Investor Can Get Paid Now Despite Pending Preference Suit

Ames Department Stores cannot withhold payment on a distressed debt investor's administrative claim until the bankrupt retailer resolves a preference action against the supplier that sold the claim to the investor, a federal appeals court has ruled.

The case involves the application of Section 502(d) of the Bankruptcy Code, which bars payment of certain claims held by recipients of preferential transfers until the improperly transferred amount is returned to the debtor's estate.

The 2nd U.S. Circuit Court of Appeals ruled that Section 502 does not apply to administrative-expense claims arising under Section 503 of the Bankruptcy Code.

Administrative expenses are those that arise while a bankruptcy case is pending and are necessary to preserve the value of a debtor's estate. Such expenses include rent, wages, insurance, utilities and trade credit.

Ames Department Stores, a Connecticut-based chain of discount stores, filed for Chapter 11 protection Aug. 20, 2001, in the U.S. Bankruptcy Court for the Southern District of New York. A year later Ames' board of directors determined that the value of the bankruptcy estate could be maximized by closing its stores and selling its assets.

Meanwhile, distressed debt investor ASM Capital LP had begun buying up claims from Ames' creditors. Among ASM's purchases were two claims from Ames supplier G&A Sales Inc. related to goods shipped on credit to Ames (a $360,100 administrative expense claim and a $33,300 reclamation claim).

Ames had suspended payment on its administrative expense claims in 2002 when it abandoned its efforts to reorganize and decided to liquidate. Later, the company filed adversarial actions against several former suppliers and other creditors, including G&A, to recover alleged preferential transfers made while the chain was insolvent.

In 2004, while the preference actions were pending, Ames began making distributions to holders of administrative-expense claims. However, it refused to make distributions to creditors that were defendants in the preference actions and those claimants (such as ASM) that acquired their claims from any of the defendants.

ASM filed a motion in the Bankruptcy Court, seeking allowance of its administrative-expense claim.

Ames opposed the motion, citing Section 502(d). It argued that even though ASM itself had not received the preferential transfer, the investor could not receive payment until its predecessor in interest (G&A) had returned its alleged preferential payments.

The Bankruptcy Court ruled that Section 502(d) applied to all administrative-expense claims. Thus, Ames could withhold payment to ASM while the fraudulent-transfer action against G&A remained unresolved.

After the U.S. District Court for the Southern District of New York upheld the decision on appeal, ASM turned to the 2nd Circuit.

The appeals court said Section 502's structure, context and language suggest that Congress intended to differentiate between claims covered by that section and administrative expenses allowed under Section 503. It noted that each section provides separate procedures for the allowance of the covered claims.

The panel pointed out that administrative-expense claims are given higher priority than pre-petition claims to encourage the continued supply of goods to a debtor.

"That intent would be frustrated by allowing a debtor automatically to forestall or avoid payment of administrative expenses by alleging that the vendor had been the recipient of a preferential transfer," the panel said.

Thus, the panel held that Section 502's ban on payments to recipients of preferential transfers does not extend to administrative-expense claim. It did not reach the question of whether a debtor could only invoke Section 502(d) against the actual recipient of the fraudulent transfer or use the section to bar payment to a subsequent holder of the claim.

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Robert J. Butler and Rebecca L. Saitta of Wiley Rein LLP in McLean, Va., represent ASM. Martin J. Bienenstock and Michele J. Meises of Weil, Gotshal & Manges in New York City represent Ames.