I Thought I Went to Law School to Avoid Math: Calculating Recovery in a Chapter 7 Liquidation in the Context of a Preference Action

kate-doorley-lawfuelKatherine Doorley is an associate with Weil law firm and wrote on August 26, 2013, published in the Bankruptcy Blog ·   Preference actions have been a frequent topic here at the Bankruptcy Blog. In the past, we have discussed releases that saved creditors from preference actions, whether assumption and assignment of an executory contract protects creditors from preference actions and whether equitable subrogation could be used as a defense to a preference action.
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In many preference actions whether the preferential transfer recipient has received a greater recovery than it would have in a liquidation under chapter 7 of the Bankruptcy Code is a key part of the analysis. Luckily for those of us with an interest in the ensuing math problem the United States Bankruptcy Court for the Northern District of Texas engaged in an in-depth analysis of a secured creditor’s recovery in a hypothetical chapter 7 liquidation in the case of Garner v. Knoll, Inc. (In re Tusa-Expo Holdings, Inc.), Nos. 08-45047, 10-04271-DML (Bankr. N.D. Tex. Aug. 5, 2013).

Background

Tusa Office Solutions was an office furniture dealer operating primarily in the Dallas-Fort Worth area. Tusa Office acquired a retail pre-owned furniture dealership by the name of Office Expo, Inc. After the acquisition of Office Expo, the shareholders of Tusa Office and Office Expo entered into an agreement to form Tusa-Expo Holdings, Inc. Tusa Office and Office Expo thus became wholly-owned subsidiaries of the holding company. Tusa Office eventually realized that Office Expo was not self-sustaining, and Tusa Office had to spend significant sums keeping Office Expo afloat, which eventually resulted in Tusa Office, Office Expo and Tusa-Expo Holdings all filing for protection under chapter 11 of the Bankruptcy Code. Prior to acquiring Office Expo, Tusa Office had entered into an agreement with Knoll, Inc. an office furniture supplier, pursuant to which Tusa Office became a certified dealer of Knoll products. Tusa Office would purchase inventory on credit from Knoll and then would sell the inventory to its customers at a markup. In exchange for Knoll selling Tusa Office inventory on credit, Tusa Office granted Knoll a security interest in all of Tusa Office’s assets and after-acquired assets, including its accounts receivable. On June 27, 2008, Tusa Office and Knoll amended their existing contract to restructure the debt owed by Tusa Office.

The amended agreement reaffirmed Knoll’s first-priority security interest in substantially all of Tusa Office’s present and after-acquired assets. Tusa Office, however, required additional financing to continue its operations. On July 10, 2008, Tusa Office and Textron Financial, Inc. entered into a loan and security agreement under which Textron provided a revolving line of credit in exchange for a first-priority security interest in all of Tusa Office’s assets, including in Knoll’s collateral. Textron also required payments from Tusa Office’s customers be sent directly to a Textron account. Textron would sweep the account on a daily basis and use the funds to reduce the balance on Tusa Office’s loan. If Tusa Office needed funds, it would submit a request to Textron, and Textron would deposit said funds directly into Tusa Office’s operating account.

Additionally, Textron and Knoll entered into a subordination agreement, which established that the Textron agreement would be subject to a “carve-out” of certain assets in favor of Knoll. Knoll would continue to hold a first priority lien in the carved out assets and a secondary priority lien in all of the other assets. Prior to the petition date, Tusa Office continued ordering inventory from Knoll, and Knoll continued to ship product and invoice Tusa Office for the same. Tusa Office also continued to make payments to Knoll from Tusa Office’s operating account.

On November 5, 2008, Tusa Office filed a case under chapter 11 of the Bankruptcy Code, in the Bankruptcy Court for the Northern District of Texas, and Knoll subsequently filed a proof of claim against Tusa Office in the amount of $6,929,783.87. On July 6, 2009, the court converted the case to a chapter 7 case. On November 4, 2010, the chapter 7 trustee filed an adversary proceeding against Knoll seeking to, among other things, avoid as preferential transfers payments made by Tusa Office to Knoll on account of prepetition invoices in the total amount of $4,592,483.90. The Bankruptcy Court held a trial on the matter.

Analysis and Holding

Section 547(b) of the Bankruptcy Code sets forth the elements of a preferential transfer and states that the trustee may avoid any transfer (i) to or for the benefit of a creditor, (ii) on account of an antecedent debt, (iii) made while the debtor was insolvent, (iv) made on or within 90 days of the petition date and (v) that enables such creditor to receive more than such creditor would have received if the case were a case under chapter 7 or the transfer had not been made. 11 U.S.C § 547(b). It was undisputed that a prepetition payment had been made on account of antecedent debt during the 90 days preceding the filing of the bankruptcy case, and accordingly, the trustee had to establish that the challenged payments enabled Knoll to receive more than it would have received in a chapter 7 liquidation.

