We are all familiar with preference claims based on a debtor’s payment of an antecedent debt.  However, on rare occasions, a preference claim is based on the debtor’s return of goods to the creditor in reduction of the creditor’s claim.  The few bankruptcy cases which have dealt with the “return of goods” issue have focused on the amount the debtor was entitled to recover from the creditor and the applicability of the ordinary course of business and the new value defenses. 

Valuation – Is Liquidation Value the Measure?

To illustrate, consider the decision of a District Court in Virginia which had to decide how much a creditor was liable for after it had reclaimed its goods pre-petition. The court limited a Chapter 11 debtor’s recovery on a return of goods preference claim to the amount the debtor would have realized from a liquidation sale of the goods (Activewear Inc. v. Parkdale Mills Inc.).  The debtor, Activewear Inc., was a yarn spinner that purchased substantial amounts of yarn from Parkdale Mills Inc. (“Parkdale”).  Parkdale’s claim included invoices for unused yarn that the debtor was still holding.  After the debtor notified Parkdale that it had ceased operations, Parkdale sent a reclamation demand to the debtor for recovery of yarn, and the debtor returned the goods in response to the reclamation demand.  Once the bankruptcy case was filed, the debtor commenced a lawsuit against Parkdale for avoidance of the debtor’s pre-petition return of Parkdale’s yarn and for recovery of the value of the yarn.  The bankruptcy court held that returns to Parkdale were an avoidable preference for which the debtor was entitled to recover the liquidation value of the returns in an amount equal to $27,459.00.  The debtor appealed the bankruptcy court’s order, arguing that Parkdale should have been directed to pay fair market value of the returns equal to the amount Parkdale could have realized from reselling the returned yarn.  However, the district court limited the recovery on the debtor’s return of goods preference claim to the sum the debtor could have realized from the liquidation sale of the returns.  The court relied on a 4th Circuit bankruptcy decision and stated that the recovery from Parkdale should be based on the extent to which the return had depleted the debtor and its bankruptcy estate.  The yarn’s value to the debtor was the amount the debtor could have realized from a liquidation sale of the yarn.  The court refused to give the debtor any credit for any greater recovery Parkdale derived from its disposition of the returned yarn, which the court attributed to Parkdale’s expertise, time, goodwill and advertising.

Perspectives from the courts: Determination of Amount Owed on a Return of Goods Preference.

Other courts have held differently when determining the recovery on a return of goods preference claim.  One Massachusetts court entered a judgment against a creditor in the amount of $1.5 million on a return of goods preference claim.  The court relied on a credit memorandum in the above amount issued by the creditor in reduction of its claim.  The credit memorandum was deemed the creditor’s contemporaneous determination of the market value of the returns, which the creditor could not rebut. 

However, a bankruptcy court in North Carolina refused to base the recovery on a return of goods preference claim on a credit the creditor had issued for all past due invoices owing by the debtor.  The court limited the recovery to the net amount, after deducting expenses, that the creditor had realized from its commercially reasonable resale for returns.

Other courts dealing with a return of goods preference claim have ordered the creditors to return the goods.  A court in Alabama directed the return of goods instead of entering judgment against the creditor in the amount of the credit memorandum that the creditor had issued in favor of the debtor.  According to the Alabama court, the credit memorandum was not proof of the value of the returns and in the absence of any proof of their value, the only remedy for a return of goods preference claim was the creditor’s return of the goods.

Applicability of the Ordinary Course of Business Defense to Return of Goods Preference Claims.

There are several defenses that can reduce or eliminate liability on a preference claim.  One of the more frequently litigated preference defenses is the ordinary course of business defense.  This defense is designed to encourage creditors to continue doing business on normal credit terms with a financially distressed company.

In a Florida bankruptcy case, the court held that a debtor’s return of excess paper to its supplier during the preference period was not an avoidable preference.  The supplier had a valid reclamation claim for the returns.  The supplier also satisfied the ordinary course of business defense.  The supplier proved the subjective prong of the defense where the debtor had previously returned goods to the supplier in reduction of the latter’s claim and the returns were not prompted by any unusual collection activity by the supplier.  The supplier also proved the objective prong of the defense where, in the paper industry, a buyer frequently returns product to the seller for a credit against the invoice value of the goods and the seller usually accepts the return on these terms.

Applicability of New Value Defense to a Return of Goods Preference Claim.

Another frequently invoked preference defense is the new value defense.  The new value defense reduces preference exposure where, subsequent to the preference, the creditor granted new value, such as the sale of goods or provision of services on credit terms, to or for the benefit of the debtor.  The new value defense is also intended to encourage creditors to continue doing business with and extending credit to financially distressed customers.  The defense protects a creditor that replenished the debtor and its bankruptcy estate by extending new credit subsequent to the preference.

There have been very few bankruptcy decisions on whether credit given for returned goods can be considered new value.  However, one creditor has successfully defended a preference action by asserting a new value defense based on the invoice price of food products that were delivered to the debtor after the alleged preference, but were then subsequently returned to the creditor.  The returns were damaged, stale, out of date and otherwise unsaleable and of no value.  Despite the condition of the returned goods, the creditor had issued a credit memorandum in the amount of $90,180.74 for the full invoice price of the returned goods.  That credit reduced the amount of the creditor’s outstanding claim against the debtor.  The court allowed the creditor to use the full invoice value of the returns as deductible new value.  The goods had a value of $90,180.74 when the creditor originally delivered them to the debtor subsequent to the alleged preference and should therefore count as new value.  The creditor was protected from preference exposure because the creditor gave full value against the invoice.  This was consistent with the parties’ course of dealings and possibly with contract obligations.  Note that the court in Activewear v. Parkdale discussed above might have found that credit for the “liquidation value” of the stale food products might have been enough if there were no controlling contractual terms requiring full credit!  Clearly the court was influenced by the fact that the debtor’s estate was not only not diminished by this return . . . in fact it was enhanced by the full credit!