defendants threatened with disallowance of their entire claim often agree to offset amounts they owe the estate against distributions on their claims.

But when one of the debtor’s affiliates paid your bill, things get more complicated.

It May Not Apply to Avoidance Actions by Non-Debtors

Tthe-transactionhat was the situation in In re Hoku Solar. A vendor received payment on its invoice from the debtor’s parent, after which both companies filed separate bankruptcy cases. The trustee for the parent then sought to avoid and recover the payment that it made to the vendor as a fraudulent transfer. The vendor, in turn, asserted a contingent claim in the debtor’s case, seeking to assert a claim for any invoices that would be reinstated if it disgorged the payments.

The trustee’s next move was to look to the language of Section 502(d), which states only that the court shall disallow any claim of an entity that has received an avoidable transfer. It does not say that the avoidable transfer has to have been made by the debtor. Based on this literal reading of Section 502(d), the trustee argued that the creditor’s claim against the debtor’s estate should be disallowed.

The Idaho bankruptcy court rejected this approach, observing that even though the language of Section 502(d) arguably applied, the section’s purposes would not be served by disallowing the creditor’s claim. Disallowing the claim, it said, would be unfair to a vendor that could be left with no place to turn for payment on its underlying (and potentially unpaid) invoice. This would be exacerbated by the fact that the parent’s creditors—not the debtor’s—would be the ones to benefit from any disgorged payments. As for using Section 502(d) to incentivize the vendor to satisfy any fraudulent transfer claims, the court similarly felt that a creditor’s distributions in one case should not be used to impact claims in another case.

Change Up.PNGThe bankruptcy court therefore held that the creditor—an avoidance action defendant in a parent company’s bankruptcy case—could file a claim in the subsidiary’s case that is not subject to disallowance under Bankruptcy Code section 502(d).  (If the vendor had received its payment directly from the debtor, however, its claim would have been disallowed.)

The Bottom Line?

Avoidance actions are complex, and small details can make a big difference. S0 make sure you understand all of the nuances before bringing a claim or responding to a demand.

As a more esoteric point, the case also illustrates the tension that sometimes arises between strict construction and more liberal or equitable interpretations of the Bankruptcy Code. When the two collide, the results can be unpredictable.

See In re Hoku Solar, Inc., 2016 WL 563036 (Bankr. D. Idaho Feb. 12, 2016)

Mette H. Kurth

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