In determining whether an undersecured creditor received a greater percentage recovery on its debt than it would have under chapter 7, bankruptcy courts in the Fifth Circuit apply the test from In re El Paso Refinery, LP. In In re El Paso, the United States Court of Appeals for the Fifth Circuit stated that two predicate issues must be resolved before conducting a chapter 7 liquidation analysis “(1) to what claim the payment is applied and (2) from what source the payment comes.”

These are known as the “Application Test” and the “Source Test.” Under the “application test”, if an undersecured creditor received a payment that was applied to the unsecured portion of the debt, the creditor would have recovered a greater percentage on its claim, assuming the estate could not pay unsecured creditors in full. If, however, the undersecured creditor applied the payment to the secured portion of the claim, the creditor essentially released some of its collateral and therefore, the creditor would not receive a greater recovery by virtue of the payment than it would have in a chapter 7 liquidation. If the creditor did not release collateral upon application of the payment then the payment is deemed to have been applied to the unsecured portion of the claim. In re El Paso, 171 F.3d at 254. Knoll did not release any collateral upon receiving payments from Tusa Office. Therefore, the court found that the payment to Knoll was a payment on the unsecured portion of the claim.

The “source test” provides that even if the payment at issue was applied to the unsecured portion of an undersecured creditor’s claim, the creditor would not be deemed to have received a greater recovery if the creditor’s collateral was the source of the payment. The parties agreed that Knoll’s collateral was deposited in the Textron account. The trustee argued that because Textron swept the account, including the Knoll collateral and used it to reduce Tusa Office’s debt to Textron, any funds subsequently released to Tusa Office constituted new and unencumbered funds, and the source of the preference payments was those funds.
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The court disagreed, noting that Knoll’s agreement to enter into a subordination agreement with Textron was a condition precedent to the Textron loan and, in fact, Tusa Office arguably was required to make payments to Knoll as part of the Textron loan agreement. The court also noted that it was unclear how funds generated from the disposition of Knoll’s collateral were not direct or indirect proceeds of the Knoll collateral because, under Texas law, “proceeds” included anything acquired upon the exchange or disposition of collateral.

The court held that even if the preferential payments were applied to the unsecured portion of Knoll’s claim, Knoll could not be deemed to have received a greater recovery as a result of the prepetition payments than it would have under a chapter 7 liquidation because Knoll’s collateral was the source of the payments.

The court also found that the trustee did not satisfy her burden to prove that Knoll received more as a result of the preference payments than it would have received in a hypothetical liquidation, supporting its conclusion by using simple math.

The court determined that Tusa Office’s hypothetical liquidation value, as of the filing, was $9,713,392 and Tusa Office’s secured claims consisted of tax claims in the amount of $653,137, Textron’s secured claim in the amount of $4,322,501 and Knoll’s claim in the amount of $6,929,784, of which $3,081,713 represented first liens in Knoll’s collateral, and $3,848,071 was secured by secondary liens subject to Textron’s full satisfaction. The court noted that under the priority scheme in section 507 of the Bankruptcy Code, the tax claims would have been paid out of the estate ahead of any unsecured claims.

Payment of the tax claims would leave $9,060,625 for other creditors. Of that sum, $4,322,501 would satisfy Textron’s first priority lien, leaving $4,737,754, of which $3,081,713 would be paid to Knoll in full satisfaction of its first lien claim, leaving $1,656,041 subject to Knoll’s second lien, meaning that Knoll would receive a total of $4,737,754 in satisfaction of its claims. If Knoll also kept the preferential payments it would have received a total of $9,330,237.90.

Returning the preferential payments to the estate would make $14,305,875.90 available for all creditors. Knoll’s claim against the estate, however, would also increase by an amount equal to the preference payments. The court found that Knoll would have still been paid $9,330,237.90 had the preference payments not been made.

The tax claims would again be paid first, leaving $13,652,738.90. Textron would again receive $4,322,501 on account of its first priority lien, leaving $9,330,237.90 for other creditors. Of that, $7,674,196.90 would be paid to Knoll in full satisfaction of its increased first lien claim, leaving $1,656,041, which would be subject to Knoll’s secondary lien. Therefore, Knoll would not have obtained a greater recovery by keeping the preferential payments. As the court made clear in its opinion, sometimes determining whether there was a preferential payment is only a question of math.

Many lessons can be learned from the Tusa-Expo Holdings decision, but the simplest one is: if you went to law school thinking you’d never have to use math again, think again.

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