On March 20, 2014, the US Court of Appeals for the Eighth Circuit, in Stoebner v. San Diego Gas & Electric Co. (In re LGI Energy Solutions, Inc.) held, in a matter of first impression, that in three-party transactions where the debtor's preferential transfer to a third party benefits the debtor's primary creditor, new value received from the primary creditor can offset the third party's preference liability, even if the third party is also a creditor, under the section 547(c) subsequent new value defense (No. 12-3899, (8th Cir. Mar. 20, 2014)).

LGI Energy Solutions, Inc. (LGI) performed utility bill payment services for large utility customers. The utilities sent customer invoices directly to LGI, which aggregated the bills and invoiced the customer. LGI deposited the customers' payments into its own commingled bank accounts from which it drew checks to pay the utility provider. However, the utilities had no separate contracts with LGI, and therefore their only recourse for any unpaid bills was against the utility customers themselves.

On February 6, 2009, LGI entered into involuntary Chapter 7 bankruptcy. During the 90 days before its bankruptcy filing, LGI transferred a total of $258,567 (LGI Payments) to San Diego Gas & Electric Company and Southern California Edison Company (Utilities), on behalf of Wendy's International, Inc. and Buffet's, Inc. (Customers) to pay their outstanding invoices. After the transfer but before the petition date, LGI received payment from the Customers for utility services in the amount of $297,000, which LGI, due to its financial troubles, never passed on to the Utilities.

The Chapter 7 bankruptcy trustee sued the Utilities to avoid the LGI Payments as preferences under section 547(b) of the Bankruptcy Code. The Utilities asserted that the $297,000 that LGI received from the Customers constituted subsequent new value under section 547(c)(4) of the Bankruptcy Code, and therefore protected the LGI Payments from avoidance. Section 547(c)(4) states that a prepetition transfer "to or for the benefit of a creditor" may not be avoided to the extent that, after the transfer, "such creditor" gave new value to or for the benefit of the debtor.

The bankruptcy court allowed only a partial offset for the new value provided, holding that section 547(c)(4) requires that the new value be supplied directly by the creditor that received the preferential transfer. Therefore, the bankruptcy court allowed the Utilities to offset only the value of utility services they provided to the Customers after the allegedly preferential LGI Payments (see In re LGI Energy Solutions, Inc., Nos. ADV. 11-4065 and 11-4066 (Bankr. D. Minn. June 11, 2012)).

On appeal, the US Bankruptcy Appellate Panel for the Eighth Circuit (BAP) reversed the bankruptcy court in part and allowed the Utilities to set off all payments made by the Customers to LGI after the allegedly preferential LGI Payments, including payments for utility services performed before the LGI Payments (see In re LGI Energy Solutions, Inc., 482 B.R. 809, 819-20 (B.A.P. 8th Cir. 2012)).

The trustee appealed the BAP's decision to the Eighth Circuit, arguing that the section 547(c)(4) new value defense requires that new value be provided exclusively by the creditor that received the preference. Therefore, the trustee argued, payments made by the Customers to LGI after the LGI Payments did not constitute new value that could offset the Utilities' preference liability.

On appeal, the Eighth Circuit reversed the bankruptcy court, and, agreeing with the BAP, held that in three-party relationships where the debtor's preferential transfer to a third party (here, the Utilities) benefits the debtor's primary creditor (here, the Customers), new value (either contemporaneous or subsequent) can come from the primary creditor, even if the third party is a creditor in its own right and is the only defendant against whom the debtor has asserted a preference claim.

The Eighth Circuit began by noting that, if the avoidance action was successful, it would create a situation in which:

This would result in the Customers having to 'doubly replenish' the estate entirely at their own expense, which would do "fundamental violence to 'the prime bankruptcy policy of equality of distribution among creditors.'"

Turning to the text of the Bankruptcy Code, the Eighth Circuit agreed with the BAP's view of the term "such creditors" in section 547(c)(4). The BAP relied on the "closely analogous" decision in In re Jones Truck Lines, Inc. in which the Eighth Circuit held that a debtor's preference payments on behalf of employees to a third-party employee benefits fund pursuant to a collective bargaining agreement were protected from avoidance to the extent of the new value provided by the employees (labor) rather than the new value provided by the fund itself (fringe benefits) (see 130 F.3d 323 (8th Cir. 1997)). In this case, LGI made preferential transfers to the Utilities based on its contractual obligations to the Customers. Therefore, under the Jones Truck Lines reasoning, further contribution of new value from the Customers should serve to offset the preference liability of the Utilities.

The Eighth Circuit distinguished the decision of the US Bankruptcy Court for the Southern District of New York in In re Musicland Holding Corp., because the subsequent new value in that case was provided by another creditor who neither received nor benefited from the preferential transfer (see 462 B.R. 66 (Bankr.S.D.N.Y. 2011)).

Finally, the Eight Circuit noted that its decision was consistent with the bankruptcy policy of encouraging creditors to deal with troubled businesses. The Customers continued to make payments to LGI as an intermediary because both the Customers and the Utilities were willing to deal with a troubled business, not because the Utilities continued to provide services to the Customers.

This decision should serve to comfort entities that continue to deal with troubled companies through their descent into bankruptcy. By extending the new value defense to parties that received a preferential payment but that are not primary creditors, the Eighth Circuit has strengthened the "new value" defenses, both from the perspective of the primary creditor, who will not be required to "double fund" the bankruptcy estate, as well as the preference recipient, who will not have to return the payment as long as the primary creditor continues to provide value to the debtor. Additionally, the decision is important to note for its emphasis on equity. The Court avoided an inequitable result by not supporting a literal reading of the Bankruptcy Code to advance the policies of equality of distribution among creditors and encouraging continued business dealings with struggling entities.

For more information on the subsequent new value defense, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors: Subsequent Advance of New Value.